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GODFREY

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

Prediction means that the theory predicts


unobserved phenomena
Has an economic focus
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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

Capital market research


and the efficient markets
Two types of capital markets research
hypothesis
the impact of the release of accounting
information on share returns
the effects of changes in accounting
policy on share prices

Most research in these areas relies


upon the EMH

Capital market research


and the efficient markets
Efficient market: one in which prices
hypothesis
fully reflect available information

3 Forms of Information Efficiency


1. Weak form
(past price information)
2. Semi-strong form
(publicly available information)
3. Strong form
(all information public and private)
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Capital market research


and the efficient markets
hypothesis
Capital markets research in
accounting assumes semi-strong
form efficiency
Financial statements and other
disclosures form part of the
information set that is publicly
available

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Capital market research


and the efficient markets
hypothesis
Based on dubious assumptions

there are no transaction costs in trading


securities
information is available cost-free to all
market participants
there is agreement on the implications
of current information for the current
price and distributions of future prices

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Capital market research


and the efficient markets
Market efficiency does not
hypothesis
assume, mean or imply

that every, or any, investor has


knowledge of all information
that all financial information has been
correctly presented or interpreted by
individual investors
that managers make the best decisions
that investors can predict the future
precisely
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Capital market research


and the efficient markets
Market efficiency simply means that
hypothesis
share prices reflect the aggregate
impact of all relevant information,
and do so in an unbiased and rapid
manner

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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

all participants are price takers


there are no transaction costs
there are no taxes
there are rational expectations by investors
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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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Impact of accounting profits


announcements on share
prices

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Impact of accounting profits


announcements on share
prices
Ball & Brown (1968) Results:
Most of the information contained in
the earnings announcement (8590%) was anticipated by investors
Evidence of information content at
time of historical cost earnings
announcement

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Impact of accounting profits


announcements on share
prices
Magnitude
Information asymmetry and firm size
Magnitude of profit releases from
other firms
Volatility

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Impact of accounting profits


announcements on share
Profit release event studies showed that
prices

accounting profit does capture a portion of the


information set that is reflected in security
returns
The evidence also shows that competing
sources of information pre-empted the
information in annual profits by about 70-85 per
cent
Annual accounting figures are not timely
Led to an another approach association
studies
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Association studies and


earnings response
The objective is to test the impact of
coefficients
accounting variables and a wider
information set that is reflected in
securities returns over a longer
period
earnings response coefficient (ERC)

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Association studies and


earnings response
Factors which can affect the association
coefficients
between profits and share prices:

risk and uncertainty


audit quality
firm size
industry
interest rates
financial leverage
firm growth
permanent and temporary profits
non-linear modeling
disaggregating profits
cash flows
balance sheet and balance sheet components

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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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Issues for auditors


There is some evidence of an association
between auditing and the cost of capital
Lower cost when firms voluntarily
purchase an audit or purchase a high
quality audit
investors value the deep resources of a large
auditor
investors value the quality assurance
regarding accounting data provided by the
auditor
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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

Significant issues relating to the


validity of capital market research
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Key terms and concepts

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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