Prepared by Arabella Volkov University of Southern Queensland

1. Prepared by Arabella Volkov University of Southern Queensland

2. References • Text – Chapter 9 Positive theory and capital market research

3. Learning Objectives At the conclusion of this lecture, you should have an appreciation of: • the philosophy of positive accounting theory • the strengths of positive accounting over normative accounting • the scope of positive accounting theory

4. Learning Objectives At the conclusion of this lecture, you should have an appreciation of: • capital market research and the efficient market hypothesis • the influence of accounting information on investor behaviourand share prices • trading strategies and mechanistic behavioural effects

5. Philosophy of positive accounting theory • seeks to explain observed accounting phenomena • economic focus • more scientific in methodology • Assumptions about the behaviour of individuals • underlies most empirical studiesin economics

6. Strengths of positive theory over normative theory Dissatisfactions with normative accounting: • Prescriptions not based upon identified, empirical observations or methods • Theories are not falsifiable • Does not explain and predict accounting practice • Do not assess existing accounting practices

7. Scope of positive accounting theory Two stages of development: • Capital market research • Did not explain accounting practice • Connection • EMH • Market model • Explaining and predicting accounting practice

8. Capital Markets Research & the Efficient Markets Hypothesis • Two types of capital markets research: • 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 efficient markets hypothesis (EMH)

9. Capital Markets Research & the Efficient Markets Hypothesis Efficient market: one ‘in which prices ‘fully’ reflect available information’ 3 Forms of Information Efficiency: • Weak form (past price information) • Semi-strong form (publicly available information) • Strong form (all information – public and private)

10. Capital Markets Research & 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

11. Capital Markets Research & the Efficient Markets Hypothesis Sufficient conditions of an efficient market (Fama): • There are no transaction costs in trading securities • All information is available cost-free to all market participants • All agree on the implications of current information for the current price and distributions of future prices of each security

12. Capital Markets Research & the Efficient Markets Hypothesis Market efficiency does not assume: • Other forms of efficiency recognised in economics • Every investor has knowledge of all information • All financial information is correctly presented or interpreted by individual investors • Managers make the best decisions • Investors can predict the future precisely

13. Capital Markets Research & the Efficient Markets Hypothesis CMR: • Empirical research • Tests hypotheses about capital market behaviour Market Model: • Derives from CAPM • Used to estimate abnormal returns on shares when profits announced

14. Capital Markets Research & the Efficient Markets Hypothesis

15. Figure 9.1: Sample market model for i = BHP and t = quarter ending June 2001 Capital Markets Research & the Efficient Markets Hypothesis

16. 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 historical cost profit figure is useful share price will react (EMH)

17. Impact of Accounting Profits Announcements on Share Prices

18. Impact of Accounting Profits Announcements on Share Prices Ball & Brown (1968) Results: • Most of the information contained in the earnings announcement (85-90%) was anticipatedby investors • Evidence of Information content at time of (historical cost) earnings announcement

19. Impact of Accounting Profits Announcements on Share Prices • Magnitude • Information asymmetry andfirm size • Microstructure extensions tofirm size • Magnitude of profit releases of other firms • Volatility

20. Association Studies & Earnings Response Coefficients Association studies • impact of accounting measures on share prices over a longer event window • Earnings response coefficient (ERC) is a subset of this literature ERC: • Ordinary least-squares regression • Dependant variable: returns • Independent variable: profit • R2 (goodness of fit) and slope (sensitivity of returns to profit) used to assess informativeness of profits

21. Association Studies & Earnings Response Coefficients Factors which can affect the ERC: • Risk and uncertainty • Audit quality • Firm size • Industry • Interest rates • Financial leverage • Firm growth • Permanent and temporary profits

22. Association Studies & Earnings Response Coefficients Determinants of firm value: • Industry • Interest rates • Financial leverage • Audit quality • Firm size • Firm growth

23. Association Studies & Profit Response Coefficients Determinants of firm value (cont’d): • Magnitude of profit releases of other firms • Volatility • Permanent and temporary earnings • Omitted variables • Changes versus levels in earnings • Profit components • Cash flows

24. Methodological issues • Ball and Brown’s original paper • Positive theory of accounting • Williams and Findlay • Argue the results of the research are supportive of EMH • Watts and Zimmerman • No attempt to differentiate EMH

25. Trading Strategies • Post-announcement drift • Winner/loser effect • Long-term association anomaly • Past winners tend to be future losers and vice versa • Debondt and Thaler • Long-term return reversals to investor overconfidence and • Biased self-attribution

26. Mechanistic or behavioural effect • Cosmetic accounting • Leftwich • Two hypotheses • Market reacted mechanistically to changes in accounting numbers, regardless whether they were cosmetic or whether they had cash flow implications • Market ignored accounting changes which had no cash flow consequences

27. Mechanistic or behavioural effect Manipulating accounting numbers:

28. Mechanistic or behavioural effect Detecting the quality and probability of accounting management:

29. 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

30. Key terms and concepts • Positive accounting theory • EMH • CAPM • CAR • Information asymmetry • Market efficiency • Impact of behaviour

31. Where to get more information • Other courses • List books • Articles • Electronic sources