Term
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Definition
uses historical accounting; doesnt consider measurement of amounts
the release of accounting information results in trading:
1. price &/or volume reaction
2. predicted direction |
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Term
| Why does the information approach use historical accounting? |
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Definition
| because historical costs are useful for decision making |
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Term
| What is the measurement approach to decision usefulness? |
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Definition
| an approach to financial reporting in which accountants undertake a responsibility to report current values into financial statements properly, providing that this can be done with reasonable reliability and therefore increasing the obligation to assist investors in predicting firm performance & value. |
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Term
| Advantage of using current values? |
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Definition
| enables better predictions |
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Term
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Definition
-reduced reliability vs. increased relevance
-reduces market inefficiency because more relevant current values aid in predicting future performance
-value-relevance focus: improves explanation of variation as window lengthens
- reduce auditor liability |
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Term
| Earnings response coefficients (ERC) |
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Definition
| an economic approach that associates earnings with returns; as earnings persistance increases so does ERC. |
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Term
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Definition
is a statistical measurement of how closely changes in stock price track earnings surprises (tries to predict return) ; falls inbetween 0 and 1
- r squared is statistically significant but many times economically insignificant |
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Term
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Definition
| the closer the dots are to the line, the higher r squared will be. A high r squared tells us that all movements in the security are completely explained by movements in the index. |
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Term
Low ERC tells us.....
Greater ERC tells us.... |
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Definition
that income will not persist.
the effect of earnings surprise on future earnings (aka persistence) |
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Term
| What could be the cause of low r squared and erc? |
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Definition
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Term
| Greater persistence is associated with..... |
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Definition
| a more permanent earnings surprise |
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Term
| What improves a low r2? why? |
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Definition
| measurement approach will make r2 higher because better measurement improves the accounting ability to explain share price changes |
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Term
| what is fundamental value? what is market inefficiency? |
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Definition
| when the efficient price is different from the fundamental value. the fundamental value is what the company is actually worth |
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Term
| issues related to market efficiency |
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Definition
| irrational investor, CAPM, prospect theory and anomolies |
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Term
| How do irrational investors contribute to market inefficiency? |
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Definition
- limited attention (focus on EPS; ignore notes to f/s)
-Conservative- revise beliefs less than that predicted by bayesian theory
-overconfidence- assign more weight on investor's own evidence
- representativeness/recency effect
- self-attribution bias- momentum(keep going on the good thing) |
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Term
Prospect theory and what does it result in?
(Tversky and Kahneman) |
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Definition
different evaluation of gains vs. losses
-- loss aversion
-- can lead to disposition effect- hold on to losers, sell the winners
--under to overweight posterior probabilities
-- is an S curve, unlike the decision theory wealth maximization
-- source of market inefficiency |
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Term
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Definition
discontinuity of reported earnings right below zero (less reporting of small losses than would be expected)
Consistent with prospect theory
suggestive of earnings management |
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Term
| Is market inefficiency a product of CAPM and beta? |
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Definition
YES.
Beta is not stationary
beta alone is not efficient to predict share prices
CAPM is too stationary nd does not take into effect other characteristics such as industry, size, risk etc. even it is included, it does not provide much different results |
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Term
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Definition
| suggests beta does not completely capture market risk, need additional measures |
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Term
| What are the additional measures to beta that will help capture market risk according to Fama and French? |
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Definition
Book to market ratio (Growth)
Firm size
Industry |
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Term
| What are market anomalies and give examples? |
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Definition
- a documented prediction of what the market will do inconsistent with what we would expect
- securities are not fully efficient but close enough to provide evidence of reporting implications
-PEAD
-accrual anomaly |
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Term
| Post Earnings announcement drift (PEAD) |
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Definition
- an economically significant anomaly
- delay of stock price change after the announcement- "drifting"
-go long on the good news, good short on the bad news. it creates abnormal returns
-want ones that will drift up so you can sell for more later |
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Term
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Definition
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Term
| Bernard and Thomas (1989) |
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Definition
-analysis of abnormal returns (CARS) around earnings announcements to see if there was post earnings announcement drift
-unexpected earnings based on forecasts and prior earnings |
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Term
| small firms vs. medium vs. large firms and their PEAD |
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Definition
s- have very drastic drift
m- no drift
l- little drift |
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Term
| What will make ERC more steady? |
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Definition
| if you have more CF info; ERC increases with the proportion of operating cash flows to accruals |
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Term
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Definition
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Term
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Definition
-studied accrual anomaly
RQ: Are accruals and cash flows info about future earnings reflected in stock prices?
-talks about two equations:
1. earnings persistence (next period earnings as a function of current period cash flow and accruals)
2. market valuation- does not consider persistence |
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Term
| What were Sloan's findings? Trading strategy? |
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Definition
-operating CF are more reliable/persistent than accruals
- next years earnings are more associated with current year's cash flows (given persistence)
- market responses to good news and bad news did not take into account the differential persistence
- trading strategy of long(short) low(high) accrual firms |
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Term
| Why do anomalies continue to exist? (2) reasons |
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Definition
1. Behavioral finance -working with irrational investors
- suggest that inconsistent CAPM results are evidence of inefficient markets
- share returns driven by over-confident investors, not beta
2. Rational investors- we cant completely wipe out the anomaly
- transaction costs
- idiosyncratic risk (to exploit, must depart from diversified investment strategy)
- inability to short all the stocks needed (increases cost and cant always short a stock) |
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Term
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Definition
financial reporting can be used to move an inefficient price toward an efficient one and an efficient one to a fundamental value.
- reduced behavioral biases
- reduced share mispricing |
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Term
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Definition
| most useful model to guide accountants about investor decision needs |
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Term
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Definition
| earnings only explains a small portion of the variation in stock price |
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Term
| What is the residual income model's focus, basis, and assumptions? Who created this model? |
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Definition
Ohlson/Feltham model
- focuses on value relevance; considers more than earnings
-based on b/s info- links valuation(discounted dividend model) to accounting information
- firm value = net assets +/- present value of future abnormal earnings
- by using clean surplus assumption and linear info dynamics, its states price as a function of BV of equity and goodwill
- assume OCI is 0 |
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Term
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Definition
| all gains and losses go through net income (ignores OCI) |
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Term
| Linear information dynamics |
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Definition
-links the future with the present
- allows one to state firm value in terms of current numbers
- allows us to use current abnormal earnings rather than expected present value |
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Term
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Definition
=f(bv of equity, goodwill)
- goodwill(in a valuation sense) is captured through expected PV of abnormal earnings (or residual income) |
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Term
| RIM vs. measurement approach |
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Definition
-more current value accounting puts more on the balance sheet
- less need to estimate unrecorded goodwill(valuation)
-supports measurement approach |
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Term
| review example 6.1 from the text |
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Definition
| seperate handout and video online |
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Term
| Why do we have conservatism? |
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Definition
pressure to stretch GAAP(manage earnings)
-- influence of auditor legal liability and investor losses |
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Term
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Definition
- correlation b/t share returns and earnings is stronger for firms doing poorly
- market is quicker to include negative performance as opposed to good performance |
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Term
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Definition
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Term
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Definition
- financial instruments
-LCM for inventory
- impairments
- asset retirement obligations
- stock based compensation
- pension |
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Term
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Definition
-recorded at cost
- no amortization
-impairment analysis
- goes on f/s |
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Term
| Self- developed intangibles |
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Definition
-hard to determine fair value
- costs are expensed as incurred |
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Term
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Definition
TW paid a lot for AOL but AOL didnt have many tangible assets.
April 2002 - $54 billion write down (primarily good will); stk price initially rose, then continued downward trend
January 2003- $45.5 billion write down; analysts didnt care but investors did. |
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Term
| what happened in result of the two write downs during AOL/ TW merger? |
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Definition
| management credibility was questionable. the write off says the buying company overpaid. |
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Term
| Lev & Zarowin (1999)What did they focus on? Why has the usefulness of financial information declined over time? |
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Definition
- focused on R&D and low change firms vs. high change firms
- Low R2, low ERCs
- accounting systems are based on old type of firms
- current accounting doesnt capture the R&D costs bc we expense them |
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Term
| What were Lev and Zaros findings? Recommendation? |
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Definition
-high change: decreasing usefulness of earnings information for research intensive firms (changing portfolio firms); reducing r2
- low change firms- usefulness increases; constant r2
Recommendation: capitalize R&D at a certain point and then amortize instead of just expensing it. |
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Term
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Definition
finance theory
discount using risk-adjusted rate (risky) |
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Term
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Definition
- multiple scenarios (risky)
- uses risk free rate |
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Term
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Definition
-residual income model
-based on financial statement information; links valuation(discount dividend model) to accounting info
- |
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Term
| look at biased accounting example |
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Definition
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Term
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Definition
-cash flows are better able to predict the future but the market reacts to accruals whether high or low. this shows market inefficiencies partially because of CAPM issues but mostly because of overconfident investors rather than beta. go long on low accruals, go short on high accruals
-" markets are close enough to being efficient on a semi strong market basis" |
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Term
| persistent earnings have ____ goodwill than nonpersistent |
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Definition
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Term
| biased accounting vs. unbiased accounting |
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Definition
biased: does not have goodwill
unbiased: has goodwill bc of historical cost accounting |
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Term
| Burgstahler and Dichev Findings |
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Definition
If earnings are increasing, then managers feel more pressure to continue the earnings increase. The pressure is even greater when earnings have increased for numerous years.
-Findings are consistent with the prospect theory |
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