Capital Markets Research

(Using Archival Data)

Oriented towards financial accounting issues

Links with finance and economics

 Questions?
• Do earnings matter? (Ball and Brown, JAR, 1968;
Beaver, JAR, 1968)
• Are earnings components valued similarly?
• Do earnings have incremental information content
over cash flows
• Does the perceived quality of an auditor affect the
relation between earnings and returns?
• Are disclosures about pension benefits or other post-
retirement benefits value relevant?
• Would financial statements be more informative if
GAAP were changed to permit managers to capitalize
R&D?
 Developments in Finance
and Accounting
Finance Literature
Market efficiency -- Fama, 1970, 1971
-- prices fully reflect all available information

CAPM -- Sharpe, 1964; Linter, 1965

-- a model of firm-specific expected returns
 Developments in Finance
and Accounting
Accounting Literature
Positive Accounting Theory -- Watts and Zimmerman,
1986
• Predicts that the use of accounting numbers in
compensation and debt contracts and in the political
process will influence a firm's reporting choices

Valuation Theory -- Ohlson, CAR, 1995

• Provides accounting with theory, based on finance
theory, on how earnings and book values map into
prices.
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1

E1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1

A1 - L1 = E1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0

+ NI1

- Div1

A1 - L1 = E1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1

- Div1

A1 - L1 = E1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1
Return1
- Div1

A1 - L1 = E1 Price1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 Price0

+ NI1
Return1
- Div1

A1 - L1 = E1 Price1

We have 2 measures
of wealth and
changes in wealth
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1
Return1
- Div1

A1 - L1 = E1 Price1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1

- Div1 ↔ Return1

A1 - L1 = E1 Price1
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1

- Div1 ↔ Return1

A1 - L1 = E1 Price1

Observations:
• E0 = Price0
• NI1 = Return1 (cum div)
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1

- Div1 ↔ Return1

A1 - L1 = E1 Price1

Observations:
Returns happen everyday.
Earnings are reported
periodically.
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1

- Div1 ↔ Return1

A1 - L1 = E1 Price1

+ NI2

- Div2

A2 - L2 = E2
Relation between Accounting Equity Values
& Stock Market Equity Values

Accounting Measure of Wealth Market’s Measure of Wealth

A0 - L0 = E0 ↔ Price0

+ NI1

- Div1 ↔ Return1

A1 - L1 = E1 Price1

+ NI2
Are current earnings
- Div2 good predictors of
A2 - L2 = E2 future earnings?
NI1 = NI2
 Common Market-Based Tests

• Returns tests
– Event study
– Association test

• Price tests
 Event Study
• “Direct” link between information and use of
information
• Event (loose definition)
– Identifiable happening or announcement
that you can pinpoint in time
that provide NEW information
relevant to the market
• Short window (days)
 Event Study
• Like ---
– Earnings announcement (Compustat, IBES)
– Auditor change (press release, Dow Jones Interactive, Lexis/Nexis)
– Change in accounting standard (press release, Dow Jones Interactive,
Lexis/Nexis)
– New laws or regulations

• Does the market react to this event (or information from this
event)?

• Model:
Unexpected Returns = Unexpected Earnings
(or Other New Information)
 Issues in Event Studies
• Event date?
• Model? Unexpected Returns = Unexpected Earnings
• Event window? (cumulative abnormal returns [CARs])
• Expectation models?
• For returns
– CAPM (estimate parameters in event window/non-event
period and apply to event period)
– market adjusted returns (adjust by market index or industry
index or small cap and large cap index)
• For earnings (or other info)
– Last year’s earnings
– Last year’s earnings with growth
– Time-series model
– Analysts forecasts
 Association Tests
• Link between information and use of
that information
• Longer window tests (year)

• Two Basic Approaches --

 Earnings Responses Coefficient
Model?
(Un)expected Returns = Unexpected Earnings

(Un)expected Returns = INT + ERC*Unexpected Earnings + e

• Earnings are like an annuity
• So, an Earnings Responses Coefficient (ERC) should be near 1 + 1/rate
(where r is the risk adjusted discount rate for equity)

Economic Determinants of ERC--

• persistence, risk, growth and interest rate
•  control for in studies
• Kormendi and Lipe, JOB, 1987; Easton Zmijewski, JAE, 1989; Collins and Kothari, JAE, 1989
Some Problems with ERC Studies
• heavily statistical based -- time series of earnings
• predictive ability
• do not control for accounting methods –
• ERC coefficients too low (1 to 3)
- price lead earnings
- inefficient capital markets
- GAAP deficient
- transitory earnings
 Another Approach
Model?
Returns = Earnings + Changes in Earnings (Easton Harris, JAR, 1991)

• Earnings are an increase in the book equity value and returns are an
increase in the market equity value.
• So the coefficient on earnings should be one.
• Changes in earnings are like an annuity so coefficient should be near
1 + 1/rate

Some similar problems --

- price lead earnings
- inefficient capital markets
- GAAP deficient
- transitory earnings
 Price Tests
-- the longest window!
-- Ohlson theoretical work

Model Variations:

1. Price = Earnings

Earnings are an annuity

So, the coefficient on earnings should be near 1 + 1/rate
where r is the risk adjusted discount rate for equity

2. Price = Book Value

Book value is the accountants' measure of equity

Market Value is the Market's measure of equity
So, the coefficient on book value should equal one.
 Price Tests (continued)
3. Price = Book Value + Earnings

Price is a weighted average of book values and earnings

So, weights are also part of coefficients

Barth, Beaver, Landsman, JAE, 1998
Collins, Maydew, Weiss, JAE, 1998

4. Price = Book Value+Residual Income (or Abnormal Earnings)

where
residual income=current year's earnings - beginning book value * r
 Some Problems --
- value of r
- persistence of earnings
- GAAP deficient (for 4 it should not matter)
- GAAP conservative
- transitory earnings
- econometric issues -- size
 Other Areas to Investigate
• accruals and accruals models
• earnings versus cash flows
• disclosure versus recognition
• financial statement analysis
• properties of accounting earnings related to
corporate governance, ownership…
• market inefficiency explanations versus
behavioral explanations related to accounting
anomalies
• Usefulness of accounting information in credit
markets
 Useful Tools
• One page summary of research idea, research
question and motivation
• Kinney paragraphs
– What is the research question?
– Why do we care? (motivation)
– How are we going to answer?
• Libby boxes
– Economic construct
– Empirical proxies (& explanation)
– Variable description (& data source)