CHAPTER 4 DISCRIMINATING BETWEEN COMPETING HYPOTHESES

The Competing Hypotheses EMH  “No-effects” hypothesis Competing hypothesis  “Mechanistic” hypothesis

The Competing Hypotheses (Cont’d) The No-Effects Hypothesis –CAPM: the market value of the firm is a function of the firm’s expected future cash- flows and the expected rate of return –Accounting change has no implications for stock prices Unless it had implications for taxes –Accounting change has to be unexpected by the market

The Competing Hypotheses (Cont’d) The Mechanistic Hypothesis –Changes in accounting procedures affect stock prices even if those changes have no effect on the firm’s cash flows –Assumption: accounting reports are the sole information on the firm –Also called: “monopolistic hypothesis”, “functional fixation hypothesis”

Discriminating between the Hypotheses 3 sets of accounting changes: –All accounting changes whether they affect taxes or not –Accounting changes that do not affect taxes –Accounting changes that affect taxes

Kaplan & Roll (1972) Investigate accounting changes that do not affect taxes –Accounting for investment tax credit From deferral method to flowthrough method –Accounting for depreciation From accelerated depreciation to straight-line depreciation

Kaplan & Roll (1972) (Cont’d) Methodology: –Calculate abnormal returns around the earnings announcement week Mechanistic hypothesis predicts: CAR > 0 No-effects hypothesis predicts: CAR = 0

Kaplan & Roll (1972) (Cont’d) The Investment tax credit: –Abnormal rates of return > 0 for change sample and = 0 for control sample. –Support the mechanistic hypothesis rather than no-effect hypothesis

Kaplan & Roll (1972) (Cont’d) The Depreciation switchback: –Abnormal rates of return = 0. –Support the no-effect hypothesis. –Contradict with results for investment tax credit.

Methodological Issues in Kaplan & Roll (1972) Study Two issues: –Specification of the hypotheses tested –Event study methodology

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested –The concentration is on the competing hypothesis – the hypothesis that the market is misled Problem: Do not specify exactly when the stock price reacts to the earnings effect of an accounting change.

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested –Specifying the mechanistic hypothesis Kaplan & Roll (1972) fail to make powerful test when they use two-tail test on the abnormal returns Should be one tail: H0 = e 0 0

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested (Cont’d) –Specifying the mechanistic hypothesis (Cont’d) Another way to increase the power of test is to calculate the earnings effect of the accounting change and then investigate the abnormal returns associated with the largest effects Kaplan & Roll use the 1 st annual earnings number, which is not necessarily the first earnings disclosed using the changed accounting method

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested (Cont’d) –Testing the no-effect hypothesis The acceptance of EMH led early accounting researchers to accept readily no-effect hypothesis when it was not rejected There are infinite number of alternative hypotheses to the null hypothesis

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested (Cont’d) –Event study methodology There are two reasons to believe that the randomization of other variable has not been achieved in Kaplan & Roll: clustering and selection bias

Methodological Issues in Kaplan & Roll (1972) Study (Cont’d) Specification of the hypotheses tested (Cont’d) –Event study methodology Clustering: investment tax credit changes occur in 1 year and depreciation switchback occur predominantly in 3 years and over represented in several industries Selection bias –When a sample is selected on the basis of one variable and it is latter found that the sample differs from the population of observation on the basis of some other variable

Ball (1972) Investigates all types of accounting changes Does not restrict his sample to changes that do not affect taxes He argues that under the “no-effects” hypothesis, accounting changes has no observable effects on the stock price at the time an accounting change is announced

Ball (1972) (Cont’d) Reasons: –Changes in the optimal tax inventory method are induced by changes in other variables affecting the manager’s decisions –Tax effects are too small to be observed –The changes in other variables occur before the accounting change enabling the market to predict the accounting change

Ball (1972) (Cont’d) Sample: –Samples are relatively spread over the 14- year period, reducing the clustering problem encountered by Kaplan and Roll

Ball (1972) (Cont’d) Results: –Abnormal returns unadjusted for risk changes for the whole sample There appears to be no price change associated with the earnings announcement  consistent with the no-effects hypothesis

Ball (1972) (Cont’d) Results: –Tests for risk changes and abnormal returns adjusted for risk changes Average estimated  for switches to LIFO increases Lack of any stock price effect in month 0 is consistent with the no-effects hypothesis

Ball (1972) (Cont’d) Results: –Abnormal returns adjusted for risk changes for particular accounting changes: Stock price do not react to earnings changes that result only from accounting changes that have no cash flow effect

Ball (1972) (Cont’d) Like Kaplan & Roll, concentrates on testing the mechanistic hypothesis Fails to account for selection biases –Contemporaneous unexpected earnings A more powerful test  using non zero stock price effect predictions –Changes in inventory methods because they affect taxes

Sunder (1973, 1975) Realizes the potential of the LIFO changes to discriminate between the two hypotheses (no effects and mechanistic)

Sunder (1973, 1975) (Cont’d) Sample: Firms switching to LIFO and firms abandoning LIFO Results: –Observe abnormal price increases associated with switches to LIFO

Sunder (1973, 1975) (Cont’d) Problems: –Doesn’t identify the switch’s announcement date and investigate the abnormal returns at that time. –Has a clustering problem –Does not allow for the contemporaneous earnings selection bias.

Ricks (1982) Attempts to control for the unexpected increase in earnings associated with LIFO switches

Biddle & Lindahl (1982) Results: –The larger the tax savings, the larger the change in value of the firm –The larger the unexpected earnings, the higher the value of the firm –Consistent with no-effects hypothesis Methodological problem: clustering (1974 changes)

Economic Consequences Economic consequences: a concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value

Accounting Policy Accounting policy  any accounting policy, not just one that affects a firm’s cash flows

Economic Consequences & Efficient Market Theory Economic consequences  the accounting policy will matter, despite the lack of cash flow effects Efficient market theory  the change will not matter because future cash flows are not directly affected

Economic Consequences Essentially, the notion of economic consequences is that firms’ accounting policies and changes in policies, matter –Matter to management –But if matter to management, accounting policies matter to the investors

Economic Consequences Accounting policy choice is part of the firm’s overall need to minimize its cost of capital and other contracting costs