Module 1

Question 1

Key findings of Ball and Brown 1968

Answer 1

• Earnings numbers of firms have information content, meaning investors do find earnings useful for decisions. Evident by the relationship between the forecast error and the abnormal share price return.
• The greatest abnormal return in share price happens when the earnings number is released (announcement date)
• There are other sources of information that the investors react to, as the reaction to the share price tends to take place in the 12 months before the earnings are released. Accounting numbers are not the sole monopoly - there are other sources.
• The market is semi-strong efficient. The market reacts quickly and unbiasedly to new information, which makes it difficult to trade on information everyone now has.

Question 2

Random Walk Model

Answer 2

• Expected EPS for the current year is the same as the actual EPS for the previous year
• Forecast error = actual EPS - expected EPS

Question 3

Market Model

Answer 3

• Measures the investors’ reactions to forecast errors
• Expected return = a(i) = b(i)xRm(t)
• Abnormal return = actual return - expected return

Question 4

Naive Investor Hypothesis

Answer 4

The market is misled by accounting methods with no cash flow implications

Question 5

No - effects Hypothesis

Answer 5

The market will not react to accounting methods with no cash flow implications

Question 6

Changes with direct cash flow implications (FIFO/LIFO)

Answer 6

• Some companies changed from FIFO to LIFO
• Using LIFO decreased their earnings but increased cash flows
• A positive reaction to LIFO due to the tax savings from a lower earnings

Question 7

Ball and Brown’s assumptions

Answer 7

• Investors find future EPS relevant for decision making
• Investors can forecast future EPS from existing data
• Investors will react to errors in forecasts when revealed by adjusting the share price