GODFREY HODGSON HOLMES TARCA CHAPTER 12 CAPITAL MARKET RESEARCH

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

Market model

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

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

Impact of accounting profits announcements on share prices

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

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

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 70-85 per cent Annual accounting figures are not timely Led to an another approach – association studies

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)

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

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

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

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

Trading strategies Two viewpoints of accounting manipulation

Trading strategies Detecting the quality and probability of accounting management

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

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

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