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Summary Financial Accounting Research (FAR) (Lectures, Tutorials, Articles)

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  • Course
  • Financial Accounting Research (6134M0038Y)
  • Institution
  • Universiteit Van Amsterdam (UvA)

This document contains a summary of all lectures, tutorials and articles for the UvA Master course Financial Accounting Research. Note: this summary does NOT include the knowledge clips.

Last document update: 4 year ago

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Document information

  • December 3, 2020
  • December 6, 2020
  • 41
  • 2020/2021
  • Summary

Subjects

  • accountancy
  • control
  • articles
  • lectures
  • tutorials
  • far
  • uva
  • financial accounting research
  • summary

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  • Universiteit van Amsterdam (UvA)
  • Master Accountancy & Control
  • Financial Accounting Research (6134M0038Y)
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Financial Accounting Research
Week 1 Lecture 1-2 Theoretical framework (1-1 course outline discussion)

IASB explains that the objective of financial reporting is to provide information that is useful to
information and identifies investors as primary users. Together, these concepts form the foundation
for academic research on financial accounting questions.

Nichols & Wahlen (2004), how do earnings numbers relate to stock returns? (overall: earnings ↑ →
stock returns ↑). They summarize the intuition and empirical evidence on how accounting earnings
information relates to firms’ stock returns.

They present a framework to link earnings and stock returns. Replicate and extend three classic
studies using newer data: 1) Relation between earnings and returns, 2) The role of earnings
‘persistence’ in this relation and 3) Market efficiency and the speed of stock market reactions to
earnings news.

Earnings, an accrual accounting measure of the firm’s profit or loss from business activities and
events during a quarter or annual period. An accounting measure of the change in the value of the
firm to common equity shareholders during a period.
Stock return, equals the change in the market value of a firm over a period of time plus any
dividends that are paid. Represents the stock market’s estimate of the firm’s bottom-line
performance over the period.

Similar research before: Ball and Brown (1968), key insights: Accounting information, as reflected in
earnings, is useful: changes in earnings are empirically related with stock returns. But, accounting
earnings information is not particularly timely in providing useful information: much of the
information (85%) has been anticipated by investors and pre-empted by other sources of
information. Stock market investors react rapidly to new information in earnings, but their reaction is
not complete, evidence of post-earnings announcement drift (PEAD).

In the long run, a common shareholder cares
about receiving a return on its investment: a
constant periodic payoff (dividends) and/or in the ability to liquidate the investment at a higher
price. Thus, the value of an equity share can be seen as the PV of expected future dividends, this
includes a “liquidating” dividend at the end of the investment horizon or end of the company’s life.
Hence, to determine the value of a share, we need to form expectations of the dividends to be paid
out in future periods.

Nichols & Wahlen (2004) use this understanding of valuation to derive the framework (based on the
framework of Beaver (1998)) underlying the relation between earnings and returns.

Link 1 assumes that earnings and financial reporting more
broadly, provides information to investors about current
and expected future profitability. “firms depend on
financial reporting to convey credible information about
their ability to generate future wealth for equity
shareholders and other stakeholders”. Similarly, the IASB
recognizes the importance of the predictive value
(relevance).

,Link 2 assumes that current and future earnings are informative about dividend distributions.
Link 3 goes back to the valuation example and assumes that share prices equal the PV of expected
future dividends to shareholders.

So, the framework explains that the information in earnings should relate to changes in stock price,
because earnings are informative about the future dividends/cashflows/earnings the company is
expected to generate.

Earnings persistence, the likelihood a firm’s earnings lvl will recur in future periods, an essential
element of link 1. E.g. on a savings account with a constant interest rate, earnings are fully persistent.
Prediction: more persistent earnings should have a stronger impact on stock prices.
Opposite of persistent earnings is one-time gain (or loss, e.g. impairment), this should not affect the
valuation through the effect on current period earnings (not a big impact on stock return).

Lecture 1-3 Empirical framework

Nichols & Wahlen (2004) test whether earnings numbers reflect information that the capital markets
believe is relevant and reliable. Why this relation might not hold:

- Press reports, macro number or other announcement by the company may pre-empt the
accounting earnings numbers as a timely information source.
- GAAP/IFRS may provide incomplete view: deferral of revenue or required expensing on R&D.
- Earnings management reduces the usefulness of earnings.

Another reason for a limited drop in stock price can be that impairment was already announced by
the company and (partly) reflected in stock. To better understand the stock market reaction to
earnings, we should have a precise measure of the “news” or surprise in the earnings numbers.
Options:

1. Same quarter of last year → used by Ball & Brown (1968) and Nichols & Wahlen (2004)
2. A comprehensive prediction model based on multiple signals
3. Forecasts of analysts made on or before the day of the earnings announcements → used by
many researchers, because it includes recent news

Event study, measures the effects of an economic event on the value of the firm. The usefulness of
such a study comes from the fact that the effect of an event will be reflected in asset prices
immediately. Thus the economic impact can be measured using asset prices observed over a
relatively short time period. Applied to a variety of firm-specific and economy-wide events. E.g. in
mergers and acquisitions, earnings announcements, issues of new debt or equity etc. Effect of the
event is typically estimated on the stock price of a company.

Design: Event window, the time period around the event in which we are interested, where time
period 0 = event period. E.g. [-12,+6] for the months around the event.
Cumulative abnormal returns (AR) on stock, measure of the total stock price change over the event
window. 𝐴𝑅 = 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 – 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 = 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐸[𝑅𝑒𝑡𝑢𝑟𝑛]

𝐶𝐴𝑅 [−1, +1] = 𝐴𝑅𝑑𝑎𝑦−1 + 𝐴𝑅𝑑𝑎𝑦 0 + 𝐴𝑅𝑑𝑎𝑦+1

Nichols & Wahlen (2004) measure stock returns after adjusting for expected returns based on
company size, so that E[Return] is the average stock returns of companies that have a similar size.
+6

𝐶𝐴𝑅[−12, +6] = ∑ 𝐴𝑅
𝑡=−12

,The test: firms with a positive earnings surprise have higher returns than
companies with a negative surprise. But by how much? → CAR[-12,0]
(positive) = 0.192 and CAR[-12,0] (negative) = -0.164, so that the
difference = 0.356 = 35.6%.

Results: Evidence is consistent with Ball & Brown (1968)→ earnings are
relevant, there’s a price jump in announcement month 0 for good news
earnings, but no such effect is visible for bad news earnings. Prices move
in the direction of earnings news before the earnings announcement,
reflecting most of the price change → earnings are not very timely.
Results are weaker for changes in cash flows. (see figure here →)

If you also look at the magnitude of the earnings surprise, beside just the
sign, it can be seen that the return difference becomes even bigger →
suggests a very strong relation. CAR (positive) = 0.498 and CAR (negative)
= -0.224, so that the difference = 0.722 = 72.2%. (see figure slide 44)

Tests of the role of earnings persistence confirm that more persistent
earnings are more associated with greater changes in stock price, but only
for positive earnings changes. (see figure here →)

Also zoom in on the days around earnings announcement → do earnings
capture new information? Focus on quarterly earnings and CAR based on
days i.o. months. Surprise is measured based on analyst expectations, not the change in earnings.
Result: The bigger the positive surprise, the higher the returns, the closer it comes to the
announcement day.

Also, evidence suggests that prices react quickly to new information in earnings (slide 48).

Final analysis on stock market efficiency with respect to earnings information:

1. Examine extent to which prices anticipate earnings information: pre-
announcement tests
2. Examine completeness of the market reaction to earnings news:
post-announcement test

Based on the figure you can see there’s a strong anticipation and quick
reaction, but ‘drift’ suggests that price reactions are not complete → Post
earnings announcement drift (PEAD), after the announcement, stock prices
react even more. Means that the stock return of next year can be predicted
by the earnings surprise this year. (see figure here →)

Expansion of findings by Ball & Brown in 2019, they find that their original results are still found, and
for a large range of countries: 1) earnings are useful, 2) earnings are not very timely and 3) evidence
of drift.

So, the original relation between news in earnings and changes in stock price is robust and still exists
today → accounting measures are value relevant. Also, results from tests of the role of earnings
persistence highlight the importance of the three-link framework in evaluating stock price responses
to earnings. Earnings reflect new information, but aren’t very timely. Finally, stock prices react
quickly to news, but subsequent drift suggests this reaction is not complete.

, The IASB cares about the relation between earnings and returns, because it helps them set IFRS-
standards.

Lecture 1-4 (not necessarily for the exam, but needed for exercises)

The overall significant and quality of a whole model is tested using R^2. 0 > R^2 > 1
It’s also called the explanatory power of the regression model. A R^2 of 0.89 means that the model
can explain 89% of the variation in the y-variable.

We evaluate the x-variables by looking at the t-stat or p-value. P-value, the significance.
T-statistic, a test-statistic that measures the deviation in your estimate in terms of standard errors.
Critical values: 1.65, 1.96 and 2.59.

Tutorial 1

Nichols & Wahlen (2004)

Q1 – Explain the intuition behind why we should expect to observe a positive relation between
earnings performance and stock returns.
Earnings should relate to changes in stock price, because earnings are informative about the future
dividends / cash flows / earnings the company is expected to generate. This future performance
affects firm value.

Q2 – The relation between earnings and returns should be stronger for companies with more
persistent earnings, explain what is meant with earnings persistence.
Earnings persistence, the likelihood that firm’s earnings lvl of this period will recur in future periods.
The greater the persistence of earnings, the greater its effect should be on the valuation of the
company.

Q3 – Explain how Nichols & Wahlen (2004) empirically identify that the phenomenon of PEAD
exists in their data.
Identified through a positive relation between the earnings surprise (ES) at time t and the future
stock returns (CAR) at time t+1. This indicates a drift.

Q4 – Explain why it’s important to have empirical insights on the relation between earnings and
returns from the perspective of the stakeholder.
The evidence indicates that the stock market is not fully efficient with respect to public information.
Investors need more time to digest the earnings news.
The more quickly and completely the market reacts to accounting information, the better the
objective of financial reporting has been achieved. E.g. a PEAD is an incomplete reaction.

Dechow (1994), investigates circumstance under which accruals are predicted to improve earnings’
ability to measure firm performance as reflected in stock returns. The stock market typically focuses
on estimates of accrual-based earnings or revenues, i.o. cash flows.

The importance of accruals is hypothesized to increase 1) the shorter the performance measurement
interval, 2) the greater the volatility of the firm’s working capital and investment financing activities
and 3) the longer the firm’s operating cycle. Under each of these circumstances, cash flows suffer
more severely from timing and matching problems that reduce their ability to reflect firm
performance.

Earnings are important, because they are used by many stakeholders as a summary measure of firm
performance. The primary role of accruals is to overcome problems with measuring firm

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