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Summary of the Lectures: Financial Accounting Research
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Every thing discussed in the lectured during FAR (Not the seminars)
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FinancialAccounting
Research
Summary of the Lectures
Given in 2021/2022 | Summary by LouisT
,Contents
Chapter 1. Introduction to the course ................................................................................................... 3
1.1 The Paper: Nicholas and Wahlen (2004) ................................................................................ 3
1.2 Back to Basic Statistics: Regression ........................................................................................ 9
2.1 Recap ..................................................................................................................................... 11
2.2 Conservative accounting ...................................................................................................... 11
2.3 Basu (1997)............................................................................................................................ 12
2.3.1 Main Hypothesis ........................................................................................................... 14
Chapter 3. Market-to-book ratio & Informativeness of accounting ................................................... 18
3.1 Last week........................................................................................................................... 18
3.1.1 Recap of Last week: Interactions ................................................................................. 18
3.2 Market-to-book ratio ........................................................................................................ 19
3.2.1 The AJAX Case ............................................................................................................... 20
3.3 Lev (2019) .......................................................................................................................... 21
3.4 Non-Gaap Reporting ......................................................................................................... 25
3.5 Summary ........................................................................................................................... 25
Chapter 4. Investors and accounting information ............................................................................... 26
4.1 Last week........................................................................................................................... 26
4.2 User’s processing of accounting information .................................................................. 26
4.3 Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future
Earnings? Sloan (1996).................................................................................................................. 27
4.3.1 Introduction .................................................................................................................. 27
4.3.2 Theory ........................................................................................................................... 28
4.3.3 Hypothesis..................................................................................................................... 29
4.3.4 Theory (Continuation) .................................................................................................. 29
4.3.5 Hypothesis (Continuation)............................................................................................ 30
4.3.6 Research Design ............................................................................................................ 30
4.3.7 Descriptive Statistics ..................................................................................................... 33
4.3.8 Results ........................................................................................................................... 33
4.3.9 Conclusions ................................................................................................................... 37
4.3.10 Behavioral Theories ...................................................................................................... 37
4.4 Learning Objectives .......................................................................................................... 37
Chapter 5. Earnings Quality .................................................................................................................. 39
5.1 Last week........................................................................................................................... 39
5.2 Case: “Under Armor” ........................................................................................................ 39
5.3 Earnings management ...................................................................................................... 39
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, 5.4 Dechow and Dichev (2002) ............................................................................................... 40
5.4.1 Why do accrual estimation errors occur? .................................................................... 40
5.4.2 Empirical Model ............................................................................................................ 42
5.4.3 Results ........................................................................................................................... 43
5.4.4 Conclusions ................................................................................................................... 44
5.4 Stubben (2010).................................................................................................................. 45
5.4.1 How to measure earnings management? .................................................................... 45
5.4.2 Measuring discretionary revenues ............................................................................... 47
5.4.3 Results ........................................................................................................................... 47
5.4.4 Evaluating the models .................................................................................................. 49
5.4.5 Conclusions ................................................................................................................... 50
Chapter 6. Economic Consequences by a change in regulation .......................................................... 51
6.1 Last week........................................................................................................................... 51
6.2 Causal Inference................................................................................................................ 52
6.2.1 Counterfactual analysis ................................................................................................ 52
6.3 Landsman et al. (2012) ..................................................................................................... 54
6.3.1 Concepts ........................................................................................................................ 54
6.3.2 X and Y and Hypothesis ................................................................................................ 54
6.3.3 Research Design ............................................................................................................ 55
6.3.4 DATA.............................................................................................................................. 56
6.3.5 Main Results.................................................................................................................. 56
6.3.6 conclusion ..................................................................................................................... 58
Chapter 7. Final Examination ............................................................................................................... 59
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,Chapter 1. Introduction to the course
During this course, we want to introduce and expose students to research topics and methods in
financial accounting and reporting. We will focus on empirical financial accounting research. So why
is this relevant?
Example: Consequences of IFRS 15
This is about new revenue recognition rules. The period in where you will recognize these revenues
changed. However, there’s no effect on the fundamental value or cash flow. This is relevant because
we usually look at what happened in the last fiscal years, while suppliers etc. generally look forward
because the past = past. In addition, we have deferred, like deferred tax liability/asset. The longer it
takes to recognize these, the longer the uncertainty.
Questions that could arise are:
• Do accounting rules matter at all?
• How does this change affect investors? Can investors see through the effects of the
accounting change on reported profits?
• How does this change affect managers’ decisions and reporting strategies?
Another example: Consequences of IFRS 16
This is about the new accounting rules for Lease. It was reported but generally off-balance sheets.
These were recorded in the footnotes. Now they changed it that it will be reported on the balance
sheet. However, this doesn’t change the payment, only the disclosure. This raises three questions:
• Does recognition versus disclosure matter? Do investors and other stakeholders understand
the difference?
• Does this change affect managers’ decision-making, and if so, why?
• Does the increase in liabilities on the balance sheet affect the cost of firms’ external
financing?
Our Focus
We will focus on: “Financial Reporting Topics” and “The consequences of accounting information
for investors and managers”.
We will not include: “Contracting”, “Regulation”, “Auditing”, “Debt markets”, “Nonfinancial
Reporting”, “CSR”, “Corporate Governance”, “Compensation”.
As we focus on the users, this is in line with the focus of standard setters, such as the IASB. Within
the Conceptual Framework, the IASB explains that the objective of financial reporting is to provide
information that is “useful to users”. Not only the IASB and investors see this relevance. CFO also
looks and wants to focus on the earnings as investors consider it relevant.
1.1 The Paper: Nicholas and Wahlen (2004)
First, think about Philips. On Monday, October 28th, 2019, Philips reported earnings lower than last
year in the same quarter. The stock price drop of -1,79% that followed, makes sense but can we also
explain this theoretically and empirically?
Introduction
The paper summarizes the intuition (the theory). Intuition/theory is a mechanism that when you do
one thing, something else happens. They don’t necessarily happen, which is the reason why we have
to determine why something happens in a specific case.
3
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,This presents a framework to link the earnings and stock returns, which replicated and extended
three prior studies, which are:
• Relation between earnings and returns: Ball and Brown (1968)
• The role of earnings “persistence” in this relation.
• Market efficiency and the speed of stock market reactions to earnings news.
Earnings = New Income = “Bottom-Line” Measure of accounting performance. This is an accrual
accounting measure of the firm’s profit or loss from business activities and events during a quarter or
annual period. It is an accounting measure of the change in the value of the firm common equity
shareholder during a period.
Stock Return = Relative change in stock price of a firm = . Stock returns equal the
change in the market value of a firm over a period plus any dividends that are paid. This represents
the stock market’s estimate of the firm’s bottom-line performance over the period.
Why would we care about this relation (Ball and Brown (1968))?
We use a lot of money in hiring accountants/auditors, why do we use this kind of money to look back
at the results, while investors generally look forward. When you look at the accounting numbers and
stock numbers. Empirically, they move together but it isn’t very timely. This means that at the time
the accounting numbers come out, most of the effect has already happened. So most of the
information is already reflected in the market value. In addition, it is not complete. The data tells us
that the market isn’t efficient as it takes time to find out the meaning. So it is useful, but not timely
and complete.
A reason why people still care is that when the firm reports its numbers now, investors will use it to
predict future earnings. Therefore, you may find the information relevant as it develops expectations
about dividends in future periods.
Lastly, you can determine the share value, which represents the value of expected future dividends,
where we can use the Discounted Dividends Model (DDM). When we know the earning numbers,
we can use this information to determine the value of the share. We care when we receive dividends
or sell the share at a certain price. This means we have to form expectations of future dividends, in
practice, some young firms do not pay dividends. Then we look at the free cash flow. Cashflows are
part of accounting earnings, when we understand cashflows, we can understand the dividends.
The Framework
4
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, Link 1
The theory of Link #1 assumes that earnings and financial reporting more broadly provides
information to investors about current, and expected future, profitability.
1. Current period earnings summarize information about the wealth created by the company
during the period for shareholders.
2. Current period earnings provide information useful for prediction.
IASB: Predictive Value
Link 2
The theory of Link 2 assumes that current and future earnings are informative about dividend
distributions. From practice and academic insights, we know this assumption is valid: dividends are
typically linked to earnings. Even if no dividends are paid, the firm could pay higher dividends it was
more profitable.
Link 3
The theory of link 3 goes back to our valuation example and assumed that share prices equal the
present value of expected future dividends to the shareholders.
Simply put, the framework explains that the information in earnings should relate to changes in stock
price because earnings are informative about the future dividends/cash flows/earnings the company
is expected to generate. Therefore, these are explained:
1. Why investors often use earnings-based valuation metrics, such as P/E multiples.
2. Why capital market participants and the media pay so much attention to earnings.
3. Why analysts develop and publish their earnings forecasts.
4. Why do companies often hold “conference calls” after their earnings announcement to
discuss the prospects for the next quarter?
In addition, the framework helps us to create tests of how the relation between earnings and returns
might vary across different firms or accounting regimes.
Earnings Persistence
This is the likelihood of whether or not the earnings level will recur in future periods. We need to
understand this to move through this framework. An example is a savings account. Consistent
interest, constant interest rate. The prediction is that more persistent earnings should have a
stronger impact on stock prices. We have to design a test and add complexity.
Persistent Earnings
A firm with an 8% discount rate and persistent earnings of 1 euro per year. V0Share = 1 Euro + 1,00 /
0,08 = 13,50 euro. The present value should yield a present value of 13,50 euro. If we know this will
happen multiple years, then we know this has a high impact as you discount more to the V0share.
One Time
In the case when a company books an additional, one-time gain of 0,50. You do not discount this as it
doesn’t happen in subsequent years. You simply just add this 0,50 to the V0Share. Therefore, this has
less impact as it doesn’t happen multiple times.
Now an impairment. Back to the example of Philips. An impairment charge is only one time, as seen
before, this does not impact the V0share too much. Therefore, the impact on the share value is
limited, which is confirmed by the only 1.7% decrease. In addition, the limited drop was that this
impairment was already announced by the company, and partly reflected in the stock price.
5
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