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Accounting Theory

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brad iwa

on 12 February 2013

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Transcript of Accounting Theory

A Review of Classic Accounting Research with Updated Evidence
By: D. Craig Nichols and James M. Wahlen How Do Earnings Numbers Relate to Stock Returns? Link #1:Current period earnings provide information to predict future periods’ earnings Link #2: Future Period Earnings Develop Expectations
About Future Dividends Link #3: Share value= PV of the expected future dividends over the remaining life of the firm Link 1 Rely on reliable info. to forecast the ability to generate future wealth

Provide 2 important elements of information useful for developing dividends expectation (1) Information about current period wealth creation

Accrual accounting principles
Effects of transactions on shareholders equity (2) Information about future earning

Operating income: ongoing operations
Special items
Nonrecurring gains or losses, extraordinary items, discontinued operations, etc
Unlikely to affect the firm’s future performance Stock returns anticipate earnings information in the weeks prior to earnings announcements

Returns react significantly during the days surrounding earnings announcements

Current and future earnings present wealth created by the firm Empirical Evidence (1) Do firms with earnings increases/decreases experience positive/negative abnormal returns? Empirical Evidence (2) Changes in earnings or changes in cash flows from operation, which have a stronger relation with annual stock returns? The Association between Annual Earnings Changes and Cumulative Abnormal Returns Earnings→CFs from operations adjusted for accounting accruals

Accruals→info. about firm wealth creation and profitability

Accounting accruals reduce the ambiguity in changes in CFs from operations Post-Earning Announcement Drift Unexpected earnings
Market reaction
Completeness - 60 day drift Empirical Evidence Abnormal returns to investing on the basis of accurate forecasts of future earnings changes are potentially large

Earning numbers contain information that relates to changes in the market’s expectation of future dividends Yes. An average difference of 35.6% in abnormal annual returns Changes in earnings When are share prices most reactive to earning news? Why do markets devote so much time into forecasting earnings? Empirical Evidence Kormendi and Lipe (1987) Earnings Increase
High Persistence = 25.3%
Low Persistence = 13.6% Earnings Decrease
Insignificant difference - decreases are considered transitory Future Earnings Create Expectations About Dividends What effect does earnings persistence have on stock returns? Liquidating Dividend Firm value $1,000 Earnings $50 Dividend ($50) (100% payout) PV firm value $1,000 If earnings are expected to continue (persistent) - share price increase reflects the present value of the expected future earnings over the life of the firm

If earnings are a one time gain (transitory) - share price increases by the one time gain (liquidating dividend) Persistent Gain: How do we determine share value? $1 per share = increase in share price of $13.50
(assuming an interest rate of 8%) Transitory Gain: $1 per share= increase in share price of $1 lending
corporate governance
management compensation
mergers and acquisition
regulation changes in earnings Reliable and relevant measure to determine a firm's valuation in a capital market Future payments a customer could expect to receive plus the liquidation of the share. Persistent Earnings Expected Dividends $1,000 FV of earnings INTRODUCTION Agenda Purpose/Hypothesis

Relationship between earnings and returns

Link 1

Link 2

Link 3

Conclusion Purpose and Hypothesis Purpose: To explain through various relationships how earning numbers relate to stock returns as well as provide an understanding of the accounting research behind this connection

Hypothesis: "New accounting earnings information that trigger a change in investors' expectations for future dividends should correspond with a change in the market value of a firm" (Nichols, Wahlen. 265. 2004) Relationship between earnings and returns This relationship depends on 3 assumptions about information contained in earnings and share prices: CONCLUSION Link 1 Link 1 1) Earnings provides information to equity shareholders about current and future earnings
Current period earning numbers show current period wealth creation
Earnings are measured using accrual accounting
Related financial statement can provide information to predict future earnings (Income from operations compared to extraordinary income) 2) Current and expected future earnings then provides shareholders with information to develop expectations about future dividends

Current earnings and forecasts of future earnings indicate dividend-paying ability
Shares of stock entitle a shareholder to any dividend distribution 3) Share prices reflect the present value of all expected future dividends

Share value is the PV of the future dividends the shareholder expects to receive over the remaining life of the firm
Classic approach to equity valuation, the theoretical earnings-dividends-value link is an underlying factor why investors commonly use earning-based valuation ratios The links assume that:
current period earnings summarizes important information useful for forecasting future earnings
Forecasts of future earnings provide information for developing dividend expectations
The present value of expected future dividends determines share price The empirical evidence shows:
Annual stock returns are significantly related to the sign of annual earnings change (Ball and Brown 1968)
Earnings persistence helps to explain differences in the relation between stock returns and earnings (Kormendi and Lipe 1987)
Share prices react rapidly to the arrival of new information in quarterly meetings (Bernard and Thomas 1989) Overview Application Final Discussion Question This article explains theoretical and empirical evidence on the capital market consequences associated with earnings information

The association between earnings and returns explains why investors, managers, analysts, auditors, regulators and others place a high importance on accounting earnings (financial statements)

The ability to isolate the effects of unexpected vs. expected earnings on stock returns depends on factors such as:
Earnings information
Earnings expectations
Market efficiency with respect to earnings information
Asset pricing How would you explain to someone (who knows nothing about accounting) how earnings relate to stock returns?
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