Chapter 5_ Notes

Chapter 5 Notes - CHAPTER 5 NOTES The Information Approach on Decision Usefulness The information approach is an approach to financial reporting

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CHAPTER 5 NOTES The Information Approach on Decision Usefulness The information approach is an approach to financial reporting that recognizes individual responsibility for predicting future firm performance that concentrates on providing useful information for this specific purpose. The approach assumes securities market efficiency while recognizing that the market will react to any useful form of information from any source, including financial statements Reasons for Market Response ●Investors have prior probabilities of future firm performance, that is, its dividends, cash flows, and/or earnings, which affect the expected returns and risk of the firm’s shares. ●Upon release of current year’s financial statements, certain investors will decide to become more informed by analyzing the income number. For example, if net income is high, or higher than expected, this may be good news. ●Investors who have revised their beliefs about future firm performance upward will be inclined to buy the firm’s shares at their current market price, and vice versa. ●As a result, the volume of shares traded will be increased. ●If the investors who interpret the reported financial statements information, particularly reported net income, as good news outweigh those who interpret it as bad news, one would expect to observe an increase in the volume of shares traded and market price of the firm’s shares, and vice versa. Beaver (1968) found a dramatic increase in volume during the week of release of earnings announcements. However, the model of Kim and Verrecchia (1997) suggests that volume is noisier than price changes as a measure of decision usefulness of financial statement information. Finding the Market Response 1. If an efficient market is going to react to accounting information, it should do so in a narrow window of a few days surrounding the date of the information release. Therefore, it is important to know when the current year’s accounting information (e.g. reported net income) first became publicly available. 2. With respect to empirical research, researchers must obtain a proxy of what best represents expected net income. Under ideal conditions, expected earnings are simply accretion of discount on opening firm value. Under non-ideal conditions, there are different approaches:
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Chapter 5 Notes i. The time series approach projects the time series formed by the firm’s past reported net income; that is, it bases future expectations on past performance. A reasonable projection is based on earnings persistence. ii. Another source of earnings expectations is analysts’ forecasts. These are now widely available for most large firms. Recent studies of the information content of earnings tend to base earnings expectations on analysts’ forecasts (see pages 160-162 for more details). 3.
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This note was uploaded on 12/14/2010 for the course ACC 706 taught by Professor Shadifarshad during the Winter '09 term at Ryerson.

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Chapter 5 Notes - CHAPTER 5 NOTES The Information Approach on Decision Usefulness The information approach is an approach to financial reporting

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