godfrey hodgson holmes tarca chapter 12 capital market research

GODFREYHODGSON

HOLMESTARCA

CHAPTER 12CAPITAL 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

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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

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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

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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

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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

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Scope of positive accounting theory

Two stages of development1. 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

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Scope of positive accounting theory

2. Sought to explaining and predict accounting practices across firms– ex post opportunism– ex ante efficient contracting

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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

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Capital market research and the efficient markets hypothesis

Efficient market: one ‘in which prices fully reflect available information’

3 Forms of Information Efficiency1. Weak form

(past price information)2. Semi-strong form

(publicly available information)3. Strong form

(all information – public and private)10

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

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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

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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

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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

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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

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Market model

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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

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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

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Impact of accounting profits announcements on share prices

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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

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Impact of accounting profits announcements on share prices• Magnitude

• Information asymmetry and firm size

• Magnitude of profit releases from other firms

• Volatility

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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

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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)

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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

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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

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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

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Trading strategies

• Post-announcement drift• Winners/losers and over-confidence

• Mechanistic or behavioural effect– no-effects hypothesis

– cosmetic accounting

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Trading strategies

Two viewpoints of accounting manipulation

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Trading strategies

Detecting the quality and probability of accounting management

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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

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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

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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

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