WEEKLY TASK

ACCOUNTING THEORY
(SUBJECT CODE: ECAU601401)
Chapter 12
CAPITAL MARKET RESEARCH
(Godfrey et.al. Accounting Theory 7th Ed)

Lecturer:
Mrs. Siti Nuryanah, S.E., M.S.M., M.Bus.Acc., Ph.D.

Group Member
1. Eggie Auliya Husna 1706105246
2. Fendhi Birowo 1706105290
3. Yolanda Tamara 1406612275

SALEMBA EXTENSION CLASS

ACCOUNTING PROGRAM
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITY OF INDONESIA
YEAR 2018
MINDMAP FOR CHAPTER 12

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 CHAPTER 12
CAPITAL MARKET RESEARCH

A. THE PHILOSOPHY OF POSITIVE ACCOUNTING THEORY

 Positive theory seeks to understand the phenomenon of accounting to observe empirical
events and using the results to make predictions about observations and or to predict the
future. This is different from descriptive theory, which focuses only on describing events,
and from normative theory, which regulates what must happen. Milton Friedman states
about positive accounting theory in economics: "The aim of positive science is the
development of valid 'theories' or 'hypotheses' and meaningful predictions about
phenomena that have not been observed."
 Zimmerman emphasizes the purpose of positive accounting theory is to explain and
predict accounting practices. This explanation means giving reasons for observed practice.
For example positive accounting theory seeks to explain why companies continue to use
historical cost accounting and why certain companies switch between a number of
accounting practice techniques means that this theory predicts phenomena. Observed
phenomena are not always future phenomena, they are phenomena that have occurred, but
are based on systematic evidence that has not been collected. Positive theory research
seeks to obtain empirical evidence about the attributes of companies that continue to use
the same accounting techniques from year to year versus the attributes of companies that
are constantly switching, even though standards have been realized.
 Positive accounting theory also has an economic focus and seeks to answer questions
below:
a) What are the costs and benefits of using alternative accounting methods?
b) What are the costs and benefits of regulations and the accounting standard-setting
process?
c) What is the effect of reported financial statements on share prices?
d) Which accounting valuation models are superior in predicting future prices, returns,
earnings or cash flows?
 In order to answer these questions, positive accounting theory is based on several
assumptions about individual behavior:
a) Managers, investors, lenders and other individuals are assumed to be rational,
evaluative financial utility maximisers (REMs).
b) Managers have discretion to choose accounting policies that directly maximise their
utility (self-interest) or to alter the firm’s financing, investment and production
policies to indirectly maximise their self interests.
c) Managers will take actions that maximize company value.

B. THE STRENGHTS OF POSITIVE THEORY

 Jensen argues that previous normative accounting theory became a positive theory of
accounting. Thus, in order for the corresponding material accounting policies, he believes

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 that it is necessary to know how the real world operates. Thus, we need to know what the
world of finance today when making adjustments to historical values before there are
normative changes in accounting standards.
 Dissatisfaction with the standard perspective, one of the criticisms of changes in
accounting standards is that accounting practices and audit practices are not entirely based
on identification, empirical observation or methods. Watt and Zimmerman emphasized
that the validity of data in accounting requires the specifications of both purpose and
objective functions. A positive example of an objective function is a specification of how
the measurement of assets at fair value affects the distribution of wealth between
shareholders, creditors and managers. This goes beyond more than setting normative goals
to change accounting to measure fair value.
 A normative theory based on value judgements, however, produces irrefutable
prescriptions even if accounting theory is developed logically, does not determine purpose
or objective functions that are independent of the problem. With this approach,
prescription validity is irrefutable. According to Popper, there is no amount of empirical
testing –that is, theoretical testing of real world data can prove the theory to be true, but
theory must be refuted, or capable of falsification.
 Several factors prevent falsifiable theories:
a) It is not possible to prove or refute the claim that financial accounts should provide
lenders with a measure of the firm’s solvency because this is an value-laden
judgement.
b) It is not possible to prove or refute the claim that an objective of a financial accounts
should be report to investors about maintenance of the operating capacity – again,
because this is a value-laden judgment.
 Theoretical requirements cannot be rated objectively because it is not possible to prove or
refute claims that either objective is more important than other. Thus, by Popper
standard’s normative and prescriptive theory is methodologically weak.
 There is a further methodological problem with normative and prescriptive theories: even
if they were falsifiable, the choice of the objective function would still have to be justified.

C. THE SCOPE OF POSITIVE ACCOUNTING THEORY

 It is instructive to look at the development of positive accounting theory in two stages.
First and chronological research phase had previously been involved in accounting and
capital market behavior. The literature from this stage did not explain accounting
practices, but it investigates the relationship between the announcement of accounting
data and share price reactions, which shows that financial statements prepared with the
historical cost method do not provide information used by the capital market in share
valuation, but, at the same time, accounting also does not monopolize information used
for companies. This value is an assumption that supports the argument that the best
accounting reports that might be able to service a function. Finally, financial economic

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 theories, especially in the efficient market hypothesis and CAPM, are included in this
literature.
 The second stage of literature seeks to explain and predict accounting practices in the
company. There are two focuses, the first center there is an attempt to explain whether
firms make certain accounting choices for opportunistic perspectives often labeled ex post,
because it assumes that managers choose accounting policies after the fact to maximize
viewpoints according to their interests. The reason for this is that it is either impossible or
inefficient to eliminate all residual opportunistic behavior by the manager. The
perspective of efficiency does not require that accounting policies actually selected ex-
ante only that choices are made as if they were chosen ex ante to maximize firm value
rather than make opportunities. Both stages of positive accounting literature attract
extensively.

D. CAPITAL MARKET RESEARCH AND THE EFFICIENT MARKETS HYPOTHESIS

 There are 2 kinds of capital market research that are particularly important to positive
accounting theory:
1. Studies that attempt to determine the impact of the release of accounting information
on share returns.
2. Studies that consider the effects of changes in accounting policies on share prices.
 Most research in this area leads to an economic paradigm – the efficient markets
hypothesis (EMH). The definition of an efficient market that “fully describes” the
information available is based on the 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
distribution of future price.
 The implication of this assumption is that in an efficient capital market, information is
fully incorporated into share prices when it is released. According to Fama, there are three
types of information, namely:
1. Weak, where current securities prices only reflect past prices
2. Semistrong, where the current security price shows all available information, apart
from past prices
3. Strong, where securities prices show all information including unpublished
information
The form of semistrong information is the most appropriate for accounting research,
because financial information is part of the subset of publicly available information.
Market efficiency does not mean that all financial information has been 'correctly' or
'properly' presented by the decision maker. Rather it shows that managers make the best
management decisions or that investors can predict future events correctly.

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  EMH is a theory about the mechanism of giving prices from the security market. Capital
Market Research (CMR) is empirical research that uses statistical methods to test
hypotheses regarding capital market behavior. Most CMRs use a market model which is
obtained from the Capital Asset Pricing Model (CAPM), to estimate unexpected returns
from ordinary shares of a company during certain circumstances.
 Market efficiency in the context of EMH, simply means securities prices describe the
overall impact of all relevant information so that it is not biased and confusing. While
EMH is a theory of price mechanisms in securities markets, capital market research
(CMR) is empirical research that uses statistical methods to test hypotheses related to
capital market behavior. Most CMRs use a market model. Assumptions in the market
model:
• Investors are risk-averse
• Returns are distributed normally and investors select their portfolios on this basis
• Investors have homogeneous expectations
• It is a perfect market

E. THE INFLUENCE OF ACCOUNTING INFORMATION ON INVESTOR

BEHAVIOUR AND SHARE PRICES
 Direction
Divided into favorable and unfavorable.
A favorable announcement  when reporting a profit that is greater than predicted.
The unfavorable announcement  when reporting a smaller profit than last year.
 Magnitude
It is possible to examine the relationship between the magnitude of unexpected changes in
profit and abnormal returns. The theory that underlies this test is that if the announced
profit contains information, then the magnitude of the abnormal return can be related to
the magnitude of the unexpected profit.
 Information Asymetry and Firm Size
The smaller the company, the more information contained in financial statements.
Empirical research shows that profits announced by small companies have a greater
impact on information.
 Magnitude of Profit Releases From other Firms
Research on other capital markets has examined that not only accuracy responds to
company returns to the announcement of their profits, but also returns on other companies'
profit announcements. This 'transfer of information' research is based on the belief that
unexpected profits in a company in a particular industry will move through the industry.
 Volatility
Other researchers have used alternative 'indexes' of information contained in announced
profits. One of them is abnormal return. The underlying theory is that if the announced

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 profit contains information, then, it can be estimated that a change in the share price is
greater at the date of the announcement.
 Association Studies and Earnings Response Coefficients
There are studies that measure the impact of accounting calculations on share prices. The
objective is to examine the impact of accounting variables and broader information that
shows long-term securities returns.
Factors which can affect the ERC:
• Risk and Uncertainty
• Audit Quality
• Industry
• Interest Rates
• Financial Leverage
• Firm Growth
• Permanent & Temporary Profits.
• Non-Linear Modelling.
• Disaggregating Profits.
• Cash Flows.
• Balance Sheets & Balance Sheet Components

F. TRADING STRATEGIES AND MECHANISTIC BEHAVIOURAL EFFECTS

 Post-Announcement Drift.
Two discoveries that represent questions related to capital market efficiency, namely the
existence of post-announcement drift and a decrease in trading rules where abnormal
returns can be obtained through trading on published accounting information. Post-
announcement drift occurs when abnormal returns continue after the announcement of
profit, so the information content of the announcement of profit does not fully reflect the
share price at the date of the announcement.
 Winners/Losers & Overconfidence
The winner/loser effect is an example of a long-term association anomaly. This effect
produces a trading strategy. Shares that produce positive returns (winners) or negative
returns (losers) are sorted based on the performance of the last 3 years and placement in
the portfolio. Overconfidence about closed information also causes investors to play down
the importance of information disseminated to the public. Furthermore, in terms of
expectations, investors hypothesize that it gives a lot of weight to the company's previous
profit performance and is very little aware of the fact that future performance tends not to
be the same as before. Here it is also believed that the market reacts slowly at the moment
and in the incorporation of new information.
 Mechanistic or Behavioral Effect
Two hypotheses developed in cosmetic accounting:

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 1. The market reaction mechanism for changing the order of accounting, regardless of
whether they are cosmetic or whether they have cash flow implications, such as
markets systematically deceived by accounting changes that increase or decrease
profits (mechanistic hypothesis).
2. The market rejects accounting changes that have no cash flow consequences, that is,
the market does not react to accounting changes other than the increase in the present
value of tax savings or other effects of the company's cash flows (hypothesis of 'no-
effects' derivative from EMH).
Testing for these two hypotheses considers the behavior of abnormal returns and the
timing of changes in accounting policies. Note for the 'no-effect' hypothesis, it must be
abnormal return when there is a 'cosmetic change' in accounting policy, because there is
no effect on cash flow.
 Manipulating Accounting Numbers
The calculation of income with GAAP is reportedly not perfect in measuring 'economic
income' or 'fundamental value'. This is because accounting standards are not precisely
explained or consistent throughout the world; the impact on accountants is subjective and
cultural interpretations of their estimates, as well as the regulation and manipulation of
financial statements very much.
In an opportunistic perspective, fraud is the most extreme type of earnings management
and is used by managers to deceive users of financial statements.
 Detecting the Quality and Probability of Accounting Management
We can use market price reactions as an indication of quality. However, research by Sloan
and others shows the market does not have sophisticated accrual understanding and hence
there is an overreaction to increase positive income accruals. The reaction of financial
analysts can also be used to assess quality because of their expertise. However, this study
states that analysts can be biased and focus on specific industry factors rather than specific
company variables. The auditor's report and opinion can also be a proxy for quality but
this is debated because the auditor is not necessarily truly independent.

G. ISSUES FOR AUDITORS

The empirical research provides evidence of benefits to companies through lower cost of
equity and debt capital when they voluntarily purchase an audit or purchase a high-quality
audit. Inventors value the insurance protection provided by the possibility of taking legal
action against a large auditor who has deep resources. In addition, investors value the
assurance provided by the auditor about the quality of the company’s financial information.
Researchers are unable to run controlled experiments on auditor choice and face
methodological challenges in designing studies using archival data that enable these
conclusions to be drawn with confidence.

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REFERENCES:
Godfrey, Jayne, Allan Hodgson, Ann Tarca, Jane Hamilton, and Scott Holmes. (2010).
Accounting Theory, 7th Ed. John Wiley & Sons, Inc. (GOD)