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ASSIGNMENT
SUBMITTED TO: PROF. Mr. SHAMS UDDIN
SUBMITTED BY: REEMA SAJU
STUDENT ID:301119165
SEMESTER:1

Question 1
Ball and Brown’s research examined the association between stock returns and earnings when the
period (or window) over which earnings and stock returns are measured is one year. In later
periods, researchers examined the association between stock returns and earnings when the period
(or window) over which earnings and stock returns are measured is greater than one year.
Part A
Discuss how the strength of the association between earnings and stock returns changes as the
window increases from one year to greater than one year. 
Part B
Identify and explain four  reasons why share prices of different firms might react differently to
earnings announcements even when these firms report the same amount of unexpected earnings.

ANSWER:
A)
Ball and Brown’s (1968) study of the association between accounting income numbers and
changes in share prices in the capital markets generate a shift in the accounting research paradigm.
Since then, accounting academics have developed a large body of theory and assembled a wealth
of empirical evidence on the relation between earnings and stock returns. the relation between
earnings and stock returns by extending three classic studies using data from 1988 through 2002.
The first set of empirical results provides evidence on links 1–3 by showing a significant relation
between the sign of annual earnings changes and annual stock returns, replicating Ball and Brown
(1968). The sample firms’ stock returns during years in which earnings increase beat similar-size
firms’ returns by an average of 19.2percent, whereas our sample firms’ returns underperform
similar-size firms by an average of 16.4 percent during years in which earnings decrease. These
results suggest that the difference in the sign of the change in earnings (whether annual earnings
increase or decrease) relates to a difference of over 35 percent in the average firm’s annual stock
returns during this period. When we extend this analysis to examine the magnitude of the change
in earnings, we find that the stock returns of the 10 percent of firms with the largest earnings
increases outperform the 10 percent of firms with the largest earnings decreases by an average of
over 72 percent per year. We further extend the analysis to consider cash flows from operations.
B)

The market’s use of information to price shares is a complex and dynamic process. As a result, the
association between unexpected earnings and stock returns depends on numerous factors, each of
which is difficult to precisely specify in empirical tests. Four such factors that researchers consider
are:

• earnings information,

• earnings expectations,
• market efficiency with respect to earnings information, and

• asset pricing.

Question 2
Arrow Inc. has been using straight-line amortization for its capital assets for many years.
Management is considering a change to accelerated amortization but has concerns that this
accelerated approach may cause confusion among some investors concerning the potential effects
of the change on share prices.
Part A
Identify and explain the three conditions under which the change from straight-line amortization to
accelerated amortization for capital assets will not  have an impact on Arrow’s share price.

ANSWER:
Accelerated Amortization is a process by which a mortgagor makes extra payments towards
mortgage principal. With accelerated amortization, the loan borrower is allowed to add additional
payments to their mortgage bill in order to pay off a mortgage before the loan settlement date. The
benefit of doing so is reduced overall interest payments.

 Give proper notes in bottom of every financial statement.

 If accelerated amortization chooses it will be beneficial for company’s Tax benefit

 
Part B
If Arrow is operating in an efficient market, explain whether it needs to present its financial
information in a manner that everyone can understand. Discuss two  reasons.
1.Post announcement drift:

In financial economics and accounting research, post–earnings-announcement drift, or PEAD (also

named the SUE effect) is the tendency for a stock's cumulative abnormal returns to drift in the
direction of an earnings surprise for several weeks (even several months) following an
earnings announcement.

2.Market Response to Accruals:

Accruals are more subject to estimation error and bias than cash flows

•Lower reliability reduces association with future net income

•Almost all accruals eventually reverse, but erroneous and biased will do so more quickly

–Cash flow component of net income more highly associated with next year’s income

–Investors do not seem to recognize differential persistence of earnings and cash flows

REFERENCE:
https://www.researchgate.net/publication/228766616_How_Do_Earnings_Numbers_Relate_to_Sto
ck_Returns_A_Review_of_Classic_Accounting_Research_with_Updated_Evidence

https://www.investopedia.com/terms/a/accelerated-amortization.asp