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Implication of Earnings
Studies support that there is no distinct causal relationship between earnings and share prices. 10-15% is a very weak correlation at best.
Earnings are based on past transaction and like Historical cost accounting are retrospective and therefore do not align with the decision-usefulness approach that investors favour.
Event studies do show that accounting earnings affect the share prices, they are short windowed studies.
PEAD refers to the price adjustments of NEW information that does not happen immediately, however continue to affect the market for numerous days after. This supports that markets are not always efficient and the effects of accounting information can be seen of a period of time.
Kristianne McCoy N8300291
Presenting Question 1 : Capital Market Research
Case Study Information
Standard setters discuss whether accounting rules should be designed according to the investors' needs to continuously assess the price of shares. Such approach is based on the view that accounting information is actually used by investors in updating the price of shares.
Argues that investors rely upon accounting earnings to revise their estimates around security prices, therefore accounting standards should reflect this.
Argues that the earnings show at best a weak association with changes in share prices, but they look like quite independent, therefore standards setters should be concerned with different quality of accounting rules.
What is Capital Market Research ?
Capital Market Research
CMR is about analysing whether financial information (financial statements) is useful for valuation purposes. It also involves investigating and identifying whether this information is important to investors, analysts and standard setters.
How do we identify whether financial information affects the share price?
We achieve this by using the efficient market hypothesis (EMH).
Using the EMH we assume:
•At any point in time the market should encompass all information that is available
•That information is shared between all market participants
•No one person has superior knowledge
We need to assess whether information affects the share price,however it is important to understand we are only testing whether NEW information affects the share price because known information is already reflected in the share price as stated above.
Two methods for assessing this theory:
Event studies are the observation of small windows in time for abnormal returns. These returns can be identified as abnormal if they deviate from the normal return for that company as well as if they deviate from the market.
Previous Events studies, such as Ball and Brown, show that there is a positive correlation between the release of accounting information and the share price.
Investors purchase shares in a company with the expectation that the company will make a profit.
Therefore investors need relevant information to make decisions which aligns the objectives with decision- usefulness.
Assesses the relationship between share prices and accounting information over a long period of time.
Studies have shown that there is a 10-15% correlation between accounting earnings and share prices and that this correlation is material.
Based on the information provided it can be concluded that markets can be efficient in that most accounting information is important, and that there are various degrees of informativeness of earnings.
This shows that the objectives of decision-usefulness align with the evidence that accounting information is important and relevant to investors.
Even though association studies show a weak correlation between earnings and share prices.
Based on the previous accounting knowledge we are aware that 10-15% is a material effect. This supports events studies which show a strong positive correlation. Therefore it is my opinion that accounting standards should reflect this.
Factors of Event Studies to consider:
- Post Earnings Announcement Drift (PEAD)
- Results reflect that accounting information matters in all countries
- New information is highly informative to investors
Some perspectives suggest that earnings have a confirmatory function, there for they do not provide any NEW information and are irrelevant