1. DISCRIMINATING BETWEEN COMPETING HYPOTHESES

2. THE COMPETING HYPOTHESES
The No-Effect Hypothesis
Accounting change has no implication for stock prices
Unless it had implication for taxes
Accounting be unexpected by the market

3. THE COMPETING HYPOTHESES
The Mechanistic hypothesis
Changes in accounting procedures affect stock prices even if those changes have no effect on the firm’s cash flow
Assumption: accounting reports are the sole information on the firm

4. DISCRIMINATING BETWEEN HYPOTHESIS
3 SET OF ACCOUNTING CHANGES:
All accounting changes whether they affect taxes or not
Accounting changes that do not affect taxes
Accounting changes that affect taxes

5. Kaplan & Roll (1972)
Investigate accounting changes that do not affect taxes
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

6. Kaplan & Roll (1972) Depreciation switchback:
Abnormal rates of return = 0
Support no-effect hypothesis
Contradict with result for investment tax credit

7. Methodological Issues in Kaplan & Roll (1972) Study
Specification of the hypothesis tested
The concentration is on the competing hypothesis – the hypothesis that the market is misled
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 = e0 ≤ 0, Ha: e0 > 0

8. Methodological Issues in Kaplan & Roll (1972) Study
Specification of the hypotheses tested
Specifying the mechanistic hypothesis
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 1st annual earnings number, which is not necessarily the first earnings disclosed using the change accounting method

9. Methodological Issues in Kaplan & Roll (1972) Study
Specification of the hypotheses tested
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

10. Methodological Issues in Kaplan & Roll (1972) Study
Specification of the hypotheses tested
Event study methodology
Clustering: investment tax credit changes occur in 1 year and depreciation switchback occur predominantly in 3 year and over represented in several industries
Selection bias

11. Ball (1972)
Investigated all types of accounting changes

12. Sunder (1973, 1975) Test the mechanistic hypothesis Result:
Risk increases contemporaneously with a switch to LIFO
Observe abnormal price increases associated with switches to LIFO

13. Ricks (1982)
Consistent with mechanistic hypothesis: the market appear to be misled by the drop in earnings caused by the LIFO change
Methodological problem:
Clustering of changes in 1974
Self selection bias

14. Biddle & Lindahl (1982) Results: Methodological problem: clustering
The larger the tax saving, the larger the change in value of the firm
The larger the unexpected earnings, the higher the value of the firm
Consistent with EMH
Methodological problem: clustering

15. ECONOMIC CONCEQUENCES

16. OVERVIEW Economic consequences
A concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can effect firm value

17. THE RISE OF ECONOMIC CONSEQUENCES
Zeff (1978):
Economic consequences: the impact of accounting reports on decision-making behavior of business, government, and creditors