Chapter 5 Flashcards
What does value relevance mean in accounting?
Financial information is value relevant if it influences stock prices when disclosed
Why is value relevance important?
It shows whether financial statements help investors make better decisions
How can we determine if accounting information is value relevant?
By measuring the impact of financial disclosures on stock prices
What is the Ball & Brow (1968) study about?
It examined how earnings announcements affect stock prices
What was the main finding of the Ball & Brown study?
Stock prices react to earnings announcements, providing that financial statements provide useful information
What does it mean if stock prices begin to change before earnings are released?
Investors may anticipate earnings trends based on other information sources
What was the main limitation of the Ball & Brown study?
it only measured earnings, not other factors influencing stock prices
What is an abnormal return?
A stock price movement that cannot be explained by overall market trends
How do we calculate abnormal returns?
Abnormal return = actual return - expected return
Expected returns are based on market movements
What happens when a company announces better-than-expected earnings?
Stock prices rise (positive abnormal return)
What happens when a company announces worse-than-expected earnings?
Stock prices fall (negative abnormal return)
What is the Earnings Response Coefficient (ERC)?
A measure of how strongly stock prices react to earnings announcements
What does high Earnings Response Coefficient (ERC) indicate?
That earnings strongly influence stock prices
What factors can affect Earnings Response Coefficient (ERC)?
Earnings quality (high-quality earnings –> higher ERC)
Firm risk (higher risk –> lower ERC)
Growth opportunities (more growth potential –> higher ERC)
Capital structure (high debt –> lower ERC)
Why is there are tradeoff between relevance and reliability in accounting?
More relevant information (example: fair value) is often less reliable, while more reliable information (example: historical cost) may b e less relevant
How does this tradeoff affect the usefulness of earnings reports?
Investors may discount unreliable estimates and focus on more verifiable numbers
What factors influence whether accounting information is value relevant?
Earnings persistence (steady earnings –> higher value relevance)
Accounting policies (transparent policies –> higher relevance)
Industry type (some industries rely less on accounting numbers)
How does earnings persistence affect value relevance?
More persistent earnings help investors predict future performance, increasing value relevance
How does earnings volatility affect value relevance?
High volatility reduced predictability, lowering value relevance
What is classification shifting in accounting?
Moving fixed costs into extraordinary items to make earnings look more stable
Why does classification shifting mislead investors?
It overstates recurring earnings, making the company appear more profitable than it is
How can classification shifting be reduced?
By separately reporting direct and allocated costs
What are some implications of value relevance research?
Earnings quality matters (higher quality earnings = high stock price impact)
Transparent financial reporting is essential (hidden adjustments reduce investor trust)
Accounting standards affect investor decisions (rules that improve comparability help markets function better)
Why is earnings persistence important for investors?
It helps predict future earnings, making financial statements more valuable
How do investors use non-GAAP measures?
They look at adjusted earnings, but these are less standardized and may be misleading
Why is full disclosure important in financial reporting?
It ensures investors have all relevant information to make decisions
What types of information should firms disclose to increase value relevance?
Earnings quality indicators
Risks and uncertainties
Changes in accounting policies
Growth opportunities
How does market efficiency impact value relevance?
In an efficient market, only new information affects stock prices
Why do stock prices react less to expected earnings?
Because expected earnings are already priced by investors
Can financial statements still be useful in an efficient market?
Yes, because they help confirm investor expectations
