TUTORIAL SOLUTIONS CHAPTER 12

Questions
1. What is positive accounting theory? How does it differ from normative accounting
theory? What was/were the major dissatisfaction(s) with normative accounting
theory which led to the development of a positive theory of accounting?

Positive accounting theory is concerned with explaining and predicting current accounting
practices. This means that the focus is on understanding and explaining the techniques and
methods that accountants currently use and why we have ended up with the conventional
historic cost accounting system. This approach can be compared with normative accounting
theories which dismiss conventional historic cost accounting as being meaningless or not
decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based
on inflation adjustments. One technique which can be used to show students the different
approaches is to contrast the assumptions used by each theory as follows:

Normative Positive
Objective of accounting Decision making Stewardship/Agency
relationship
Behavioural assumptions Functional fixation/fooled Rational economic man-
by cosmetic accounting able to analyse and
distinguish
Economic assumptions Little comment costs Financial reports are an
economic commodity.
Information has a price.
Semantic assumptions Accounting serves a Measurement role is a
measurement role secondary function to
monitoring and bonding
Pragmatic assumptions Accounting is Accounting is a political
neautral/unbiased economic/social
commodity

The dissatisfactions with normative accounting are:

(i) To be normative one must specify an objective function, e.g., economic

efficiency, decision usefulness, estimation of future share prices, improved
quality of financial reports etc. However, many of the above objectives are
conflicting and it is difficult to decide which one is a superior objective. It should
be noted that the definition of an objective of accounting continues to be a
contentious issue (note that the objective is usually defined in a very broad, non-
specific manner).

Popper also makes the point that no amount of empirical testing can prove or
disprove the validity of normative accounting prescriptions — they are irrefutable
— therefore they are weak hypotheses.

(ii) There was usually no attempt to justify — empirically — that the prescriptions
from normative theories are ‘better’ than the status quo. For example, the
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 redefinition of the objective of financial accounting from the traditional
stewardship role into a decision making role (usually to aid investors) was never
justified by empirical research.

(iii) Before condemning the usefulness of conventional accounting as a decision

making tool it would be more scientific to analyse and compare the decision
making processes induced by conventional accounting and the proposed
alternatives. Part of this research would encompass whether cosmetic
manipulations fooled market participants and the role that financial accounting
played in economic decision making.

1. Normative inflation models have been widely known in the literature for
over 30 years, and have not been readily accepted by the market place.
Positive theories sought to obtain a rational explanation for the status quo.

2. This leads positivists to attempt to model the connection between financial

accounting, firms and markets in a rational economic framework, rather
than to take the stance of normative theorists who dismissed current
practice and took a prescriptive attitude.

2. Explain the meaning of an efficient market. What is meant by the following terms:
weak-form efficiency, semistrong-form efficiency and strong-form efficiency?
Which form is the most important to accounting research? Why?

An efficient market, in the context of the sharemarket, is a market which adjusts rapidly to
new information and fully reflects the available information in an unbiased manner. The
implication of this theory is that if sharemarkets fully reflect all the available information in
prices, then there is no marginal benefit in collecting and analysing information which bears
on the price of any individual share.

Market efficiency only refers to information efficiency and does not relate to exchange
efficiency or production efficiency.

Furthermore, it does not mean that all financial information has been ‘correctly’ presented by
firms or ‘properly’ interpreted by individual analysts. Nor does it imply that managers make
optimal management decisions or that investors can predict future events with certainty.
EMH means that, in aggregate, all information which is relevant is impounded into security
prices in an unbiased and rapid manner — hence the term — market prices are a fair game.

To accommodate different types of information sets and to enable empirical testing (capital
market research), Fama distinguished between three information sets (past price movements,
publicly available information and all information, both public and private) as follows:

(i) The ‘weak form’ of market efficiency implies that a security’s price at a
particular time fully reflects the information contained in its sequence of past
prices — that is, there are no trading strategies based on cycles in prices (Dow
theory), price patterns (head and shoulders) or other rules such as oddlot
behaviour, moving averages and relative strength which will give excess profits.

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 (ii) The ‘semistrong form’ asserts that a security’s price fully reflects all publicly
available information which includes past prices. This means that there are no
trading strategies available to make excess profits from analysing publicly
available economic, political, legal or financial data.

(iii) The ‘strong form’ suggests that a security’s price fully reflects all information,
including information that is not publicly available — for example, insider and
private information.

Of the three, the semistrong form is the one most directly related to the accounting
profession, because accounting information, when released, is part of the subset of publicly
available information. Normative accounting theorists and accounting standard-setting bodies
give quite considerable effort to arguing the merits of the form in which accounting
statements are disclosed to the public. However, if prices already reflect all publicly available
information, which includes current values and general inflation, then their arguments for
‘proper’ measurement are considerably weakened.

It is also important to distinguish the market related effects that different accounting
standards may have on share prices. These effects may be caused by a higher cost structure
(e.g., more complex accounting systems or regulation), or by the imposition of political,
social or renegotiation costs by participants who are located outside the relatively efficient
security market.

Addendum: Relation between efficient markets and capital market research

An article by Wyatt attempts to explain the impact of capital market research and the efficient
capital market hypothesis on practising accountants.
Wyatt gives a number of examples which he argues denies the propriety of the efficient
market hypothesis (EMH). For example:
(i) LIFO — accountants report higher profits by using LIFO even though (in the US)
it has the economic consequence of a higher taxation payment.
(ii) Off balance sheet finance — one of the predictions of EMH is that the form of
accounting has no effect on share prices. However, Wyatt points out that some
accountants use off-balance sheet lease financing even though it has a higher cost
than on-balance sheet debt.
(iii) Business combinations — EMH predicts that company share prices will be
unaffected by the accounting method of merger accounting. However, one
company Wyatt was aware of didn’t go ahead with a merger because it believed
that the purchase method of accounting would knock down the market value of its
shares to unacceptable levels.
(iv) Foreign operations — Wyatt states that there is some evidence of managers
changing their cash management and hedging operations to hedge accounting
risks associated with foreign exchange accounting.
Overall, Wyatt concludes that accountants, in general, ignore or dispute EMH. ‘If EMH
is valid why do businessmen continue to act as if it isn’t?'

Counter Arguments

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 (a) Wyatt uses casual or anecdotal evidence. The value of such evidence is
strengthened by expanding and analysing the evidence so that it is statistically
acceptable.
It is also questionable whether the behaviour of market participants (pragmatics)
is appropriate evidence when analysing EMH and CMR.
(b) Managers’ actions may be justified in choosing accounting techniques for rational
reasons other than trying to fool the market. For example, to increase their own
compensation, to meet debt or equity convenants, for political expediency or for
other reasons which might affect the economic well being of the firm or
managers.
(c) The focus of EMH is to present an hypothesis about the reaction of share prices to
information sets. CMR is statistically based research which examines the reaction
of share prices — it is a semantic theory. Therefore, the question can be raised
whether the beliefs and reactions of managers (pragmatics) is appropriate
evidence to counter a statistical theory (semantics) about the movement of share
prices.

3. Explain the importance of examining the impact of profits on share prices for
financial analysis. Can this analysis be used to make abnormal returns from share
markets?

In general the empirical research on the information content of accounting earnings has the
following implications:

(i) historical cost income releases have significant information content for the
marketplace in terms of CAR’s and the effect on volatility and trading volume

(ii) there is a continuous information set which is employed by the market and,
therefore, accounting reports are not the only source of information

(iii) there are limited opportunities for abnormal returns after the release of earnings.
Hence the analysis of financial reports well after the release of those reports is
unlikely to result in abnormal returns for the analyst.

(iv) empirical research on the mechanistic and no-effects hypotheses are inconclusive,
but these tests were hampered by the lack of a well-formed predictive theory
about accounting policy choice.

(v) current earnings are correlated with contemporary movements in share prices.

(vi) Most of the research has been undertaken on large firms in the US stock market.
There is evidence that financial analysts who concentrate on small firms may
earn excess returns. Furthermore, there is no mention of the important role that
financial analysts play in keeping the market efficient or in making the market
when the stock is unlisted.

Further, Beaver argues that CMR has the following implications for accounting standard
setting:

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 (i) many accounting issues are capable of a simple disclosure solution (for example,
by footnote)

(ii) the role of accounting data is to prevent superior returns accruing to insiders and
can be achieved by a policy of fuller disclosure

(iii) financial statements should not be reduced to the level of naive investors

(iv) accounting policies should take into account excessive costs and their economic
consequences.

Additionally, Deitrick and Harrison believe that the EMH and CMR have important
implications for practising accountants, such as:

(i) counselling clients against making costly accounting changes if their sole purpose
is to ‘fool’ share markets
(ii) the fact that the substance of an accounting disclosure is more important than its
form or location
(iii) as a defence against claims for damages in courts of law and to quantify estimates
of economic loss.

4. Does a study of the information content of profits announcements explain why firms
use particular accounting practices? Does it help to predict which firms will use
particular accounting practices?

No. This is one of the major shortcomings of this type of research which simply looks at the
aggregate effects of accounting practices (earnings) on share prices. There is no theoretical
background to explain why firms use particular accounting techniques or no predictive theory
as to the circumstances in which a firm would be expected to change its accounting policy
(see Leftwich 1990 ). This leads into the second stage of positive theory — covered in
chapter 10 — which encompasses rational economic models of voluntary and mandatory
changes of accounting techniques.

7. Outline the research that has been undertaken on the impact of permanent and
temporary increases in profits. Why is this research important?

Research is summarised in the chapter. Permanent and temporary earnings will have
differential impacts on share prices in an efficient market. This has important impacts on
research design (linear vs non-linear models) and assessing the sophistication of the market in
analysing the impact of earnings on stock prices (see the next question).