Our study of single person decision theory, investment theory, and efficient market theory has been motivated by the idea that these theories, if accurate, can be useful to accountants in shaping our thinking about the type of information that accounting should provide to investors in order to facilitate their decision making.
Thus, it is important to determine whether these theories are reasonably accurate predictors of how investors behave. In this chapter, we will review the findings of research that addressed this issue.
The first study that we’ll consider is Ball and Brown (1968). This study represents a watershed event in the contemporary history of accounting research. Prior to Ball and Brown, many accounting scholars viewed accounting earnings based on historical cost accounting as a largely irrelevant number. Ball and Brown set out to prove or disprove that conjecture.
Ball and Brown assumed that investors used prior year reported earnings as a benchmark for the level of earnings they expected the firm to report in the current year. Thus, if earnings in the current year were up relative to the prior year, the market would regard that as “good news.” Similar, a decline in earnings relative to the prior year would be regarded as bad news.
They then selected a sample of 261 NYSE-listed firms with earnings across the period 1957-1965. They classified a firm as a good news firm or bad news firm based upon whether current year earnings were up or down relative to the prior year earnings. Then, they tracked the stock price performance of the good news firms relative to the bad news firms across the 18 month period starting 12 months before the current year earnings were announced. To facilitate comparison across firms, they examined stock returns (change in stock price during a period scaled by beginning of period stock prices) rather than stock prices. Also, to control for market-wide movements in stock prices they examined abnormal returns rather than raw returns (roughly speaking, abnormal returns are the difference between the raw stock return and the average market return). Much to the surprise of many doubters, they discovered that stock returns of good news firms increased over the period, and the stock returns of bad news firms declined. In particular, if an investor had bought good news (sold bad news) firms at the start of the accounting period, the investor would have outperformed the overall market by 6 (9) percent. See Figure 5.3 in the textbook. Thus, they showed that unexpected earnings have information content in the sense that they “reflect” the economic events that drive investor decisions during the accounting period.
The logical extension of Ball and Brown’s study was to see whether the magnitude of unexpected earnings (as opposed to merely the sign of unexpected earnings) was related to the magnitude of the stock price response. Beaver, Clarke and Wright (1979) addressed the issue and discovered, in fact, that the magnitude of unexpected earnings was related to the magnitude of the stock price response. Again, they focused on market-adjusted stock returns to facilitate across-firm comparisons and to control for market-wide movements in stock prices.
Ball and Brown (1968) and Beaver, Clarke and Wright (1979) show that despite the deficiencies of historical cost accounting, accounting earnings are potentially useful to investors. They also ushered in the so-called information perspective on the decision usefulness of accounting. The information perspective implies that investors’ response to accounting information can provide a guide as to what type of information is or is not valued by investors.
The next logical question to ask was whether the market responded more strongly to unexpected earnings in some firms, and less strongly in other firms. This question is quite pertinent to accountants because we potentially would be better able to design financial statements if we knew the factors that predict when and why investors respond more strongly (less strongly) to financial statement information. Consistent with the literature, we’ll use the term “Earnings Response Coeffcient” to describe the strength of the market response to unexpected earnings.
To understand this line of research, we need to have an intuitive understanding of how investors might respond to accounting information in light of single person decision theory, portfolio theory, and efficient market theory. Here is the basic idea: Let’s say that last period’s earnings were $1 and, accordingly, that is the level of earnings an investor expects this year. When this year earnings are announced, the level of earnings are, say, $1.25, implying a $0.25 earnings surprise. If the investor believes this $0.25 level of unexpected earnings is a one-time shot that will not recur into the future, the investor will increase his assessment of stock value by $0.25. However, if the investor believes this $0.25 unexpected increase in earnings is a permanent boost to earnings that will recur in future years, then the investor’s increase in stock price is $0.25 + the present value of receiving $0.25 into perpetuity.
Given this framework for thinking about how investors should respond to unexpected earnings, we can predict that investors will respond more strongly to unexpected earnings when those earnings are expected to persist into the future. We can also predict that investors’ response to unexpected earnings will be smaller the higher the discount rate they use in discounting those unexpected earnings that are expected to be received into perpetuity.
A number of studies have tested these predictions, and here is what they found:
- single person decision theoryERC are increasing in the persistence of earnings. This has implications for accountants because it suggests the importance of clearly identifying on the income statement those transactions that are nonrecurring transactions.
- ERC are decreasing in the riskiness of the firm and the leverage of the firm because both imply that investors demand higher expected returns and thus will use a higher discount rate in discounting the unexpected earnings expected to persist into the future. Thus, accountants should minimize the opportunities for off-balance sheet financing (or make sure the off-balance sheet financing is transparent).
- ERC are increasing in the growth opportunities of the firm because unexpected earnings reported by growth firms are expected to persist into the future. Thus, the forward-looking MD&A disclosures are particularly important because they provide information about growth opportunities.
- ERC are increasing in the quality of accounting accruals. Thus, detailed information about the components of accounting accruals might be useful to investors.
Although the information perspective is based on the idea of letting investors’ response to accounting information guide us as to the type of information that is or is not valued by investors, this does not mean that the “best” accounting policy is the one that produces the largest market response. This is because accounting information is a public good. Let me elaborate.
Private goods are those characterized by exclusivity of consumption (if I own an apple, either I can eat it or you can eat it—both cannot occur). In contrast, public goods are not characterized by exclusivity of consumption (my consumption of national defense provided by the federal government does not limit your consumption of national defense—we are both still equally protected). Thus, private markets tend not to develop for public goods and the government must step in and provide the service or mandate that it be provided. Financial reports can be viewed as a public good that the government has stepped in to require firms to produce. To investors, the financial statements appear “free” even though they may be quite costly to the firm to produce.
Recall that economic theory tells us that economic agents will continue consuming scarce resources until the marginal benefit of consumption equals marginal cost. However, since investors view financial reports as “free”, they perceive zero marginal cost for consuming financial reports, and hence they will continue consuming financial reports until the marginal benefit of consumption is zero. From a social perspective, this is inefficient overconsumption. If investors could be made to consider the true cost of the accounting information in their consumption decision, the investor might decide that use of the information didn’t pass a cost-benefit test and hence would not use the information. Thus, showing that investors find an accounting datum to be useful does not mean that the accounting datum should be produced because it is possible that the investor is overconsuming financial information because they perceive it to be free. So, because of the public-good nature of accounting, we cannot conclude that market use of accounting information means that production of the information is beneficial to the whole society.