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 • the philosophy of positive accounting theory • the strengths of positive accounting over normative accounting • the scope of positive accounting theory

4. Learning Objectives • 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. Normative vs Positive

6. Normative vs Positive

7. Normative vs Positive

8. 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

9. 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

10. 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

11. Capital Markets Research & the Efficient Markets Hypothesis • Two types of capital markets research: • Impact of the release of accounting information on share returns (C9) • The effects of changes in accounting policy on share prices (C10 • Most research in these areas relies upon the efficient markets hypothesis (EMH)

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

13. 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

14. 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

15. 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

16. 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

17. Examples of research scopes • Events studies • Association studies • Mechanistic behavioural approaches Test the relationship between accounting and the efficient market

18. Major results Implication on positive accounting theory • Historical cost income releases have significant information content for the marketplace in terms of CARs and the effect on volatility and trading volume. • There is a continuous information set that is employed by the market and, therefore, accounting reports are not the only source of information. • 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.

19. Major results • Empirical research on the mechanistic and no-effects hypotheses is inconclusive, but these tests were hampered by the lack of a well-formed predictive theory about accounting policy choice. • Current earnings are correlated with contemporary movements in share prices. • 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.

20. Major results Implications for accounting standard setting (Beaver): • Many accounting issues are capable of a simple disclosure solution (for example, by footnote). • The role of accounting data is to prevent superior returns accruing to insiders and can be achieved by a policy of fuller disclosure. • Financial statements should not be reduced to the level of naive investors. • Accounting policies should take into account excessive costs and their economic consequences..

21. Major results Implications for practising accountants (Deitrick and Harrison ) • counselling clients against making costly accounting changes if their sole purpose is to ‘fool’ share markets • the fact that the substance of an accounting disclosure is more important than its form or location • a defence against claims for damages in courts of law and to quantify estimates of economic loss.

22. 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

23. 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

24. 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

25. 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

26. 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

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

28. 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

29. 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

30. 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

31. 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

32. Mechanistic or behavioural effect Manipulating accounting numbers:

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

34. 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

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

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

38. Capital Markets Research & the Efficient Markets Hypothesis

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

40. 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)

41. Impact of Accounting Profits Announcements on Share Prices