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Summary Financial Accounting Research (UVA)
A summary of all lectures, tutorials and articles of Financial Accounting Research (UVA). Include the homework and tutorial questions and answers
[Meer zien]Voorbeeld 4 van de 78 pagina's
Voorbeeld 4 van de 78 pagina's
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Voorbeeld van de inhoud
Financial Accounting ResearchLecture 1:
The objective of financial reporting is to provide information that is usefuls to users.
Our primary group of users are investors.
The concept or foundation of academic research is that we have to understand how investors use and think
about financial accounting information.
Nicholas & Wahlen (2004)
How Do Earnings Numbers Relate to Stock Returns? A Review of Classic Accounting Research with Updated
Evidence
So, How do earnings relate to stock returns? Why do we see that when earnings goes up, stock return on
average also tends to go up.
Voorbeelduitwerking:
On Monday October 28, 2019, Philips reported earnings lower than last year in the same quarter (a negative
earnings change). This is caused by an impairment charge of 29% with a negative reaction on the stock return
of -1,79%. Why does this drop of 1,79% makes sense? Can we explain this theoretically and empirically?
When we look back at the first example (Philips -29% impairment charge, -1,79% stock price), the reduction in
earnings for Philips was substantial, but the stock price went down by less than 2%, why?
The major driver of the negative earnings change was an impairment charge. Impairments are one-time,
transitory, events. Thus: the impact on value should be limited.
Research question
Do earnings capture information that investors consider useful and value relevant?
Earnings
Are often called the ‘bottom-line’ measure of accounting performance.
Is the result of an accounting process, in which you measure a lot of accounting flows such as revenues and
expenses. Looks at the change in common equity.
Revenues -/- Expensens = Earnings
Stock return
Change in the stock price of a firm.
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 from Ball and Brown:
- When earnings change, stock return also changes. This means it is useful.
- But earnings information is not very timely.
- Stock market investors react rapidly to new information in earnings, but their reaction is
not complete, evidence of post-earnings announcement drift (PEAD)
Theory
The objective of financial reporting conform the IASB is to provide information that is useful to users
(investors).
Nichols and Whalen use a framework that illustrate three links that form the foundation of the relation
between earnings and returns.
1. Current earnings are informative about future earnings;
2. which provide information to predict future dividends;
3. which provide information to determine share value, which represents the present value of expected
future dividends.
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
, Financial Accounting Research
Why the earnings number might not reflect information that the capital markets believe is relevant and reliable
1. Other announcements by the company may pre-empt the accounting earnings number as a timely
information source.
2. Accounting rules do not allow firms to report all the news (expense R&D).
3. Managers have incentives to show good earnings (earnings management).
Link 1
When we look at the reported earnings in year t, this provides information of how much we will earn in year
t+1, t+2 enz. The earnings determine how much dividend we will get and the share price is just the present
value of all these dividends.
1. Current period earnings summarizes information about the wealth created by the company during the
period for shareholders.
2. Current period earnings provides information useful for prediction. This prediction is going to drive the
value of the firm.
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
“predictive value”.
Link 2
If earnings are predictive, than current earnings tells use something about future dividends.
Even if firms don’t pay dividends, the firm could pay higher dividends later.
Link 3
Share prices equal the present value of expected future dividends to the shareholders.
So simply, the framework explains that information in 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.
The frameworks helps explain why earnings are seen as important.
Earnings persistence
Earnings persistence refers to the likelihood of a firm’s earnings level will recur in future periods, an essential
element of link 1.
More persistent earnings should have a stronger impact on stock prices.
The opposite of earnings consistence is an one-time gain. Impact of one-time gain on share price is limited.
, Financial Accounting Research
Kind of study
Event study. We want to measure the effect of an event.
This requires some design choices:
- Event window
How many days, weeks or moths do we consider for the event window, the time period around the event.
- Cumulative abnormal stock returns
Calculate an abnormal return for that period of time.
An abnormal return measures what is earned by the investors what is expected by that day.
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:
- Other announcements by the company may pre-empt the accounting earnings number as a timely
information source.
- Accounting rules do not allow firms to report all the news (expense R&D).
- Managers have an incentive to show good earnings.
Because of early announcements which could influence the stock price, we should have a precise measure of
the ‘news’ or ‘surprise’ in the earnings number to better understand the relation between stock market
reaction to earnings. Three different ways to make sure that we have a precise matter:
- If there is a change between last year and this year, than that change is a surprise.
- Use a prediction model.
- Use the forecast of analysts.
Nichols and Wahlen test if companies with positive earnings surprise have higher returns than companies with
a negative surprise. And if so, by how much?
Results
1. Earnings are 'value relevant'
If you invest well, the value increases. If you invest unwisely, the value decreases.
price jump in announcement month 0 for good news earnings, but no such effect is visible for bad
news earnings.
2. Earnings are not very 'timely'
Prices move in the direction of earnings news before the earnings announcement, reflecting most of
the price change. (If earnings were timely, we would see nothing happening before the earnings
announcement and a big jump after the earnings announcement)
, Financial Accounting Research
3. Results are weaker for changes in cash flows compared to earnings.
So earnings, and not cash flows, are important to investors.
4. Magnitude (=omvang) of the earnings surprise
So, does it matter how much earnings are reported? We can see that the return difference becomes
even bigger. This suggests that there is a very strong relation between earnings and stock return.
5. More persistent earnings (=The likelihood that what is earned this year, will also be earned in future
periods.) are associated with greater change in stock price, but only for positive earning changes.
6. There is a post-earnings announcement drift (PEAD), which suggests that price reactions are not
complete.
We also conclude that the theory that if you can use current earnings to predict future earnings, then it’s useful
for investors.
Summary of results
- Accounting earnings are value relevant.
- The role of earnings persistence is relevant.
- Earnings reflect new information, but are not very timely.
- Stock prices react quickly to news, but subsequent drift suggest this reaction is not complete.
Homework questions
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 is the likelihood that firm’s earnings level of this period will recur in future periods.
Example: persistence of 0.8 means that a €1 increase in earnings will recur as €0.80 earnings in the next
year (and €0.64 two years ahead, €0.41 three years ahead, etc.)
The greater the persistence of earnings (or a specific gain or expense), the greater its effect should be on
the valuation of the company.
- Effect of €1 of earnings with no persistence (“transitory”): Value up by €1 (one-time gain).
- Effect of €1 of earnings with high persistence: value up by > €1, because the earnings will recur in next
periods as well.
Q3 – Explain how Nichols & Wahlen, empirically identify that the phenomenon of PEAD exists in their data.
After the public release of earnings information, stock prices should fully reflect the information: we should not
be able to predict the direction of stock returns based on this public information. “Postearnings announcement
drift” (PEAD): stock returns still “drift” in the direction of the earnings news.
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 more completely, the market reacts to
accounting information, the better the objective of financial information has been achieved (recall the IASB
conceptual framework). E.g. a PEAD is an incomplete reaction.
Tutorial
Q1: Nichols & Wahlen (2004) observe a positive realtion between earning performance and stock returns, and
argue that therefore earnings are relevant. What is the implication of this observation for investors, who are
interested in predicting returns?
A) When earnings are positive, stock prices will move higher
B) When earnings are negative, stock prices will move lower
C) Earnings and Returns tend to move in the same direction
D) Earnings and returns tend to move in the same direction only when earnings are positive
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