CHAPTER 5 The Information Approach to Decision Usefulness 5.1 5.2 Overview Outline of the Research Problem 5.2.1 Reasons for Market Response 5.2.2 Finding the Market Response 5.2.3 Separating Market-Wide and Firm-Specific Factors 5.2.4 Comparing Returns and Income 5.3 The Ball and Brown Study 5.3.1 Methodology and Findings 5.3.2 Causation Versus Association 5.3.3 Outcomes of the BB Study 5.4 Earnings Response Coefficients 5.4.1 Reasons for Differential Market Response 5.4.2 Implications of ERC Research 5.4.3 Measuring Investors’ Earnings Expectations 5.4.4 Summary 5.5 5.6 Unusual, Non-recurring and Extraordinary Items A Caveat About the “Best” Accounting Policy
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Instructor’s Manual—Chapter 5
The Information Content of Other Financial Statement Information Conclusions on the Information Approach
LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1. To Appreciate the Information Perspective on Decision Usefulness of Financial Reporting I begin coverage of this chapter by pointing out that we are now starting to apply decision theory and efficient securities markets theory to better understand the role of financial reporting to investors. The first step is to develop the concept of the information perspective. I briefly review the Bill Cautious decision theory example 3.1 and emphasize that it is Bill Cautious, not the accountant, who has the primary responsibility, and motivation, to predict future firm performance. The role of the accountant is to supply useful information in this regard, and not necessarily to make direct predictions about current and future firm value. To the extent that it facilitates investor predictions of future firm performance, historical cost-based information can be useful even though it does not directly reveal values. This is the essence of the information perspective. I often play “devil’s advocate” at this point and suggest to the class that the information perspective implies that the accountant/auditor is “off-the-hook” should a firm fail without a warning from the historical cost-based financial statements. I suggest that if the role of the financial statements does not include a direct prediction of firm value, the accountant/auditor is not responsible if it turns out that, in retrospect, the financial statements proper did not foresee financial distress. I try to steer the resulting discussion to a conclusion that while accountants/auditors may like this argument, it is not clear that investors, regulators, and the courts will accept it. I also point out that accountants are in competition with other information sources, pursuant to Beaver’s 1973 paper reviewed in Section 4.3. Repeated complaints by investors that financial distress was not predicted can only erode the accountant’s competitive position. With a view to the measurement perspective to be introduced in Chapter 6, I ask if accountants Copyright © 2009 Pearson Education Canada 127
Instructor’s Manual—Chapter 5
could improve their competitive position by assuming greater responsibility for reporting on fair values. 2. To Introduce Empirical Securities Markets-Based Accounting Research
The body of research in this area is vast. I concentrate in this chapter on providing a framework within which the research can be interpreted, rather than trying to cover very much of it per se. To establish this framework, I begin by pointing out that the empirical research addresses some very fundamental and interesting questions — do investors use the accountant’s product? If they don’t, of what value is financial reporting? I then argue that the framework is provided by the decision theory model, again referring back to Example 3.1 — if investors find financial accounting useful, then we should see trading volume and securities prices responding in predictable ways to accounting information. Having said this, I then point out...