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HODGSON
HOLMES
TARCA
CHAPTER 12
CAPITAL MARKET RESEARCH
Philosophy of positive
accounting theory
Seeks to explain and predict accounting practice
Seeks to explain how and why capital markets
react to accounting reports
Does so by observing practice empirical
evidence
Explanation means providing reasons for
observed practice
e.g. why do firms continue to use historic cost
Philosophy of positive
accounting theory
Positive theory is based on
assumptions about the behaviour of
individuals
assumes investors and financial
accounting users and preparers are
rational utility maximisers
rejects arguments based on anecdotal
evidence and nave acceptance of
political or academic prescriptions
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Strengths of positive
theory
In order to prescribe an appropriate
accounting policy, it is necessary to
know how the world actually
operates
We can then normatively prescribe
accounting practice
Strengths of positive
theory
Positive hypotheses are capable of
falsification by empirical research
Provides an understanding of how the world
works rather than prescribing how it should
work
obtain an understanding about how valuerelevant accounting numbers are for share prices
attempt to understand the connection between
accounting information, managers, firms and
markets, and analyse those relationships
Dissatisfaction with
prescriptive standards
Normative standards
Prescriptions not based upon identified,
empirical observations or methods
Theories are not falsifiable
Do not explain and predict accounting
practice
Do not assess existing accounting
practices
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Scope of positive
accounting theory
Two stages of development
1. Capital market research into the
impact of accounting and the
behaviour of capital markets
did not explain accounting practice
investigated connection between the
accounting data and share prices/returns
efficient markets hypothesis (EMH)
capital asset pricing model
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Scope of positive
accounting theory
2. Sought to explaining and predict
accounting practices across firms
ex post opportunism
ex ante efficient contracting
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Market model
Market Model:
Derives from CAPM
Used to estimate abnormal returns
on shares when profits announced
Share prices and returns are affected
by both market-wide and firmspecific events
Market-wide events must first be
controlled for
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Market model
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Market model
Based on dubious assumptions
investors are risk averse
returns are normally distributed and
investors select their portfolios on this basis
investors have homogeneous expectations
markets are complete
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 the historical cost profit figure is
useful the share price will react
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Methodological issues
To argue that the results of the research
are supportive of EMH and that the form
of accounting is not that important for
valuation purposes derives, in part, from
the fact that the EMH is assumed to be
descriptively valid
This assumption may not be warranted
There is increasing evidence that markets
can be fooled by accounting numbers
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Methodological issues
No attempt to discriminate EMH from
competing hypothesis
mechanistic hypothesis
managers use accounting to deliberately
mislead the share market
market participants can be fooled
no-effects hypothesis
the market ignores accounting changes that
have no cash flow consequences
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Trading strategies
Post-announcement drift
Winners/losers and over-confidence
Mechanistic or behavioural effect
no-effects hypothesis
cosmetic accounting
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Trading strategies
Two viewpoints of accounting
manipulation
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Trading strategies
Detecting the quality and
probability of accounting
management
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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
Prescriptive standards
Positive accounting theory
Capital market research
EMH
CAPM
CAR
ERC
Information asymmetry
Market efficiency
Impact of behaviour
Mechanistic hypothesis
No-effects hypothesis
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