Chapter 5 The value of relevance in accounting information

5.1 Overview

what is value relevance theory?

 When securities prices respond to accounting information, we say that accounting
information has a relevance value.
 It’s assumes securities market efficiency - accounting information is useful to
investors in helping them estimate the expected values and risks of security returns.
 Investors responsible for predicting future firm performance.
 Usefulness of financial statement information evaluated by magnitude of security
price response to that information which will helps accountants to evaluate decision
usefulness of different accounting policies.

5.2 Reasons for market responses

Why do we expect the market to react?
 Investors have prior probabilities of future firm performance, which effect the
expected return and securities risk. these prior beliefs need not all be the same
because investors will differ in the amount of information they have obtained and
the extent to which they become informed.

 Investors obtain useful information from financial statements. Example: For

example, if net income is high, or higher than expected, this may be good news. If
so, investors would revise upward their beliefs about future firm performance.
Other investors, who perhaps had overly high prior beliefs of what current net
income should be, might interpret the same net income number as bad news.

 Investors revise their beliefs. Hence, leads to change buy/sell decisions. Example:
Investors who have revised their beliefs about future firm performance upward,
they will buy the firm’s shares at their current market price, and vice versa for those
who have revised their beliefs downward. Investors will revise their evaluations
about the riskiness of these shares.

 Security price and share return change.

Findings the market response

Efficient markets theory implies that the market will react quickly to new information.
 As a result, it is important to know when the current year’s reported net income became
publicly known

 Its important to know when the current’s year net income become publicly known.
So, if the researcher looks for volume and price effects a few days late, no effects
may be observed even if its existed. To solve this problem: using the date the firm’s
net income was reported in the financial media or news conference

 The good or bad news in reported net income is usually evaluated relative to what
investors expected. Example: If a firm reported net income of, say, $2 million, and
this was what investors had expected, there will be no much information content in
reported net income because investors’ prior beliefs would have already been
revised. But if investors had expected $2 million and reported net income was $3
million. This good news would rapidly revised belief about the future performance of
the firm.

 There are many events that affect a share volume and price. This means that is very
difficult to find a market response to reported net income. For example, suppose a
firm released its current year’s net income, containing good news, on the same day
the government announced a substantial increase in the deficit. Such a public
announcement would probably affect prices of most securities on the market. Thus,

it is desirable to separate the impacts of market-wide and firm-specific factors on share

returns.
5.2.4

Day 0 means, the financial media to find the day of the firm’s current earnings announcement.
In a market, the effect of good or bad earnings news, might lead positive or negative abnormal
returns which possibly continue for a day or two after day 0. The summing of abnormal returns
for a three-to-five-day narrow window around day 0 seems more reasonable than examining
day 0 only, which helps and protect the possibility that the announcement date of current
earnings may not be a completely accurate estimate of the date of their public availability.
Positive and negative abnormal returns surrounding good or bad earnings news, the researcher
concluded that predictions based on the decision theory and efficient securities market theory
are supported.

There are ways to separate market-wide and firm-specific returns that ignore beta:
1. Estimating firm-specific returns by the difference between firm A’s stock return during period 0
and the average return on its shares over some prior period.
2. The difference between firm j’s return during period 0 and the (*)The Value Relevance of
Accounting Information return on the market portfolio for the same period.
3. Total share returns and not factor out market returns.
5.3 The Ball and Brown Study:

 In 1968, Ball and Brown (BB) began a tradition of empirical capital markets research in
accounting that continues to this day

- They were the first to provide convincing scientific evidence that firms’ share returns
respond to the information content of financial statement that is, that financial
statements have value relevance
- since it studies the narrow window securities market reaction to a specific event,
this research type called event study
- BB examined a sample of 261 New York Stock Exchange (NYSE) firms over nine years
from 1957 to 1965. They concentrated on the information content of earnings.
- One reason for testing the sample of NYSE is that NYSE firms announced earning in
media prior to actual release of annual report.
- reported earnings were greater than what the market had expected (GN) or good
news or less than expected (BN) or bad news
- it was been observed that the investor who bought the shares of all GN firms one
year before good news was released and hold them, the investor gained more 5%
returns and for BN observed a loss of Over 9%
- BB analysis was based only on a Sign of unexpected earning.
- Thus, A logical next step is to ask whether the magnitude of unexpected earnings is
related to the magnitude of the security market response
- The question of magnitude of response was investigated by BCW and they examined
276 NYSE firms for 10 years data.
- BCW found that the greater the change in unexpected earnings, the greater the
security market response. This result is consistent with the CAPM and decision
usefulness.

5.4: Earnings response coefficient:

The abnormal securities market return identified by BB study the averages and the GN firms
enjoyed the increasing in positive abnormal returns, on the other hand the BN firms got
negative returns and we can conclude that some firms’ abnormal returns were well above
average and below.

Frequently asked question why the market might respond more strongly to the good or bad
news in earnings for some firms than for others?
accountant improves their understanding of how accounting information is useful to investors
and could lead to prepare more useful financial statement, and the study of BB were focus on
identification and explanation of differential market response to earnings information (ERC)
that measures the extent of a security’s abnormal market return in response to the unexpected
component of reported earnings of the firm issuing that security. To calculate it (abnormal
shares return / unexpected earnings for the period)

5.4 Earnings response coefficient (ERC): measures the extent of a securitys’ abnormal market
return in response to the unexpected component of reported earnings of the firm issuing that
security.
 Reasons for differential market response:
1- Beta: the riskier the sequence of a firms’ future expected return is, the lower its
value will be to a risk averse investor. If a security has a high beta this will increase
the portfolio risk, therefore, the demand of firms shares will be lower when beta is
higher. The decrease in demand leads to a lower increase in market price.
2- Capital structure: for highly levered firms, an increase in earnings adds strength and
safety to bonds and other outstanding debt.
3- Earnings quality: a- Earnings persistence: the ERC is expected to be higher and
expected to persist into the future & current earnings provide a better indication of
future firm performance.
b- Accruals quality: which could stem from an error in estimation or a
deliberate misstatement by management to increase NI.
4- Growth opportunities: the GN/BN in current earnings may suggest future growth
prospects for the firm, increasing the ERC. If a firm gets profits from one of its
investment projects this will indicate to the market that the firm will enjoy strong
growth in the future.
5- The similarity of investor expectations: If for example investors base their earnings
expectations on analysts forecasts & current earnings are less than the forecast they
will regard this as BN & will be inclined to sell rather than buy. So, the more precise
analysts’ forecasts are, the more similar are investors earnings expectations & the
greater the ERC.
6- The informativeness of price: The more informative the price is, the less information
content of current accounting earnings will be, the lower the ERC.

 Why should accountants be interested in the market’s response to financial

accounting information?
The reason is that improved understanding of market response suggests ways that they
can further improve the decision usefulness of financial statements. The higher the ERC
leads to higher earnings quality which is valued by equity investors.
The importance of earning persistence to ERC means that disclosure of the components
of the net income is useful for investors.
As accountants gain a better understanding of investor response to financial statement
information, their ability to provide useful information to investors will further increase.

5.5 A caveat about the best accounting policy:

The best accounting policy is the one that produces the greatest market price response.
Security market response is a measure of usefulness to investors.
Accountants provide useful information to investors.

There are two types of information characteristic:

Public good: an investor can use the information in annual report without eliminate its
usefulness to another investor.
Private good: users can use the information in annual report with eliminate its
usefulness to another users.

If the firms tried to charge investors for its annual report may be not attract many
customers because the report once produced could be downloaded to many users.
Investors perceive annual report as free, but firms annual report not free. Production of
annual report is costly.
So, investors may incur cost to inform themselves by two ways:
Directly: by paying to receive information as soon as possible.
Indirectly: by paying to analyst or other information service.
Investor may perceive accounting information as useful even though society’s
standpoint the cost of this information outweigh the benefits to investors
The social value of information depends on:
The benefit to potential investors and competitors.
The cost to managers and shareholders.

When we look to information as private good, we can’t charge investors the full cost of
the information they use, form social perspective we can’t rely on the extent of security
market response to tell us which accounting policies should be used.

5.6 The value of relevance of other financial statement information:

Other financial statement such as the balance sheet and supplementary information.
It is difficult to find direct evidence of usefulness of other financial statement
information.
Can be used the indirect approach to finding evidence of usefulness of other financial
statement information.
5.7 Conclusions on value relevance:
It has been difficult to find evidence of market response to other financial statement
information as strong as to earning information.