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,Lecture 1 IntroductionWhat is accounting research?
- What are the broader implications of accounting beyond recording numbers?
• Focus on determinants and consequences of accounting and disclosure practices (choices)
• Implications of accounting information for investors and capital market (valuation role)
• Implications of accounting information for corporate governance and contracting (stewardship
role)
- Closely related to finance/econ research, but within the rich institutional setting of accounting.
Why does accounting information matter?
Role of accounting information is to mitigate information asymmetry problems at capital and managerial
labor markets:
- Capital market: to mitigate adverse selection problem
• Context: Information asymmetry between sellers and buyers (e.g., of stocks) with the seller as
the typically better-informed party
• Role: Convert inside information to outsiders and facilitate decision-making of less informed
party / buyers (to improve operation of capital markets)
- Labor market: to mitigate moral hazard problem
• Context: after reaching agreement, less informed party cannot observe the behavior of the
better-informed party
• Role: Control unfavorable behavior (e.g., manager shirking), improve corporate governance by
facilitating contracting bet-ween parties (to improve operation of managerial labor markets)
• Both roles crucial if markets are to work well but can be in conflict.
Whether accounting information is useful? → it is useful when investors react to the accounting
information
- “presenting financial performance of a firm”
- “used to reach decisions about how to manage the business, or invest in it”
- “helps market participants make informed decisions on their investments”
- “by comparing the stock prices [of firms] on their information release date”
, Lecture 2 Value Relevance
1. Is financial reporting useful/informative? When an accounting number is value relevant?
1) Do earnings provide new information?
Information content studies
• Underlying assumption: equity markets are efficient
• Event study methodology -> does release of accounting information result in a market reaction?
• Early example: Ball and Brown (1968)
2) Do earnings reflect economic value?
Value relevance studies
• Association studies -> e.g., is an earnings number associated with market return in that year?
• In other words, do earnings capture information also contained in stock prices?
Example of answers: When an accounting number is value relevant?
1) Accounting number is value relevant when the news component of the number causes a share
price reaction, or when accounting amounts are associated with equity market value.
2) Value relevance is the ability of financial statement information to capture and summarize firm
values as reflected in equity capital markets.
“An accounting amount is deemed value relevant if it has significant association with equity market
value.” (Barth, Beaver, and Landsman, 2001, p. 79)
2. Reasons for market response:
- An application of decision theory model:
• Investors have prior probabilities (expectations) of future firm performance
• Investors obtain useful (NEW) information from financial statements
• Investors revise their probabilities
• Leads to buy/sell decisions
• Security price and share return change -> usefulness
- Demand for (and hence the value of) accounting information is derived from improved decision
making under uncertainty!
Unexpected earnings <-> Abnormal share returns
3. How to detect a market response?
- When is new information released?
• Earnings release date.
- Which part of the released information is new?
• Investors have certain expectations of earnings.
• Unexpected earnings (page 7 of lecture 2.2)
4. Which part of the market response can be attributed to the new information? (page 9 of
lecture 2.2)
• Numerous events affect returns.
• Filter out reaction to firm-specific (e.g., earnings) news.
• Abnormal share return.
• Use market model (i) to separate market-wide and firm-specific returns and (ii) to estimate
expected market-return on event date
5. Compare “abnormal” share return with “unexpected” earnings.
Besides graphical inference: If positive unexpected earnings are correlated with positive abnormal
share return, and vice versa, this suggests earnings information is decision useful.
6. Ball and Brown (1968) evaluation of accounting numbers
Research question: Does net income have an impact on investment decision, i.e., is it reflected in
security prices?
Idea: Assess the usefulness of existing accounting income numbers by examining their information
content and timeliness.
• Does earnings number capture information that is contained in stock prices?
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