Module 1 - Info Theory

Module 1 - Info Theory

1. To explain and predict Acctg practice, we examine 2 theories

2. LOs

   • Importance of Acctg numbers
   • Research (establish importance)
   • Regulatory implications (on standards)

3. Addresses USEFULNESS of Acctg info in investment decisions

4. Historical dissatisfaction with prescriptive theories

   • Led to empirical research
   • Prescriptive: what firms SHOULD BE doing
     • E.g. Told to use reducing balance for Depn, but they are using SL instead
   • Researchers trying to understand why prescriptive theories not being used

5. Is Acctg info useful to investors?... YES!

6. Ball & Brown Study, 1968

   • Examine relation between earnings and share prices
   • Assumptions of Investors
     • 1. Find future EPS
       • Relevant for decision making
       • Provides info about firm's future cash flows
     • 2. Can forecast EPS from known data
       • i.e. Acctg Financial statements
     • 3. React to errors in forecasts when revealed
       • 'Share price reaction'
         • Measure investors' reactions - abnormal return in share price
           • Share prices affected by
             • Market events
               • Create systematic risk (affect everyone in market
               • e.g. Reserve bank announces increase in interest rates
                 • ALL firms decrease share price
                   • Investors can earn better returns by putting money into debt market
               • e.g. Inflation
                 • Share price decreases
                   • Increased inflation erodes returns earned
                     • Firms less profitable
             • Firm-specific events
               • Unique to firm only
               • e.g. Earnings announcement
                 • Share price reaction for THAT FIRM ONLY
               • Only reduced by fully diversified share portfolio!
       • If there is a share price reaction - it has INFORMATION CONTENT and is USEFUL!
       • Errors a surprise to investors
         • Adjust share trading price
           • F errors should have a related and similar share price reaction
       • Actual EPS compared to forecasted EPS
         • Difference? = Revaluing shares of firm
         • Measure the forecast error (Random Walk Model)

7. ESTIMATING the market model

   • Firm specific events reduced
     • In theory, unobservable, but we're trying to find out what it's at
   • Abnormal return associated with negative forecast error in EPS
     • i.e. Positive F Error in EPS = Positive abnormal return
       • Actual EPS greater than expected EPS
         • Increase in share price
   • Greatest AR/SPR around EPS announcement date, but not before!

8. Acctg info NOT monopoly supplier of info to investors

   • Other info provided (85%) by firm that is causing SPR
   • This info causes SPR PRIOR to announcement
     • e.g. release of semi-annual numbers

9. Market is semi-strong

   • Reacts quickly and unbiased to new info
     • After announcement, share price reaction flattens
       • Once everyone has that info, you cannot make any money
   • Small/spot-on F error = small SPR

10. Market fooled by changes that have no cash flow consequences?

    • e.g. SL vs Acc. Depn
      • In long run, total earnings is the same
        • In short run, SL appears better
          • Can fool market into thinking firm doing better
    • There are NO cash flow consequences from changing policy!
    • Direct cash flow consequences?
      • e.g. FIFO/LIFO
        • FIFO increases earnings
          • Income increasing technique
        • LIFO decreases earnings
          • Income decreasing technique
        • Negative reaction to changing to LIFO
          • Adverse affects like high agency costs
            • Override initial tax benefits
            • Less money to pay in dividends or invest in firm

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