Prepared by Arabella Volkov

University of Southern Queensland

References

Text Chapter 9

Positive theory and capital market research

Learning Objectives

At the conclusion of this lecture, you should have an appreciation of:

the philosophy of positive accounting theorythe strengths of positive accounting over normative accountingthe scope of positive accounting theory

Learning Objectives

At the conclusion of this lecture, you should have an appreciation of:

capital market research and the efficient market hypothesisthe influence of accounting information on investor behaviour
and share pricestrading strategies and mechanistic behavioural effects

Philosophy of positive accounting theory

seeks to explain observed accounting phenomenaeconomic focusmore scientific in methodologyAssumptions about the behaviour of individualsunderlies most empirical studies
in economics

Strengths of positive theory over normative theory

Dissatisfactions with normative accounting:

Prescriptions not based upon identified, empirical observations or methodsTheories are not falsifiableDoes not explain and predict accounting practiceDo not assess existing accounting practices

Scope of positive accounting theory

Two stages of development:

Capital market research

Did not explain accounting practiceConnection EMHMarket model

Explaining and predicting accounting practice

Capital Markets Research & the Efficient Markets Hypothesis

Two types of capital markets research:Impact of the release of accounting information on share returnsThe effects of changes in accounting policy on share pricesMost research in these areas relies upon the efficient markets hypothesis (EMH)

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)

Capital Markets Research & the Efficient Markets Hypothesis

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

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 participantsAll agree on the implications of current information for the current price and distributions of future prices of each security

Capital Markets Research & the Efficient Markets Hypothesis

Market efficiency does not assume:

Other forms of efficiency recognised in economicsEvery investor has knowledge of all informationAll financial information is correctly presented or interpreted by individual investorsManagers make the best decisionsInvestors can predict the future precisely

Capital Markets Research & the Efficient Markets Hypothesis

CMR:

Empirical researchTests hypotheses about capital market behaviour

Market Model:

Derives from CAPMUsed to estimate abnormal returns on shares when profits announced

Capital Markets Research & the Efficient Markets Hypothesis

Capital Markets Research & the Efficient Markets Hypothesis

Figure 9.1: Sample market model for i = BHP and t = quarter ending
June 2001

Impact of Accounting Profits Announcements on Share Prices

Ball & Brown (1968):

Seminal work in positive accounting and finance literatureTested the usefulness of historical cost profit figure to investment decisionsIf historical cost profit figure is useful share price will react (EMH)

Impact of Accounting Profits Announcements on Share Prices

Impact of Accounting Profits Announcements on Share Prices

Ball & Brown (1968) Results:

Most of the information contained in the earnings announcement (85-90%) was anticipated by investors Evidence of Information content at time of (historical cost) earnings announcement

Impact of Accounting Profits Announcements on Share Prices

MagnitudeInformation asymmetry and
firm sizeMicrostructure extensions to
firm sizeMagnitude of profit releases of other firmsVolatility

Association Studies & Earnings Response Coefficients

Association studies

impact of accounting measures on share prices over a longer event windowEarnings response coefficient (ERC) is a subset of this literature

ERC:

Ordinary least-squares regressionDependant variable: returnsIndependent variable: profitR2 (goodness of fit) and slope (sensitivity of returns to profit) used to assess informativeness of profits

Association Studies & Earnings Response Coefficients

Factors which can affect the ERC:

Risk and uncertaintyAudit qualityFirm sizeIndustryInterest ratesFinancial leverageFirm growthPermanent and temporary profits

Association Studies & Earnings Response Coefficients

Determinants of firm value:

IndustryInterest ratesFinancial leverageAudit qualityFirm sizeFirm growth

Association Studies & Profit Response Coefficients

Determinants of firm value (contd):

Magnitude of profit releases of other firmsVolatilityPermanent and temporary earningsOmitted variablesChanges versus levels in earningsProfit componentsCash flows

Methodological issues

Ball and Browns original paperPositive theory of accountingWilliams and Findlay Argue the results of the research are supportive of EMHWatts and ZimmermanNo attempt to differentiate EMH

Trading Strategies

Post-announcement driftWinner/loser effect Long-term association anomalyPast winners tend to be future losers and vice versaDebondt and ThalerLong-term return reversals to investor overconfidence and Biased self-attribution

Mechanistic or
behavioural effect

Cosmetic accountingLeftwich Two hypotheses Market reacted mechanistically to changes in accounting numbers, regardless whether they were cosmetic or whether they had cash flow implicationsMarket ignored accounting changes which had no cash flow consequences

Mechanistic or
behavioural effect

Manipulating accounting numbers:

Mechanistic or
behavioural effect

Detecting the quality and probability of accounting management:

Summary

Philosophical objective of positive accounting theory is to explain and predict current accounting practicePositive theory developed in two stagesCapital market researchContracting theory

Key terms and concepts

Positive accounting theoryEMHCAPMCARInformation asymmetryMarket efficiencyImpact of behaviour

Where to get more information

Other coursesList booksArticlesElectronic sources