Question

The following is an actual headline that was recently reported in the media about the New Zealand company Sky TV:

“Sky TV’s profit dropped 20.9 per cent in the year to the end of June. The pay TV company released its full-year results today, which showed a net profit of more than $116.3 million, down from $147.1 million the previous year.”

(a). Discuss the key findings of the Ball and Brown (1968) study and explain how the above earnings announcement might affect Sky TV’s share price.

Answer 1

AN EMPIRICAL EVALUATION OF ACCOUNTING INCOME NUMBERS : Published by BALL AND BROWN (1968) KEY FINDINGS:

Previous to Ball and Brown (1968) study share prices not effected by accounting income numbers had any value and accounted differently by different companies and considered useless to determine share prices companies.

These assumptions are not verified by actual data of real world observations . In 1968 Ray J.Ball and P.Brown published AN EMPIRICAL EVALUATION OF ACCOUNTING INCOME NUMBERS',JOURNAL OF ACCOUNTING RESEARCH,AUTUMN 1968 changed the way of conducting  the research in accounting Ball and brown questioned the uselessness of accounting income numbers by performing an empirical test on relation between Accounting income numbers and Share prices.

What Ball and brown studied is if accounting income numbers released at the year end are useful for investors usefulness can be defined in two ways

• Timeliness
• Content.

Ball and brown compared Firm specific changes in stock prices with unexpected changes in accounting income numbers from one year before the announcement of the accounting numbers until six months after accounting income numbers released.

UNEXPECTED CHANGES OF ACCOUNTING INCOME NUMBER = ACTUAL INCOME CHANGE -

EXPECTED INCOME CHANGE.

Firm stock return consists of market component and firm specific component. But market component includes external factors like Interest rates,Inflation rates,Macro economic factors which applies to all the firms in share market.

Firm specific component includes information to that particular firm. Both market and firm specific information affects firm stock prices as market wide information affects all firms, firm specific information affects the firm over and under performance in the stock market.

Firm specific information can available through firms quarterly financial statements or board announcements.

Ball and brown idea is that information is already incorporated in the stock prices by investors as they adapt their buyer and seller behavior to this information during the year.

They found a relation between the unexpected changes of accounting income numbers and the abnormal change of stock prices.

The relation Ball and brown found is supported by three different models as follows.

• EPS model
• NET INCOME model
• NAIVE model

EPS and Net income model are regression models and Naive model is consider by Ball and brown most reliable forecast model in this case.

The study also shows that accounting income numbers are useful when the expected income differs from change in actual income this is because market react as the same direction of the unexpected change . So we can conclude that by comparing firm specific stock return and unexpected accounting income number two things 85%-90% of the information of the accounting income number is already captured in the stock price at the moment of the announcement. Therefore accounting numbers are not timeliness or they roughly announced too late as in vetted investors are already made up their minds though about one half or more of the information before the accounting income number announcement is already included in the firm specific component of the stock price . Accounting income numbers announcement its content is therefore considerable .ThusBall and brown conclude accounting income numbers are useful but for and foremost because of the content not of its timeliness so investors should not fear for huge fluctuations in the stock price by the announcement of accounting income because at the moment of the announcement most of the information is already valued in the stock prices of investor shares.

EXPLANATION:

In the given information SKY TV's profit dropped information is already reported in media so SKY TV's announcement of lesser profit of the year later date cannot influence the SKY TV's share prices because investors already takes media announcements of previous date in his decision making so firm specific component already taken into consideration.