Capital Market Research Session 11Course: F0812 Accounting TheoryYear: February 2011

GODFREYHODGSONHOLMESTARCACHAPTER 12CAPITAL MARKET RESEARCH

Philosophy of positive accounting theorySeeks to explain and predict accounting practiceSeeks to explain how and why capital markets react to accounting reportsDoes so by observing practice empirical evidenceExplanation means providing reasons for observed practicee.g. why do firms continue to use historic costPrediction means that the theory predicts unobserved phenomena Has an economic focus

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Philosophy of positive accounting theoryPositive theory is based on assumptions about the behaviour of individualsassumes investors and financial accounting users and preparers are rational utility maximisersrejects arguments based on anecdotal evidence and nave acceptance of political or academic prescriptions*

Strengths of positive theoryIn order to prescribe an appropriate accounting policy, it is necessary to know how the world actually operatesWe can then normatively prescribe accounting practice*

Strengths of positive theoryPositive hypotheses are capable of falsification by empirical researchProvides an understanding of how the world works rather than prescribing how it should workobtain an understanding about how value-relevant accounting numbers are for share pricesattempt to understand the connection between accounting information, managers, firms and markets, and analyse those relationships

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Dissatisfaction with prescriptive standardsNormative standardsPrescriptions not based upon identified, empirical observations or methodsTheories are not falsifiableDo not explain and predict accounting practiceDo not assess existing accounting practices

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Scope of positive accounting theoryTwo stages of developmentCapital market research into the impact of accounting and the behaviour of capital marketsdid not explain accounting practiceinvestigated connection between the accounting data and share prices/returnsefficient markets hypothesis (EMH)capital asset pricing model*

Scope of positive accounting theorySought to explaining and predict accounting practices across firmsex post opportunismex ante efficient contracting

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Capital market research and the efficient markets hypothesisTwo types of capital markets researchthe impact of the release of accounting information on share returnsthe effects of changes in accounting policy on share pricesMost research in these areas relies upon the EMH

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Capital market research and the efficient markets hypothesisEfficient market: one in which prices fully reflect available information

3 Forms of Information EfficiencyWeak form (past price information)Semi-strong form (publicly available information)Strong form (all information public and private)

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Capital market research and the efficient markets hypothesisCapital markets research in accounting assumes semi-strong form efficiencyFinancial statements and other disclosures form part of the information set that is publicly available

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Capital market research and the efficient markets hypothesisBased on dubious assumptionsthere are no transaction costs in trading securitiesinformation is available cost-free to all market participantsthere is agreement on the implications of current information for the current price and distributions of future prices*

Capital market research and the efficient markets hypothesisMarket efficiency does not assume, mean or implythat every, or any, investor has knowledge of all informationthat all financial information has been correctly presented or interpreted by individual investorsthat managers make the best decisionsthat investors can predict the future precisely

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Capital market research and the efficient markets hypothesisMarket efficiency simply means that share prices reflect the aggregate impact of all relevant information, and do so in an unbiased and rapid manner*

Market modelMarket Model:Derives from CAPMUsed to estimate abnormal returns on shares when profits announcedShare prices and returns are affected by both market-wide and firm-specific eventsMarket-wide events must first be controlled for *

Market model*

Market modelBased on dubious assumptionsinvestors are risk aversereturns are normally distributed and investors select their portfolios on this basisinvestors have homogeneous expectationsmarkets are complete all participants are price takersthere are no transaction coststhere are no taxesthere are rational expectations by investors*

Impact of accounting profits announcements on share pricesBall & Brown (1968):Seminal work in positive accounting and finance literatureTested the usefulness of historical cost profit figure to investment decisionsIf the historical cost profit figure is useful the share price will react

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Impact of accounting profits announcements on share prices*

Impact of accounting profits announcements on share pricesBall & Brown (1968) Results: Most of the information contained in the earnings announcement (85-90%) was anticipated by investors Evidence of information content at time of historical cost earnings announcement

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Impact of accounting profits announcements on share pricesMagnitudeInformation asymmetry and firm sizeMagnitude of profit releases from other firmsVolatility*

Impact of accounting profits announcements on share pricesProfit release event studies showed that accounting profit does capture a portion of the information set that is reflected in security returnsThe evidence also shows that competing sources of information pre-empted the information in annual profits by about 70-85 per centAnnual accounting figures are not timelyLed to an another approach association studies

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Association studies and earnings response coefficientsThe objective is to test the impact of accounting variables and a wider information set that is reflected in securities returns over a longer periodearnings response coefficient (ERC)

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Association studies and earnings response coefficientsFactors which can affect the association between profits and share prices:risk and uncertaintyaudit qualityfirm sizeindustryinterest ratesfinancial leveragefirm growthpermanent and temporary profitsnon-linear modelingdisaggregating profitscash flowsbalance sheet and balance sheet components

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Methodological issuesTo argue that the results of the research are supportive of EMH and that the form of accounting is not that important for valuation purposes derives, in part, from the fact that the EMH is assumed to be descriptively validThis assumption may not be warrantedThere is increasing evidence that markets can be fooled by accounting numbers*

Methodological issuesNo attempt to discriminate EMH from competing hypothesismechanistic hypothesis managers use accounting to deliberately mislead the share market market participants can be fooledno-effects hypothesis the market ignores accounting changes that have no cash flow consequences*

Trading strategiesPost-announcement driftWinners/losers and over-confidence

Mechanistic or behavioural effectno-effects hypothesiscosmetic accounting

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Trading strategiesTwo viewpoints of accounting manipulation

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Trading strategiesDetecting the quality and probability of accounting management

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Issues for auditorsThere is some evidence of an association between auditing and the cost of capitalLower cost when firms voluntarily purchase an audit or purchase a high quality auditinvestors value the deep resources of a large auditor investors value the quality assurance regarding accounting data provided by the auditor

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Summary Philosophical objective of positive accounting theory is to explain and predict current accounting practicePositive theory developed in two stagescapital market researchcontracting theorySignificant issues relating to the validity of capital market research

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Key terms and conceptsPrescriptive standardsPositive accounting theoryCapital market researchEMHCAPMCARERCInformation asymmetryMarket efficiencyImpact of behaviourMechanistic hypothesisNo-effects hypothesis

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