Chapter 8: Capital market research and accounting Contemporary issue 8.1 Economists and the global financial crisis Questions Who was John Maynard Keynes? To what does the author attribute the causes of the global financial crisis? How did the efficient market hypothesis contribute to the crisis? 1. John Maynard Keynes was a British economist who influenced the theory and practice of macroeconomics (Keynesian economics), as well as the economic policies of governments. Refining the existing work on the causes of business cycles, he advocated the use of both fiscal and monetary policies and measures to mitigate the adverse effects of economic recessions and/or depressions. 2. The author attributes the causes to two dimension, one microeconomic and the other macroeconomic. The microeconomic refers to “the epoch of privatisation, public-private partnerships and market-mimicking arrangements of many different types, all based on the assertion that ‘state failure’ was invariable a more serious problem than market failure”. The macroeconomic dimension has two parts. “The first was a belief in the underlying stability of the (private) capitalist economy, if it was not disturbed (‘shocked’) by mistaken government intervention. The second was a belief in the efficiency of financial markets, which therefore required only the lightest of government regulation, if any at all”. 3. Belief in the EMH lead to much deregulation of national and international financial transactions, deregulation which encouraged “foolhardy behaviour on a massive scale by large corporate players in financial markets and in discouraging any serious attempt at governmental regulation”. Contemporary issue 8.2 Mathematical models Questions If mathematical models were abandoned, what could replace them? Discuss whether mathematical models are better to be partly right rather than totally wrong. Should decision makers be more mathematically literate so that they understand the limitations of the models they use or should the models be extensively tested before use? 1. Models would probably be expressed in verbal terms with accompanying diagrams or flowcharts - a back to the future solution. 2. Discussion should include the realisation that no model is likely to be completely accurate, that there is a need to test models before they are put into use, and that users of the model should understand what has been simplified in the model and the ramifications of that simplification. 3. Both alternatives could be defended. Contemporary issue 8.3 Black swan events Questions What is a black swan event? How do black swan events illustrate the limits of theory? Why was the global financial crisis labelled a black swan event? What advice can be drawn from financial market black swan events? 1. Until black swans were discovered in Western Australia it was thought (hypothesised) that all swans were white. Since the discovery of white swans, the term, black swan event, refers to an impossible event that should not happen. Currently black swan events are rare events beyond the realm of expectation so that they come as a surprise, have a major impact or consequence and are only rationalised with the benefit of hindsight. 2. Theory can either be confirmed or refuted. Karl Popper’s idea was that no amount of data can confirm a theory and that a single conflicting datum can falsify the theory. Each time a European saw a white swan, it confirmed the theory that all swans were white. The sighting of black swans meant that the theory no longer held. Researchers who find results that confirm their theory should expect that a black swan event is possible. Most researchers do not discard a theory when something disagrees with it but look for reasons why there is this disagreement. This search may result in the revision of the theory. 3. The mathematical models (collateralised debt obligations) behind the sub-prime mortgages global financial crisis (GFC), allowed the determination of the correlation between the default rates of different securities so that the chances of default on the securities could be predicted. As profit margins on the CDOs narrowed, lesser quality loans (housing mortgages) were brought into the CDOs. The models did not include these risky loans so that the financial crash of the United States housing market in 2008 caused a black swan event because the GFC began with a credit crunch, which led to a loss of confidence by US investors in the value of sub-prime housing mortgages which in turn caused a liquidity crisis. By September 2008, the crisis had worsened as stock markets around the globe crashed. No theoretical model saw it coming. 4. Because black swans are hard to predict they will probably cause a major shift in the perceptions of investors. With black swan events in the recent past, could others be lurking? Answers are hard to come by. Neither market analysts nor media outlets are likely to be reliable guides for when and where potential black swans might emerge again. The advice that can be drawn is that strong convictions about shares or the stock market in the long term is surely more foolish than believing something on a shorter time frame. The longer the timeframe the more guesswork. As well, to think that a long-term promise about a share or to make a long term judgment about a share on the basis of the available evidence is irrational.
Review questions 8.1 Explain what is meant by an ‘efficient market’. An efficient market is one in which share prices reflect fully all available information. 8.2 Distinguish an event study from an association study. An event study examines the changes in the level or variability of share prices or trading volume around the time when information is released. This information is assumed to be information new to the market if share prices or trading volume reacts to this information. In contrast, an association study aims to see how quickly accounting measures capture changes in the information reflected in share prices over a given period. 8.3 Explain why accounting earnings do not capture all the information contained in share prices. Accounting earnings do not capture all the information contained in share prices because they are calculated using the conservative principles of revenue realisation and expense matching which do not recognise all the events that are incorporated into share prices. Additionally, these principles result in bad news being disclosed in a more timely manner than good news, reflecting the less stringent accounting recognition criteria for bad news. 8.4 Explain how accounting’s recognition and realisation principles affect the relationship between earnings and share prices. Accounting’s recognition and realisation principles are conservative and backward looking so that they do not allow the recognition of all events that investors use to make predictions about future performances of the reporting entity. 8.5 What is meant by the term ‘post-earnings announcement drift’? What implications does this phenomenon have for the efficient market hypothesis? ‘Post earnings announcement drift’ refers to the evidence that stock markets underreact to earnings information — there is not an instantaneous, complete reaction to value-relevant information but rather a gradual adjustment to the information. This gradual adjustment contradicts the EMH which assumes that markets react instantaneously and completely to all value-relevant information. 8.6 In what ways are the finance definition of ‘relevance’ and the Conceptual Framework definition provided in chapter titled ‘The Conceptual Framework for Financial Reporting’ similar? According to the finance literature, an item of information is relevant if it has the ability to make a difference to the decisions of users of that information so that these users modify their expectations about future payoffs or associated risk. Accounting definitions of relevance refer to information which influences the economic decisions of users by helping them either predict or confirm their past evaluations or past events. In both definitions, users are expected to modify their beliefs based on the information. 8.7 When is an accounting number said to be ‘value relevant’? An accounting number is assumed to be value relevant only if the amount reflects information relevant to investors in valuing an entity, and if the amount is measured reliably enough to be reflected in share prices. 8.8 Explain why earnings are not good measures of value relevance. Accounting earnings capture only those events that pass the criteria for recognition. Investors are assumed to focus on all events that affect future cash flows of an entity. Additionally, accounting earnings can be negative which tells investors little about the future cash flow generating ability of the reporting entity. 8.9 International accounting standards are conservative in their treatment of intangibles. Will this conservative treatment conflict with investors’ perceptions of the value of intangibles to a firm? Accounting’s conservative treatment of intangibles (largely they are expensed) conflicts with investors’ perceptions of the value of intangibles to an entity. The costs of intangible assets have been shown to be relevant to investors, but investors perceive the expenditures as capital acquisitions, in contrast to the accounting treatment of expensing such expenditures. 8.10 Summarise the main findings of the value relevance literature in relation to accounting. The relationship between accounting earnings and share returns is weak. Accounting earnings do not capture all the information incorporated into share prices. Evidence on decomposed earnings and share prices is contradictory. Investors seem to value fair value accounting more than historical amounts. Consolidation improves the value relevance of earnings. There is information content in earnings announcements. 8.11 What principles are blamed for financial statements being poor indicators of value? How do these principles inhibit valuation? Revenue recognition and expense matching are blamed for financial statements being poor indicators of value. These principles inhibit valuation because they favour the recognition of bad news over good news. 8.12 Read the section on earnings management in chapter 6. How does that view of earnings management differ from the view held in the finance literature? Why would investors react positively to earnings management? When managers use accounting choices to bias disclosures, the choice is called earnings management. Earnings management doesn’t affect cash flows, therefore, investors, who are assumed by the EMH to see through opportunistic accounting choices, will not alter their assessments of associated share prices. However, investors may react positively to earnings management because they are unable or unwilling to unravel the effects of earnings management. Investors have been shown to react positively to ‘big bath’ accounting because it allows improved performances in subsequent periods. 8.13 What is prospect theory? What are the implications of prospect theory for finance? Prospect theory is based on the simple idea that the pain associated with a given amount of loss is greater than the pleasure derived from an equivalent gain so that investors attach more importance to avoiding a loss than deriving a gain. Researchers finding evidence of market inefficiency draw on prospect theory for support in arguing that investors are not rational. Because rationality is one of the assumptions of many of the models used in finance, those models will not predict accurately if investors do not act rationally. 8.14 In the literature on which this chapter is based, the notions of the efficient market hypothesis and the CAPM are referred to as a ‘paradigm’. Findings that conflict with these hypotheses are called ‘anomalies’. Find definitions of these terms. How do they explain the progress of knowledge in the finance discipline? In these circumstances, a paradigm is usually defined as a set of concepts, principles, ideas and such shared by a community of scholars. An anomaly is a deviation from the commonly accepted tenets of a paradigm. An increase in the number of anomalies weakens faith in the paradigm. At some point, another paradigm may replace the existing one. It is akin to evolutionary principles — a better explanation will replace a weaker one. In the finance discipline, if anomalies reach a critical point where the EMH is no longer seen to offer a satisfactory explanation, then another explanation will take its place — an explanation which is accepted by a greater number of scholars than those still accepting the EMH. 8.15 Behavioural finance, in contrast to mainstream finance, focuses on what aspects of capital markets? Behavioural finance focuses on decision making under uncertainty and, unlike mainstream finance, on the decision makers, using the cornerstones of cognitive psychology and the limits to arbitrage. The limits to arbitrage suggest that low-frequency market evidence does not support market efficiency and the rationality of investors. 8.16 What does cognitive psychology tell us about investors? Cognitive psychology tells us that: investors are not rational they make systematic errors in the way they think investors use heuristics to make decision making easier investors, especially male investors, are overconfident about their abilities they place too much reliance on recent experience investors are influenced by the way information is presented, so that good image and high awareness associated with a particular company results in a lower perception of risk investors avoid realising paper losses but seek to realise paper gains investors’ evaluation of returns is distorted by the size of the anchor they use as a starting point for the evaluation investors’ emotions affect their risk-return perceptions and investment behaviour. 8.17 Does cognitive psychology supply explanations of why investors have flocked to subscribe in high-profile companies such as Woolworths or Telstra? Companies such as Woolworths and Telstra have high brand awareness within the Australian market. Cognitive psychology suggests that the brand and image awareness of these companies will result in investors perceiving them as a lower risk investment than other less high profile companies. 8.18 Evaluate whether behavioural finance is able to explain the main anomalies of efficient markets. Student evaluations will depend on the evidence used by the student to support their position. 8.19 What are heuristics? How can they lead to poor decision making? Heuristics are the rules of thumb used by decision makers to make decision making easier. Affect heuristics suggest that positive emotional associations with a particular company will result in that company being a lower perceived investment risk. Other heuristics relate to an investor’s past experience — they place too much weight on that experience so that they place too little weight on long term experiences. Other heuristics separate decisions that should be combined. 8.20 How would you evaluate large amounts of research findings that are based on associations, without much theoretical underpinning? Answers to this question depend on the standpoint taken. For example, the use to which the associations are put will determine how these research findings are evaluated. If the findings are reasonable predictors of future events, then they may be valued by those using them as predictors. Application questions 8.21 Marcus Padley, a stockbroker, made the following statements in an article in the Sydney Morning Herald. I love ‘The Warren Buffet Way’. In fact, one of my first clients introduced himself by saying, ‘I am Fred and I’d like to invest the Warren Buffet Way’. Well whoopee do! What shall we do? Get the annual reports of the top 200 companies. Analyse the accounts of each, assess ‘value’ and then go to the stock market and find out that ‘wow, I’m right and the whole market is wrong’ and the share price is trading below the true ‘value’. Then purchase the shares and wait for that value to inevitably emerge. In fact most Warren Buffett-based approaches are terrible at timing, which in reality is about the only thing that really matters. In an increasingly impatient market it is not just about ‘what’, it is becoming all about ‘when’. Investors who sat through the 54.5per cent fall in the market in the financial crises need to earn 113% to get their money back. That’s 13 years of compounding average annual returns. Not caring about ‘when’ just cost us 13 years. Critically evaluate the two statements made by Marcus Padley in the context of capital market research. In relation to the first statement, a critical evaluation should take into account that: EMH says that share prices reflect all available information – the client is assessing available information. The accounts in the annual reports are based on accounting principles which do not capture all the information relevant to share prices, particularly information about intangibles which make up a high proportion of the assets held by many listed firms. Earnings management may distort the accounts. In relation to the second statement, a critical evaluation should focus on behavioural finance – investors do not sell early enough. Behavioural finance says that investors will try to avoid the loss by holding onto their shares hoping for a rise in the market. 8.22 In December 2015, OZ Minerals wrote down its assets by $201 million. In its 2017 accounts it reversed this impairment charge, recording an increase of $141.1 million to net profit. The impairment reversal was a non-cash adjustment — it did form part of OZ Minerals’ operating earnings. As a result, the market was reported to have found the reversal of historic interest only. However, after the announcement of its 2017 earnings, OZ Minerals’ share price outperformed the broader mining market, rising by over 3%. If the reversal was of ‘historic interest only’, how can the share price reaction be explained? Intuitively, the increase in net profit should result in an increase in the share price as an increase in net profit is good news; good news is expected to increase share price. The impairment reversal may have been part of earnings management. The EMH suggests that investors should see through cosmetic earnings management but behavioural theory suggests otherwise. Investors decisions are multifaceted, easily changed and seek satisfactory solutions rather than optimal ones. Perhaps the 2017 earnings announcement was “satisfactory”. 8.23 In September 2008, the Seven Network revealed it had incurred losses on its strategy to ‘park’ hundreds of millions of dollars in listed securities which were the result of the sale of half of its TV and magazine interests to a private equity firm, a strategy which the company had not revealed to the market. Seven’s share price closed at its lowest level since January 2005. What is a ‘private equity firm’? Why do you think the share price fell? Was it a response to the lack of disclosure? Was it a response to the losses incurred by the strategy? (a) A private equity firm is an investment manager that makes investments in the equity of companies through a variety of investment strategies including leveraged buyouts and venture capital. It raises funds that will be invested in accordance with one or more specific investment strategies and will receive periodic management fees as well as a share in the profits earned from each of its managed funds. One of their well-known strategies is to acquire a controlling position in a company and then look to maximize the value of that investment. (b) Probably due to investors finding out about the transaction whether by insiders who publish investor news sheets, or though disclosure by non-Seven media. (c) Debatable, but probably to the fact that the Seven Network revealed the losses. (d) Intuitively, that is a possibility, although post earnings announcement drift suggests that because the announcement was of losses, the fall in the share price should have been delayed. 8.24 Talking to the financial press about the David Jones 2010 earnings from its department store business, its CEO acknowledged that it had been a tough time for the company due to the departure of its former CEO after sexual harassment claims against the former CEO. The current CEO said the company should be judged on two indicators: sales and share price. He distinguished between the man (the former CEO) and the David Jones’ 170-year old brand. David Jones’ shares rose 2%. Do you agree that a company such as David Jones should be judged on sales and share price? Why is the distinction between the ‘man’ and the ‘brand’ important? If brands are so important to a company’s share price, why are internally generated brands not recognised under accounting rules? (a) Answers will depend on the point of view adopted. Shareholders who want dividends and capital gains would favour sales and share price. Stakeholders would be wider in their views, judging a company from a corporate citizenship perspective. (b) The brand is longer lasting. CEO life expectancies are short especially if they do not deliver on what the Board of Directors want. (c) Accounting standard setters are conservative in relation to intangibles such as brands. See the chapter on special reporting issues. 8.25 The behaviour of the former CEO of David Jones apparently did not impact the company’s share price. However, according to a study by two American economists, the transgressions of Tiger Woods were responsible for wiping up to $US12 million off the value of his sponsors (Gatorade, Nike, Gillette, Electronic Arts). Gatorade and Nike were the worst hit of his sponsors. (a) How can this apparent contraction between the impact of the David Jones’ CEO and Tiger Woods be explained? (b) What does the impact on sponsors’ shares say about the adage that ‘any publicity is good publicity’? (a) Tiger Woods was promoted as the personification of the ideals that were built into the brands of companies such as Gatorade and Nike. When he was shown not to incorporate those ideals, the share price was punished for those companies probably for using him as their brand image. The DJ’s CEO did not feature in advertisements for the store and its owning company. The media also suggested that the Board’s decisive move to remove him as CEO reflected well on shareholders, hence the lack of punishment of the share price. (b) In this case, the adage did not apply. 8.26 Read accounting standard AASB133/IAS33 Earnings per Share and answer the following questions. (a) How is earnings per share calculated? (b) What are some of the allocations, predictions and wild guesses that go into the calculation of net income? (c) In light of the allocations, predictions and guesses, how reliable do you think the earnings per share are as a summary of a firm’s activities for a period? (a) EPS is calculated by dividing profit or loss attributable to ordinary equity holders of the parent entity (the numerator) by the weighted average number of shares outstanding (the denominator) during the period. (b) Definitions of income, revenue, and expenses which exclude certain transactions Recognition criteria which excludes further transactions Allocations of revenues and expenses to prior or future periods Depreciation calculations (c) Students should address the meanings of “reliable” both from a dictionary meaning and the accounting meaning. Answers will depend on how well the student can support their argument. 8.27 For the 2016 financial year, Clean Water Solutions had: revenues from ordinary activities up by 79% earnings before depreciation, amortisation, tax and interest improved by 40% net loss for the period improved by 33% over the previous year’s loss. (a) What would you intuitively expect to be the market reaction? (b) Over the following two weeks, the company’s share price fell by a third. The directors could not offer a business reason for the fall. Can you suggest a reason(s) for the fall? Explain your reasoning. (a) Intuitively the share price should have risen. (b) Answers should be assessed by the student’s argument behind their explanation. 8.28 The listed investor, Djerriwarrh, had a solid year in 2016, but not according to IAS rules. Its net operating profit rose by 21.1% despite holding nearly 29% of its portfolio in bank shares. Because of AASB139/IAS39 Financial Instruments: Recognition and Measurement, it had to report a pre-tax ‘impairment’ charge of $70.9 million and a net charge of $49.7million pushing its results to a loss of $14.1 million. Shares in the Djerriwarrh portfolio qualified for the charge, shares that were not even remotely close to going broke but were impacted by the global financial crisis share market rout. The problem is that as share prices recover, impairment charges already taken against earnings cannot be reversed. (a) Does the accounting impairment rule, as it stood in 2016, make sense? (b) What changes were made to AASB139/IAS39 Financial Instruments: Recognition and Measurement as a result of the unforeseen consequences such as that suffered by Djerriwarrh? (c) As a result of the changes, will investment companies that book impairment losses to the balance sheet be able to report dividend income as income? (a) No, it did not as the companies in which Djerriwarrh had shares (AMP, Brambles and AIG) were not likely to go broke. The rule did not envisage a share market crisis of the size of that generated by the GFC. The rule also did not make sense in that reversals in the share price (future gains) had to by-pass the profit and loss (income) statement, being taken to the balance sheet as adjustments to reserves. (b) The main change was to allow companies like Djerriwarrh to book changes in the value of their shares against balance sheet reserves. (c) No, they are no longer able to report dividend income as income! Case study questions Case study 8.1 Explainer: are share buybacks good for investors? Questions What would be the expected impact on a company’s share price under a share buyback arrangement? What information might a share buyback be signalling to potential investors? 1. A share buyback transaction changes the funding mix of a company by decreasing the amount of issued capital with either a corresponding decrease in excess cash or an increase in debt. The impact this will have on the share price of a company will ultimately depend on whether the buyback is viewed by investors as good news (causing an increase in share price) or bad news (causing a decrease in share price). If the entity is a large company, and regularly monitored by investment analysts and fund managers, the news of a share buyback may have been expected. In this situation, there tends to be very little impact on a company’s share price and the impact tends to occur gradually over a period of time. However, if the buyback announcement came as a surprise for investors, the impact on the share price tends to be greater and more immediate. 2. Consideration needs to be given as to whether a share buyback is a signal to investors of some ‘value relevant’ information. Information is ‘relevant’ if it has the ability to make a difference to the decisions of its users. The article suggests there can be either a positive or negative interpretation of the signal given by a company’s announcement of a share buyback. The positive signal is that the company is willing to focus on shareholder value and use excess cash to purchase back some of its shares, thus returning the cash to investors. This can reassure investors that the excess cash will not be lost on bad investments in the future. In turn, this reduces investor risk which can lead to an increase in share prices. The negative signal that may be interpreted is that there are no future growth opportunities for the company, thus increasing the investor risk and decreasing share prices. Solution Manual for Contemporary Issues in Accounting Michaela Rankin, Kimberly Ferlauto, Susan McGowan, Patricia McGowan 9780730343530
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