ADVANCED

ACCOUNTING THEORY

Reactions of Capital
Markets to Financial
Reporting

Narmada Balasuriya
B.Sc. Accounting (Special) – USJ, CIMA (UK)
Department of Accounting and Finance
Faculty of Business
Outline

• Overview of CMR

• Results of CMR into financial reporting

• Market efficiency and CMR

• Relaxing Assumptions of Market Efficiency

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Introduction to CMR

• Explores the role of accounting and other financial information in equity markets

• Involves examining statistical relations between financial information and share prices

• Reactions of investors evident from capital market transactions

• Many studies have examined capital market reactions to corporate earnings

announcements.

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Capital Market Vs Behavioral Research

•Capital market research (the topic of this lecture)

• assesses the aggregate effect of financial reporting on investors

• considers only investors

•Behavioral research (the topic of the next lecture),

• analyses individual responses to financial reporting

• examines decision-making by many groups

• e.g. bank managers, loan officers, auditors

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Reasons for capital market research

• Information about earnings and its components is the primary purpose of financial reporting.

As the IASB Conceptual Framework states:

‘The objective of general-purpose financial reporting is…..?

Why we need to look at capital market research?

The use of accounting information by investors is therefore of central importance to the accounting
profession, in particular, the issue of whether accounting information is used by investors in their
decision-making processes.
• capital markets research explores the market’s (investors in aggregate) reaction to various releases
of information – including accounting information – and therefore capital markets research should
be of interest to the accounting profession
Why have so many research studies been undertaken that focus on the market’s response to
accounting earnings announcements?
• Earnings are oriented towards the interests of shareholders
• Earnings is the number most analyzed and forecast by security analysts
• Reliable data on earnings is readily available
So...the questions often asked by capital markets researchers are...

• What is the impact of the release of accounting information on share

returns?

• Which accounting information is relevant for valuing shares in a company?

Underlying assumption of CMR —EMH

• CMR relies on the assumption that equity markets are efficient

• in accordance with Efficient Market Hypothesis (EMH)

• Efficient market defined as a market that adjusts rapidly to fully impound information into share

prices when the information is released

Three forms of market efficiency

• Weak form prices reflect information about past prices and trading volumes

• Semi-strong form all publicly available information is rapidly and fully impounded into share

prices in an unbiased manner when released

• most relevant for accounting-based capital market research

• Strong form security prices reflect all information (public and private)
Assumptions about market efficiency

• Any assumptions about market efficiency are simply that – assumptions that are used within a

model – and as we have emphasized throughout this course/subject, models or theories will not

always fully reflect what actually happens in the ‘real world’.

• indeed, there have been many researchers who have rejected claims that securities markets

are efficient
Market Efficiency - Implications for Accounting

• Assumptions about market efficiency have implications for accounting.

• if markets are efficient, they will use information from various sources when predicting future

earnings, and hence when determining current share prices

• if accounting information does not impact on share prices, then, assuming semi-strong-form

efficiency, it would be deemed not to provide any information over and above that currently

available

• at the extreme, accounting’s survival would be threatened

Market efficiency – share prices react to information from various sources

For example, studies have found that share prices have been found to react not only to earnings data
but also to such things as:
• news about senior executive resignations

• takeover rumors posted to internet discussion sites

• which raises possible issues about the regulation of information provided on such sites

• concerns raised by auditors, particularly in relation to going concern considerations (unless

anticipated by the market)
• industry-wide changes, such as the implications associated with the introduction of particular
legislations (such as the Sarbanes-Oxley Act in the US)
Share prices react to information from various sources....

• Again, a share price reaction indicates that the ‘news’ has ‘information content’

• But remember, the information might later prove to be either correct or incorrect

• Conversely, no share price reaction indicates that the news or event did not act to cause the

market to revise any previous expectations held about a firm’s future cash flows

• the absence of share price movement indicates either that the information is irrelevant or

that it confirms market expectations

Event Study

• Studies which look at the changes in share prices around a particular event, such as the release of accounting

information, are often referred to as ‘events studies’.

According to Kothari (2001):

• whether an event, such as an earnings announcement, conveys new information to market participants as reflected in

changes in the level or variability of security prices or trading volume over a short time period around the event

• if the level or variability of prices changes around the event date, then the conclusion is that the accounting event

conveys new information about the amount, timing, and/or uncertainty of future cash flows that revised the market’s

previous expectations

• the maintained hypothesis in an event study is that capital markets are informationally efficient in the sense that

security prices are quick to reflect the newly arrived information

Confounding Events

• Within event studies there is typically a risk of ‘confounding events’

• It should be noted that across time there will be many events that will affect share prices and trading volumes

• One of the difficult tasks in undertaking ‘event studies’ that review share price reactions to particular

announcements is to try to ensure that there have been no other (confounding) events around the same time

which might also have influenced share prices

• For example, if accounting profits are announced on the same day that the chief executive officer has

resigned then it would be difficult to determine what caused any possible share price reaction – was it the

profits, or the resignation?

Results of CMR into Financial Reporting

• CMR investigates the information content of corporate earnings announcements as well as of other

accounting and disclosure items.

• The knowledge of these results are useful in making financial reporting decisions.
Results of CMR - Ball and Brown (1968) Study

• One of the most highly cited papers in the accounting literature

• Examined data from 261 US firms
• Tested whether firms with unexpected increases in accounting earnings had positive abnormal
returns, and firms with unexpected decreases had negative abnormal returns
• Found that:
• information contained in the annual report, prepared using historical cost was useful to
investors
• 85 to 90% of earnings announcement is anticipated by investors
• much of information is obtained from other sources
Results of CMR - Permanent and Temporary Changes

• Research examined relationship between the magnitude of unexpected changes in earnings (EPS)

and magnitude of abnormal returns

• known as the earnings response coefficient

• some research has shown that a 1% unexpected change in earnings associated with 0.1 to

0.15% abnormal return

• Not all unexpected changes in earnings result in changes in share prices

• depends on whether earnings increases expected to be permanent or temporary

Results of CMR—relative magnitudes of cash and accruals

• Earnings persistence depends on proportion of accruals relative to cash flows

• firms with large accruals relative to actual cash flows unlikely to have persistently high

earnings

• Share prices found to act as if investors ‘fixate’ on reported earnings without considering relative

magnitudes of cash and accrual components

Results of CMR - Information announcements of other firms

• Earnings announcements by one firm also results in abnormal returns to other firms in the same
industry

• known as ‘information transfer’ effect

• Related to whether the news reflects a change in conditions for the entire industry, or changes in
relative market share within the industry

• For example, if an organisation within an industry is the first to prepare its financial results for the
year, and it reports record profits (lower profits) that were unexpected by the market, then this
would often cause share price increases (decreases) across the industry.
Results of CMR—benefits of voluntary disclosure

• Voluntary disclosures include those in annual reports as well as media releases etc.

• Firms with more disclosure policies have

• larger analyst following and more accurate analyst earnings forecasts

• increased investor following

• reduced information asymmetry

• reduced costs of equity capital

Results of CMR—recognition versus footnote disclosure

• Recognizing an item in the financial statements is perceived differently to disclosure in footnotes

• Investors place greater reliance on recognized amounts than on disclosed amounts

Results of CMR – Size of the Entity

• Relationship between earnings announcements and share price movements is inversely related to

the size of the entity

• Earnings announcements found to have a greater impact on share prices of smaller firms than

larger firms

• More information generally available for larger firms

Relaxing Assumptions about Market Efficiency

• Recent years have seen a number of researchers questioning some assumptions about market

efficiency

• Market reactions to information often found to be longer than would be anticipated from an

‘efficient market’.

• Also, market found to sometimes ‘under- react’ to particular announcements (Earnings Drift)

• Created new areas for research—for example what factors influence ‘earnings drift’
Thank You!