ERC (Earning Response Coefficient)

Earning Response Coefficient - ERC

The earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements. The ERC is an estimate of the change in a company's stock price due to the information provided in a company's earnings announcement.
The ERC is expressed mathematically as follows:
UR = a + b(ern − u) + e
R = the unexpected return
a = benchmark rate
b = earning response coefficient
(ern-u) = (actual earnings less expected earnings) = unexpected earnings
e = random movement

Good News (GN) firms enjoyed positive abnormal returns, and negative for their Bad News (BN) firms. This raises the question of why the market might respond more strongly to the good or bad news in earnings for some firms than for others. If the answer can be found, accountants can improve their understanding of how accounting information is useful to investors. This, is turn, could lead to the preparation of more useful financial statements.

Consequently, one of the most important directions that empirical financial accounting research took since the BB study is the identification and explanation of differential market response to earnings information. This is called earnings response coefficient (ERC).


“Earnings response coefficient measures the extent of security’s abnormal market return in response to the unexpected component of reported earnings.”


Reasons for differential market response:
 BETA: The more risk related to the firm's expected returns the lower will be the investor's reactions to a given amount of unexpected earnings.
 CAPITAL STRUCTURE
ERC for a highly levered firm is lower than for a firm with little or no debt, Any good news passed on means that the debt holders get this benefit instead of the investors.
(Thus it is important to disclose the nature & magnitude of financial instruments including off-balance sheet)
 PERSISTENCE
Source of increase in current earnings affects the ERC:
- if earnings are expected to persist into the future this will result in a higher ERC
- if the component in the earnings is non-persistent (i.e. unusual, non recurring items) this will result in lower ERC

OR
The earning response coefficient refers to the anticipated relationship between the returns of the equity and the unexpected earnings announcements of a company. Earning response coefficient is also known as ERC.

According to the arbitrage pricing theory of the financial economics, the price of a particular equity shares a theoretical relationship with the information on a particular equity that is available to the market participants. The efficient market hypothesis says that the equity prices are expected to reflect all the necessary and relevant information on the equity at a given point of time. Consequently, if any change in the value of the equity occurs, it is understood that this is due to the change in relevant information. There are market participants who are having superior information and they can exploit that information until the share price is affected by the information.

Hence we can say that depending on the changes in the relevant information on a particular equity, which is available in the market, some changes in price of the shares may occur. It can also be said that the earning response coefficient is actually an estimate of the stock price change of a company because of the changes in information supplied in the earnings announcement of the company.



The use of earning response coefficient is primarily visible in the research of finance and accounting. To be more specific, the earning response coefficient is applied in the positive accounting research. Positive accounting research is a branch of the financial accounting research that is used for the theoretical analysis of the market depending on the various events of information. ERC is used in the finance research to study the activity of the investors depending on the information events.

Securities Markets Efficiency & Accounting Information (증권시장의 효율성과 회계 정보).

Securities Markets Efficiency & Accounting Information. (증권시장의 효율성과 회계 정보).

or

Reasons of Security market inefficiency.

Some people argue that stock market is efficient and some others people argue that stock market is not efficient. News is happening all the time. The capital market is efficient if at any time the security prices fully and correctly reflect all the available information and news at that date.
But market may not respond to information exactly as the efficiency theory predicts. Share prices sometimes take some time to fully react to financial statement information. If the information is not fully and correctly reflect in the market at the right time then we can see securities market anomalies or excess stock volatility or stock market bubbles. So, the security market will be inefficient.
Reasons of Security market inefficiency are as below:
1.Overconfidence: -Psychological evidence suggests that individuals tend to be overconfident. They overestimate the precision of information they collect themselves. If, on average, investors behave this way, share price will overreact.
2. Self-attribution bias:-Self-attribution bias occurs when people feel good decision outcomes due their own skills or abilities, whereas bad outcomes are due to unfortunate realizations of states of nature or unsuccessful outcomes on bad luck, hence not their fault. Suppose that following an overconfident investor’s decision to purchase a firm’s shares, its share price rises (for whatever reason). Then, the investor’s faith in his or her investment ability rises. If share price falls, faith in ability does not fall. If the average investor behaves this way, share price will increase.
3. Post –announcement drift: Once a firm's current earnings become known, the information content should be quickly digested by investors and incorporated into the efficient market price. However, it has long been known that this is not exactly what happens. For firms that report good news in quarterly earnings, their abnormal security returns tend to drift upwards for at least 60 days following their earnings announcement. Similarly, firms that report bad news in earnings tend to have their abnormal security returns drift downwards for a similar period. This phenomenon is called post-announcement drift.
For the post-announcement drift investors can earn arbitrage profits (risk free profit). By buying good news firms on the day announced earnings and selling short shares of bad news firms. But post-announcement drift is workless if a greater portion of a firm’s is held by institutional investors (Sophisticated investors).
4. Buying and short-selling shares based on non earnings financial statement information such as changes in sales, accounts receivable, inventories and capital expenditure.
5. Another possible explanation for the anomalies is transaction costs. The investment strategies required to earn arbitrage profits may be quite costly in terms of investor time and effort, requiring not only brokerage costs but continuous monitoring of earnings announcements, annual reports and market prices, including development of the required expertise. For the transaction costs sometimes investors can’t take advantage of post-announcement drift.
6. Another reason is “jump on the bandwagon”. To take advantage people get involved in something that has recently become very popular. When people see positive feedback then they join the group then increase the stock market volatility.
On the above discussion we can say that securities markets are not fully efficient. Improved financial reporting may be helpful in reducing inefficiencies and security price will be protected. Improved financial reporting, by giving investors more help in predicting fundamental firm value. Indeed, by reducing the costs of rational analysis, better reporting may reduce the extent of investors’ behavioral bias. So, financial accounting information is very important and helpful to investors in securities market to protect securities market inefficiency.

Historical Cost Accounting & Fair Value Accounting

Historical cost accounting, however, is an income statement approach, also called information perspective. Historical cost ignores the amount the asset could be sold for in the open market, called the fair value, until the asset is actually sold. The company carries the asset on the balance sheet at the purchase cost less any depreciation taken. At the time of sale, the company records a gain or a loss against the purchase cost of the asset less any depreciation if applicable.
For example, if Sunny purchased an asset for $5,000 and estimated depreciation expense of $500 per year for 10 years, the cost of the asset after the first year less depreciation is $4,500. If the market value of the asset were $4,800 after year one in the open market, Sunny would not write up the asset after the first year. Rather, the asset would remain at original cost less any depreciation until the asset is sold.
If Sunny sold the asset for $4,800 after year one, Sunny recognizes a realized gain of $300.

Fair value: Fair value accounting or Present value accounting is a balance sheet approach to accounting, also called a measurement perspective. In recent years, international standard setters and regulators such as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have begun to favor the use of fair value accounting over historical cost accounting in financial reporting. A key reason for this shift in methodology is to improve the relevancy of the information contained in financial reports. The general principle underlying the shift is that up-to-date information improves investors' and regulators' abilities to make informed decisions.

Historical Cost and Fair Value Accounting: Relevance and Reliability Revisited

The historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However, the historical price is not necessarily relevant information. Land that was purchased 20 years ago could be worth much more than the balance sheet shows. Likewise a building purchased many years ago and recorded on the balance sheet at the original cost does not reflect the current market price.

For this reason, many accountants and users of financial statements argue that the market price, or fair value should be used when reporting financial information. The fair value is more relevant, but is not necessarily reliable

More fundamentally, historical cost accounting is a way to “smooth out” current period cash flows into a measure of the longer run or persistent earning power that is implied by those cash flows. Too smooth out of cash flows, the accountant has to calculate accruals, that is, to much costs and revenues. At this point historical cost accounting faces a major challenge. Because of, without historical cost accounting usually there is no unique way to match costs with revenues.

Proponents of historical cost accounting believe that this method is superior to market valuation for several reasons. One of the main reasons proponents favor this method is because they believe that it is more reliable. They believe it is more reliable because it is based on transactions that have already occurred, are verifiable and free from management bias. The opportunity for manipulation of asset values by management is a major concern of those who do not approve of the market valuation of company assets.
Those persons who believe market valuation (Fair value or Present value) is the best method of accounting cite many valid reasons for this belief. Proponents of market valuation argue that because historical cost valuation can include data that is up 10 years old, this data does not provide the most relevant information to investors. They also argue that historical accounting methods do not take into account the possibility that an asset's value may actually be higher or lower than what is reported on company books.

Reference:
Financial Accounting Theory-Third Edition by William R. Scott
http://business-accounting-guides.com/historical-cost/
http://www.ehow.com/info_7948456_market-value-vs-historical-cost.html

Expert and Novice Problem-Solving Behavior in Audit Planning Jean Bedard and Theodore J. Mock
Presenter - Soumitra kundu

This study talking about how well auditors perform the problem-solving process & where it can be improved ie problem-solving behavior of expert & novice auditors.

Expert auditors ( औदितोर्स)-Computer audit specialist or CASs
Novice auditors - haven’t much more computer knowledge in audit program
Expert are more efficient & perform rapidly than novice to acquire the knowledge.
Experts appear to have more knowledge than novices & have better organization of knowledge.
Novice auditors are more likely to use a sequential search strategy than expert auditors.

This paper focuses on the information search phase of the decision process and the effect of expertise on auditors’ information search. And this is done by using a computer-controlled information retrieval system (CIRS).

Three dimensions of information search behavior are examined:
-Information search strategy
-Information acquisition
-Information search duration

The CIRS, which runs on a microcomputer, keeps track of the individual information items accessed, the order in which information is accessed, the search duration, and the subjects‘ decisions.

Used following categories of information:
1) INSTRUCTIONS
(2) BACKGROUND INFORMATION
(3) APPLICATION CONTROLS
(4) GENERAL COMPUTER CONTROLS
(5) DECISIONS.
Expert auditors were more efficient and acquired significantly fewer information items than the novices in their specific area of expertise, general computer controls. Experts also acquired significantly fewer redundant control than novices. Although they acquired fewer general computer controls, experts attached significantly more importance to those controls.

Finally, experts required significantly less time to perform the task.

Budgetary Slack, Information Asymmetry, Budgetary Participation & Budget Emphasis.

The influence of information asymmetry and budget emphasis on the relationship between participation and slack.

Chong M. Lau and Ian R. C. Eggleton*

Presenter: Soumitra kundu

Introduction
Budgetary slack -when the people involved in creating a budget deliberately under-estimate the amount of revenue to be generated, or over-estimate the amount of expenses during the budget period.
Three crucial predictor variable of Slack
Information Asymmetry: one party has more or better information than the other.
Budget Emphasis Meeting budget goal target Reward
Participation an opportunity of budget holders to participate in setting their own budgets.



Theory development
Prior studies have theorized that budgetary participation, information
asymmetryand budget emphasis are three important predictor variables which may
influence the subordinates' propensity to create slack but empirical results remain
unclear.
Dunk (1993) tried to resolve—by three predictor variables into a single model
High budgetary participation is associated with slack creation.
High information asymmetry is associated with slack creation.
High budget emphasis provides the motive to create slack.
None of these hypotheses were supported by his results.
Prospect theory (Kahnemanand Tversky, 1979) find that high budgetary
participation,are likely to be discouraged from slack creation activities.
And
propensity to create slack is likely to be low when high participation is allowed in a
high budget emphasis situation. (Hopwood, 1972 & Lau et al., 1995)

Thisstudy,whichadoptedacontingencyapproach,thattherelationshipbetweenbudgetaryparticipationandthesubordinatespropensitytocreateslackismoderatedbyinformationasymmetryandbugetemphasis.Itisbasedontheassumptionofself-interestservingindividuals.

Thanks

Slack
1.Information Asymmetry
2.Budget Emphasis
3.Participation

Mental Accounitng & Sunk Cost

The Mental Accounting of Sunk Time Costs: Why Time is not Like Money.
DilipSoman
Presenter: Soumitra Kundu

Mental accounting
An economic concept established by economist Richard Thaler(1980),
-which contends that individuals divide their current and future assets into separate, non-transferable portions.
The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.
Mental accounting
•Utility theory is a common currency theory
•All options are evaluated with respect to utility
•But all gains and losses are not viewed as the same.
–People seem to have a variety of mental accounts.
Imagine you are shopping for a calculator and a jacket, and you find them both at the same department store. The calculator costs $25, and the jacket costs $120. You are told that a store across town has both items, but the calculator is $15 cheaper at that store. Do you buy the items at that store or do you go across town.
Most people say yes. If the jacket is $15 cheaper, most people say no.
In each case, they have spent the same amount of money.

The idea is that people are creating separate mental accounts for different goals.
–Money for necessities
–Money for entertainment
–Spending money from one account does not affect others.
Imagine you have gone to the movies to see a show. You got to the front of the line and realized you lost $10, do you still go to the movie?
Most people say yes
Imagine you have gone to the movies to see a show. The ticket costs $10. You buy the ticket early in the day. When you get to the theater, you realize you lost the ticket. Do you buy another one? Most people say no.

Sunk Cost Effect
Traditional economic theories predict that people will consider the present and future cost and benefits when determining a course of action. Past costs should not be a factor.
Contrary to these predictions, people routinely consider historic, no recoverable costs when making decisions about the future. This behavior is called the sunk cost effect.
The sunk cost effect is an escalation of commitment and has been defined as the “greater tendency to continue an endeavor once an investment in money, time, or effect has been made.”
Sunk costs have two important dimensions:
Size (Monetary) and
Timing.
Consider the following two scenarios by exampleAfamilyhasticketstoabasketballgame,whichtheyhavebeenanticipatingforsometime.Theticketsareworth$40.Onthedayofthegame,abigsnowstormhitstheirarea.Althoughtheycanstillgotothegame,thesnowstormwillcauseahasslethatwillreducethepleasureofwatchingthegame.Isthefamilymorelikelytogotothegameiftheypurchasedtheticketsfor$40oriftheticketsweregiventothemforfree?The common belief is that the family is more likely to go to the game if they purchased the tickets. If the tickets been free, the account could be closed without a benefit or a cost

Sunk Cost Effect ----Will an individual exhibit a sunk cost effect if he or she had invested time (rather than money) in a endeavor?
Do individuals mentally account for time investments using the same principles as monetary investments?
Do they set budgets?
Time VS Money
Time can’t be inventoried or replaced Time is not as easily aggregated as money Accounting for money is a routine activity, but accounting for time is not


The Mental Accounting of Time Cost
Key components of mental accounting model
Individuals track costs that are relevant to a particular expense and assign these costs to the relevant mental account.
The prospect theory value function dictates that the negative value of the cost displays diminishing marginal utility.
Expenses and funds are grouped into categories and spending is constrained by implicit & explicit budgets.
Researcher examined whether time investments follow these principles by 8 statement with time & monetary version

The Mental Accounting of Sunk Time Costs: Why Time is not Like Money.
DilipSoman
Presenter: Soumitra Kundu
Mental accounting
An economic concept established by economist Richard Thaler(1980),
-which contends that individuals divide their current and future assets into separate, non-transferable portions.
The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.
Mental accounting
•Utility theory is a common currency theory
•All options are evaluated with respect to utility
•But all gains and losses are not viewed as the same.
–People seem to have a variety of mental accounts.
Imagine you are shopping for a calculator and a jacket, and you find them both at the same department store. The calculator costs $25, and the jacket costs $120. You are told that a store across town has both items, but the calculator is $15 cheaper at that store. Do you buy the items at that store or do you go across town.
Most people say yes. If the jacket is $15 cheaper, most people say no.
In each case, they have spent the same amount of money.

The idea is that people are creating separate mental accounts for different goals.
–Money for necessities
–Money for entertainment
–Spending money from one account does not affect others.
Imagine you have gone to the movies to see a show. You got to the front of the line and realized you lost $10, do you still go to the movie?
Most people say yes
Imagine you have gone to the movies to see a show. The ticket costs $10. You buy the ticket early in the day. When you get to the theater, you realize you lost the ticket. Do you buy another one? Most people say no.
Sunk Cost Effect
Traditional economic theories predict that people will consider the present and future cost and benefits when determining a course of action. Past costs should not be a factor.
Contrary to these predictions, people routinely consider historic, no recoverable costs when making decisions about the future. This behavior is called the sunk cost effect.
The sunk cost effect is an escalation of commitment and has been defined as the “greater tendency to continue an endeavor once an investment in money, time, or effect has been made.”
Sunk costs have two important dimensions:
Size (Monetary) and
Timing.
Consider the following two scenarios by exampleAfamilyhasticketstoabasketballgame,whichtheyhavebeenanticipatingforsometime.Theticketsareworth$40.Onthedayofthegame,abigsnowstormhitstheirarea.Althoughtheycanstillgotothegame,thesnowstormwillcauseahasslethatwillreducethepleasureofwatchingthegame.Isthefamilymorelikelytogotothegameiftheypurchasedtheticketsfor$40oriftheticketsweregiventothemforfree?The common belief is that the family is more likely to go to the game if they purchased the tickets. If the tickets been free, the account could be closed without a benefit or a cost

Sunk Cost Effect ----Will an individual exhibit a sunk cost effect if he or she had invested time (rather than money) in a endeavor?
Do individuals mentally account for time investments using the same principles as monetary investments?
Do they set budgets?
Time VS Money
Time can’t be inventoried or replaced Time is not as easily aggregated as money Accounting for money is a routine activity, but accounting for time is not


The Mental Accounting of Time Cost
Key components of mental accounting model
Individuals track costs that are relevant to a particular expense and assign these costs to the relevant mental account.
The prospect theory value function dictates that the negative value of the cost displays diminishing marginal utility.
Expenses and funds are grouped into categories and spending is constrained by implicit & explicit budgets.
Researcher examined whether time investments follow these principles by 8 statement with time & monetary version

The Mental Accounting of Sunk Time Costs: Why Time is not Like Money.
DilipSoman
Presenter: Soumitra Kundu
Mental accounting
An economic concept established by economist Richard Thaler(1980),
-which contends that individuals divide their current and future assets into separate, non-transferable portions.
The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.
Mental accounting
•Utility theory is a common currency theory
•All options are evaluated with respect to utility
•But all gains and losses are not viewed as the same.
–People seem to have a variety of mental accounts.
Imagine you are shopping for a calculator and a jacket, and you find them both at the same department store. The calculator costs $25, and the jacket costs $120. You are told that a store across town has both items, but the calculator is $15 cheaper at that store. Do you buy the items at that store or do you go across town.
Most people say yes. If the jacket is $15 cheaper, most people say no.
In each case, they have spent the same amount of money.

The idea is that people are creating separate mental accounts for different goals.
–Money for necessities
–Money for entertainment
–Spending money from one account does not affect others.
Imagine you have gone to the movies to see a show. You got to the front of the line and realized you lost $10, do you still go to the movie?
Most people say yes
Imagine you have gone to the movies to see a show. The ticket costs $10. You buy the ticket early in the day. When you get to the theater, you realize you lost the ticket. Do you buy another one? Most people say no.
Sunk Cost Effect
Traditional economic theories predict that people will consider the present and future cost and benefits when determining a course of action. Past costs should not be a factor.
Contrary to these predictions, people routinely consider historic, no recoverable costs when making decisions about the future. This behavior is called the sunk cost effect.
The sunk cost effect is an escalation of commitment and has been defined as the “greater tendency to continue an endeavor once an investment in money, time, or effect has been made.”
Sunk costs have two important dimensions:
Size (Monetary) and
Timing.
Consider the following two scenarios by exampleAfamilyhasticketstoabasketballgame,whichtheyhavebeenanticipatingforsometime.Theticketsareworth$40.Onthedayofthegame,abigsnowstormhitstheirarea.Althoughtheycanstillgotothegame,thesnowstormwillcauseahasslethatwillreducethepleasureofwatchingthegame.Isthefamilymorelikelytogotothegameiftheypurchasedtheticketsfor$40oriftheticketsweregiventothemforfree?The common belief is that the family is more likely to go to the game if they purchased the tickets. If the tickets been free, the account could be closed without a benefit or a cost

Sunk Cost Effect ----Will an individual exhibit a sunk cost effect if he or she had invested time (rather than money) in a endeavor?
Do individuals mentally account for time investments using the same principles as monetary investments?
Do they set budgets?
Time VS Money
Time can’t be inventoried or replaced Time is not as easily aggregated as money Accounting for money is a routine activity, but accounting for time is not


The Mental Accounting of Time Cost
Key components of mental accounting model
Individuals track costs that are relevant to a particular expense and assign these costs to the relevant mental account.
The prospect theory value function dictates that the negative value of the cost displays diminishing marginal utility.
Expenses and funds are grouped into categories and spending is constrained by implicit & explicit budgets.
Researcher examined whether time investments follow these principles by 8 statement with time & monetary version