1. GODFREY HODGSON HOLMES TARCA
CHAPTER 12
CAPITAL MARKET RESEARCH

2. Philosophy of positive accounting theory
Seeks to explain and predict accounting practice
Seeks to explain how and why capital markets react to accounting reports
Does so by observing practice – empirical evidence
Explanation means providing reasons for observed practice
e.g. why do firms continue to use historic cost
Prediction means that the theory predicts unobserved phenomena
Has an economic focus

3. Philosophy of positive accounting theory
Positive theory is based on assumptions about the behaviour of individuals
assumes investors and financial accounting users and preparers are rational utility maximisers
rejects arguments based on anecdotal evidence and naïve acceptance of political or academic prescriptions

4. Strengths of positive theory
In order to prescribe an appropriate accounting policy, it is necessary to know how the world actually operates
We can then normatively prescribe accounting practice

5. Strengths of positive theory
Positive hypotheses are capable of falsification by empirical research
Provides an understanding of how the world works rather than prescribing how it should work
obtain an understanding about how value-relevant accounting numbers are for share prices
attempt to understand the connection between accounting information, managers, firms and markets, and analyse those relationships

6. Dissatisfaction with prescriptive standards
Normative standards
Prescriptions not based upon identified, empirical observations or methods
Theories are not falsifiable
Do not explain and predict accounting practice
Do not assess existing accounting practices

7. Scope of positive accounting theory
Two stages of development
Capital market research – into the impact of accounting and the behaviour of capital markets
did not explain accounting practice
investigated connection between the accounting data and share prices/returns
efficient markets hypothesis (EMH)
capital asset pricing model

8. Scope of positive accounting theory
Sought to explaining and predict accounting practices across firms
ex post opportunism
ex ante efficient contracting

9. Capital market research and the efficient markets hypothesis
Two types of capital markets research
the impact of the release of accounting information on share returns
the effects of changes in accounting policy on share prices
Most research in these areas relies upon the EMH

10. Capital market research and the efficient markets hypothesis
Efficient market: one ‘in which prices fully reflect available information’
3 Forms of Information Efficiency
Weak form (past price information)
Semi-strong form (publicly available information)
Strong form (all information – public and private)

11. Capital market research and the efficient markets hypothesis
Capital markets research in accounting assumes semi-strong form efficiency
Financial statements and other disclosures form part of the information set that is publicly available

12. Capital market research and the efficient markets hypothesis
Based on dubious assumptions
there are no transaction costs in trading securities
information is available cost-free to all market participants
there is agreement on the implications of current information for the current price and distributions of future prices

13. Capital market research and the efficient markets hypothesis
Market efficiency does not assume, mean or imply
that every, or any, investor has knowledge of all information
that all financial information has been correctly presented or interpreted by individual investors
that managers make the best decisions
that investors can predict the future precisely

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

15. Market model Market Model: Derives from CAPM
Used to estimate abnormal returns on shares when profits announced
Share prices and returns are affected by both market-wide and firm-specific events
Market-wide events must first be controlled for

16. Market model

17. Market model Based on dubious assumptions investors are risk averse
returns are normally distributed and investors select their portfolios on this basis
investors have homogeneous expectations
markets are complete
all participants are price takers
there are no transaction costs
there are no taxes
there are rational expectations by investors

18. Impact of accounting profits announcements on share prices
Ball & Brown (1968):
Seminal work in positive accounting and finance literature
Tested the usefulness of historical cost profit figure to investment decisions
If the historical cost profit figure is useful the share price will react

19. Impact of accounting profits announcements on share prices

20. Impact of accounting profits announcements on share prices
Ball & 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

21. Impact of accounting profits announcements on share prices
Magnitude
Information asymmetry and firm size
Magnitude of profit releases from other firms
Volatility

22. Impact of accounting profits announcements on share prices
Profit release event studies showed that accounting profit does capture a portion of the information set that is reflected in security returns
The evidence also shows that competing sources of information pre-empted the information in annual profits by about per cent
Annual accounting figures are not timely
Led to an another approach – association studies

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

24. Association studies and earnings response coefficients
Factors which can affect the association between profits and share prices:
risk and uncertainty
audit quality
firm size
industry
interest rates
financial leverage
firm growth
permanent and temporary profits
non-linear modeling
disaggregating profits
cash flows
balance sheet and balance sheet components

25. Methodological issues
To 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 valid
This assumption may not be warranted
There is increasing evidence that markets can be fooled by accounting numbers

26. Methodological issues
No attempt to discriminate EMH from competing hypothesis
mechanistic hypothesis
managers use accounting to deliberately mislead the share market
market participants can be fooled
no-effects hypothesis
the market ignores accounting changes that have no cash flow consequences

27. Trading strategies Post-announcement drift
Winners/losers and over-confidence
Mechanistic or behavioural effect
no-effects hypothesis
cosmetic accounting

28. Trading strategies
Two viewpoints of accounting manipulation

29. Trading strategies
Detecting the quality and probability of accounting management

30. Issues for auditors
There is some evidence of an association between auditing and the cost of capital
Lower cost when firms voluntarily purchase an audit or purchase a high quality audit
investors value the deep resources of a large auditor
investors value the quality assurance regarding accounting data provided by the auditor

31. Summary
Philosophical objective of positive accounting theory is to explain and predict current accounting practice
Positive theory developed in two stages
capital market research
contracting theory
Significant issues relating to the validity of capital market research

32. Key terms and concepts Prescriptive standards
Positive accounting theory
Capital market research
EMH
CAPM
CAR
ERC
Information asymmetry
Market efficiency
Impact of behaviour
Mechanistic hypothesis
No-effects hypothesis