Why Stock Markets React to Accounting Information

Introduction

Stock markets are systems susceptible to influences from various types of information. They are especially affected by accounting information (Wang, Fu & Luo 2013). Due to the varying interests of investment entities, this kind of data usually elicits reactions in the stock markets. Creditors, investors, and regulatory authorities make decisions based on their comprehension of accounting information. Understanding the ‘informativeness’ of some aspects of these updates can help in explaining the behaviour of the stock market.

The current study seeks to explain the reasons why stock markets react to accounting information. The study reviews empirical surveys conducted by other scholars in this field with regards to the responses of the stock markets. Another of elements related to financial reporting are explored in this paper. They include, among others, growth in earnings, increased revenue, profit margins, free cash flows, and guidance revisions. The reactions of stock markets to such accounting issues as LIFO vs. FIFO, allowance for doubtful accounts, and valuation contraction are also reviewed.

Growth in Earnings, Profit Margins, Increased Revenue, and Stock Markets

Earnings indicate the amount of profit that a particular company makes over a specified duration of time. In most cases, the term is used to refer to the net profits generated after tax (Charitou, Lambertides & Theodoulou 2011). Consequently, they are the main determinant of share price. The reason is that earnings (and the conditions surrounding them) are an indication of the long-run success and profitability of a business (Liansheng 2000).

Revenue, on the other hand, indicates the actual amount of money the company receives over a specific duration of time (Charitou et al. 2011). They are the gross earnings from which the net income is determined by subtracting costs (Liansheng 2000). Generally, revenues indicate the amount of money that the company is able to generate from its business activities.

Profit margins also provide the company with a measure of profitability. The margins show the earnings of the organisation per “every amount derived from sales” (Xie 2007, p. 45). High profit margins are an indication of the fact that the company’s management can effectively control costs. As such, this piece of financial information is very significant when making comparisons between organisations operating in the same industry. The information is especially important when making investment decisions.

Indexes in accounting are derived from growth in earnings, profit margins, and revenues. They can be used to explain the behaviour of stock markets in relation to this information. According to Liansheng (2000), more than half of investors use earnings per share index (EPS) to make decisions related to investment. Other indexes used include rate of return on common stakeholder’s equity (ROE) and income from main operation ratio (NPPOR). There are also those who use the price to earnings ratio (PE) when selecting the company to invest in.

The indexes highlighted above are directly related to earnings and revenue growth. As such, they are representative of the company’s profitability, debt paying, and operation ability. They also indicate the entity’s potential for development (Wang et al. 2013). Many scholars in this field agree that the relationship between information about profitability on the one hand and its impacts on stock markets on the other is determined using correlations in stock prices (Liansheng 2000; Xie 2007).

Wang et al. (2013) highlight the effects of returns and earnings growth on stock markets. To this end, they analyse accounting information representative indexes for annual reports using SPSS 17.0 statistical program. Further analysis of the regression models of accounting and reaction of stock prices helps them recreate the final deductions. According to Wang et al. (2013), all kinds of accounting information (and the reactions of stock prices associated with it) rely on the following regression model:

P=α+β1EPS+β2ARR+β3JZC+β4YYLR+β5LR+β6QR+β7IR+ε.

Where:

  • ε” is the influence of accident.
  • α” denotes the impacts of non-accounting information on stock prices.
  • βi” represents sensitivity.

The stocks price to accounting information indexes selected include EPS, ROE, NPPOR, and PE.

The following table is an illustration of the descriptive statistics used in analysing all forms of accounting information indexes using SPSS 17.0:

Table 1: Descriptive Statistics and Accounting Information Indexes

Index Quantity MIN MAX AVG STDEV
Earnings per Share 60 0.01 2.22 0.3792 0.40940
Rate of Return on Common Stakeholder’s Equity 60 1.43 1071.10 59.7067 153.93311
Income from Main Operation Ratio 60 -4.3300% 31.7200% 9.289667% 8.6168221%
Quick Ratio 60 0.13 2.89 0.9623 0.54839

The sample data assumes concentrated distribution. However, due to the varying nature of industries, the standard deviation of some indexes exceeds one. As such, the data is predominantly scattered distribution.

Table (2) below shows the correlation analysis of selected accounting information indexes and share price:

Table 2: Correlation Analysis of Indexes and Share Price

Stock Price EPS ROE NPPOR
Stock Price Pearson
Coefficient of correlation
1 0.658** 0.659** 0.102
Significance Two-Tailed Test Value P 0.000 0.000 0.437
NNT 60 60 60 60

*** implies that the confidence probability of two tailed test is 99%.

From these results, it is apparent that all accounting information correlation coefficients are positive. As such, it can be argued that earnings per share, income from main operations ratio, and rate of return on common stakeholder’s equity correlate positively with stock prices. In addition, these indexes are highly influential in relation to stock price. Their impacts are evident in the entire stock market.

Many scholars agree with this postulation. They include Charitou et al. (2011), Wang et al. (2013), Liansheng (2000), and Xie (2007). From a theoretical point of view, Wang et al. (2013) highlight the impacts of earnings and dividends on the stock market. As already indicated, the earnings and returns indexes indicate profitability and long run survival of the company. As a result, most investors respond to them.

According to Aghion and Stein (2008), companies can decide to either pursue growth in sales or improve their profit margins (through lowering unit costs). Firm managers who are concerned over stock prices usually favour the growth strategy (Aghion & Stein 2008). Consequently, the stock market has a mechanism of evaluating the strategic implications of these developments. The markets react appropriately to this information. The reaction is essential especially when the market is sensitive to growth numbers.

The Effects of Free Cash Flow Accounting Information on Stock Markets

The information is important in relation to the behaviour of a ‘giver’ company’s stock in the market. However, it is disregarded by many analysts in favour of earnings. Free cash flow measures the amount of money that a business organisation is able to yield after maintenance and expansion expenses are deducted (Liu & Liu 2007). High amount of this flow is an indication of the ability of the company to pursue other opportunities. Such capabilities are known to enhance the value of shareholders.

According to Yook and Gangopadhyay (2010), free cash flow influences the stock market as a result of a hypothesis formulated to examine abnormal returns resulting from repurchasing. The unusual returns are determined through cash flows and Tobin q ratio. Yook and Gangopadhyay (2010) hold that businesses exhibiting free cash flows earn high and abnormal returns. Empirical evidence to support these hypotheses is generated from cross-sectional regression analyses. The analyses involve variables affecting stock repurchasing announcement-period abnormal returns.

Available literature reports that stock repurchases are increasingly used by companies to enhance the wealth of shareholders. The enhancement is achieved through distribution of the free cash flow to the owners (Dittmar 2000; Guay & Harford 2000). The positive relationship between cash flow and stock repurchases is analysed by the scholars cited above. The interaction results in constant holding of investment opportunities.

Free cash flow hypotheses have been tested by other authors using Tobin’s q ratio. The ratio defines the market value of a given firm and the replacement cost of its assets (Yook & Gangopadhyay 2010). Table (3) below illustrates sample statistics used by Yook and Gangopadhyay (2010) in evaluating the various effects of free cash flow on a company’s stock:

Table 3: Effects of Free Cash Flow on Stock

Variables Repurchasing Firms Non-Repurchasing Firms Test of differences in Median
Mean Median Mean Median
Tobin’s q 1.51 1.05 1.73 1.19 0.0745
Cash flow ($ mil) 301.45 34.23 241.43 21.52 <0.0001
Cash flow/Total assets 0.0702 0.0672 0.0415 0.0520 <0.0001
Market value of firm ($ mil) 9,973.82 931.87 9,856.20 917.62 0.1534
Earnings available for common Stakeholders ($mil) 282.63 24.22 244.87 18.99 <0.0001
Return on assets (%) 4.13 3.72 2.86 3.07 0.0571
Cash Dividends ($ mil) 81.73 1.51 69.32 1.12 0.0050
Firms paying cash dividends (%) 59.19 1.00 49.54 0 0.0195

The descriptive statistics are based on repurchasing firms and a control sample identified by the authors. The 3205 organisations announced 7,136 repurchase programs. The announcements were made between 1995 and 2007.

The statistics show that repurchasing firms exhibiting free cash flow are profitable. In addition, the free cash flow of these organisations was higher compared to that of other companies. The repurchasing firms also exhibited a high ratio of cash flows to total assets. Their median earnings and average dividend payments exceeded those of non-repurchasing firms.

The assumption that free cash flow affects stock markets through repurchasing is validated. Organisations exhibiting this trait are able to increase the wealth of shareholders by this cash to them. The huge announcement-period abnormal returns by these firms also support this hypothesis. The phenomenon explains the reaction of stock markets to free cash flow accounting information.

Guidance Revisions Accounting Information and its Effects on Stock Markets

Studies have been conducted to analyse the behaviour of stock prices following announcements of earnings and how guidance affects these outcomes. Guidance revisions entail the information provided by businesses as estimations of their future earnings. The approximated earnings are the expected results communicated to shareholders.

The stock market reacts variously to this information. In most cases, the revisions feature pessimistic earnings guidance (Halme, Kanniainen & Nordberg 2013). At times, market prices are influenced by this bias. In addition, penalties for failure usually exceed the rewards associated with beating the guidance. The significance of guidance revisions in relation to stock markets can be proven statistically. Stock ratings and investor decisions are also influenced by these reports. In their study, Halme et al. (2013) indicate that stock prices react to changes in earnings guidance. They also respond to actual earnings surprises.

Revisions in earnings guidance normally occur before reporting of the financial information. The stocks of companies with upward revisions indicate high average returns compared to low revising firms (Charitou et al. 2010). Estimates also indicate consensus or disagreements with earnings guidance. They elicit mixed reactions from the market. In most cases, companies raise their earnings guidance as opposed to lowering it. The study by Halme et al. (2013) also determined that the markets usually regard the lack of news as a bad sign. Companies that lower their guidance earnings are penalised (Halme et al. 2013).

Accounting Issues and their Impacts on the Stock Markets

In spite of the importance of financial information, accounting issues may negatively affect the markets. The issues include, for instance, differences in the reporting standards employed by firms. Others are International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principle (US GAAP). Inventory management factors may make it hard to determine the exact impacts of this information on the stock market. Such factors include Last in First Out (LIFO) and First in Last Out (LIFO) ratios. For instance, in the long term, rising prices may lead to variations in the valuation ratios because of the accounting methods adopted.

However, some accounting issues affect the stock markets directly. A case in point is the allowance for doubtful accounts. The ratio falls under the contra-assets account. It reflects the firms’ accounts receivables that might never be collected (Liansheng 2000). Companies with huge allowances are characterised by poor management. The reaction notwithstanding, actual customer pay might differ ultimately. As such, this information may be misleading to the investors.

Easton and Zmijewski (1989) argue that investors must understand at least one form of reporting utilised in the accounting world. They may incur huge losses if they fail to use the correct accounting information. According to Barth, Beaver, and Landsman (2001), the information seeks to reduce knowledge asymmetries. Symmetric information would ease trade in the stock markets.

Valuation Contraction and Effects on Stock Markets

The primary objective of valuation is the determination of the value of a firm’s assets for the purposes of financial reporting (Barth et al. 2001). The procedure is governed by various accounting rules. Numerous valuation methods exist. Petruska and Wakil (2013) view valuation contracting as a way of deterring litigations by shareholders.

Empirical evidence on valuation contraction could not be established. However, the importance of this practice in the stock market is undeniable. It reduces the problem of asymmetric information agency. It is especially beneficial to external parties, such as shareholders (Ahmed, Billings, Morton & Stanford-Harris 2002). Barth et al. (2001) acknowledge that valuation has received little attention from scholars. The information generated from these contractions, however, impacts variously on the stock market.

Conclusion

It is clear that shareholders and investors react to accounting information when making decisions. Growth in earnings, revenues, and profit margins are the major indicators of a firm’s profitability. The information is very important as it influences the behaviour of stock markets. Other elements of accounting data, such as free cash flow and guidance revisions, provide stakeholders with additional information on their choice of investment. The current study revealed how accounting reports influence stock markets. The reaction of the markets was attributed to the interpretation of this information by shareholders.

References

Aghion, P & Stein, J 2008, ‘Growth versus margins: destabilizing consequences of giving the stock market what it wants’, The Journal of Finance, vol. 63 no. 3, pp. 1025-1058.

Ahmed, A, Billings, B, Morton, R, & Stanford-Harris, M. 2002. ‘The role of accounting conservatism in mitigating bondholder-shareholder conflicts over dividend policy and in reducing debt costs’, The Accounting Review, vol. 77 no. 4, pp. 867-890.

Barth, M, Beaver, W & Landsman, W 2001, ‘The relevance of the value relevance literature of financial standard setting: another view’, Journal of Accounting and Economics, vol. 31, pp. 77-104.

Charitou, A, Lambertides, N & Theodoulou, G 2011, ‘Losses, dividend reductions, and market reaction associated with past earnings and dividends patterns’, Journal of Accounting, Auditing and Finance, vol. 28 no. 2, pp. 351-382.

Dittmar, K 2000, ‘Why do firms repurchase stock?’, The Journal of Business, vol. 3 no. 3, pp. 331-355.

Easton, P & Zmijewski, M 1989, ‘Cross sectional variation in the stock market response to accounting earnings announcement’, Journal of Accounting and Economics, vol. 11, pp. 117-141.

Guay, W & Harford, J 2000, ‘The cash-flow permanence and information content of dividend increases versus repurchases’, Journal of Financial Economics, vol. 57, pp. 385-415.

Halme, T, Kanniainen, J & Nordberg, M 2013, How stock market reacts to guidance revisions and actual earnings surprises, Web.

Liansheng, W 2000, ‘A survey and an analysis of investor’s demands for listed companies’ accounting information’, Economic Research Journal, vol. 4 no. 1, pp. 41-48.

Liu, J & Liu, C 2007, ‘Value relevance of accounting information in different stock market segments: the case of Chinese A, B, and H shares’, Journal of International Accounting Research, vol. 6 no. 2, pp. 55-81.

Petruska, K & Wakil, G 2013, ‘Firm valuation, market responses, and accounting conservatism’, The Journal of Applied Business Research, vol. 29, no. 3, pp. 793-808.

Wang, J, Fu, G & Luo, C 2013, ‘Accounting information and stock price reaction of listed companies: empirical evidence from 60 listed companies in Shanghai Stock Exchange’, Journal of Business & Management, vol. 2 no. 2, pp. 11-21.

Xie, X 2007, The Study on the stock price reaction to the accounting information, Sichuan University, Sichuan.

Yook, K & Gangopadhyay, P 2010, ‘Free cash flow and the wealth effects of stock repurchase announcements’, Quarterly Journal of Finance and Accounting, vol. 49, no. 3-4, pp. 23-42.

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