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L05supplementary_ERC - Earnings Response Coefficients(ERC 1...

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Earnings Response Coefficients (ERC) 1. Introduction Ball and Brown (1968) document that abnormal returns are related to the sign of earnings surprises (GN/BN). A logical next step is to ask whether the magnitude of earnings surprises is related to the magnitude of abnormal returns. i.e., given that two firms both have good earnings news, will the abnormal return be greater if the earnings surprise is higher? Accounting research has found the answer to this question to be positive. Another follow-up question would be: given that two firms have the same amount of earnings surprises, will the market reaction be different because these two firms have distinct characteristics such as beta, capital structure, and etc.? The answer to this question can help improve our understanding of how accounting information is useful to investors and thus leads to the preparation of more useful financial statements. One stream of research originated after Ball and Brown (1968) study was the identification and explanation of differential market response to earnings information. This is called Earnings Response Coefficient (ERC hereafter) research. 2. Definition ERC measures the extent of a security’s abnormal return in response to the earnings surprises of that firm. Here is an example: ILOVEACCTG Inc. is a public firm on Toronto Stock Exchange. Before the 2009 annual earnings announcement (EA) came out, the market price for the firm was $500/share. 2008 annual earnings (ie. Investors’ expected earnings for 2009) was $40/share. The cost of capital for the firm is 8%.
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