Things to learn

Is accounting information relevant to stock markets?

Historical cost/Fair value?
Efficient market hypothesis
Expectations
Ball and Brown 1968
Beaver 1973
Lemons, Ackerlof 1970
Cost of Capital Disclosure
Signalling
Functional Fixation Hypothesis
Recognition Lag

Before Ball & Brown (1968)

1. Financial statement information prepared under existing reporting rules is

meaningless; (heterogeneous rules, a proverbial apples and oranges issue)
and
2. Radical changes in the nature of financial statement information are required.
Chambers, 1976; It is futile to expect a "financial position" to be "fairly
presented"
Due to different measures: historical costs, depreciation, fair value... LIFO FIFO..
Etc
Aggregates of such amounts have no meaning whatever; they fairly

present nothing in the nature of a dated financial position.

Only a system of accounting which makes use of one valuation method

will yield
intelligible figures for assets and income,
Only figures that use consistent valuation method and "dated value in
exchange"

Pre BB68 research Issues

data availability
The share market was not seen as a suitable area of accounting research.
Accounting literature was focused on its own accounting measurement models
Demonstrating that financial statements are in some sense imperfect does not
mean that they are inefficient and should be changed. Leftwich (1980)
A related problem is that financial reporting is an economically costly activity.
The existence of pathological cases such as bankruptcies and accounting
scandals in which reporting imperfections were subsequently revealed does not
imply that the frequency of such cases is too low, too high, or optimal.
Andersen and Leftwich (1974)
Considerable quantities of other information are used alongside accounting
information, and even to explicitly adjust accounting information. An efficient
aggregate information environment is not inconsistent with imperfections in any
individual source, financial statements included.
Fama (1965a, 1965b) made the conceptual breakthrough of framing stock
prices as a function of information flows

BALL AND BROWN (1968)

Are accounting numbers useful?

Two derivative questions are:
useful to whom?
useful for what purpose?
The Efficient Market Hypothesis (EMH) is a core component of the BB68 research
design
EVENT STUDY
The event we chose is the announcement of the annual accounting
income number, or earnings for the year.

Three statistical measures of the newsworthy component, or forecast errors

they were computed by fitting:
(1) a Market Model to the year-to-year changes in prior years net income of
the firm and in a self-constructed market index of earnings,
Gave consistency between models of earnings changes and of stock
returns
(2) a similar Market Model of changes in EPS
(3) by assuming EPS could be sufficiently well described by a random walk, which
we viewed as a special
case of the Market Model
(when the firms earnings changes were uncorrelated with the earnings
changes of other firms, and the firm was stagnant so that the constant
term in the Market Model had a true value of zero)
Used as a robustness check.
The initial objective was to assess the usefulness of existing accounting income
numbers by examining their information content and timeliness. Its content is
considerable. However, the annual income report does not rate highly as a
timely medium Ball and Brown (1968)
the relationship between the sign of the income forecast error and that of the
stock return residual might have persisted for as long as two months beyond the
month of the announcement (1968)
because accounting has been practiced for centuries and accounting reports are
costly to produce, accounting as an economic activity could not possibly have
survived for so long unless there was a demand for it Ball and Brown 2013
Findings
Around 85-90% of the price adjustment occurs before the announcement month
Possible sources of the leakage of earnings-related information are earlier
announcements of dividends, earnings in interim periods, contracts won,
production figures, and so forth.
However, most of the information contained in reported income is anticipated by
the market before the annual report is released. In fact, anticipation is so
accurate that the actual income number does not appear to cause any unusual
jumps ... in the announcement month (1968)
measuring the unexpected component and forecast error in earnings
announcements (1968)
conducted a variety of robustness tests, including arithmetic versus log returns,
different earnings expectation models, an ex post version of the Capital Asset
Pricing Model versus the Market Model of stock returns, etc.

AFTER BALL AND BROWN

IX. SOME LITERATURE THAT ENSUED

One reason for the success of BB68 was that it opened up a variety of research
possibilities on the relation between financial statement variables and stock
prices. The following is a sampling of research that ensued in approximate
chronological order:

1. International replication of the results, starting (no surprise here) with

Australia
(Brown 1970, 1972);

2. Extending the results to quarterly earnings announcements, in

Brown and Kennelly (1972);

3. Investigating the time-series behaviour of accounting earnings, starting with

the
Ball and Watts (1972) verification that the random walk process we assumed
when
calculating unexpected earnings is in fact a reasonable characterization;

4. Extending the earnings-returns relation to higher moments by studying the

relation
between accounting and market measures of risk
(Ball and Brown 1969; Beaver et al. 1970);

5. Studying the relation between firms changes in accounting techniques and

their stock
prices (Ball 1972). Following the insights of Watts (1977), this work took a
radical
turn to studying firms opportunistically lobbying standard setters to influence

mandatory accounting techniques (Watts and Zimmerman 1978) and

choosing
accounting techniques to influence debt constraints and management
compensation
(Holthausen 1981). This line of thinking then led to the modern earnings
management literature.

6. Earnings forecasts issued by managers (Foster 1973) and analysts (Griffin

1976); Applying the automobile industry analogy above, how can cars be
redesigned without any knowledge of how
they are driven, what they are used to transport, whether they are simply kept
for show, etc?

7. Using daily returns (Foster 1977) and short event windows to estimate linear
earnings response coefficients (Beaver et al. 1980; Hagerman et al.
1984);

8. Information transfers between firms that are associated with earnings

announcements
(Firth 1976; Foster 1981);

9. The nature and determinants of post-announcement drifts in share prices

(Foster et al.1984; Bernard and Thomas 1990);

10. The distinction between recognition and disclosure

(Beaver et al. 1989).

11. Non-linearities in the returns-earnings relation (Freeman and Tse 1992),

which
Hayn (1995) attempted to explain in terms of corporate liquidation options and
Basu
(1997) attributed to conditional conservatism, under which timely loss
recognition
generates more large negative transitory earnings components than positive;

12. Earnings decomposition into cash flow and accruals

(Dechow 1994; Sloan 1996);

13. Exploiting cross-regime effects such as international differences (Ball et al.

2000) and
differences between private and public companies (Ball and Shivakumar
2005) to
better identify the economic and political determinants of important properties of
financial reporting, such as timeliness and conservatism.

14. Aggregate earnings and returns (Kothari et al. 2006).