Week 1, lesson 1: Value relevance and Information content
Value relevance and aggregate beliefs (BB68)
Information content and individual beliefs (LM02)
Role for ‘accounting’ theory
Economics and finance
o Efficient market hypothesis (BB use this in their paper)
o CAPM
o Valuation models
o Human capital theory
o Agency theory
Psychology
o Prospect theory
o Learning theory
o Valuation models
o Human capital theory
Sociology
o Critical theory
o Social process theory
Ball and Brown 1968 – Empirical evaluation of earnings numbers
Predictive validity framework
Key question: What can we learn from link 4 (results) wrt link 1 (theory/hypotheses)?
Why: what is the contribution of this paper.
**Economics’ undertakes to study the effect which will be produced by certain causes, not
absolutely, but subject to the condition that other things are equal and that causes are able
to work out their effects undisturbed.
The control variables keep all else equal (link 5).
How to measure corporate governance? In this paper they take the number of times they
meet.
You want to have a strong theory and a tight link between 2 and 3 (conceptual model and
empirical model).
Results
Why do we have 3 variables?
We have 3 different measures for earning, we have 3 measures for bad versus good news.
, What does the line represent?
The abnormal returns over time, relative to the annual report (months)
The market return drift into the direction of the accounting return
Low timeliness of earnings information!
Only 10% of Income Information has not been anticipated till the reporting month (meaning,
90% is anticipated)
Methodology
How to measure relation between stock price and accounting information?
o You need a measure that reflects:
Firm specific news about accounting information (unexpected earnings)
Stock market reaction to firm specific news (unexpected returns)
It is about expectation models, you need to measure some expected part.
Naïve model: the expected earnings of this year, is the earnings of a previous period.
Why would they use a naïve model like this?
To show the relevance of a second model.
The naïve model uses limited assumptions.
Change in income is equally weighted (unexpected earnings c’d), this causes that the small firms get
overweight.
If you use a valuated index, than you get an overweighting of the large firms.
Good news: observed > expected
Bad news: observed < expected
Why do stock prices, and therefore rates of returns from holding stock, tend to move together?
Due to competition, It impossible to sustain abnormal returns for a long period of time.
Critique: They use 3 proxies for earnings news, and only 1 for market.
Bad news is temporary. Good news is persistent. There is a bigger response on bad news than on
good news.
If the capital market is fully efficient, you don’t see a drift. You see a drift here in this model.
This is an anomaly, this can be a bias.
There is a decrease in the relevance of earnings, and an increase in the
relevance of book value.
, Landsman and Maydew (2002) – Has the information content of quarterly earnings announcements
declined in the past three decades?
Information content
Beaver (1968): Earning lack informational value
Measurement error earnings too large
Other information sources obtain the same information but are more timely
Information content = change in investors’ assessment of the probability distribution of
future returns/prices such that there is a change in the equilibrium value of current market
price.
o Direction/magnitude price change unknown but greater when earnings announced
o Shift in portfolio (volume) greater when earnings are announced.
Abnormal Volume
Based on daily volume
Abnormal volatility
2 2
AVAR¿ =u¿ /δ i
Week 1, lesson 1: Financial Reporting Quality
Dechow, Sloan, Sweeney – Detecting Earnings Management
Predictive validity framework
Key question: What can we learn from link 4 (results) wrt link 1 (theory/hypotheses).
Value relevance and aggregate beliefs (BB68)
Information content and individual beliefs (LM02)
Role for ‘accounting’ theory
Economics and finance
o Efficient market hypothesis (BB use this in their paper)
o CAPM
o Valuation models
o Human capital theory
o Agency theory
Psychology
o Prospect theory
o Learning theory
o Valuation models
o Human capital theory
Sociology
o Critical theory
o Social process theory
Ball and Brown 1968 – Empirical evaluation of earnings numbers
Predictive validity framework
Key question: What can we learn from link 4 (results) wrt link 1 (theory/hypotheses)?
Why: what is the contribution of this paper.
**Economics’ undertakes to study the effect which will be produced by certain causes, not
absolutely, but subject to the condition that other things are equal and that causes are able
to work out their effects undisturbed.
The control variables keep all else equal (link 5).
How to measure corporate governance? In this paper they take the number of times they
meet.
You want to have a strong theory and a tight link between 2 and 3 (conceptual model and
empirical model).
Results
Why do we have 3 variables?
We have 3 different measures for earning, we have 3 measures for bad versus good news.
, What does the line represent?
The abnormal returns over time, relative to the annual report (months)
The market return drift into the direction of the accounting return
Low timeliness of earnings information!
Only 10% of Income Information has not been anticipated till the reporting month (meaning,
90% is anticipated)
Methodology
How to measure relation between stock price and accounting information?
o You need a measure that reflects:
Firm specific news about accounting information (unexpected earnings)
Stock market reaction to firm specific news (unexpected returns)
It is about expectation models, you need to measure some expected part.
Naïve model: the expected earnings of this year, is the earnings of a previous period.
Why would they use a naïve model like this?
To show the relevance of a second model.
The naïve model uses limited assumptions.
Change in income is equally weighted (unexpected earnings c’d), this causes that the small firms get
overweight.
If you use a valuated index, than you get an overweighting of the large firms.
Good news: observed > expected
Bad news: observed < expected
Why do stock prices, and therefore rates of returns from holding stock, tend to move together?
Due to competition, It impossible to sustain abnormal returns for a long period of time.
Critique: They use 3 proxies for earnings news, and only 1 for market.
Bad news is temporary. Good news is persistent. There is a bigger response on bad news than on
good news.
If the capital market is fully efficient, you don’t see a drift. You see a drift here in this model.
This is an anomaly, this can be a bias.
There is a decrease in the relevance of earnings, and an increase in the
relevance of book value.
, Landsman and Maydew (2002) – Has the information content of quarterly earnings announcements
declined in the past three decades?
Information content
Beaver (1968): Earning lack informational value
Measurement error earnings too large
Other information sources obtain the same information but are more timely
Information content = change in investors’ assessment of the probability distribution of
future returns/prices such that there is a change in the equilibrium value of current market
price.
o Direction/magnitude price change unknown but greater when earnings announced
o Shift in portfolio (volume) greater when earnings are announced.
Abnormal Volume
Based on daily volume
Abnormal volatility
2 2
AVAR¿ =u¿ /δ i
Week 1, lesson 1: Financial Reporting Quality
Dechow, Sloan, Sweeney – Detecting Earnings Management
Predictive validity framework
Key question: What can we learn from link 4 (results) wrt link 1 (theory/hypotheses).
