Abstract
Is it possible to quantify the information content of accounting reports? If possible, then how? This study examines accounting as a classical communication system with the purpose of providing a framework with which to approach these fundamentally important questions. Information theory was established in the early-mid 20th century to describe the properties of classical communication systems. Applying concepts from this theory to an accounting context provides insight into the questions asked above. Specifically, a measure of the information content of financial statement numbers is developed from these information theory concepts. The measure is also applied to several large companies’ earnings numbers and aids in predicting their price movements.
Highlights
Does the financial accounting and reporting process provide non-redundant information to market participants? The over-arching goal of capital markets accounting research is to speak, in some way, to this question
The purpose of this paper is to show why the long-standing criteria for deciding whether accounting numbers contain information does not logically reconcile with Shannon’s description of information in the context of a classical communication system
This paper defines information as that subset of knowledge that changes a users’ uncertainty regarding the state a particular variable of interest will assume in the future. This definition is firmly grounded in an information theory framework
Summary
Does the financial accounting and reporting process provide non-redundant information to market participants? The over-arching goal of capital markets accounting research is to speak, in some way, to this question. We do not capture “information”, as defined according to classical information theory, with our stock price-based measure of the information content of accounting numbers. Claude Shannon (the father of modern information theory) was at the forefront of this revolution His landmark 1948 paper, A Mathematical Theory of Communication [1], was the first paper to formally describe a communication system in which information plays a central role. Concepts such as the capacity of an information channel, the uncertainty of a source and the optimal rate of information transmission in a noisy environment revolutionized how we think about information. Information 2016, 7, 48 information in an observed earnings realization (for example) as the percentage change uncertainty (relative to maximum) regarding which state earnings will be in the period
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