Information Content of Earnings within the Overall Model of Investors Decision Making - Literature review Example

?In the context of capital market research what is the importance of published financial information and the information content of earnings within the overall model of investors’ decision making? Can this model be justified in light of the present financial crisis? Discuss 1. Introduction Market research is a popular means for gathering information related to the performance of businesses in different industrial sectors. The information retrieved through market research can be used for evaluating various aspects of a business. Reference can be made, for example, to financial reporting; the specific task cannot be developed without the support of appropriate market research. Moreover, it has been proved that financial information and information content of earnings have the power to affect the investors’ decision making process. The interaction between the overall model of investor’s decision making and the published financial information, as well as the information content of earnings, is critically discussed in this paper. The justification of the above model in the context of the current financial crisis is evaluated. In order to secure that all the issues discussed above are covered, the paper has been divided into several sections, highlighting the various aspects of this paper’s subject. Apart from the introduction section, where the overall scope of the paper is presented, of particular importance are the literature and the Discussion sections. In the literature review section the following issues are addressed: the key characteristics of market research and its value on financial reporting, the published financial information and the information content of earnings as factors influencing investors’ decision making and potential use of the model of investors’ decision making within modern market which is under the continuous pressures of global financial crisis. The value of the literature findings in the context of the present crisis are further analyzed in the Analysis and Discussion section, so that valid assumptions are developed in regard to the study’s key subject. In the last section of the paper, Conclusion and recommendations, the key findings of the research developed for the issues addressed in this paper are summarized and recommendations are made, as appropriate, so that future failures are avoided. 2. Literature Review 2.1 Market research – characteristics and relation with financial reporting Market research is employed in a variety of business activities. For example, when having to decide in regard to the entrance of the business in a new market or in regard to the development of a new product/ service market research is used for gathering information related to the host market or the consumer preferences as related to the new product/ service (Wahlen et al. 52). In regard to financial reporting and investment decision making, market research has a similar role. It helps to gather information required in developing a firm’s financial statements so that the position of the firm and its competitiveness is made clear (Wahlen et al. 52). Market research can be developed through a high range of research methods, such as surveys and field studies (Wahlen et al. 52). Preferably, market research should be based on empirical research methods, aiming to show the current market trends in regard to one or more critical business sectors. Capital market research is part of market research, it its broad meaning. Capital market research focuses on the review of ‘value-related information, such as share prices’ (Wahlen et al. 52). At this point it would be necessary to explain the key context of financial reporting, as a key activity in all organizations. Carmichael, Whittington and Lynford note that financial reporting is a process ‘for gathering information that will be used by investors or creditors for developing their investment or credit decisions accordingly’ (Carmichael, Whittington and Lynford 62). In general, financial reporting can be considered as a process through which ‘information necessary for critical business and investment decisions is retrieved’ (Carmichael, Whittington and Lynford 62). The relationship between market research and financial reporting cannot be doubted. In fact, market research is necessary in any case that the effects of external events on the organizational performance have to be identified and assessed (Schroeder, Clark and Cathey 176). For example, market research has been used by financial analysts in order to understand the potential effects of the events of September the 11 on USA firms (Schroeder, Clark and Cathey 176). In addition, market research is also used when having to evaluate the potential influence of ‘changes on accounting methods on a firm’s income’ (Schroeder, Clark and Cathey 176). In other words, market research can have different roles as a tool for assessing various business processes. Alexander and Simon (2008) present a different perspective of the relationship between market research and financial reporting. According to the above researchers, market research is quite necessary for identifying the market areas related to each particular organization (Alexander and Simon 31.02). Market areas incorporate two different elements: ‘the business segments or the geographic segments’ (Alexander and Simon 31.02) of each business, meaning the products of the business or the geographic area in which the business operates accordingly (Alexander and Simon 31.02). Information related to the market areas of each business can be retrieved only through appropriately customized market research. After gathering data related to its market areas, as described above, a firm can develop its financial statements (Alexander and Simon 31.02). At the same time, Walton notes that financial information has to be credible, otherwise its use may result to a series of severe consequences for the organization, reaching to high penalties from financial authorities or even to the suspension of the firm’s activities, either totally or partially (Walton 100). For ensuring that they have met the requirements of law in regard to the accuracy and credibility of the financial data included in financial statements, the top managers and auditors of modern organizations can use market research (Walton 100). 2.2 Published financial information as part of the overall model of investors’ decision making As noted earlier, the decisions of investors need to be based on credible and accurate data, as related to the operations of a particular business. This means that published financial information cannot influence the decisions of investors unless it is valid and credible, a condition that can be met if appropriate market research schemes have been used for gathering the relevant data (Needles, Powers and Crosson 210). It should be noted that financial reporting cannot always support organizational growth. In fact, as noted in the study of Needles, Powers and Crosson financial reporting needs to meet specific requirements, ensuring that investors and third parties having interests on a particular organization are able: a) to assess the current status of the organization in terms of its cash flow, b) to understand and evaluate the stewardship of the organization (Needles, Powers and Crosson 210), meaning especially the distribution of control among the organization’s top managers, auditors and shareholders (Needles, Powers and Crosson 210). In case that the information incorporated in a firm’s financial statements cannot help investors to develop the above activities the value of the relevant information is almost eliminated (Needles, Powers and Crosson 210). From another point of view, Nikolai, Bazley and Jones note that investors’ decision making need to be based on information that it is continuously updated (7). This term is set since investment decisions have to be reviewed continuously as of their value (Nikolai, Bazley and Jones 7). In this context, the ‘timely communication of information to investors and other decision makers’ (Nikolai, Bazley and Jones 7) is necessary for the development of effective investment decisions. 2.3 Information content of earnings and the overall model of investors’ decision making When trying to assess the level of organizational performance accountants have to face an important dilemma: the information included in the financial statements of organizations need to be relevant, accurate and up-to-day (Schroeder, Clark and Cathey 40). In this context, ‘evaluating the information content of financial statements’ (Schroeder, Clark and Cathey 40) has become the key priority for accountants and auditors in all industries. Particular emphasis has been given on the ‘information content of earnings’ (Schroeder, Clark and Cathey 40) and its use for understanding the performance of each organization. In practice, it has been proved that ‘information content of earnings can be used for evaluating equity security returns’ (Schroeder, Clark and Cathey 40); still, the level at which earnings can affect equity returns is not standardized (Schroeder, Clark and Cathey 40). According to Ahrens, the use of information content of earnings for understanding the value of a particular organization can be traced in 1960s (Ahrens 2). It was at that period that the importance of earnings quality was revealed, a fact that affected the business decisions in regard to a series of issues (Ahrens 2). Reference can be made, as an example to the level of earnings of managers as a criterion for deciding the level of their compensation if such need appears (Ahrens 2). In regard to investors’ decision making information content of earnings can have a similar role. More specifically, it is possible for information content of earnings to be used for assessing the income of shareholders during a particular period of time; the increase in share prices can be used for justifying the necessity of an investment, but only in markets that the development of forecasts is feasible (Schroeder, Clark and Cathey 44). Indeed, in highly-risk markets the information content of earnings could not be a credible tool for assessing the expected payback and profit of a particular investment (Schroeder, Clark and Cathey 44). 2.4 Applicability of the model of investors’ decision making in the context of the present financial crisis In order to understand whether the overall model of investors’ decision making can be used in the context of the present financial crisis it would be necessary to refer to the potential effects of this crisis on the particular process. Financial crisis leads to the increase of uncertainties in regard to the performance of capital markets; this phenomenon cannot be controlled since the level of share prices in high turbulent markets can change continuously decreasing the prospects of profits, even of average ones (Ahrens 4). Because of the above, the development of the investment decision making process can be a challenging task; the use of an investment decision making process that incorporates risk, as related to each investment decision, would increase the effectiveness of the investment decision making process, even during periods of strong financial crises (Maggin et al. 16), like the current one. A model that meets the above criterion is the ‘expected utility model’ (Lumby and Jones 206) that ‘addresses the risk attitudes of shareholders’ (Lumby and Jones 206). On the other hand, Maggin et al. (2010) note that the investment decision making process, in its traditional form, emphasizes on the potential of investor to choose the investment that has the lowest possible risk and to be fully informed in regard to the potential performance of the chosen investment using a high range of forecasts (Maggin et al. 12). 3. Analysis and discussion of the issue under examination in conjunction with recent financial crisis and literature reviewed above Through the literature presented above it has been made clear that the value of market research in financial reporting is high. In fact, it has been proved that market research can have different roles in regard to financial reporting. More specifically, market research is considered as quite necessary for gathering data required for developing important economic decisions in each organization (IASB 290). In addition, the information retrieved through financial reporting is used for understanding and evaluating the role of external events on organizational performance (Schroeder, Clark and Cathey 176) but also for identifying the market areas of each organization (Alexander and Simon 31.02). At this point, the following issue appears: can the market research keep its powers in the context of present financial crisis? The answer should be positive. The accuracy and credibility of the information included in a firm’s financial statements should not be affected by the status of the economy, either locally or globally. Indeed, the law related to the punishment imposed on firms that provide inaccurate financial statements is not depended on the market’s performance (Schroeder, Clark and Cathey 51). This means that if a firm is found to violate the rules of law related to the accuracy and the credibility of its financial statements will have to face a series of consequences no matter the status of the market in which it operates (Schroeder, Clark and Cathey 54). If a different treatment would exist, then firms in all countries would periodically justify the inaccuracy of their financial data by referring to the downturns of the local economy. In any case, it has been proved that financial information is critical for the development of effective investment decisions (Needles, Powers and Crosson 210) but only under the terms that certain requirements are met (Needles, Powers and Crosson 210). The timely provision of information to investors has been found to be a critical term for the successful involvement of financial information in investors’ decision making (Nikolai, Bazley and Jones 7). This means that the necessity of financial information for the development of effective investment decisions is not doubted but it is required for the financial information used in the particular process to meet specific criteria. Emphasis should be also given on the following fact: in the context of the current financial crisis the effectiveness of the investment decision making, even in its traditional form, cannot be doubted since the specific process incorporates, necessarily, risk assessment tools that allow to the investor to identify the potential risks related to a particular investment decision (Lumby and Jones 206, Maggin et al. 12). 4. Conclusion and recommendations The development of effective investment decisions is depended on a series of factors. The use of traditional investment decision making process for assessing the potential value of an investment would minimize the risks involved. Still, the risks related to investments are difficult to be eliminated, as explained above. The use of certain practices by investors would help them to control risks in regard to their investment decisions even during periods of strong financial crises, like the current one. More specifically, investors that would aim to eliminate risks in regard to their investment decisions should proceed to the following initiatives: a) check the financial history, at least the last 5-10 years, of the organization to which the investment is involved; b) check the past performance of the organization to market turbulences; c) check the popularity of the organization among investors either locally or globally and d) identify and check the performance of the firm’s control mechanisms, especially of its auditing department. The existence of conflicts with the state in regard to violations of law by the firm’s representatives should be carefully checked so that the exposure to severe risks is avoided. In this context, the rating of the organization in terms of accountability and use of business standards should be taken into consideration before deciding to invest on the particular organization. Works Cited Ahrens, Bianca. Capital Market Implications of Earnings Quality. Lohmar: BoD – Books on Demand, 2010. Alexander, David and Simon, Archer. International Accounting/Financial Reporting Standards Guide 2009. Chicago: CCH, 2008. Carmichael, D., Whittington, Ray and Graham, Lynford. Accountants' Handbook, Financial Accounting and General Topics. 11th ed. Hoboken: John Wiley & Sons, 2007. International Accounting Standards Board, IASB. International financial reporting standards (IFRSs) 2009: official pronouncements as issued at 1 January 2009. London: Kluwer, 2009. Lumby, Steve and Chris M. Jones. Corporate Finance: Theory & Practice. 7th ed. Belmont: Cengage Learning EMEA, 2003. Maginn, John, Tuttle, Donald, McLeavey, Dennis and Jerald E. Pinto. Managing Investment Portfolios: A Dynamic Process. 3rd ed. Hoboken: John Wiley & Sons, 2010. Needles, Belverd, Powers, Mariah and Susan V. Crosson. Financial and Managerial Accounting. 9th ed. Belmont: Cengage Learning, 2010. Nikolai, Loren, Bazley, John and Jefferson P. Jones. Intermediate Accounting. 11th ed. Belmont: Cengage Learning, 2009. Schroeder, Richard, Clark, Myrtle and Jack M. Cathey. Financial Accounting Theory and Analysis: Text and Cases. 10th ed. Hoboken: John Wiley and Sons, 2011. Wahlen, James, Stickney, Clyde, Brown, Paul, Baginski, Stephen and Mark T. Bradshaw. Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective. 7th ed. Belmont: Cengage Learning, 2010. Walton, Peter. The Routledge Companion to Fair Value and Financial Reporting. London: Routledge, 2012. Read More