5.2.1 The theoretical case for the relevance
of accounting information
Empirical research in the UK spanning over 20 years has shown that ac- counting information is one of the principal sources of information used by
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investors and analysts in domestic equity analysis. Despite having an es- tablished history1, attempts to establish atheoreticalrelationship between accounting numbers and economic values of companies have been contro- versial. Many commentators continue to insist that anything other than risk adjusted cash flows is irrelevant to equity valuation. Accounting is viewed as a record-keeping exercise and the outputs of the double-entry account- ing system are deemed to be entirely irrelevant to the value of the firm.
Others have made the more moderate criticism that accounting profits or book values are relevant only to the extent that they are useful for providing information about future cash flows (see Penman (1992) for examples of, and responses to, such criticisms).
The theory of accounting and equity valuation developed by Peasnell (1982) and Ohlson (1989; 1990; 1991), however, posits a central role for financial statement data, rather than as a mere proxy for cash flow. These authors show that provided the ‘clean surplus’ relation applies, market value can bedefinedin terms of book value, earnings and capital charges. They also show that a model based on such variables can be reconciled to the dividend discount model described in Chapter 4. The clean surplus relation requires the change in book value to be equivalent to prior period book value, plus earnings, less dividends, thus:
B Vt =B Vt−1+Xt−dt (5.1) whereB Vt represents book value at timet,Xtrepresents accounting earn- ings in yeart, anddt represents dividends paid in yeart(all on a per share basis and where capital contributions are treated as negative dividends).
If this relation holds, Peasnell (1982) and Ohlson (1990) show that, irre- spective of the accounting policies adopted by companies for items such as depreciation and research and development, share price at timet(Pt) can be defined by the following equation:
Pt = B Vt +∞
τ=1
E(Xt+τ−B Vtk)
(1+k)τ (5.2)
wherekrepresents the cost of capital. Thus, the value of a share is equal to the book value per share, plus the discounted value of expected earnings (based on information available at timet) after a charge on beginning of period book value has been made at the cost of capital.2 Therefore, the balance sheet (which captures book value) and the profit and loss account
1For example, as noted by Lundholm (1995) and Barker (1999), the model presented in this section was originally presented in Preinreich (1938).
2Note that this model is what underpins Stern Stewart’s EVARapproach to equity analysis discussed in Chapter 4.
(which captures earnings) should be useful in identifying securities that are over or under-valued.
5.2.2 Empirical evidence on the use of accounting information in domestic equity analysis
5.2.2.1 UK research
In line with the theory outlined above, empirical research into the informa- tion used by UK analysts and fund managers consistently shows that ac- counting information is heavily used in domestic equity analysis. In their UK study, Lee and Tweedie (1981) found that, along with the interim state- ments, the annual report was the most important source of information to fund managers. In particular, the profit and loss account and balance sheet were read thoroughly by 90% of respondents. Similarly, Arnold and Moizer (1984) identified the profit and loss account as the most influential informa- tion source used by UK analysts and fund managers. The balance sheet was the next most important information source, followed by interim results.
The annual report has also been found to play a reference role. In a study of fifteen UK investment analysts, Day (1986) found that although the annual report was not considered a timely source, it was nevertheless vital in the decision-making process, as analysts review it upon receipt, read it thoroughly at their leisure and refer to it throughout the year. The items referred to most frequently by analysts were long term debt, the balance sheet and profits. However, because Day’s approach involved no other sources of information, it was not possible to ascertain therelative importance of the annual report.
Further evidence for the ‘reference’ role for the annual report is pro- vided by Holland (1998). He found that, along with other components of the reporting cycle, the annual report forms the structure around which dis- closure in meetings with investors is organised. Holland found that both the financial statements and narrative information were used as a benchmark against which future performance was to be judged: ‘The case companies argued that if the financial report did not exist the users such as [financial institutions] would lack a baseline to see how the future evolved’ (Holland 1998, p. 265). Thus, despite primarily containing historical information, the annual report is therefore still useful to investors for the future predictions upon which their decisions are based.
5.2.2.2 Differences between analysts and fund managers
Because of the differences between analysts’ and fund managers’ roles outlined in Chapter 2, research is increasingly treating these two groups
as heterogeneous in their use of various information sources, including accounting information. In the first study to fully acknowledge the differ- ences, Moizer and Arnold (1984) found that analysts generally used most sources more often than fund managers. They attributed this to the fact that analysts are not required to manage a portfolio and therefore devote more time and effort to equity analysisper se. Annual reports and interim reports were used significantly more by analysts, and fund managers were found to rely more on other analysts as they performed less frequent and less detailed analysis themselves. Analysts also made more use of discussions with company personnel.
Using cluster analysis, Benceet al. (1995) also detected significant differ- ences between fund managers and investment analysts, although account- ing information was deemed important to both groups. The predominant cluster of information sources for investment analysts included preliminary statements, interim statements, annual reports, company presentations and personal interviews. Fund managers, by contrast, were found to rely more heavily on company visits, preliminary and interim statements and personal interviews. The clusters (which are proxies for the groups of information sources) indicated that analysts tend to use routinely acquired information, whereas investors prefer to use actively acquired information.
In the most recent and most detailed examination of this issue, Barker (1998) found that the interim results and the annual report differed in import- ance for sell-side analysts, finance directors and fund managers. Although finance directors did not think the annual report constituted ‘news’, it was seen as useful in its role as a public relations document and, consistent with Holland (1998), formed the basis of a track record. Analysts ranked the an- nual report behind personal managerial contact and results announcements.
Barker attributes analysts’ preference for managerial contact over the an- nual report to their short-term ‘news’ orientation. Fund managers attached more importance to the annual report than analysts did, ranking it behind only formal meetings with company management.
5.2.3 Annual reports and the Efficient Markets Hypothesis Although prior research demonstrates that the annual report and financial statements are considered useful in analysts’ and investors’ decision mak- ing, they rarely address the intriguing question of why this is the case when considered in light of the Efficient Markets Hypothesis (EMH). As Hines (1982) points out, the evidence supportive of the EMH implies that annual reports cannot be used by shareholders to make abnormal profits for two reasons. First, because the annual report is publicly available and therefore
the information contained in it is immediately impounded into the share price on release; and second, because the preliminary statements precede the annual report and convey much of the information to the market weeks before the annual report is published. Therefore, the annual report should contain no new information.
One reason for this apparent conflict is that the annual report is not necessarily used as a short-term information source, i.e., it does not contain price sensitive information. The results of Holland (1998) and Barker (1998) are consistent with this contention. Furthermore, as discussed in Chapter 4, much recent research provides evidence that challenges the notion of market efficiency (e.g., Shleifer, 2000).
An alternative theoretical view of stock markets’ interpretation and use of accounting information is provided by Hand (1990). Hand moderates the EMH and extends the ‘functional fixation hypothesis’ (which posits that users of accounting information cannot unravel the true economic implica- tions of accounting information),3contending that share prices may be set by either sophisticated or unsophisticated investors. The former will be aware of the cash flow implications of accounting data, whereas the latter will not. This hypothesis implies that the share price response to the release of accounting information will be contingent upon the likelihood that share prices will be set by an unsophisticated investor. In an empirical study of market reactions to announcements of swap transactions that had no real economic implications, Hand found evidence inconsistent with the EMH, but in line with the extended functional fixation hypothesis. Specifically, he found that the reaction to the announcements was contingent upon the level of institutional ownership (a proxy for the relative proportions of sophis- ticated and unsophisticated investors). However, Tinic (1990) challenges Hand’s view by pointing out that any valuation errors made by unsophis- ticated investors should be exploited by their sophisticated counterparts via arbitrage trading.4
Irrespective of the predictions of the EMH, prior research shows clearly that the annual report and the financial statements represent a primary information source. However, the validity and relevance of accounting in- formation has been questioned in recent years. For example, Beattie (2000) points to the lack of timeliness and the historic focus of accounting in- formation as areas of financial reporting which sit uncomfortably with the contemporary business environment. Against this background, therefore, it
3Such a view is consistent with Breton and Taffler (1995), who found that analysts did not adjust accounts for creative accounting policies.
4Ball and Kothari (1991) also express reservations about Hand’s empirical findings, attributing them to size factors. However, Hand (1991) addresses some of their concerns in a response.
is unsurprising that accounting information is increasingly augmented by analysts and fund managers by other information sources, especially contact with company management.
5.3 DIRECT COMPANY CONTACT AS AN