Prepared by Arabella Volkov University of Southern Queensland

References Text – Chapter 9 Positive theory and capital market research

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: the philosophy of positive accounting theory the strengths of positive accounting over normative accounting the scope of positive accounting theory

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: capital market research and the efficient market hypothesis the influence of accounting information on investor behaviour and share prices trading strategies and mechanistic behavioural effects

Philosophy of positive accounting theory seeks to explain observed accounting phenomena economic focus more scientific in methodology Assumptions about the behaviour of individuals underlies most empirical studies in economics

Strengths of positive theory over normative theory Dissatisfactions with normative accounting: –Prescriptions not based upon identified, empirical observations or methods –Theories are not falsifiable –Does not explain and predict accounting practice –Do not assess existing accounting practices

Scope of positive accounting theory Two stages of development: 1.Capital market research –Did not explain accounting practice –Connection –EMH –Market model 2.Explaining and predicting accounting practice

Capital Markets Research & the Efficient Markets Hypothesis Two types of capital markets research: –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 efficient markets hypothesis (EMH)

Capital Markets Research & the Efficient Markets Hypothesis Efficient market: one ‘in which prices ‘fully’ reflect available information’ 3 Forms of Information Efficiency: 1.Weak form (past price information) 2.Semi-strong form (publicly available information) 3.Strong form (all information – public and private)

Capital Markets Research & 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 Markets Research & the Efficient Markets Hypothesis Sufficient conditions of an efficient market (Fama): There are no transaction costs in trading securities All information is available cost-free to all market participants All agree on the implications of current information for the current price and distributions of future prices of each security

Capital Markets Research & the Efficient Markets Hypothesis Market efficiency does not assume: Other forms of efficiency recognised in economics Every investor has knowledge of all information All financial information is correctly presented or interpreted by individual investors Managers make the best decisions Investors can predict the future precisely

Capital Markets Research & the Efficient Markets Hypothesis CMR: Empirical research Tests hypotheses about capital market behaviour Market Model: Derives from CAPM Used to estimate abnormal returns on shares when profits announced

Capital Markets Research & the Efficient Markets Hypothesis

Figure 9.1: Sample market model for i = BHP and t = quarter ending June 2001

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 historical cost profit figure is useful share price will react (EMH)

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 Microstructure extensions to firm size Magnitude of profit releases of other firms Volatility

Association Studies & Earnings Response Coefficients Association studies impact of accounting measures on share prices over a longer event window Earnings response coefficient (ERC) is a subset of this literature ERC: Ordinary least-squares regression Dependant variable: returns Independent variable: profit R 2 (goodness of fit) and slope (sensitivity of returns to profit) used to assess informativeness of profits

Association Studies & Earnings Response Coefficients Factors which can affect the ERC: Risk and uncertainty Audit quality Firm size Industry Interest rates Financial leverage Firm growth Permanent and temporary profits

Association Studies & Earnings Response Coefficients Determinants of firm value: Industry Interest rates Financial leverage Audit quality Firm size Firm growth

Association Studies & Profit Response Coefficients Determinants of firm value (cont’d): Magnitude of profit releases of other firms Volatility Permanent and temporary earnings Omitted variables Changes versus levels in earnings Profit components Cash flows

Methodological issues Ball and Brown’s original paper –Positive theory of accounting Williams and Findlay –Argue the results of the research are supportive of EMH Watts and Zimmerman –No attempt to differentiate EMH

Trading Strategies Post-announcement drift Winner/loser effect –Long-term association anomaly Past winners tend to be future losers and vice versa Debondt and Thaler –Long-term return reversals to investor overconfidence and –Biased self-attribution

Mechanistic or behavioural effect Cosmetic accounting –Leftwich Two hypotheses –Market reacted mechanistically to changes in accounting numbers, regardless whether they were cosmetic or whether they had cash flow implications –Market ignored accounting changes which had no cash flow consequences

Mechanistic or behavioural effect Manipulating accounting numbers:

Mechanistic or behavioural effect Detecting the quality and probability of accounting management:

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

Key terms and concepts Positive accounting theory EMH CAPM CAR Information asymmetry Market efficiency Impact of behaviour

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