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

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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 value-relevant
accounting numbers are for share prices
attempt to understand the connection between
accounting information, managers, firms and markets, and
analyse those relationships

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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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Capital market research and the
efficient markets hypothesis
Two types of capital markets research
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

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Capital market research and the
efficient markets hypothesis
Efficient market: one in which prices 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 hypothesis
Market efficiency does not 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 hypothesis
Market efficiency simply means that 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 firm-specific 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 (85-90%) 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 prices
Profit release event studies showed that 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 coefficients
The objective is to test the impact of
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 coefficients
Factors which can affect the association
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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