Question

Questions:

1)Discuss Ball and Brown (1968) research design, main findings, and its significance.

2)List and explain the Ohlson's clean surplus formula and OJ residual income valuation model.

3)Explain the concepts of historical accounting principle and the current value accounting principle, what are the two measurements for current value accounting, and compare these two principles regarding their decision usefulness for investors.

4)What is earnings management and what are possible motivations for earnings management?

Answer 1

1). In 1968 Raymond Ball and Phillip Brown published ‘An empirical evaluation of accounting income numbers in the Journal of Accounting research.
The Ball and Brown research transformed the study of accounting by showing what for us today seems obvious: there is a relationship between stock price fluctuations and the information contained in accounting reports. At the time of this ground breaking paper while researchers had hypothesised on whether there was a connection between what a company said its earnings per share would be, any changes to this forecast and its share price 12 months later.
In their research Ball and Brown sought to answer the simple fundamental research question are accounting numbers useful? They considered both the relevance and the timeliness of income announcements to equity markets because, as Ball and Brown saw it, “....usefulness could be impaired by deficiencies in either.

Ball and Brown found that when stocks had a positive income surprise, the abnormal stock price returns for the event window were also likely to be positive. In the other case when stocks had negative income surprises, the abnormal stock price returns were likely to be negative.They also found that a majority of the increase in the abnormal returns was before the announcement date, which implied that analysts have fairly accurate forecasts of whether firms will outperform or underperform. Ball and Brown postulated that this could be through ‘leakage’of earnings related information such as earlier announcements of dividends, earnings in interim periods, contracts won, production figures etc.

Of the two central conclusions reached in the accounting literature of the day, the conclusion that radical changes in the nature of financial statement information are required could not be directly tested by Ball and Brown because they could not observe the counter-factual. They concluded that “all standard setting in accounting is to some degree an act of faith, and that applied to the copious advice that the accounting literature was giving to the standard setters of the time”. However what they could empirically and statistically test was the first proposition that financial statement information prepared under existing reporting rules is meaningless. Their research demonstrated that this proposition failed the test. Under the assumption that changes in share prices incorporated real changes in underlying firm value to at least some degree, Ball and Brown were able to empirically prove that accounting information is in fact correlated with these changes. These findings thus made it difficult to maintain that accounting information was meaningless.

2). Clean surplus accounting is the estimation of company's earning and expected return. It is calculated on the basis of effect of the operation of business. We can estimate the earning by making estimated income statement. If we add goodwill in it, it will become clean surplus. Goodwill is just excess of actual earning over expected earning. It is the present value of future abnormal earning. It is important to know that we calculate clean surplus for knowing company's total estimated earning not the given portion of shareholders. So, we do not include dividends on share capital in it.

Formula = Expected Earning from Business + expected PV of future abnormal earnings (goodwill)

3). A historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. The historical-cost method is used for assets in the United States under generally accepted accounting principles (GAAP).
Current value accounting is the concept that assets and liabilities be measured at the current value at which they could be sold or settled as of the current date.

4). Earnings management is the use of accounting techniques to produce financial reports that present an overly positive view of a company's business activities and financial position.The primary reason to engage in earnings management is to make the stream of earnings seem more predictable and less volatile. The belief is that the stock market rewards a steadily growing and predictable earnings stream rather than a volatile one. The market punishes negative earnings surprises, so the key is not to miss on the downside.
earnings management is efficient because it helps resources to be properly allocated for economic growth, and financial statements with earnings management function as a signal, distinguishing economically stronger firms and firms with better management from others.