capital markets research (using archival data) oriented towards financial accounting issues links...
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Capital Markets Research (Using Archival Data)
Oriented towards financial accounting issues
Links with finance and economics
Questions?• Do earnings matter? (Ball and Brown, JAR, 1968;
Beaver, JAR, 1968)• Are earnings components valued similarly?• Do earnings have incremental information content
over cash flows• Does the perceived quality of an auditor affect the
relation between earnings and returns?• Are disclosures about pension benefits or other post-
retirement benefits value relevant? • Would financial statements be more informative if
GAAP were changed to permit managers to capitalize R&D?
Developments in Finance and Accounting
Finance Literature
Market efficiency -- Fama, 1970, 1971
-- prices fully reflect all available information
CAPM -- Sharpe, 1964; Linter, 1965
-- a model of firm-specific expected returns
Developments in Finance and Accounting
Accounting Literature Positive Accounting Theory -- Watts and Zimmerman,
1986• Predicts that the use of accounting numbers in
compensation and debt contracts and in the political process will influence a firm's reporting choices
Valuation Theory -- Ohlson, CAR, 1995• Provides accounting with theory, based on finance
theory, on how earnings and book values map into prices.
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth
A0 - L0 = E0
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth
A0 - L0 = E0
+ NI1
- Div1 E1
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth
A0 - L0 = E0
+ NI1
- Div1
A1 - L1 = E1
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0
+ NI1
- Div1
A1 - L1 = E1
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1
- Div1
A1 - L1 = E1
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
We have 2 measures
of wealth and
changes in wealth
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
↔
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
↔
↔
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
↔
↔
Observations:
• E0 = Price0
• NI1 = Return1 (cum div)
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
↔
↔
Observations:
Returns happen everyday.
Earnings are reported periodically.
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
+ NI2 - Div2
A2 - L2 = E2
↔
↔
Relation between Accounting Equity Values & Stock Market Equity Values
Accounting Measure of Wealth Market’s Measure of Wealth
A0 - L0 = E0 Price0
+ NI1 Return1
- Div1
A1 - L1 = E1 Price1
+ NI2 - Div2
A2 - L2 = E2
↔
↔
Are current earnings good predictors of future earnings?
NI1 = NI2
Event Study
• “Direct” link between information and use of information
• Event (loose definition)– Identifiable happening or announcement
that you can pinpoint in time
that provide NEW information
relevant to the market
• Short window (days)
Event Study• Like ---
– Earnings announcement (Compustat, IBES)– Auditor change (press release, Dow Jones Interactive, Lexis/Nexis)– Change in accounting standard (press release, Dow Jones Interactive,
Lexis/Nexis)
– New laws or regulations
• Does the market react to this event (or information from this event)?
• Model: Unexpected Returns = Unexpected Earnings
(or Other New Information)
Issues in Event Studies
• Event date?• Model? Unexpected Returns = Unexpected Earnings• Event window? (cumulative abnormal returns [CARs])• Expectation models?• For returns
– CAPM (estimate parameters in event window/non-event period and apply to event period)
– market adjusted returns (adjust by market index or industry index or small cap and large cap index)
• For earnings (or other info)– Last year’s earnings– Last year’s earnings with growth– Time-series model– Analysts forecasts
Association Tests
• Link between information and use of that information
• Longer window tests (year)
• Two Basic Approaches --
Earnings Responses CoefficientModel? (Un)expected Returns = Unexpected Earnings
(Un)expected Returns = INT + ERC*Unexpected Earnings + e
• Earnings are like an annuity
• So, an Earnings Responses Coefficient (ERC) should be near 1 + 1/rate (where r is the risk adjusted discount rate for equity)
Economic Determinants of ERC--• persistence, risk, growth and interest rate control for in studies• Kormendi and Lipe, JOB, 1987; Easton Zmijewski, JAE, 1989; Collins and Kothari, JAE, 1989
Some Problems with ERC Studies• heavily statistical based -- time series of earnings• predictive ability• do not control for accounting methods –• ERC coefficients too low (1 to 3)
- price lead earnings
- inefficient capital markets
- GAAP deficient
- transitory earnings
Another ApproachModel?Returns = Earnings + Changes in Earnings (Easton Harris, JAR, 1991)
• Earnings are an increase in the book equity value and returns are an increase in the market equity value.
• So the coefficient on earnings should be one.
• Changes in earnings are like an annuity so coefficient should be near 1 + 1/rate
Some similar problems -- - price lead earnings- inefficient capital markets- GAAP deficient- transitory earnings
Price Tests-- the longest window!-- Ohlson theoretical work
Model Variations:
1. Price = Earnings
Earnings are an annuity So, the coefficient on earnings should be near 1 + 1/rate where r is the risk adjusted discount rate for equity
2. Price = Book Value
Book value is the accountants' measure of equityMarket Value is the Market's measure of equitySo, the coefficient on book value should equal one.
Price Tests (continued)
3. Price = Book Value + Earnings
Price is a weighted average of book values and earnings
So, weights are also part of coefficientsBarth, Beaver, Landsman, JAE, 1998Collins, Maydew, Weiss, JAE, 1998
4. Price = Book Value+Residual Income (or Abnormal Earnings)
where residual income=current year's earnings - beginning book value * r
Some Problems -- - value of r
- persistence of earnings
- GAAP deficient (for 4 it should not matter)
- GAAP conservative
- transitory earnings
- econometric issues -- size
Other Areas to Investigate• accruals and accruals models• earnings versus cash flows• disclosure versus recognition• financial statement analysis • properties of accounting earnings related to
corporate governance, ownership…• market inefficiency explanations versus
behavioral explanations related to accounting anomalies
• Usefulness of accounting information in credit markets