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GODFREY
HODGSON
HOLMES
TARCA

CHAPTER12
CAPITALMARKETRESEARCH

Philosophyofpositive
accountingtheory
Seekstoexplainandpredictaccountingpractice
Seekstoexplainhowandwhycapitalmarketsreact
toaccountingreports
Doessobyobservingpractice empiricalevidence
Explanationmeansprovidingreasonsforobserved
practice
e.g.whydofirmscontinuetousehistoriccost

Predictionmeansthatthetheorypredicts
unobservedphenomena
Hasaneconomicfocus
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Philosophyofpositive
accountingtheory
Positivetheoryisbasedonassumptionsabout
thebehaviourofindividuals
assumesinvestorsandfinancialaccountingusers
and preparers are rational utility maximisers
andpreparersarerationalutilitymaximisers
rejectsargumentsbasedonanecdotalevidence
andnaveacceptanceofpoliticaloracademic
prescriptions

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Strengthsofpositivetheory
Inordertoprescribeanappropriate
accountingpolicy,itisnecessarytoknowhow
theworldactuallyoperates
Wecanthennormativelyprescribeaccounting
We can then normatively prescribe accounting
practice

Strengthsofpositivetheory
Positivehypothesesarecapableoffalsificationby
empiricalresearch
Providesanunderstandingofhowtheworldworks
ratherthanprescribinghowitshouldwork
obtainanunderstandingabouthowvaluerelevant
accountingnumbersareforshareprices
attempttounderstandtheconnectionbetween
accountinginformation,managers,firmsandmarkets,and
analysethoserelationships

Dissatisfactionwithprescriptive
standards
Normativestandards
Prescriptionsnotbaseduponidentified,
empiricalobservationsormethods
Theoriesarenotfalsifiable
h i
f l ifi bl
Donotexplainandpredictaccountingpractice
Donotassessexistingaccountingpractices

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Scopeofpositiveaccounting
theory
Twostagesofdevelopment
1. Capitalmarketresearch intotheimpactof
accountingandthebehaviourofcapital
markets
didnotexplainaccountingpractice
investigatedconnectionbetweentheaccounting
dataandshareprices/returns
efficientmarketshypothesis(EMH)
capitalassetpricingmodel
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Scopeofpositiveaccounting
theory
2. Soughttoexplainingandpredictaccounting
practicesacrossfirms
expostopportunism
exanteefficientcontracting
ex ante efficient contracting

Capitalmarketresearchandthe
efficientmarketshypothesis
Twotypesofcapitalmarketsresearch
theimpactofthereleaseofaccounting
informationonsharereturns
theeffectsofchangesinaccountingpolicyon
shareprices

Mostresearchintheseareasreliesuponthe
EMH

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Capitalmarketresearchandthe
efficientmarketshypothesis
Efficientmarket:oneinwhichpricesfully
reflectavailableinformation
3FormsofInformationEfficiency
1. Weakform
(pastpriceinformation)
2. Semistrongform
(publiclyavailableinformation)
3. Strongform
(allinformation publicandprivate)
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Capitalmarketresearchandthe
efficientmarketshypothesis
Capitalmarketsresearchinaccounting
assumessemistrongformefficiency
Financialstatementsandotherdisclosures
form part of the information set that is
formpartoftheinformationsetthatis
publiclyavailable

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Capitalmarketresearchandthe
efficientmarketshypothesis
Basedondubiousassumptions
therearenotransactioncostsintradingsecurities
informationisavailablecostfreetoallmarket
participants
thereisagreementontheimplicationsofcurrent
informationforthecurrentpriceanddistributions
offutureprices

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Capitalmarketresearchandthe
efficientmarketshypothesis
Marketefficiencydoesnotassume,meanor
imply
thatevery,orany,investorhasknowledgeofall
information
thatallfinancialinformationhasbeencorrectly
that all financial information has been correctly
presentedorinterpretedbyindividualinvestors
thatmanagersmakethebestdecisions
thatinvestorscanpredictthefutureprecisely

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Capitalmarketresearchandthe
efficientmarketshypothesis
Marketefficiencysimplymeansthatshare
pricesreflecttheaggregateimpactofall
relevantinformation,anddosoinanunbiased
and rapid manner
andrapidmanner

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Marketmodel
MarketModel:
DerivesfromCAPM
Usedtoestimateabnormalreturnsonshares
when profits announced
whenprofitsannounced
Sharepricesandreturnsareaffectedbyboth
marketwideandfirmspecificevents
Marketwideeventsmustfirstbecontrolled
for
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Marketmodel

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Marketmodel
Basedondubiousassumptions
investorsareriskaverse
returnsarenormallydistributedandinvestors
select their portfolios on this basis
selecttheirportfoliosonthisbasis
investorshavehomogeneousexpectations
marketsarecomplete

allparticipantsarepricetakers
therearenotransactioncosts
therearenotaxes
therearerationalexpectationsbyinvestors
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Impactofaccountingprofits
announcementsonshareprices
Ball&Brown(1968):
Seminalworkinpositiveaccountingand
financeliterature
Testedtheusefulnessofhistoricalcostprofit
d h
f l
f hi
i l
fi
figuretoinvestmentdecisions
Ifthehistoricalcostprofitfigureisusefulthe
sharepricewillreact

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Impactofaccountingprofits
announcementsonshareprices

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Impactofaccountingprofits
announcementsonshareprices
Ball&Brown(1968)Results:
Mostoftheinformationcontainedinthe
earningsannouncement(8590%)was
anticipated byinvestors
by investors
Evidenceof informationcontentattimeof
historicalcostearningsannouncement

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Impactofaccountingprofits
announcementsonshareprices
Magnitude
Informationasymmetryandfirmsize
Magnitudeofprofitreleasesfromotherfirms
Volatility

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Impactofaccountingprofits
announcementsonshareprices
Profitreleaseeventstudiesshowedthataccounting
profitdoescaptureaportionoftheinformationset
thatisreflectedinsecurityreturns
Theevidencealsoshowsthatcompetingsourcesof
informationpreemptedtheinformationinannual
profitsbyabout7085percent
Annualaccountingfiguresarenottimely
Ledtoananotherapproach associationstudies

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Associationstudiesand earnings
responsecoefficients
Theobjectiveistotesttheimpactof
accountingvariablesandawiderinformation
setthatisreflectedinsecuritiesreturnsovera
longerperiod
earningsresponsecoefficient(ERC)
earnings response coefficient (ERC)

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Associationstudiesandearnings
responsecoefficients
Factorswhichcanaffecttheassociation
betweenprofitsandshareprices:

riskanduncertainty
auditquality
firmsize
industry
interestrates
financialleverage
firmgrowth
permanentandtemporaryprofits
nonlinearmodeling
disaggregatingprofits
cashflows
balancesheetandbalancesheetcomponents
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Methodologicalissues
Toarguethattheresultsoftheresearchare
supportiveofEMHandthattheformof
accountingisnotthatimportantforvaluation
purposes derives in part from the fact that
purposesderives,inpart,fromthefactthat
theEMHisassumedtobedescriptivelyvalid
Thisassumptionmaynotbewarranted
Thereisincreasingevidencethatmarketscan
befooledbyaccountingnumbers
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Methodologicalissues
NoattempttodiscriminateEMHfrom
competinghypothesis
mechanistichypothesis
managers
managersuseaccountingtodeliberatelymisleadthe
use accounting to deliberately mislead the
sharemarket
marketparticipantscanbefooled

noeffectshypothesis
themarketignoresaccountingchangesthathaveno
cashflowconsequences

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Tradingstrategies
Postannouncementdrift
Winners/losersandoverconfidence
Mechanisticorbehaviouraleffect
Mechanistic or behavioural effect
noeffectshypothesis
cosmeticaccounting

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Tradingstrategies
Twoviewpointsofaccountingmanipulation

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Tradingstrategies
Detectingthequalityandprobabilityof
accountingmanagement

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Issuesforauditors
Thereissomeevidenceofanassociation
betweenauditingandthecostofcapital
Lowercostwhenfirmsvoluntarilypurchasean
audit or purchase a high quality audit
auditorpurchaseahighqualityaudit
investorsvaluethedeepresourcesofalarge
auditor
investorsvaluethequalityassuranceregarding
accountingdataprovidedbytheauditor

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Summary
Philosophicalobjectiveofpositiveaccounting
theoryistoexplainandpredictcurrent
accountingpractice
Positivetheorydevelopedintwostages
capitalmarketresearch
contractingtheory

Significantissuesrelatingtothevalidityof
capitalmarketresearch
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Keytermsandconcepts

Prescriptivestandards
Positiveaccountingtheory
Capitalmarketresearch
EMH
CAPM
CAR
ERC
Informationasymmetry
Marketefficiency
Impactofbehaviour
Mechanistichypothesis
Noeffectshypothesis
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