Theoretical Underpinnings and Empirical Methods Applied by Researchers to Measure Non-GAAP Earnings - Coursework Example

Analysis Value Relevance of Earnings Name Institution Date Introduction Earnings are the benefits that corporations, businesses among other financial institutions get from their operations. They can be from the operations of a business or from investing in common stocks among other sources of revenue. For the sake of records of a company the earnings have to be valued and from this point of reasoning many theories on the value of earnings have been developed by many scholars such as the valuation theory among other theories. According to Lorie and Fisher (1964), the scholars did not just stop at finding theories to determine the value of earnings; they also went ahead and sought to establish the relationship between earnings and value of common stocks. The essay critically looks at the value relevance of earnings. Part 1 Motivations for reporting firms to disclose an alternative measure of earnings in addition to GAAP (Generally Accepted Accounting Principles) Earnings Under the GAAP (Generally accepted accounting principles) disclosure of earnings took the format of net profit after tax (NPAT). However, in recent years many firms are opting for the non-GAAP earnings (NGE) and the number is still increasing over the years. According to Brian Gaynor (2010) there are a number of reasons as to why many firms are opting for the non-GAAP earnings and some of them include; some companies believe that the international financial reporting standards relays an inaccurate performance of the company by posing a possibilities of double standards in accounting (Gaynor, 2010). Another possible motivation for reporting firms to use alternative measures of reporting other than GAAP earnings is that users of the accounting information released may not be accustomed to the GAAP earnings reports and they might require more information as they transit into the GAAP earnings reporting according to the International Financial Reporting Standards. This is because compared to the non-GAAP earnings the GAAP earnings have no information content. If the motivation for using non-GAAP earnings was to help users that are unaccustomed to the international Financial Reporting Standards in their transition then the use of non-GAAP earnings will reduce with time (Gaynor, 2010). Another possible motivation for using non- GAAP earnings to measure the value relevance of earnings is that managers can use the non-GAAP earnings to manipulate the expectations of the investors also known as manipulation hypothesis (Gaynor, 2010). Part 2 Theoretical Underpinnings and Empirical Methods Applied by Researchers to Measure Non-GAAP Earnings I/B/E/S Institutional Brokers Estimate System This is a service that collects earnings estimates for different countries and therefore can be an alternative measurement of value relevance of earnings other than the IFRS (International Financial Reporting Standards) GAAP earnings. I/B/E/S purports that a change in the consensus earnings estimates could lead to the identification of opportunities of capturing excess returns in the following periods. Information Content in Earnings Information content refers to a variation in the expected outcome of any event or transaction. However, with regards to this essay on the value relevance of earnings information content is the level of variation in the future earnings of the common stock securities according to the assessment of the investors. The variation detected by the investors should be such that there is a change in the equilibrium in the market prices (Markowitz, 1959). The variations in the prices of the common stock securities are most notable when the annual GAAP earnings reports are being released. Fama, (1967) notes that information content refers to the variation in the outcome of an event or transaction but information can also be defined as variations in earnings that are large enough to stir a change in the behavior of a decision maker. Therefore there is only value in the information if there is a change from the investors’ investment portfolio. This means that the investors either opt to buy more shares or sell some or all the shares that the investors already possess. The change in the investors’ portfolio will be seen in the change in the volume of his or her investment portfolio or shares held. There are a number of tests that have been carried out to determine the relationship between earnings and the common stock securities and one of them is the volume test. Relationship between Price and Volume Tests Economists have established that there is no relationship between the volume of common stock securities and the price of the common stock. They believe that the lack of reaction of the prices with changes in the volume of the common stock is as a result of the earnings report. Investors have different interpretations of the annual earnings report and its take a while before the investors can reach a consensus with regards to report. The volume test comes in when the economists observe the changes in the volume and prices within the time taken to reach a consensus. If the investors reach a consensus immediately the annual GAAP earnings reports are released the prices of the common stock securities will be varying although the volume will remain the same. This reaction will only happen if the risk preferences taken by the investors are homogenous. The reaction could be different if the risk preferences in the investors were to vary because then the volume would also change even after the common stock securities have reached their maximum or equilibrium price. It is important to note that changes in the prices of the common stock securities reflect the change in the market expectations in general while changes in the volume of the common stock securities held by investors reflect the variations in the expectationsof the investors. The prices of the common stock securities change after the annual earnings reports have been released but sometimes there is a change in the equilibrium price of the common stock when there is no announcement of the results. The price and volume tests may yield results for one test or if any observations are made from both tests they will not happen collectively (Theil, 1967). Part 3 Empirical Methods of determining Value Relevance of Earnings and the Association between Alternative Measures of Earnings and their Value Relevance Sample Design One can determine the relationship between the GAAP earnings and the common stock security by studying a sample of earnings by different firms over a certain period of time. If the economists opt to use the sample design there are certain prerequisites that should be observed and these include; the firm should be within the compustat tape, the compustat tape or population represents 90% or more of the market value of the common stock securities that public corporations hold. The other prerequisites include; the firm should be a member of a certain stock exchange in the country it belongs to, the financial year for the company should end on any date except for 31st December, the dividends of the firm should not be announced in the same week as the announcement of the annual earnings reports and also the announcements made in the wall street journals should not exceed 20 as well as absence of any stock splits reports during the 17 weeks prior to the announcement of the annual earnings reports. While using the sample designs the following steps were followed; selecting a sample from firms within the compustat tape, collection of data such as the time lag between the release of financial statements or GAAP earnings reports and the date of announcement and thedefinition of the variables such as volume, price and dividends among others. Vit = no. of shares traded of firm i in a week * 1 no, of shares outstanding for firm i in week t * no. of trading days in week t VMt= no. of shares traded for all firms in the exchange market in week t * 1 No. of shares outstanding for all firms in the exchange market in week t * no. of trading days in week t RMt= In Dit+ Pit Prit - 1 RMt= In (SP)t (SP)t-1 Where; Dit= is the cash dividend paid out by the firm in week t Pit = is the closing price for the shares of the firm at the end of week t Pit-1 = is the closing price for the share of the firm at the end of week t-1 after adjustments such as capital changes (SP)t= the closing value of the stock according to auditors standard and poor’s price index at the end of week t (SP)t-1 closing value at week t-1 according to auditors Vit= is the weekly average of shares traded on a daily basis. VMt = is the volume level of shares by all firms in the exchange market Rit = is the measure of the rate of return of security, it measured the price changes Volume Analysis The volume analysis aims to eliminate the effects of the events or transactions form the market on the volume of individual’s common stock securities. According to Benston (1967), there are two possible motivations for such an analysis and these motivations are; the possibility that abnormally high volume of common stock securities are a result of pieces of information found in the market at the same time as the release of the annual earnings reports and the second motivation is that the analysis could help reduce unnecessary movement of the volume of the common stock securities in the market that could cause an increase in the volume levels of common stock securities for individuals (Benston, 1967). There is a model that was created to help determine the market factors that affected the volume of the common stock securities. The model is as follows; Vit= ai+ biVMt+ eit Whereaiand bi are factors made out of observations during the period of non-reporting. This model proves that the market events have little impact on the volume of shares individuals hold and by removing the market factors it will also have a minor effect on the volume analysis. There is a portion that cannot be explained by the market forces and this portion is referred to as the residual ei. The residual is calculated on a weekly basis using the following model; eit = Vit– ai- biVMt The variables aiand bi are retrieved from the non-reporting period and the residual is computed on a weekly basis. Above normal volumes indicate a positive residual whereas a negative residual indicates a below normal residual. A normal volume has a zero residual value. The residual volume behaves in such a way that in week zero the mean volume is higher than any other week in the non-reporting period. After the announcement of the annual earnings reports the volume stays high that is above normal for a short while (Miller & Modigliani, 1966). Price Analysis Price analysis looks at the changes in the current market price for the common stock securities from the equilibrium price due to the release of annual GAAP earnings reports. If such changes occur the following observations will be made; in week zero (0) the size of the price changes should be larger than any other week during the non-reporting period. If the price analysis is to succeed then the market forces influencing the changes in prices should be eliminated and the following model can be used to achieve that; Rit = ai+ biRMt+ uit This model is also known as the Sharpe model. Rit measures the price change of security i, during the time period t whereas RMt measures the average or mean price change during the time period t. in the Sharpe’s model uit represents the portion of individual security change that cannot be influenced by market forces, events or transactions. The direction of the price change cannot be determined and therefore information from the investors ought to be transformed so as to abstract the market influences. One of the transformational options includes squaring the residual (uit)2. Normally GAAP earnings report contain no information content but if they do in this particular case the square of the residual (uit)2 should be greater in week zero than in any other week during the non-reporting period. A ratio can be used to determine the relationship between the average squared residual in week zero and the average squared residual in the non-reporting time frame and thereafter expressed as follows; (uit)2: (s2i) where the (uit)2 is the numerator whereas (s2i) becomes the denominator. Analysis of non-reporting Period The variation of the residuals during reporting period and the variations between the non-reporting periods are not the same this is because of the observations made from the regressions in both periods where it is assumed that the announcement of the annual GAAP earnings reports have no information contents whatsoever because if they had any information content they were deleted as they were breaking and violating the classical regression model. Lower returns represented by Rit meant the firms or investors took lesser risks or the sample firms bin used in the analysis were less risky than the real firms making the index (Miller & Modigliani, 1966). The Price Residual Analysis The residual value uit is computed on a weekly basis using the following model; uit= Rit– ai - biRMt The residual was then squared and divide by the variance of the residuals during the non-reporting period of the firm or corporation to get the following model; Uit = u2itv ∕S2i The price residual analysis in contrast to the other analyses holds that annual earnings reports have informational content, this is because the size of the price changes are super abnormal during week zero than the average changes during the non-reporting period. Such changes are expected when equilibrium prices are going to change because of the release of annual earnings reports. The high price activity during these times that is in week zero and the week after the release of the earnings reports could be as a result of information leakage to the market or the information had been released by other sources other than the wall street journal. Low price activities start to show during the 8th week after report release during the time when information in the market is practically below normal (Fama, 1965). The residual price analysis therefore holds that earnings reports contain information content because of the behavior of the price and the changes it goes through. This information is obtained from observing the reactions of the price as well as the reactions of the volume and the analysis shows that these reactions (price and volume reactions) reveal that earnings reports change the individual expectations of investors as well as changing the market expectations as a whole. Relationship between the Volume and the Price By observing the changes in the prices of common stock securities at a given period of time, explanations for scenarios such as a lot of security action (security exchange transactions) influences the increased price changes. According to Beaver (1968), the number of the transactions conducted in given period of time can be measured using volume and the one unaccounted for will be as a result of the changes in the equilibrium prices of the common stock securities. The transactions involved could either be explicit or implicit, either way they influence the market prices of the common stock securities. Another factor that influences the prices of the common stock with regards to the size of the transactions is the expectations of the investors regardless of the fact that they may engage in the purchasing of the common stock or selling of the common stock (Beaver, 1968). Frequency of other News Announcements during the Report Period For a proper analysis of the value relevance of earnings one of the prerequisites was to ensure that new announcements were less than twenty (20), this is because clustering or crowding of news of non-GAAP earnings might cause unrequired reactions on the volume and prices of the common stock securities. Most of the times the set of news announcement of non-GAAP earnings that might crowd or cluster the Wall Street before or during the release of the annual earnings report is the dividends announcements by firms in the stock exchange.Sometimes the clustering or crowding of announcements of non-GAAP earnings in the immediate weeks prior or after the announcements of the annual GAAP earnings reports may not stir any reaction in the volume or prices of the common stock securities (Graham, Dodd, & Cottle, 1962). Recommendations It is very evident that investors only use the reported GAAP earnings and no other variables considering (non-GAAP earnings) the dramatic reactions of the price and volumes of the common stock securities. Given the small to no reaction by the price and volume of the common stock with the frequency of news announcements during the release of earnings reports, it is also evident that the news announcements bear no information content of the reported earnings. From these findings more expectation models should be created to help in determining the size and direction of the price residual of the common stock. Investors perceive that reported earnings are somewhat associated with other events and transactions that also affect the market prices for the common stock. Some reports or news announcements released before the GAAP earnings reports contain the same details as the earnings reports and the investors have opted to use that information to adjust the prices accordingly by evaluating their predictions on the earnings. As much as the information the investors use to reevaluate their market predictions might be useful, the earnings reports still remain significant to the market prices as evidenced by the reactions on the volume and prices of the common stock after the annual earnings reports are released. Other methods can also be used to analyze the different volume and price reactions of the common stock such as observing the price and volume changes during the news announcements of other non-GAAP earnings such as the interim earnings or even dividend reports. Conclusion The value relevance of earnings is a very significant topic as it looks at the relationship that is brewed between GAAP earnings and the value of common stock securities. It also looks at the various models and methodologies created by various scholars such as Modigliani, Miller, Dodd, Graham and Cottle among others in an attempt to explain the value relevance of earnings as well as the relationships that are build therein. These scholars have looked at the volume analysis models, price analysis models, price residual models and analysis for both reporting and non-reporting periods among others to determine the value relevance of earnings. This topic has also given us insights on the prerequisites of what is required to ensure that value relevance of earnings is well calculated and explained such as conditions for the firm and corporations are required to fulfill to ensure value relevance of earnings is well calculated accurately. List of References Beaver, W 1968, The Information Content of Annual Earnings Announcements: Journal of Accounting Research, vol. 6, pp. 67-92. Miller, M. & Modigliani, F 1966, Some Estimates of the Cost of Capital to the Electric Utility Industry: American Economic Review, vol. 56, pp. 1954-1957. Graham, B., Dodd, D. & Cottle, S 1962, Security Analysis, McGrawHill, NewYork. Benston, G 1967, Published Corporate Accounting Data and Stock Prices: Empirical Research in Accounting, Selected Studies, vol. 5, pp. 1-54. Theil, H 1967, Economics and Information Theory. Rand McNally and North Holland Publishing Company, Chicago. Markowitz, H 1959, Portfolio Selection: Efficient Diversification of Investments, John Wiley and Sons, New York, Fama, E 1965, The Behavior of Stock Market Prices, Journal of Business, vol. 28, pp.34-105. Fama, E 1967, The Adjustments of Stock Prices to New Information, International Economic Review. King, B 1966, Market and Industry Factors in Stock Price Behavior, Journal of Business, vol. 39, pp. 139-190. Gaynor, B., 2010, Crisis of Accounting’s Double Standards, The New Zealand Herald, 2. Lorie, J & Fisher, L 1964, Rates of Return on Investment in Common Stocks, Journal of Business, vol. 37, pp. 1-21. Read More