-12

Ch

After reading thh chapter,you should have an appreciation ofthe folbwing:

Il the philosophy of positive accounting theory

El the strenSths ofpositive theory

E the scope of positive accounting theory

!l capital market r€search and the efiicient markets hypothesis

! the;nfluence of accounting information on investor behaviourand share prices

E trading strategies and mechanistic behavioural effects

A ksues for auditors.

F@:r
The distincrion b€tween (he 'moral' ord€r (lhal which owht to be) and the 'physical'
order (that which is), together with the €rctent to which one can be derived ftom the
other, is a dilemma that has challenged philosophers for cenluries. Th€ accounting
community, similarl, is divided in the priority it gives to 'normative' as opposed
10 'posftrve' theories. Pressiptive theories are rcfened to as hormative', sinc€ they
are derived ftom the notion of a norm, a standard, or a model which is seen as an
ideal. Normative accouoting theory, for example, presoibes the'conect or'best way
to account. Theodes ihat oelain or predict real world phenomena and are tested
ernpirically (according to their con€spond€nce with observations from rhe real world)
are refered to as 'positive' theon€s,
An appreciation of th€ diff€rence between posilive and normative accountinS th€odes
is nec€ssary for any undeEtanding of accounting theory and accotrnting regolation. This is
especially positive accounting theorists have stron8ly supported the historical
so because
cost systern, which hes been th€ norm for s€venl centuries. MoIe r€.el)tv, support€rs offair
value measurement have been influential through ihe adoption oflntemational Financial
Reponing Standards in Europe and Australia in 2005. That is, the relative imponance of
positivism and normauvism in accounting has be€n ke€nly debated over fte last 40 y€ars.
This claprer examines how capital markets react to accounting information.

@-. pnnosoPHY oF PosrnvE

ACCOUNTING THEORY
Positive theory seeks to under{and accouniing phenomena by obseFing empirical
evelts and to use these r€sults to mak€ predictiong about a wider set of observations
and/or to predict futurc ev€nls. This diffeB fiom descriptive theory which focus€s only
on d€scribing events, and fiom no.mative theory, which pr$cribes what should occur.
Milton Friedman championed positiv€ theories in economics. He $ated:
The uldmai. Boal of a posiriv€ 3.ienc is the daelopment ofa 'theot or'hypotb6is'that ields
valid d neaDintfirl (i.e. noi tdistic) predicrions .bout ph€nom€na not yet observed.r

consistentwith Friedman's view, watts and Zimmerman a$ened:

'nre obj€ctive of [positivel accotrntins th€ory is ro erplain and preditt accountinS Pm.tie . . -
Aqlzrorion means providins reasons for obseNed pnctice. Ior eranple, positiv€ accounting
$eory seeks ro qplain pl), fims continue to use historical cost accounling and why ce.tain
nrms swnch berwen a numbd of accountint l€chniques. Preditdot of ac.olntin8 phclice
means rhat the theory predicts unobsened ph€nomena.2

Unobs€rved phenomena are not necessarily future phenomena; they indude

phenomena that have occuffed, but on which s]stematic €videnc€ has not yet been
collect€d. For e)(ample, positive theory research seeks to obtain empirical eviden<e
about rhe att ibut€s of firms that continue rc use the same accounting techniques fiom
year to year versur the attribul€s of firms that continually switch accountint techniques.
We might also be interest€d in predicting the reaction offirms to a proposed accounting
standard, rogether wiih an er<planation ofwhy firms would lobby for and against such
a standard, €ven though the standard has already been released. Testing these theories
provides evidence that can be used to predi(t the impact of accountin8 regulations
befor€ they are implemenled.
Positive accounting th€ory also has an economic focus and seeks to answer such
questions as those below:
. whal arc the costs and benefit! ofusing ahemativ€ accounting methods?
. what ar€ the costs and benefits of regulation and lh€ accounung slandard-setting
processS

.,.404 PART 3 AccountinS and rcs4rch

 . what is the effect of repofied financial statements on share prices?
. Which accountinS valualion models are srDerior in predicring future prices, rerurns,
earnings or cash flows?
In order to answer these queslions, positive accounting theories are based on some
assumptions about the behaviour of individuals:
. Managers, investors, lenders and other individuals are assumed to be rational,
evaluativ€ financial utility nra)dmisers (REMS).
. Managers have discretion 1o choos€ a(counlin8 policies thal diredly maximise lh€ir
utili!, (selfinteresi) or ro alter the 6rm's fiDancing, in\,estm€nl and production
policies to indirectly marimise their s€lf-interest.
. lvlanagers will take actions thal maximise lhe value of the firnr.
Posiiive accouniing theorists argue that any proposed normative accounting model
be tested and verified to assess irs impacr before being made an accounting s(andard-
They argue against the Llse of anecdoral evidence and naive acceptance of political or
academic prescriprions. Posirive theorisrs argire rheir theory is more scienti6( in its
medrodolog/. Watts and Zimmerman comnrent:
therheory and ne rodolo8_y uderiyinE the €.o'r o nics-bascd cnrpiftal hcra rt[. ir ac.oLrnti os
. k based on the scientinc concepr of reoryl

@. STRENCTHS OF PoSlTlvE THEORY

IenseD argues that normat;ve accounting lheory precedes positive accollnting theory.a
hr order ro prescribe an appropriat€ accountinS policy, be belieles it is necessary to
know how dre world acl ally operares. To suppor( his a.gumenr, he pro!,ides the
following example using one form of a nrarket value adiustment ro the accounrs to
improrc d€cision making:
l^l..ouDtams hav. been lustili.bll' .on.eh€d wi rhe elf..ts ofgeneral pri.e lcvel adjlsrcd
accountin8 (CPLAI on a.counring numbe$. Bur a manager inte!$(ed ifl Daximisingrh.
'alu€
ofhis finn als. musr esiiDule eirhe! splicirly o! implicjll.v,how $rh ac(.uDtnr8 pbcedures
will ift€ct 6rnr value. And how GPLA affeds 6rm value is a punll poskive issue in lhr sense
rhar rhc (€rm is used in tltcsocial scirn.es.5

t€nsen goes on to say:

ln lhe end, olcoursr, we are alL int{rcsted iD normatile questionsr a d$irc hoh' k) acn)mplish
go.ls mod$r$ our inre.$( in these med,odok'gi.al rorics aDd ih posirne th€ori.s.6
'lhus, we need to know how the financial world currentl.v makts (or'!\'ill make)
adjusrments to histbrical cost (i.e. do lhey actually ntlke use of CPLA in their decisions)
before normariv€l),prescribiDg a chanBe iD .rccounting standards

Dissatisfaction with prescriptive standards

One criticism ofchansing accounting standards is that rey make ctrtain pres(riptions
for accounting aDd audiiing practice which ar€ not cntirely based on identified,
empirical observalions or methods. watts and Zinrmcrman assen that valid pr$criPtion
requires specincation of both an obiedivc and ar objective lunclion.T An objc.tive
nlight be moniloring and controlting manageln€nt perqlrisiles, or econon]ic decision
making and predicting future cash florvs or aiternaiivcl-v, it miSht l)€ a more equilable
distributioD of$,ealth.3 Neither is an d pri()rt superior obiective, aDd posilivc theorists
question wheth€r accountants have any advantage over other individuals or soci€ral
groups in formulatnrg accounling obieciir.es A positive example of an objective
function is dre speciicnrion ofhow thc measurclnent of rssets at their fair vnhes affecls

CllAPTllt 12 (:apilnL n,arkel 405

'cscrrch
F:

the distribution ofw€alth b€tween shareholders, lenders and managers. Note that this
"l
goes funher $an iust sp€cirying a normative obi€ctiv€ to chang€ accounting to measwe
fah values.
A normative theory based on value iudg€menis, howev€t produces i(€futable
prescriptions, even if it is developed logically. Normative accounting theory, in making
prescriptions, specifi€s neitheran objective nor an obiective function that is ind€penden!
of subiective preferences. The problem with rhis approach is l}lar the validiry of its
prescdptions is irrefutable. According ro Popper, ,m amouni ofempirical testinB
is, tests of a theory against 'real,world' data
- rhat
can pruve a th€ory !o be corec! but a
-
theory should be refutable, or capable of falsincation.e Should the main objective of
accountinS be to provid€ information to investors so that they can predict furure valug
to provide a yardstick to assess the valuation ofslock markets by reporting current mlues,
to conuol management compensation payouts by requiring cons€Irative accounting
practic€s, or to disseminate wealth evenly throughout society? Because these obiectives
are subiective there is no means of assessing the appropriateness of their objectives.
For e,(ample, assume that one normative obi€crive pr€scdb€s that accountanb should
measure ass€b at current selling prices to provide lenders with informarion about the
solvency ofthe 6rm. Assume that another normativ€ theory prescribes tha! accountants
should measurc assets at drei cufient cost to show investors how well th€ir funds hav€
been mana8ed to maintain the operating capacity of the 6rm. Sev€ral factors prevent
€ither theory being falsifiable:
. lt is not possible to prov€ or refute the €laim rhat nnancial accornts should
provide lenders with a measure of the firm's solvency because this is a value-laden
judgement.
. h is not possible ao prcve or refute the claim that an obtective offinancial accounts
should be to repon to invesiors about maintenalce of the op€tating capacity
again, because rhis is a valueJaden judgement.
-
The theories, therefore, canirot be ranked obiectively because it is impossible to
prove or refut€ claims that either objecaive is roore important than the other. Thus, by
Popper's standards, normative and prescriptive theory is methodoloSically weak.
There is a funher methodoiogical problem wir-h normative and prescriptive theodes:
even if they were falsiiable, the choi(€ of th€ obje.tive tundion would still have to
be iustified. Ifwe were to attribute to nomative accounting theories an obiective such
as the imprcvement of (he quality of information in accountin8 repo(s, it would be
necessary to show that their prescriptions did actually serye that purpose. For instance,
would users (including regulators, unions, debrholden, shareholde$ and manag€ment)
find the aacounting information produced by fair value acnially improved decision
making by shareholde$?To answer this question, it would be nec€ssary to ascenain the
usefulness ofbalance sheeb and income statements prepared on the basis of historical
cost, and to show that the altematives Io historiaal cost w€re mor€ useful.
This taises funherquestions. Does the profil number, prepared according to historical
cost accounting prinoples, convey adequate information to mark€t panicipants, and
are rhey deceiv€d by 'manipulations'? Ar€ markets in€fEcient because of inadequate
information disclosur€ or is accounting information becoming less relevant?
Funhermore, rvhy is it that after almost 40 years of proclamations of rhe meri$ of
altemative fairvalu€ m€asurement tecbniques only a handful ofcompani€s voluntarily
adopted them as supplementary disclosures? And, finally, have International Financial
R€porting standards (IFRss) usine fair value measurement had undesirable economic
and social impacrs on businesses and society, and have these accoundng standards
be€n decided without political int€rfer€nce? These qu€stions illustrate the view of

4A6 PART 3 AccounlinB and research

 positive theorists that writerc of pr€scriptive accouming standards may have fajted (o
fully understand the effed ofthe adoption offair value measur€ment methods.
From the above discussion, it should be clearwhy proponents ofpositive accounting
theory may b€ viewed as taking th€ role of'devil's advocate'.
First, they argue that theor.v should be able ro generate ht?otheses capable of
falsification through empirical testing. Sc(ond, they deem it desirable to understand
the hislorical application of a(coumin8 pracdc€ aising fiom th€ commercial markel
place, ratherrhan nlake wholesale normative changes. Sud an approach ov€rcomes rhe
need lo supply ao objective for accounting, gilen that no obieqive is d priori superior
ro any other.'lhird, if it is nccessary 10 re-assess historical cosr rules based accounling
principles, then fair value accoundng lacks a theory aDd has no1 as yel supplied a
s-vst€maric and empirical conceptual fianrework that und€.pins its use. Finally, ir is one
of the imperatlves of positive ;lccounling theory that there be at least some atlempl to
nodel lhe conn€ciion betr\,e€n accounring numbe$, finns and markets and 10 analysc
problems within an economic framework.

@-.scope oF posrlvE AccouNTrNc rHEoRy

It is inslructive 1() vier{ the developmeDt of positive accounting theory in ti{o stages.
The 6.sr and chronologically earli€r stagc involved research in(o accountiDe and the
behaviour of capital narkets.'lhe litera(ure from this stage dil llot explain ar€ountiog
practice. Rather, ir investigared the connecrion between the announcement ofacrounling
data and the reac(ioD of share prices. 'lhe studies suggest that financial statements
prepared according ro historical (ost melhods did provide infonnadon lvhich is used by
the capital marke! in the valuation ofthe shares but, at the same tinle, accounting does
not monopolise the infomalion set used to value 6rms. Thar is, ih€ assumption that
accounring numbers are the primary driver of share pric€s was nor obs€rved and rhis
suppotu the argument ihar perhaps accounring reports may b€st sere a sl€lvardship
functioD. Finall)', the theories of linalcial econonics, panicularly the ef6cient markels
hlpothesis and the capital asset pricing model, were incorporated into this literature.
The second stage literature soughr to expla;n and predid accounting pracrices across
Iirms. lher€ were rwo cenlral focuses. first, there \a'as an aitemlt io explain whether
lirms make particular accounling choices ibr opponunistic reasons, such as 1o transter
wealth away froDr orher clainrholders to managers. Ihis opporlunistic perspectiYc is
ofien labelled rjr post, since it nssumes lhat Dranagers choos€ accountin€i policies,r/t()
tfieldcr lo maximise rheir own self inte rest. 'fhe second perspe(ive assumes that firms
select accounting practices for etfi.ienry reasons, that is, accounling policies ar€ pul in
place ar ante to reduce the cosls of(ontracring between the linn and its clannholders.
tt is important io remember that these two views are not m(tually exclusive. lhe
selection of an accounling method er ank for reasons of efnciency does not preclude
managers from the opportunistic s€lection, ar post, of accorrnting meihods. l he reason
for this is thar ir is either impossible or ineffi(ient to attempt (o €liminare all residual
oppo(unisiic behaviour by nranagers.'Ihe eficienry perspective, similarly, do€s not
require thal accourrting policy is aclually selected er rnle
- only lhat th€ choic€ is nade
as ifit wer€ chosen ex dr e to nraximise firm yalu€ rarher than made oppor(unistic:rlly.
Bo|h focuses of tlris second staSe of positive accounting lir€rarure draw enensively
from the prop€dy righls conrrdcting lileralure. Firs!, horvever, we outline capital marl(et
res€arch, $'hich coDstituted lhe iniiial and ongoiDg research work in the posilive
accounting paradigI11.

Cr'lAPTER 12 Crpita n,rrkot esea,., 407

 @.. CNEITNT MARKET RESEARCH AND THE
EFFICIENT MARKETS HYPOTHESIS
Ti{o typ€s of capital mark€t res€arch are panicularly imponant to positive accountinS
theory: ( I ) those studie! that att€mpt to d€temine the impact ofthe release of accounting
information on share retums, and (2) drcse $udies that consider ihe effects of chang€s
in accountiog policy on share pric€s. Most research in thes€ areas has been conduaed
within a prevailiq pamdigm in financial economica
- the efficient markets hypothesis
(EMH).'Ihe EMH draws on micioeconomic price theory. which is characterised by its
emphasis on $e demand and supply of information in markets.Io In a competitiv€
capital market the ma€iDal cosr of info.mation equals the marginal revenue.
It was Fama arld his associates who fiIst coined the phrase 'emcien! market' as being a
'market that adiusts mpidly to new infoImation'.r I Fama later formalis€d the dednition
ofan efrcient market as one'in which prices "fully r€flect' available information' based
on assumptions that12
. there ale no uansaction costs in trading securities
. information is a ilabl€ aost-free to all market panicipants
. there is agreement on the implications of current information for the cunent price
and disuiburions of future prices.t3
The implication of these assumpdons is that in a capital market that is ef6cien!
information is fully incorporated into share prices when it is released. A! such, it is
impossible, oD averaSe, to €am economic profits by lnding on information. However,
we are aware that these assumptions are rot satisned in any market. H€nce, to
accommodat€ different types of information sets and to enable empirical testin& Fama
distinguished between &r€e information se!s:
. The 'weak foIm' of ma*et effcien€y where a seoriys price ar any paniorlar lime
fully reflects the ioformation contained in its sequence of past pric€s
- that is,
inv€stors carnot profit from €rcacting information based on cydes in pric€s (Do',
th€ory), pIice pattems (head and shoulde$), ot other rules such as odd-lot behaviour,
moving averages and relative strength,
r The 'semistrong form' form assert that a securivs price fully reflects all publicly
available informaiion, in addirion to past price.. This means that there ar€ no
profitabl€ ilading strat€i€s available to mak€ exce$ profits ftom analysing publicly
available economic, political, le8al or financial data. or more importantly by
adiusting accounting reports for fair values that ar€ not rcpon€d.
. The krong form' suggests that a secrrity's price fully rellects all information,
including inforfiration that is not publidy availablq for erdmple, private information
only available to manag€rs, directors or financial analysts who have acc€ss to insid€r
information.
Of the thr€€ forms, the semistrong form is the one most direcdy related to accouoting
res€arch, because accounting information is part of the subset of publicly availabl€
information. Normative accounting theorists and accounting standard{etting bodi€g
Sive coNiderable effon to arguing th€ merits of the form in wbich accounting statements
are disclosed to inv€sto$ for decision making. Horvever, if prices .efiect all publicly
available information (includint current values ofassets and liabilities), then normative
arguments for 'prop€r' measurcment and reponing arc consid€rably w€akened.
Note that, when we speak of the mark€t as being emcient w€ do not sugg6t that
every or any, investor has knowledSe of all ioformation. Market efftciency does not
mean that all financial information has be€n 'corr€ctly' pr6€nr€d by a firm or'properly'
interpreted by individual decision makers. Nor does it imply rhat manaSers make the

PART 3 Ac.ouoting and research

b€st managem€nr decisions or that inv€srors can predicr future events with absolute
precision. Market eficiency in the context ofthe IMH simply nreans rhat security pric€s
refled the aggregate impact of all rel€vant informaiion, and do so in an unbias€d and
rapid manner; thatis, ma.ket pric€s are a'fairgam€'and are close 10 'fundamenral value'.
Markets are notp€rfect but they do anticipate and incorporate relevantdara.

ls relevant information incorporated into th€ price of shares?

Deregulation aids earnings at CrainCorp

Higherthan expected grain receivals and exporttonnages have prcpelled Crrincorp to a second
iull-year earnin8s upgrade, and thc company is tipplnS a net profit ol up to $63 million.
Aunralia's larSest grain handlor on lhe easl coast expccls net prolit to be betwccn
$53 million and $61 nrilljon in 12 months to Scptember 30, compared $,ith a nei loss ol
nearly $20 mi lion lasl vear.
Craincorp mana8ing director Mark l^vin tol.l lhe Australian f,nrncdl Review the ke!
drivers of better earnings were a result of the dereSulated bulk whcat export market.
"The deregulated market has meant that our system has attracted more post-harvest Snin
lhan we anticipated.ll pulled on-farm Srain intoour system beca usc the exporters are happier
to buy in th€ system rather than on-iarm," he said.
The lmproved periormance was underpinned by h gher grain receivals, on target to ex.€ed
9.5 million tonnes, compared wr$ p.evious BUidance of 9.2 million toncs and 9.4 million

Cr€ater than expected high margin expoi' volumes of 4.5 million ronnes to 5 million
tonnes ve6us 4 million lonnes forecasi previously, and hiBher than budSeted export sales,
ako helped earninSs.
Craincorp shares jumped 50 c, or 6.7 per ceni, lo finish at $8 yesterday alter the upbeat

In mid-May the company upgraded fu l-year net earnings expectat ons to betueen
$37 mill on and $42 milLion from its Februrry forecast oi between $23 nri ljon and 528 milljorr.
This is a significant lurnaround in pe ormanclr aiter posling back to-back losses of nearly
$20 million in iinancia years 2007 and 2008.
ABN Amro MorSans analysl Bcl ndaMooresaidtheamountotlheupgradewas argerrh.rn
expc.ted; hcr previous nct profit forc.irst was 5.11.5 million-
"ll is also clear thal a de€g! ated wheat nrarket has provldcd Graincorp lvith ne\\,and
lmproved earnlnSs strcams," she sald
Therc was a lo\rer nel inlercsl cxp.Jue after a thrce,month con(ribution ircm the reconl
eqLrr\ r. i,'18
"l-F io.
A kcv risk to Gralncorp's forecast s the onsct of an El N no cvent, which is associatcd
with lower than nomal rainfall in spring. The Bureau oi Metrobgy noted lhere,!vas a hi8h
probability of El Nino developing
Mr lrwin said there was still the prospcct of another Sood wiftcr grain harvest, but that
iinishinS rain across Ihe Srain belt was an absolutc necessily.
"we still have a lofg way until we sec ncxi harvest," hc sajd. "The prof lc looks 8ood, blt
il's all aboul spring ralrs in late Augl]st and Septcmber."
fhe Aurtt.lia, rn rt(,.t R.\r1i. L\n$osl 20U9, | 19. $1!ra.ir..orn
'out.e:
Questions
I . \,Vhat impJct has thc ri nexpected iocrease in cd nr ings had on C ra incorp's sharc price?
2. Apa( from higher than expected graln receiv.ls. what other factors havc had a posil vc
impact on earnjn8s?
3. Docs the arlicle 5u88est markcl eliicjcncy? lvhy or why not?

CHAP-IeR 12 CrpilJlnrarkel ..search 4W

F:-
Whereas the EMH is a theory about the pricing mechanism of security ma*ets,
capiral market r€sear.h (CMR) is empirical r$earch which us€s statistical m€thods
to te$ hypotheses conceming capital market behaviour. Most CMR uses the ftarfter
model,Ia which deriv€s ftom the capital asser pricing model (CAPM),I5 to estimae the
unexpected (or abnormal) retums on th€ ordinary shares of a company at the time of
an event occurriDt (e.8, profit announcements).

Market model
Share prices and retums are aff€oed by both market-wide and film-specific €vents.
Therefore, if we are attempting to resea(h and identit the impact of firm-unique
information such as the release of€amed profits, the retums arising from general market-
related information (e.9. state of lhe economy, inflation etc.) must be fiIst contolled.
For er<ample, if a securityt r€tum on th€ profit alnouncement day was +2.0%, this
could be due to favourable market infonnation affecting all share6, favourable firm-
specific information, or a combination ofboth. To isolat€ that pan ofa s€curity's return
that is unique to the frrm, we use the market model:

tr;;l t'"*r!
""T'ii""'
I [l""'""*; L."--";
I'"'"'' n,,
l=l l.l'"*'-.'"l.l''"'""''"
P,(R..)
I
a2.r)

where
ii-,= the retum on the frrm i in period t
dr = the constant avemg€ return (re8ardless of th€ reium on the market)
Bi = the beta estimate of firm i (which is a measure of sensitivity to the return on the
market)
R",r = the retum on the a8gregate ma*et pordolio during period I
pi,=the residual error in period t the ponion of the raw rctum due to frm-
unique €vents (individual €amings, dividend announcemenis or management
policies).
Frtimates ofoiand pi are determined by using ordinary least-squarB regtessionwhith
relates historical fifm rates of retum with historical market retums. The regressions are
normally run using 60 pre-event monthly returns (t= 0 to -59) over a five-year period.
The market model has a number of assumptions which should be made clear:
. investors are sk averse
. returns are notmally distributed (the mian and standard deviation are sufficiendy
descdptive ofsecurity retums) and investors select their portfolios on this basis
. investoF have homogeneous expectations
. markeb are complete (all pa(icipants ar€ price takers, there are oo transactions costs,
no taxes, and there are rational expectations by investors).
According to Fama's conception of effioent markels, tie abnormal rate of retum on
6rm i for the period !(pr,) is equal to th€ realised rate of rcturn (Ri.,) less th€ et(pected
rate of return for the period r, for asset i (E(Ri,)),8ruen the infonnalion set anilable at
time [- (0,- r).16 This is €xprcssed mathematically asi

4.,=R,.-E(Ri,:0. r) o2.2)
Taking ep€ctations:

E(RrJ = dr+PE(R,,.,) (12 3)

4lptil PARI 3 Acco!.ti.g and

'ese.rch
rhe estimaled abnormal mte of return for the shares for period t is rhe difference
betiveen the actual retum and the expected return:
ptj=R,.| dt pp{R..) (12.4)

In an eflicient market, such abnormal rates of r€tum will average to zero across mary
periods (r):

ii p,,= o (12 s)

Th€ abnomal return derived from the market model /4., captures that part ofthe total
rerurn nor attributable to factors affecting the markel portfolio but, Iather, to firm
specifrc factors. It is for this r€ason that abnormal returns, A.r, are studied in capital
market research when researchers are interested in the short-term rcactions of share
prices to accounting facrors hlpothesis€d to afiect sp€cific companies.
'lhese concepts can be illustrated by ihe following e\ample. Assume you are given
1he following one-period market model data on BHP Billiton (Bj-lll fol the calendar
quarter ending JuDe 2009:
lsrr - 12 0o/o
Bnn =o t RM = 10.00/0

These data are displayed in figur€ 12.1. lf the market index (e.g. th€ Alrstralian All
Odinaries) had a return of 0 per cent, the expected return on BHP Billiton would be
2 per cent (o). Ho$,ever the market had a 10 per cent return. The prHr of 0.7 indicates
rhat a 10 per cent inde\ retum is etpectetl to result in a 7 per cent return or BHP
B;lliton above the constant 2 per cent. Adding tle 2 per cent and 7 per cent resulls in
an eqecttd retum of 9 per cent. However, BHP Billiton's aclual relum was 12 per ceDl
'lhe difference between the actual 12 per cent and the o\pecled 9 per cenl is rhe error
dudng Gis time period, 3 per cenr, and is called the abnormal return

I,",,= ,.

t
1270
Etror

i
""),=

tf 2%

FIGURE'12.1 Sanrple markeL model for i = BHP and I = quarter ending Jun€ 2009

Tvr'o additional sleps are usually laken before data from capital market research are
anal)6ed. First, an average unique reLum (AR.) is found for each monfi (or disclete
fm
penod selecred) for all firms in the study, by addinc up and divjNding as {oilows:

Aveias. narkei 6odel !€sidual in nodth I rAR,=+-

2a'

d'r'. 4ll
'PAPTIRL: F , d '
 where
/Rr = avemg€ firm-un que rctum for month !
A, = firm-uniqu€ retum on stock i during month I
N = number of firms examined in a given month.
Se.ond, dmul4tiue auetuge abnorrnal rtm-uni4ue zturr (O{R) is found for each monlh
^
by summing all averagc finn-unique retums for a panicular month. Marhematicall,
using 18 monrhly obseruations (6 after the sp€cified event and 12 up to the event day)

cumulative marker hodel r€'idual in no h!:c^R,= i AR,

wh€re-r2StS6
To empirically evaluate the price impacl of accountrnt information, eirher the ,ARr or
the C{R. valu€s may be er(amined, Ifthe released accounting numbers have increm€ntal
information (i.e. not previously known and act€d on by ahe lnarket) then there will be
upward or downward residuals, ifnot then they will be zero (or dose). If they are zero
rhen either the accounting numben do not have information content or the market
has used other irformation and does not awair the release of accounting r€pons befor€
making pricing decisions.
Having lhe pr€r€quisite understanding of the market model we now tum to a
consideration of the empirical studies.

@.. ttrlenCT OFACCOUNTINC PROFITS

ANNOUNCEMENTS ON SHARE PRICES
Direction
A study by Ball and Brown is the foundation stone of positive accounting.t? As already
suggesied, oDe motivation behind positive accounting theory was to determine
the infomation contmt that accouming profrt had for &e stock markel in lighi of
the criticisms by normative rheorists of historical cost methods of calculating profir.
The Seneml view by nomative theorisB was that histori.al cost profit rvas meaningless,
siDce it agge9ted tlre r€sults of appling diveFe procedures to various types of
economic data. On this point Ball and Brown noted:
]t€ salu€ of aralyrical alt€mpts to d*lop mduremenls epabl. of d€fniile inkrpreradon
is nol aI i$ue. what is ar issle is the fa( $at an analtdcal nodel does not irself a$e$ the
siSni6cance of dQadurd from it! implied measureme s. Hence it is dan8erous to condude,
in the abs€ne oftunher€mpirical lestin& that a lacl ofsubsBntive me inS implied a la€k of
utility.rs
Ball and Brown tested the usefulness ofde historical cost profii fi8ure to investment
decisions. They argued that if the information contain€d in th€ pro6t figure were useful
and informative in making investm€nt decisions, then share prices would adiust to
r€fl €ct that information.
Ball and Brown arSued thar unerpectai in(leases in profits r€preseht new information
for the markel. In an emcient capital marke! any change in sqectatrons of a firmt
cash flow (imbedded in current profits) will l€ad to changes in share prices and this
will occur bdore, or very qui&ly after the pro6t figure is released. Further, significant
posilive economic retums can be expected to cease aft€r announcement date, sin e
in a semistrong"form efEcient market the market will move quickly to impound that
info.mailon

-,.!12 PART3 A€.oonring and rcsearch

 Ball and Brown us€d US data for 261 firms for the period 1946-66 to er€mine the price
impact from unexpec(ed prolit announcements. They idemified each announcemenr as
eidrer 'favourable' or 'unfavourabl€'. Favoumble announcements were case. in which
reponed pronts were greater than predicted by a naive mechanical forecasting model
(i.e. greaier than last year's profit). Unfavourable announcements h'ere cas€s in which
reponed profits wer€ less than last year. For each group/ Ball and Brown calculat€d
CARS forthe 12 months before and the 6 monlhs followingthe announcement. Results
are shown in 6gure 12.2.

o.12

0.10

0.08

0.0.1

0.02

S oo

-0.02

-0.04

-0.06

-0.08

0.10

-12 -10 -8 -6 -1 2 0 2 4 6
Month relative to annual report announcement dat€
FICURT 12.2 Share price moveNent around'abnormal' profit announcements
sou'.. R Ball nrd P Erown, An empricrl e\Jh'.iion oi.c.ounr n8 in.omc nunrbc's'. /ou,Lt dr
l..ou,rnrg ner.,r./r, vol. {,, no 2 Aullm. ')b8, p la9. R.tr nle(lw(h pernr ss or.

Note lhar th€ market anticipates favourable or unfavourable profit reports, and prices
are adjusted accordiDsly. Tbe L-AR rises throughout the )€ar for favourable profrts and
falls fo. udavourable profits.'l-his is elideDc€ lhai the market is capable offorecasting
firms'profits (more accurately than a naive profir model) and adjusting share prices
ac.ordingly. FLrnher, some of rh€ favourable, or unfavourable, announcemcnts \rcre
nor complet€ly anticipated, and priccs conrinued to adiust after the announcemenl.
Although post-announ.em€r! price dlifts were not inslantaneous, they wer€ fairly small
and nright nol have been large enouSh to offs€r transaction (osts (commissions a d
search cosls). Ov€rall, llall and Brown concluded ihat much ofrhe price adiustment lo
rhe change in profirs (85-90%) occurs before the announcenent month, and lhat this is
a[ribuhble ro rhe con(inuous release ofinformarion (o rhe market in boih nc(ountilg
(e.g quanerly profit) and non-accounting format (e.9. analysts, financial ioL'rnalists).

CHAPTTR l2 Capilrl mrrl.r resear.h 413

 Ball and Brown's results had several impli@rions for financial accounrirB rheory.
First, therc was siSnificant information content in the historical profit figure despit€ the
apparendy haphazard way it was generated. Second, the evidence suggested there was
a coDiinuou$ r€lease of information to the market and thus accounting was not the
only source of information abour firms
- in fact it is fahly minor and may only seffe
as a feedback to the mark€t. Third, rhe marker seemed to be reasonably consistent in
anticipating the information in accounring repons, and it was not possible to trade on
accounting information, after its rclease, to ea r economic profits after tansaction costs
were taken in(o accounl
The studies whicb followed Ball and Brown's mostly supported their conclusions. In
1970, Brown replicated the study for Australian companies.te The resuhs were similar,
althouSh he found that lhe adiustment during the year was slower and that there was
more of a pdce adiu{m€nt in rhe 'announcemani monah'. Watb and Zimmerman
suttest that this may b€ anributed to the fact that Australian companies issue
half-yearly reports, not quarterly reports as in the United States.2o This suggests that' in
Australia, annual rcports are a more important source of information about companies
than they are in the United States. WatG and Zimmerman also suggesr rhat this is
because companies trading on Australian sto(k exchan8$ ar€ smaller, on av€rage,
than companies tradint on the New York Stock Exchan8e and that, apan from annual
r€porls, ther€ tends to be fewer sources of informaiion about smaller 6rms.
Foster sought funher evidence on Ball and Brown's finding that only 10-15 per cent
of the information value of profits was conveyed by tle annual announcemenb-?r
He asked whether this was attributable io the fact that quanerly profils had be€n
announced in lhe interim. The other issu€ he investigated was whether the f0-15 per
.ent frgJ're underst!14d reality, since a part or aU of the adjustment could have been
made in the weeks or days during the month preceding th€ actual announcement.
H€ anaiysed quanerly profit announcemenB and daily rather than monthly rates of
return. An important finding was $at approximalely 32 per cent of the cumulaiive
abnormal returns found over 60 trading days were er(perienced on the announcement
date. This is a siSnificant insease over the 10-15 per cent Ball aDd Brown reported
and sug8ests that quan€rly accounaing profils are a timely source of information for
the capital market Foste/s findings have b€€n suppo(ed in subsequent studi€s using
Ausrralian data.,,

Magnitude
the st[dies just discussed concentrated oD the diection of un€xpected profils and
abnormal retums, that is, positive/negative abnormal returns are associated wiah
unexpected increas€s/decreases in profits. However, it is also possible to investigate
the retationship betw€en the a*nituAe of the unexpected change in profits and
abnormal r€tums. The theory underlying these tesis h that if an accounting profi(
releas€ has informaaion content, th€ magnitude of abnomal rerurns will be related
to the matnitude of unexpeoed profirs. The 6$t published work to investiSate this
question \r,as by Beaver, Clark€ and wright.'1r Companies listed on the New York Sto&
Exchange were divided into 25 portfolios, bas€d on the magnitude ofeach company's
unexpecied profits (as a percentage of erpected profits). The mean annual abnormal
rate of letum for lh€ 12 monrhs ending 3 months after the frm's financial year was
calculated for each ponfolio- These measures, together with unexpected profits, were
l}l.n ranked from highest positive to most negative and a strong relationship was found
with magnitude.

PART 3 Accounlinsand research

 In a turther study of rhis relationship, Beaver, Lambe( and Morse found that, on
avemge, there was only a 0.1-0.15 per c€nt abnormal relurn associated with I per cem
nenpected profiis.r4 One r€ason for the small response measur€ is likeiy to be that
the lesls did not permit the possibility thar lirms miEhl have diffe|ent proportional
relalionships between unexpected profiN and abnormal retums That is, they did not
allow for the fac1 that the sensitivity ofthe relaiionship between abnormai retlrns and
unexpect€d profits (theearnings respolse coef6 cient, ERC)r5 canvary from firnl to firm

lnformation asymmetry and firm size

The information contem of unexpected profits announc€ments may be inversely
related to firm size; that is, the smaller the lirm, the more irformation is contained
in accounting r€pons. This diff€r€ntial inlornation ProPosition relies on the fact that
the amounl of information avajlable from sources oiher than accounting rePofls is an
increasing function offirm size, and is developed from the theory of transaction costs
aDd diff€rent incentives for information search. lf tie costs of informarion s€arch are
fixed and .onstant across flrms, then the incentive to undenake research for mispricing
is greater for large finns than for small 6ms. There are a larger number ofsha.€s h larg€
firms and a more liquid market that makes it €asier to sell and to hide your sup€rior
trading activities. '*1us, armed with knorvledge of mispricing, iarger loral profits can be
made compared to knowledge of mispricing in a small firm.
But, Freeman'z6 argues that the possibilily of increased search cosrs associated with
increased complexity oflarger firms is offset b)':
. larger firms providing a greal€r variety of information than smaller lirms
.larg€r6rmshavingahigherdegreeofetposurebyconstantrepotinginthefinancial
press and by the search aciivities offinancial analysrs
Finall]', institutionalinvestors are more likeLyto trade in larye firms o ingro liquidity
and contractual coDstraints. For exaDple, instilulions cannot hold a large pe.centage
of the shares in small firms and expec! to be able to sell ihe shares immedialely
without price discounls. Funher, because institut;ons are a maior source of demand
for iffonnation, then Iinancial anal-vsts may concentrat€ rheir s€arch activities on la€e.
lirms. ln summary, the differeniial information hypothesis impli€s that the infomration
contained in accounting releases should be nor€ imPortanl for smaller firms than 1or
larger 6rms
Empi.ical research has sholrn that prcfr1 releises have greater infornation
inpact for small firnls cranl first compared the information content of annual
profit announcenents fbr smaller ov€r-th€-coulter (OTC) Iirms againsl New York
Stock B\rhange 1irms.']7 He found that the reaction of the mirket ro annual profir
announc€menis $ras considerabLy greater for O1C flrms. Atiase analysed th€ differential
impact ofquanerly pro6t announceDr€nts lromAnerican Srock Exchange and NewYorh
Stock Exchange fiIlns. He conclLrded that th€ degree of a firm's seclrriq' Pric€ chinge
associated with a plo{it an.ouncenent was inverceiy rclated to {irm siz€.23
Fre€man focused on th€ liming differ€nces in the adjustnenl process of snrall and
large Erms 1o prolil announcenents.'?e He sho$'ed that:
. security prices of large firms reflect pro61 informaiion €arlier than th€ securily p ces
ofsnall firms
. rh€ magnitude ofcuNulari\,€ abDormal .€tu.ns suroundinS a profi1 announceme t
is larg€r for small firtns rhan fbr large firlns
The above studies $'ere confinned by Shores who used a finer daily data sei to
analnine markd r€actions r0 Shores's results supported the hypothesis of a llnn size
differcntial

CHAPTER 12 Crr ta nrarket rescar.h 4'15

lF::i'
Magnitude of profit releases from other firms
Other capital market research has inv€stiSat€d not only the responsiveness of firms'
retums to their own profits announcements, but also lhe responsiveness of returns to
other 6rms'profrts announcemenG, This 'information transfel {€search is based on the
belief thal unexpected profits for one firm in a panicular industry would tnnsfer across
the industry. Thus, the first reporter contains the most information.
Foster examined informatron tmnsfers using US data fot 10 indirstries and fouod that
the variance of abnormal rerurns for competing firms inqeased when another frm in
the same industry made a profit announcement.3r Clinch and Sindair reported rcsults
similar to Foste/s usiDg Australian data concerning mana8€ment forecasts inst€ad
of profits announcemen$.32 Fu(h€r, they showed that the last 6rm in rhe industry
to announce its profits for a particular period had the smallest share price reaction.
Followiflg on ftom the Clinch and sinclair approach, Freeman and Tse examined ttre
potential for investors to r€vise their profit predictions in the liSht of othel companies'
profits annormcements.33 Consistent with previous resultg they found signifi.ant price
reactions by non-annoudcing firms to early announce$' sales and profit chaD8es.
They extended previous studies by examininS the relation betw€en actual information
transfers (non-announcers' price rcaciions to the announcements of other 6lms in the
industry) and potential information transfe$ (the strenSlh of the co-movement of
profrts reponed by firms in the industry). consistent with their ht?othesis, they found
the association between late announcers' pdce reactions and early announcers' news
was srongest for those industries with th€ highest ploit correlations.

Volatility
Other res€arche$ have us€d alternative 'indexes' of the infomation content of profits
announcements, One altemative is the variance of the abnormal return, first used by
Beaver.sa The theory underlying this test is that if there is information content in profrt
announcem€nts, we would expect to obseffe larger price changes on the announcement
date. Beavet's results were consistent with this hlpothesis, because in rhe announcement
\veek ahe riance of firms' returrs was 67 per cent larlaer than normal The r€sults of
Beavels study can be s€€n in 6gure 12.3.

1.6

E 1.5

rg..
0.9
08
-8-{-4-20+2+4+6+8
We€ks relative to announcement
frGURt 12,3 Residual price changes in squared unsysiematic returns
jou/ce: w seaver, ,The iatonation conlent oiannurl ea.ninSs announcementt', EmpnicaiResearch in
AccauntinS: Sele.E.J studiet 1964, supPlentnt Io /orrnal ol A.tothttng Rese \o1 6,1969 p 91'
'h,

415 PART i Accounhng and research

 Crant noted that OTC firms experience a greater variance of abnormal returns than
New York Slock Exchange firms at announcement date, which funher supporls the
contention that the informalion content of profits will be grealer where the firm is
smaller and there are fewer altemative sources ofinformation.
Other studies investigating the information contenl of pronts announc€ments
have used different researdr methods. These inchd€ the behaviour of implicit return
variances derived from opiion prlcjngtheory and movemenls in tradirgvolume around
the announcemenl date.rs hr general, they confirm that ihere is abnormal volatility in
return or trading volume on or about the date ofprofils announcements.
Thus, while profit repons are relatively less imponant for large firms they play an
increasing role as the size of the 6rm decreases and the access to other informalion is
reduced. So ir markeis which have reduced informalion flows, accounting becomes

Association studies and earnings response coefficients

Although pront release event studies clearly demonstrated that accountirg prolit at
de same time captured a portion of the information set ihat is reflected in security
returns, the evidence also suggested that competing sourc€s ofinformation pre emPted
ihe information in annual profits by about 70-85 p€r cent. ln this sense, the release
of aDnual accouniing figures is not a panicularly timely so rce of informarion to the
capital markets.
This observation led to another capital market approach labelled association studies-
These studies measure the impact of accounting measures on share prices over a longer
evert window (usually one year or longer). Basicallt the obiective is to test the impact
of accounting variables and a \\'id€r information set that is rcflected in secuities
rcturns over a longer period. The ERC is obtained by running an ordinary least squares
r€gression with returns (or unexpecred r€tums) as the dep€ndent variable and Profiis
(or unexpect€d pro6rs) as the independent vaiable. The n'? ($e 'goodness-of-fir' of the
regression model) and the slope (ERC) coeflicient (the sensitivity ofreturns to prolits)
can then be used io assess rhe irformaliveness (value relevance) ofprofits.

Determinants of firm value

Brownrc applied a simpli6edvercion oflviodigliani and Miller'sr7 firm valuation nodel
ro depicr the ERC as fie reciprocal of ihe nrlll's cost of capital. The ivlodigliaDi-Miller
(Mlv1) nod€l.is given by equation 12.6:
v rD=x(l i)/p + G (12 5)

V 1D = capitaiised value oflhe lirm adjusted for the tir-,. b€nefit of leverage
X = 'sustainable' eanings before inler€st and tax
x(1 - = tr! adjusied earnins
r)
p = cost of.apital
c = value of$owth oppoftuDities.
There are a number of ljnear regressjon models used 1o estimale the ERC. The more
common models ar€:
APr = dr + llrll,+Ei (12 7)
AP, = c, + Prt, +llz^E +€, (12 8)
P,= (,r + ll,NBv, + P,Er + P3Atr +€, (12.t)

CHAPTER 12 Cap ta market rejearch 417

 E
G7_ i

P, = the pric€ ofany share

E, = a m€asure of€arnings
NaY, = net book value
A = the change \ariabl€.

The 6rst tr,/o models are des.dbed as information models ihat r€late eamings levels
and chanSes to chanSes in price (ERC = Br). The second model is derived from the
research of Easton and Hanis and simply adds changes in €amings as an additional
oelanatory riable (ERC = Br + pr). The third model is a variant of the Ohlson
model and is mor€ €ommonly described as a luarion mod€l because ir combines
the eamings coefficient (ERC = p, + p3) lvith a n€t book or equity coefficient (A) to
e(plain the stock pdce level. The book coe{ncient can then be funher decompos€d into
its differcnt components and tested for their imremental Iue relevance. For example,
into total asseb and liabilities, and then (say) assets decompos€d inro differem asset
cla$es [€.9. curlen! financial, tangiblq intantible) in ords to reveal the main ddverc
The valuatioo approach appea$ to be the approach adopted by the IASB because of it3
emphasis on 'fair value' measuremem and the $atement of financial position raiher
than takiog an income apprcach,

Factors which can affect the ERC

There are a number of €conomic factoB which can affect the association between profits
and prices. Th€s€ ar€ €xamined belol\r.

Risk and uncertainty

Researchers offer a definitive €xplanation as to why risk negatively affects th€ ERC.33
creater isk dir€ctly tmnslates into a la4er di$ount rate, which in tum r€duces th€
discounted preent value of the revisions in expected future profits, and the ERC.
Hence. there is a significant n€ative essociation between b€ta and th€ ERC using
reverse regressions of unenpected profits on raw refirns.3e
On the other hand, un(€ftaidty has a rather more iodirect €ffect on tbe ERC.
Uncertainty about firture operations can affect either the expected future economic
benents or the discount Iate. In either casq the predicted impact on the ERC will be
neSative. Collins and DeAngelo found that unc€(ainty regardiog a nrm's future profits
in.reased durinS a proxy contest for board seals and reduced rhe ERC.ao tlncenainty
can also be introduced by accounring manipulations that garble the 'true profits' signal
about fum value.ar In tum, rh€s€ defcienr accounting procedures produce low-quality
profits that only have a weak association with prices. l€v states:
h'hile missp€rification ofde relum/emints relarion or the €risrmce of investor imtionality
(noise l.adinS) may conrribute to fi€ weak association b€n{een earnings and stock retrm!, the
possibility thd the fauh lies wift lhe low quality (informarion conlero of r€pofied eamings
looms ta4e.a'

The concept of 'noise' in reponed profts being responsible for lower ERCS was
indirecdy dis{uss€d via hr?othesised agency/contracting arrangements.a3 An agency/
contnclint arSum€nt alises wh€n manaSers of poorly performinS firms manipulate
reported accounting figures to avoid debt covenant violation or to enhance the
likelihood offut!rc bonus€s. The predicEd conltacting-based relationship betrveen low
profltability and low ERCS was found by leter and Chaney to be significanr, consisient
wirh a mark€t perception ihar poorly performing firms' profit reports contain more
noise. other studies suggested that 'noise' is induced by the use of liberal (as opposed
o conservatrve) atcounting policies-'!

41A PART 3 Accoonrins and research

Audit quality
Ifthe magnitude oflhe ERC is a funcrion oflhe credibility ofrepo(ed profits, and ifrhe
enemal auditingprocess is inlended to enhance profit credibility,4s then ERC magritude
should be a funcdon ofaudit quality.46 Analytical r€s€arch sugtesrs thar audir frrm siz€
and audit quality are positively related,aT and empirical evidence consistent with this
argumenl is presented by others.43 Additionally, Knapp presents evidence thar audir
committee members p€rceive that auditor size significanrly influences the qualiry otrhe
audit service provided-ae Another facet ofaudir quality, audir indusry specialisadon,so
was investigated and sholved a significant posit;ve association between audir induiry
specialisation amonS Big 6 auditors and client firm ERCS.sr
The r€search fiDdings of Choi and teter looked at audit quality in the conren of
uncenainty with reSard to tle future profir stream.5! They compared pre- and posr-
qualification ERCS for 13o firms and found a qualified audit repon signals ro the
market that tle pro6t numbers generated by the firm are'noisier', less reliable, and
resuh in lorver ERCS.
More direct evidenc€ of a positive correlarion b€tw€en ERC magnirude and audit
quality has been presented53 by using Securities and Exchange Commission (SlC)
sanctions against auditors as a measure of audit quality, wher€ il was observed that
ahere was a decline in the ERCS of companies whose (Big 6) auditors were subje.t to
SEC sanctions.

lndustry
An alternative approach to iDvestigatirg the relationship beaween ERCS and uncenainty
and/or the information €nvironment was adopted by a ferv authors who argued that
firms within a panicular industry because they face similar factor and product markets,
should b€ more homogeneous in terms oI outcome unce(ainty than firms in other
industries.5a
They hypothesised dat industri€s r{ith the greatest pereiv€d outcome uncenainty
(due ro eithe. market uncenainties or lack of available irformation) vrorld have the
greatest IlRCs. The finding oi signili.ant cross-industry variation in [RCs, although
consistenl with their argum€nt, added litde to our unders(anding of hol!'industry-
specific factors influen{e rhe sensitivity of the returns pro6l relation. Lik€ firm size,
industry is unlikely 10 be imporlant in its o1\'n right, but is capable of acting as a
surroBate fo. o(her factors (such as risk) thal determine the markefs responsiveness to
a profrt innovation.

lnterest rates
Collins and Kothari predict a negative t€mporal relation between ERCS aDd the risk-
free mte of interes(. The logi. h€re is straighttorward. The discount rate at any point
in time is th€ sum of the risk-fie€ rate of return and a risk premium. If the isk,free
rate of inreresr rises, then, orher things being equa!, the present value of the revisions
in expectations ol ftrture prolll innovations falls; rhus inducing a negative associntion
betb'een interest rate levels and [RCs- Horvever this argument ignores the possibility
that chanSes in interest are simplychanges in e)pecled inflation and that the 6rm passes
on the changes in inflat;on to its customers in the form of higher prices ln this case,
BRCS would be unrelated to interest rate changes. Thus, ihe negative relation berween
int€rest rates and ERC implicilly assumes interesr rate chaDg€s co vary positi\,ely $,ith
changes in real interest ntes.
Therc is another related concern regarding rhe temporal relation between inter€st
rates and ERCS. lhe question is lrfiether rhe inlerest rate is a causal determinant of
ERC.S given that a large conrponeni of nominal interest rales is inflation, The finance

CHAPIER 12 Cip tal markel research 419

 nl
and macroeconomics litelature documenb that shocl(s to inflauon are n€atively relared
to both shocks to r€al economic activity and stock mark€t Eturns.55 FuRh€finore, real
economic aclivrty and busin€ss outlook is negatively related to expected rates of retums
on shares and bonds.s6 This means that interest rates might be posilively related to
the risk premium. Thus, the int€rest rate effect on ERC9 migbt be via a time-varying
risk piemium, rhat is, the exp€cted retum on the market minr$ the risk-free rate of
inrerest.5T Relativ€ly little res€arch has be€n done on this aspect of int€rest rates having
a time-varying impact on th€ ERC, and it is an area for future r€search.

Financial leverage
Th€ impact of leveiag€ was analysed by t€t€I and chaney who found a negative
association betw€en leverage and the ERC.SB They also found the *rength of the
association between beta and ihe ERc was insignifrcant after controlling fot ihe effects
of leverage, suggrsting that a firm's debt to equity ratio better (aptures diff€rences in
risk more effectiv€ly than beta.
Th€re ar€ a number of other theories. the 6rst is t}te 'defaull' theorem in which ERC
is positiv€ly relatd to the profit pe$istence factor, and negatively related to ihe 6rm's
default risk (i.e. the financral leverage level).s' This suggesa that as hnancial Iev€rage
sreadily inseases, the !?lue of the firm falls in r€sponse and, hence, profits have less
informalion for prices.
Second, the 'maximum debt theorem aryues that when finaocial l€verage increases,
share pdces concurrently increase for two r€asons. The first is that the tax deductibility
of interest on bonowed funds creates a tax shield whicb incteases with the level of
corporate debt, thereby lowerinS the weight€d averaSe cost of capital-6o Tbe s€cond
relates to the posirive si$al that corporate lev€nge conveyg. The willingness of
managers to increase financial leverage is an expression of manageN' confiden.e in the
future and th€ beliefthat the firm will generate funds in excess ofthe adjusted weiShted
average cost of capital.6l
Finally, th€ 'opdmal lev€ra8e' approach assumes lhere is an ideel financial leverage
position for €ach 6rm. That is the benefits of th€ tax shield will not be infiniie. As
a firm increas€s financial leverage, th€ level of risk and the po$ibility of bankruptcy
inqease, and to compensate for increased leverage, both debl and equity invettors
require higher rates of return. Funher, agency costs also increase as debt and
equilyholders impose iDcreasingly higher monitorirt and bonding costs on the firm.
llenc€, the optimal leverage approach predicts that the direction of changes in share
pric€s is conditional on the 6rm's fnancial leverage relative to its ideal. Hodgson
and Stevenson-Clark€ shou'ed that ifth€ 6rm is above th€ hypolhesised ideal level of
debt, then the ERc is lower.6'z Conversely, if the 6rm is below ideal leverage, the ERC
is higher'

Firm gro\ rth

Crowth opponunities will be rellected in higher ERcs. crora'th oPPortunities include
existing projecB or opportunities to inves! in proiecb that are €xpecled to yield ntes
of retum that orceed th€ risk'adiusted rate of relum commensuEte wiih th€ systematic
risk of th€ proiect's cash flows. Collins and Kothari argued that the ptice reaction
would be Sreater than that impli€d by the time series Persistence of profts, because
peEistence €stimates from hbtorical data a-re likely to be 'defici€nt in accurately
re{l€cring cllnsnt Srowth opponunilies'. They then demonstrated a siSnificant positive
conelation betlveen the ERC and th€ market to book value of equity ratio which they
used 10 m€asurc expected gowth,63 Other research has been undenaken on the relation
betwe€n a firm's life cycle a'ld business strat€gy to explain the cross-sectional variation

420 PART 3 Accounting aod rcsearch

in ERCs.6a It has been aryued draf depending on a firm's stage in its life {:ycle, financial
sratement informalion is differentially informaiive about a 6rm's value, such that ERCS
are predictably related to a firm's srage in its life cycle.65
This area of research has had limired work and offers the opponunity io uudenake
r€search inio metrics that may predict future growlh such as the level of intangibles,
markedng, brand a$,areness, research and developmert, and so on.

Permanent and temporary profits

Other work in the area ot ERCS has linked the finance theory emphasis on discounred
cash flows and accouDting measuremen(s in the following manner:
. Profits announcements are anal)ted by investors who estimate hou mucl of any
unexpected pro6t lvill be permanenr (i.e. they estimate profi1persistence)
. With rhe belief lhal permanem (persistent) increases in profits wiil eventually
appear as perman€nt increases in dividends, investors value shares at their rcvised
e\pectation ofthe discounted cash flows altributable 1o the shares
Ihus, if a large (small) amount of unaxp€ded profit was etPected io persisl, h€e
(smal1) abnormal returns s'ould b€ €xpected. TheL€ is therefore a posirive relationship
b€tween the siz€ of the revision to e\pected 'P€nnanent' Profi1 and ERCS. However'
note that the sensitivhy ofthe relalionship is likely 1(r vary between firms according 1{r
the risk factor used in discounring the revised e\Pected casb ilows aitrjbutable ro the

Ali and Zarowin e\amined the modelling ofboth Profit persistence and ERCS, arguing
rhat when the usual estimaies of unej{pecled Proits as ihe difference between current
year prolir and ptevious year profit are combined wilh th€ usual assumption thai
uneapected profits are purely Permanent, the result is an overestimate of ihe Pemanent
componenrs ofannual profit and the ERc.66

Non-linear modelling
one cdticism of the ERC research is that the explanatory Polver of Profits for prices is
lo$' (tlpically the R squares are below 10%) The prevjously meDtioned ERC studjes
applied linear statistical techDjqu€s 1(r estimate the ERC, but some recenl research has
considered rorlin€ar techniqu€s. A non lir€ar r€lationship rests on the premise that
the absolute value ofun€reect€d pronts is negatively correlaled $'ith profit Persistence'
That is, as the surprise in prolits increases, the lil€lihood that the proits sdrpris€ is
permanent will decrease. Pragmatically, kno ledge ofthes€ relationships is impotu!rt,
because valuation theory predicrs thal anal-vsts and iN€stors should place greater
€mphasis on forecasting high-persislence Pronts than lo$'-persistence profits.
Freenan and Tse6? argued une\pected Profits-returns would be better explained
by an S-shaped arctan relalionship which is convex for bad-news firms and concave
for good-n€i{s firms. Figure 12.4 provides an illustratior of some h}?othesis€d non
hne;r relationships. Measuring uDexpected earnings (profrts) as deviations from
median qua(erly analyst forecasts, Freeman and Tse fotnd that the application ofthe
non-linear arctan model resulted in increased ERCS and Sreater Predictive Power ir
lhe form of higher adjusted Rsquares. fhey concluded thai previous research which
hrpothesised and applied simple lirear nodels mav have misspecified rhe profirs-
rerurns relationship.
The archn model of ihe relationship between profits and share reiurns poslulares a
symmetrical relationship be6\'een positiv€ and negative uDer.pected profils lt is, howevet
possible tlat good news has a differential impact on shar€ Prices rvhen compared widr
bad nervs. For example, increased una{Pected profits may mean greater internal lunds

CHAPTER r2 CaPila nariel research 421

 available to fund expansion,
which leads to a low€ring of
levera8e and financial risk and
great€r exP€ctaiion of Permaned
increases in profits. On th€
other hand, Iower uneJp€cted
profits may force firms to take
on additional debt or r€son ro
increased equity raisin& with
/ subsequ€nt additional cosrs.
62
The flatter relationship beM€€n
negative unoqected profiB and
91 unerpected retums also represents
E the fact that, as the value of firms
decreases, equity takes on more
of the attributes of an option
EI and also provides management
with incentives to improve
4-2 peformance. This relarionship
is represented as an exponential
function in 6gure 12.4.
-3 Research in Australia shows
that an arctan model h a
descriptive representation of the
r€lationship betw€€n profitr and
prices.63 Thal is, large changes in
profts arc not incorporaled in
prices and the combination of
pro6t lev€ls and profit changes
3 2 -1 012l inoeases the explanatory porver
Per cent unexpected eamings {profits) of the ERC by about 20 per
FIGURE 12.4 Hypothelical nonlinea. functions rclalinS cenl. We ran also obs€rve ihat
un€xpected returns (UR) to price'deflated unexpected earnings betwe€n -l p€r cent
earninSs (Uf). Unexp€cted .eturns are 0.04 arctan and +1 per aent in the arclaD
{300 UB for the long-dashed line, 0.03 a.ctan (400 UE) models represent expected
for lhe solid line, 0.10 arctan (10 UO fo! the shod- pernanenl eamings or 'cof€/
dashed line, and the exponential ftrnction eur-l for th€
earnings.

ManaSing costs doirg brrsiness betler

New Wattyl boss to target cosG

wattyl's incoming managing director will keep the countryt second-biggest painl mak€r
ind€pendent, aiming instead to cLrt costs as high levels ofdebt and sluggish housing demand
hurt profils and narrow the company's options.
Tony Dragicevich will replace wattyl's cuffent managinS director, iohn Nolan, on
Oclober t9, the company said yesterday. Mr Nolan has been jn the role sinc€ May 2005.
"l didn't join the company to find a buyer," Mr Dragicevich said- "At thc end of the day
you have to do what's besl for shaeholdert but it'e not on my agenda." "ltt really abolt

424 PARI 3 Accounting and rerearch

managing your costs well and doing yo!r busjness better' when you're facing problems with
volumes it adds pressure to hone your cosl structure."
Rising unelnployment and slLrmping business investment have put pressure on building
materials snles as consumers and bLrsinesses defer big iicket purchases and refurbishments
untll confiderce returns.
wlth rivals inclLrding orica owned Dulux and Nippon Paint, hardware retallers such as
Bunnings have had more everage to squeeze prices/ afalysts said "lf BunninSs can play
thrce pai nt makers off (aga inst) eac h other you w i I have a situation where everyone/ 5 margi ns
\\,il be below cost of capital," one analyn said on condilion of anonymity "Wattyl can'l buy
anything. lt nceds to be bought oul."
Even so, Wattyl expects to improve on profits during the 12 monlhs to iune 30, 2010,
Mr No an said. The comp:ny which has forecast annLral profit to be about $300,000 when ii
r€ports later thjs nronth, l\'ants to cut costs by $26 million in the two years io June 30, 2010,
in part by shedding staff and using cheaper packinS materials.
The compafy has more than $60 mill on in debt, equivalent to 70 per cent of its outstanding

"We've reshaped ouuelves to dea $/lth those changes," Mr No an 5ajd "We\'e 8ot this
business moviig forward with the str!ctura changes rve've made and the cons we've taken
out of the business."
"We'Ll start to see more benefits as we 8lr into ihis next year. lt's just the cut and thrusl of a
competitive marketplace."
This is Mr Dra8iccvich'sflrstrole as managing directorofa pLblicly listed company CurrentLy
chief executlve ofiicer of CWA'S bathroo'n fjxture divlsion, Caroma Dorf, Mr Dragicevich
sald he brings his nebvork of reiail conlacc to WattyL.
The€ have been two takeover altempts of Wattyl in receni years, jrrcLuding a iilt by Soulh
Airica's Barloworld, which was bLocked by the Australian Competition and Consumer
Commission in 2006.
The announccmcni marks the end of an unexpectedly ong tenure for Mr Nolan He
originally assumed the role on a lemporary basis aftcr the suddef depatur€ of lan Jackso.
in ,005. Ihe steady deterioration of the markel and a series of management changes made it
tough io hand the company over until now Mr Nolan said.
Watyl shares closed s ishdy higher on the day at 78 c.
|ou.e: fhe AusL lian Fine..ra/ fefie't, I Augun 2009, P 16, r !\!.af c..l

Questions
1. Wattyl ha, announced that its debt s equ valent to 70 per cent o{ iis outstandln8 shares
and its aims to drastlcdlly clrl cosG if response to fa lin8 proits yet ii5 share price
indeased. Caf you exp ain th s?
2. What other econornlc informalion besides the repoded accountlng prolit does the rnarket
appear to be lsing to price shares if Watty ?
3. What ls the likelv impact on thc share price of Watt,vL if it werc to become the target of a
takeover bid as inrpljed by the anonymou5 analystl

Disaggregating profits
6e
An early study to examine the information contained in disaSSregared Profits was LiPe
sL{ profit components (gross proiits, general and administrative exp€nse, depreciation
expense, interesl expense, incoll]e tax, and other items) were invesrigated, with abnormal
retur ns being regressed on r-rnerpected changes in the components sisnificant incremeotal
e{planatory po!!€r (beyood aggr€gaie Profrl) l\,as demonstnted for all si{ components
jointly and individuaily. As well, directestimates ofrhe rcturD reactions to the component
70
sho&s were positively associated ivilh persistence measures across componenls
An alternative approach to the disaggregation of accounting prcfit is to decompose
profit into cash flows and accruals components. This apProach has been adopted by a

CHAPTER l? Capitalmarkel rusearch 423


flcURt !2.5Alte.n-
ative outcomet of the
information conlent of
p.ofits
LA Da ley, 'The inc.€menl.l
ac.rual veulscash flowj.
PART 3 Accountins
number of r€searchers, indudint Sloan who sho\^,s lhat investo$ do nor undenland
the difier€nt peBistent attributes of cash flows and accruals. ln panicular, they over-
estimate rhe persistence levels in accruals and significant retums (an be made from
hedSin8 high and low accnral ponfolios?r in $e United States. ln Australia, Chia
Czemkowski and Lofius compared aSSretate eamings with cash ftom opemtions,
current accruals and non-drrrent accruals in terms of rheir associations witb annuai
share returns.T2 They observed that R-squares were consisteBtly hither for reSr€ssions
using disag$egated profits, suppodng the hypoihesis thar aggregation of cash flows
and accrual component results in a Ioss of information content.
Cash flows
Bowen, Burgslahler and Dal€y argue that cash flow should be added as an additional
eplanaiory variable for price,?3 because both profit ard cash are ildividually and
incrementally important, or both are individually imponant but neilhs is incrementally
important, or each is individually important but one is much more imponant and
N Both are individually and incrementally dominates. Thes€ argumenls arc replicated
usingVenn diagrams in figure 12.5.
Eaaly research into the value relevance
OTHER INFORMATION
of cash flow data provided inconsistent
results. For example, Bowen, Burgsrahl€r
and Daley report€d that cash flow data have
incrcmental information content relative to
profits aod workinS capital from operations
(wCFo), but w€re unabl€ to demonstrate
any increm€ntal inf;ormation content for
B: Both arc individualy inpo anL but neither WCFO over proit6.7a On the other hand,
is incrcmenta y impo ant Boand and Day showed that neiiher cash
OTHER INFORMATION
flows nor funds now data contain any
increm€ntal information (ontent beyond
profiL75 Ali argued th6t the failure of some
studies to detect incremental information
PROFITS conren( for non'pro6( kriables may have
been due to the assumption of a linear
relation between abnonnal retums and the
unexpected componenb of the relevant
c. Both arc individually inpottant but prolits variables.T6 FollowinS rhe argument of
a.e nore in(enenta y inpottant Freeman and Tse, h€ suggested thar high
OTHER INFORMATION concentrations of transitory components
in high-magnitude observarions of
unexpected .ash flows mitht have
produced r€Bression coefticients, which
were biased towards z€ro.77
Using the nonlinear arctan mod€|, Ali
and Pope and Hodgson and Stevenson-
Clarke found that cash flows add
information but not as much as profi$ (see figure 12.5, part C).73 In an €xtemion to
this research, Chen& Liu and Schaefer argued that the incremental information rontent
ofcash flow data is likely to increase as profirs become less informativ€.7e Profits werc
predicted to become less informative as the level of ttansirory profit elements increased.
Their empirical resuhs were consistent with cash flows ftom operations playing a larger
.ole as an additional vahralion signal in the presence of transient pm6t items.
and resear.h
 The relative strengths ofthe associations between share returns and profrts and share
returns and cash flow for New York Stock L\change firms was olamined by Dechow.so
Obsewine thai the contemporaneous association between share returns and pronts
was slronger than that between share retums and net cash flows/cash from operations,
Dechorv argued thatthis was because the accrual process alleviates timingand matching
problems which cause cash flow to be a noisy measure offirm performance She funher
shoued that cash flows play a more impoftant role in the marketplace (a) the smaller
rhe absolute magnitude ofaccruals, (b) ihe longer th€ measurement inteFal, and (c) rhe
shor.er the firm's operating cycle, and fiis demonsirates the ability of firm-sPecific
factors to influence the magnitudes ofboth profit and cash flows resPonse coefficients
The previously mentioned research by Sioan who showed that investors do not
understand the different peNistent auributes of cash flows and accruals is Probably
the mosi important piece of research in this area. Sloan decomposed earnings into
cash and accrual components and found signifcanl economic profits can be made
from investing in a h€dged portfolio of high and low accrual 6rms lhis is an area of
continued research in financial accounling.

Balance sheet and balance sheet components

ohlson argues that the balance sheel, tos€ther with Profit, provides a hiSherproponion
ofthe er?lanatory power for prices (se€equation I2 9) 3r Subsequent research by Francis
and schipper indeed showed thal profit and net bookvalue account for approximately
60 per cent of p ce.3'z However, over the Period 1952 94, profit declined in r€levance
from as high as 45 per cent down to 5 10 Per cent, and asset and liability components
in the balance sheet inceased fsee 6gure 12.6) from 20 per cent to 55 per cent

Regression of returns on profit and change in profir

0.50
0.45
0.40
0.35
0.30
0.25
0.20
015
a t0 in relevance,
0.05
0.00

Resression of price on asseis and B:lnnce shect

0.80
0.70
d 0.60
f, o.so 1952-94
f; o.,ro
r-
<
0J0
0.20
0.10
0.00

a+er'C C.""- C.4"C po"

""""
C
FICURE 12.5 The changing value relelance of accounting natements
5odr.e: Alrer J. Fra..ir rnd K. sch Fper, 'Havc lin;n.ia srabhe.h ost their (lelan'e? /ou"a/ ot
,1..o! trg Rerear.h, vo 37, no.2, 1999, p r10.

CHAPTER 12 Capilal market reseJr.h 425

 -!
Decomposin8 profit and balance sh€e1 items alont lines sugt€st€d by investment
analysb (see tev and Thiagaraiar) and adiuslin8 for other maqoeconomic conditions
also increases the fundarnental explanatory power of the accounting variables for
price.83 These modelling issues are fundamenul to ass$sing the determinants of pric€
and intrinsic vaiue. Overall, with dese adiusunents and modelling r€fin€hents we
might expect to get the explanatory power from fundamental accounting variables up
to about 70-75 per cent.

Methodological issues
Many ofthe studies oudined in this (hapter are developments of Ball and Brown's odginal
paper.3a As williams and Findlay suggest, to artue that the results of lhe research are
supponive of EMH and that rhe form of accounting is not that imponant for valuation
purposes derives, in par! ftom the fact that the EMH is assumed to be descriprively lid.35
There was, as wans and zimmeman suggests6 no attempt to differentiate the DMH ftom
two competing h)?otheses ma[ageni us€ accounting to st$ematically mislead the share
-
market or that th€ market is efnci€nt and ignor€s accoudting changes that have no cash
flow consequ€nces. ln other words, are markets aware of the implicalions of accounting
manipulations and adiust for them or are th€y fooled by manipulations?
We now tum to a consideratron of the literature that does att€mpt to discriminate
between these h)?othes$. The ht?otheses at the centr€ ofahis literaNre are refeFed lo
as the mechanistic and th€ no-€ffects ht?otheses, and the research seeks to determine
whether accounting manipulations can 'fool' market participants and if there are
trading strat€ties that arise from different forms of accounting.

@'rnnolnc STRATEGIES
Post-announcement drift
ln mosr studies of the information content of accouniing numbers, capital market
efficiency has been assumed or dre test of efficiency has related to whether the
accounting numbers have associated cash flow consequences, How€ver, some res_
earchers have question€d rhis assumption. The two findinSs which initially questioned
the efficiency of capital markets are the presence of poslannouncement drift that
has t'een documented in a number of studies, including the original Eall 3nd Brown
papetsT and ou and Penman's d€rivalion of a tradin8 rule whereby abnormal
returns can be eamed by tradinS on accounting information that is already public.38
The post-announcement drift occurs where abnormal retums continue after a pro6t
aDnouncemen! so that the information conte[t of the profit announcement is not
fully incorporated into the shaie price at lhe announcement date. A large fraction of
the drift occurs on subs€quent profit announcement dales and ahe drift consfutently
has the predicted sign for the €ntrem€ profits ponfolios. These properties diminish lh€
likelihood of an efncient mark€rs €xplanation for the drift. Kothari comments:
'rh€ suNival of the anomaly 30 years aft€r ir was fircr discovered leads me 10 beliel€ that there is
. Etionat o.planalioD for but didence consis.ent with dlionality remains €lusiv€-3t
'l
Further the post-announcement drift has survived a battery of tests in Bernard and
Thomas and many other attempts to explain ir awateo It appears to be incremental to
a long list of anomalies that are inconsistent with the ioint hyPothesis of market and
accountln8 inf;ormation efnciency.

PART 3 AccountinE and research

 ou and Penman's studies e,Gmined wherher the cunent yea/s financial statement
accounling informalion could be used to forecast the sign ofthe following year's pro6t
change sufficiently to enable positive abnormal returns They found thal usinS sineen
accountinq variables to predict the possibility that a 6rmt profil will increas€, and then
buying shares if the probabjiily exceeded 0 6 and selling shares iftbe probabiiitv was
less than 0.4, they could earn market-adir.rsted retums ol 12 6 per cenl ov€r a 2-year
holding period.
The significance ofthe challenge !o a major assumPtion underlying much of capital
markets theory cannot b€ understated. As Ball has commented:

The appi.€nt prediclabilny ol abnormal returns aft€r earninSs announcemen6 has beconre
one ollh€ mosr signilicant aDomalies in financial markets tsear.h, for s'veral r'asons Fns!
rhe nragnilu.le is dauntinS; for sampl€, the estimated abnomal relurn ftom mdirg on
'old'ea;ninss info.madon q.eeds rhe nomal relurn on dre markel Second' the anomalv is
ubiquirous: earnings announ.ements occur €very quane! for €very sro(k Thi'd th€ anomalv
is scieniiicallv indispuhble; n aPPeared in Ball and Brown (1968) and has be€n r€plicared,
consisrently and widr incrcasinS Precision, in one of rh€ most carefullv and drorcughll
researhed areas ollhe emPnid financial econonric lnerarure. Founh, hken at face value 1he
anofraly nnplies fiat slure markers, which are c€ntral 1o the €conomv and which one would
think are laradiSm €xamPles ol the comPetitive model, gro$lv lail the test of codpedlive
economiciheory. FifL\, the anomaly challengestbe theoryund{lving mon ofde wid€ll used
mod€ls ir modern financial <conomics.er

Several sludies, sffh as Sloan 1996, examine long_horizon siock market efnciency
i{,ith .esp€ct to accflral rnanagement and analysts' oPtinistic profil growth forecasts'
Their a€ument is that infonnation from firms' owners and/or managers and financial
analjTsts abo{rt 6rms'prosPects, such as proiit growth, reflects th€ir optimism and tbat
th€ market behaves naively ir that it takes fie optimjslic forecasts at face value' Some
studies show that discretionary accruals in p€riods immediately before initial pubiic
oller.ng. ard \ei'oned equiq ol errrrE\ dr' o'rrive
Evidence aiso sug€ests that the market fails to tecogrise the profit maniPulation'
\.rhi.n is inferred on the basis of prediciable subs€quent negativ€ long horizon price
perfo.mance. Research also axamines whelher analysts afliliated wiih the irvestment
tankng lirm prov;ding clieni servic€s are more optinistic in rheir prolits fore'asrs
and share recomnendations than unaffiiiated analysis. A Dumber of researchers
repoft that afliliated analysts issue more oPtimistic grow$ forecasts lian unaffiliated
anal)'sts,er and others 6nd that afilialed anal)'sts'share reconm€ndations ar€ more
favourable than unaffiliated analysts' tecomm€ndalioDs 'r There are also many srudies
that show that financial analysts are fooled by profrt figur.s and are oPtimistic ln their

The controversy surrounding comprehensive income

Reo. c.l ]llornr1e i- omp,41 o- (an . a ecrimd-o a onoli' rr 'omp f' \ ra
a'lo'a e ro r: onal b'rnr-,^ pos'ror\ nrl'Fn"d Lre gtn ol tlre
a' o.nr-gporslrur l'g 'ldrron d.d .u un M!I or l-P IrnrrrolJ ' our rrngrpa't l
snndira settlng efforts have revoLved arornd moving fojsv accountjng representations
"na
tos,ar.ls ldeal meaiures that provide more in{ormation on the ulrderlyinB microeconornics
ofrnF im. A. J porr'r'lp,o e 'rarp ' r\'d".el'f-rFn I' rl p orli rrFar. or a
.'net" e or ngt -q.".'rt ura" .'rd o"""l.'o,edb'8ol d ' or-; 'r'1d"J' ' ''
ww\!. asb.org.uk).
The Drscussion PapeP5 sLrggests that lncomc should conceptually include all relevant
events {including prlce restatementsl and transactions during the period and display
them tz

CHAPlER 12 Capltal markel resetrrch 427

 as part of the toial amount ot comprehensive income. Separate staiemenb of unrealised
gains and losses that allow flexibility in reporting fair value changes as'difty surplus'
reserue adjustments (as in the United Kingdom or SFAS 130 in the United States) will not
be allowed. standard settem ask: how should we allocate and rcport these events: (a) across
operatin& investin& and financing functions (similar to a cash flow disaggregation) or,
(b) by nature or the economjc characteristic of the activity by separatinS out tansaction
income from changes in prices that are unrealised (the disaSEre8ation problem). The
lnternational Accountin8 Standards Eoad (IASB) initially expressed a preference for
allocation by function, but now proposes allowing the functional allocation to be fufther
dissagregated by nature.
Ihis lair value approach and the point of revenue reco8nilion (the IASB suppo(s re\/enue
beioe recognised when lhe cLrslomer is siSned up and an cxil price detemined),"6 have
be€n politically controversial and have not always had the unanimous support of national
standard setteB. For example, the Accounting Standard Setting Board of Japan initially
exprcssed concern about the direction of the project and requested that it be stopped
Moreover, the European Financial Reporiing Action Croup (EFRAC) has been formed in
oder to make a contribution to the wo* of the IASB. EFRAC plans to be influential at an
early stage by commenting on revenue recognition, which it believ€t has now become
critical because ofthe apprcach taken by the IASB and FASB in Iinking revenue recognition
to tair value remeasurement of financial assets. EFRAG has echoed the concems of financial
statement preparers about the lack ot ma.ket prices, the obliSation to provide reliable data
and the duty of auditors to attest to the reported data.
Some empiricdl rcsu lts show thar I tad itiona I nel operating inLome dominales compreh€n) ivF
e7
incomeasavdludtion mer c; howeve., thc(F is 3 lack of research in Iurcpe, Asia and Afri. a
Thus, the lAsB's decision to extend the rcco8nition of income beyond tradi$onal realisation
concepts will not ne€essarily achieve the stated obiectives ot enhanced visibitity and
increaied value relevance- lndeed, the proposed IASB comprehensive income performance
report is a presentation tormattbatcould add further noiseratherthan informaton, to income
reporting. The issue of how income is to be determined and repoted is an iniernational and
a cultural issue,

Biddle, Gc, & Choi, J'H 2006, 'ls comprehensive incom e\tsefdl' , lounal ofcontznryary Ae.ounting
and Economks, !ol- 2, no. r, pp- l-32.
Cahan, S, Counenay, S, Gron€woller, P, & Upton, D 2oOO, Value relevance of mandated
compr€hensive income disclosur6', /o',lrral o/ 86iness, Finance ann Ac.ou,tinS, vol. 27, nos
9-10, pp. 1273-301.
Newberry s 2003, 'ReponinS performance Comprehensive inome and its componeots , Abac6,
vol.39, no. 3,pp. 325-39.
S.hipper K:A, Schrand, CM, Shevlin, T, & wiLl6, T, 2009, 'Recosidering R@eDue R€cosnition,
A..ot tin8 Hodaon' \ol.23, ro. 1.

Winners/losers and overconfidence

Th€ winner/loser effect is an exarnple of a long-term association anomaly This €ffed
produces a tGding strateg.. Shares that produc€ exueme posftive retums (winnerc) or
extreme negative relums (los€B) are rank€d on their last three-year performance and
placed in portfolios. Past winners tend to be fulure loseN, and vice verca. The studies
_thalere8
of leBonit and suggested that a statistically significant abnormal retum of up
to 15 per c€n1 can be mad€ from this strategy Th€se results have been confirmed in
subsequent studies that adiust€d for size and differential pedormance.ee

PART 3 Accolnling and resear.h

 DeBondt ard Thaler attribute these long-relm rcturn reversals to invesror
overconfidence and biased self-aitribution. Overconfidence about privale information
also causes investors to downplaylh€ importance ofpublicly disseminated information.
Frlrther, in forming e{pectations, investors are hypothesised to give too much weight
to the past profit performance of firms and too little to the facl that performance tends
to mean revert. There is also a belief that the market is slow to react to events and in
incorporating new information. There are also momertum effects obsen€d, wi!h shares
that have high retums over the past_vear tending 10 have high relurns over the follolring
3 to 6 monlhs.rooThis is attributed 1o cons€rvalism bias, $rhereby investors are slorv to
update rheir b€liefs, which contributes to investor underreacdon.
other research examines whether indicaiors other than proit generate iong horjzon
abnormal slock performance. Examples include rests based on cash flowyield and sal€s
gowih;r01 tests of marker overreaction stemming from analysts' opdmism; and tests of
thc markei's overreaclion to extreme accrual portfolios.lo']The common firding is thar
the financial market ove.reacts to accounting indicators offirm value and coffects itself
only ov€r a long horizon.
The overreaction is explained by marl€r panicipants' naive fl\ation oD reported
numbers and their lendenct ro e\lrapolate f.om past performance. However, because
ther€ ismean revenion inth€enremes. the markels initial reaction to extreme indicators
ofvalue overchoots fundamental valuation and, in tltrn, provides an opporturityto €arn
abnormal returns. The oveneaction hypothesis is extended by Bradsh aw, Richardsor and
Sloanr03 nho examined whether professional analysts understand ti€ mean reversion
properry- of extreme ac.ruals. They found draf investors do not ful]y anricipate the
negative implications ofunusually high accruals', and hence fail to incorpomte them in
their profr ts forecasts.
Ou and Penman analys;s tunher extended this researdr by exploiting traditional
rules ol frnancial ralio based fuldamental analysis to earn abnomal returns.rol This
resear.h finds rhat rhe resuhing fundanental strategjes pay double digit ab ormal
retunN in a 12 month period following the portfolio formalion date. The conclusion
of the market's sluggish adjustment to th€ information in the ratios is strength€ned
by 1he faci that ftrture abnormal returns appear to be concentrated around profit
announ.ement dates when ihe profit predictions of the analysis conle true. Finally,
the multivariate fundamental anal)'sis to estimating fundam€ntat values of shares and
;nvesting in mispriced shares has been en€rd€d by the use ofthe Ohlson residual pront
llrod€l conbined with analysis' forecasts io estimate tundamental values and show that
abnormal returns can be earned.

Mechanistic or behavioural effect

Cosmetic accounting
Two hypolheses have been developed:
1. Tire lnarket reacts mechanistically to changes in accounting numb€rs, regardless of
whether L\ey are cosmetic or whether lhey have cash florv implications; as such, the
market is systematica lly deceiv€d by accounting chang€s which iDcreas€d ordecreased
profits Ghe 'mechan istic' hypotllesis) .
2. The market igDores accounting changes which have no cash flow consequences
thal is, rhe market does not rea.t to accounting changes other than those sivitches that
inoease ihe pr€sent valu€ of ta-\ saviDgs or otherwise affect dre finn's cash florvs (the
'no-effecis' hlpothesis deriving from the EMH).

.HAPTFR r2 a:nitil mrrl.r r.s.ar.h 429

 The 'tesB ofihes€ two hypothd€s consider rhe b€haviour ofabnormal iates ofretum
at and around the time of a change in accounting policy. According ro the no-effects
h,?oihesis, there should be no abnormal retums when there is a 'cosmetic change'
in accounring policy, since th€re will be no effecr on cash 0ows. Under the no-€ffects
hypoihesis, creative accounting chang€ is undersrood by capiral market panicipant.
and they are able to unravel and det€rmine ir effect$. On rhe other hand, if an
accounting policy has an efLcr on cash flows (e.9. as a resuh of tax regimes), we would
e\pect to see abnormal retums at the date of announcemen!. Therefore, the no.effects
h'?othesis is a ioint hytorhesis of the EMH, the CAPM and zero moniroring costs.lo5
ln contmst, under th€ mechanistic hlpodesis we would expect to see abnormal retums
at the date ofannouncing accounting changes even rhough rhe change has no effect on
cash flows
- that it
cosmetic or creativ€ accounting can fool market panicipanb.
One of the fiIst studies that attempred io discdminate between these compedng
hlpotheses was undenaken by Kaplan and Roll.to6 They studied two a.counting
changesi
l. a chenge in accounring for investmenl tax qedirs from deferral to immediare
recognition
2, a switch back ftom accelerared depreciation ro sraighl"liDe depr€ciation-
Both chang€s were 'cosmetic', and both would be expected ro increase the profrts of
the company in the year of implementation.
Kaplan and Roll's result showed that the inarket was 'fooled' for some time. For the
firms lhat changed to the immediate recoSnilion ofrhe investmenl tax cr€di! lhe CARS
behaved 'strangely', showing negalive abnormal r€turns at announcem€nt date/ then
rising to a p€ak about nine weelc afrer announcement before aeverting to around zero,
The behaviour of th€ control group of firms was also unusual, as the CARS suSSest that
abnormal cumulative excess return6 of 9 per cent could be eam€d by purchasing thes€
shares at announcement date-

Manipulating accounting numbers

lncome calculated under CAA? is a noisy imp€rfect measure of'economic income' or
'fundamental value'. This is because accounting standards are not pre.isely d€fined
or consist€nt across countdesi accounianB are affected by subiectivity and ohuaal
interprctations in their esdmates, and manaSe or manipulate financial statem€nts to
varying degrees. How do we interpret and cla6si& the wide scope of literature in this
area? Regerdless of the county, management has insider knowledSe of the quality of
the firmt perfoamance, Manag€ment €an choose 10 move accounting numbers towards
fundamental value (implyinban informational perspective) oraway from fundamental
value (i.e. taking an opportunistic pe$pectiv€). (See 6gure 12.7.)
Under the opponunistic perspective, ftaud is the most exEeme variant of eamings
management and it is used by manage$ to deceive financial sbtements nsers. Industry
regulation is when 6rms are conuolled and have inc€ntives to increase or reduce
earnin8s so that they can insease the prices they ciarge or obrain subsidies from
the govemment or are not in breach of accountin8'based risk ntios (e-9. banking
r€gularion). Equity otTerinss occur when man€ers lry to manipulate the a.counts in
order to raise share prices to increale the tolal oftheir wealth held in equityor options
or to increase the price of initial or seasoned equity offerings. Debl covenants refer to
managinS the a.counts so that debt or oth€r covenaDts are not breached and 6rms are
nol in default and do not incur the increased costs associated rvith default. Finallt
manaSem€nt comPensation is when managers ma ipulate acaounts 3o as lo maximis€
utiliry ftom bonus schernes lhat are tied to accounting numbers.

430 PART 3 Accounting and r$earch

 Accounting nandards

Earnings management

earnings management

GURE 12.7 Two viewpoint5 of accounti.S manipulation

The informalional pesp€ctive mainly revolv€s around signalhrg theory' Signallirg

refers io the practice whereby managerc use insider knoNledge of the linanchl
starem€nls to signat e.onomic informatjon ibout dre firnl io interested panies For
example, ih€ in.ome smoothing literature signals thai clrrrent incoIr1€ is permanent
income. lair value accounting refers to managers making accounting choices (uot)
complying\vilh accounring standards but reflecting the und€.lying fundamentals oithe
bLrsiDess. the us€ of approPriate fair values, aldloLrgh rheo.€iicall-v defensible, Iaises
issues about u,hy managers mighr use dilier€ri accounling techniques

Detecting the quality and probability

of accounting management
'l'he capital ma.ker evid€nce suggests thar manage.J cosm€tic (hanges to accruals alfect
share prices. The eviderlce also shows that prices I'ill r€ven lo fundamenlal l'aiue bul
thal may rak€ some lillle - even up to a year or lnore. whrl also is ol interest 1()
capital market research€rs is the type of research that can help indicate ihe qualitv of
the accrual nanagemenr. Figur€ 12.6 provides an overvie$', f iih the arrolv p'ovidin8 a
olur L rndr' ror or edrnir g.quiliI d r, rron
\\'e can use share pic€ reaction as an indicarion ,rf quality. Hon'ever' research by
sloantoT and olhers has shown tlial ihe mark€t as a does not have a soPhisricrted
'!hol€
positiv€ incon€-increasing accrujls
underslancling ofaccmals, and henc€ olerreacrs 11r

the reaction olfinancial analysts.an also be used to ass€ss qLraLitv because of r€ir
expertise. Hoseve., .esearch jn this area has getrerailv suggested that anil)'sts may
be biased and focused oD indostry sPecilic lactors ralher tlun llrm'stecific vari.lbi's
Auditors' reports and opinions can also be us€d to proxy for qLtalit-v blrt therc is some
debat€ over $41ether auditors are rl1Ilv independent.

.HAPTER rr a,p t' I le r ' r {ll

 No
snd€rstandinS

FlGUlf 12.8 Detecting eamings nanagement

The strength of corporale Sovernanc€ can also be an indicator and, unlike the
pr€vious three €xamples, is a surogat€ for information quality. Dechow, Sloan and
Sweeneyr@ found that opponunistic accounting manipulations ar€ more likely to occur
when th€re is a desire to attract finaocial resourc€s and the company has a board of
dircctors dominated by a CEO who serves as the chairman ofrhe board, does not have
an audir committe€ and is less likely to have an outlid€ block of dircctors. Th€ type of
acmral is also imponant. Marquardt and Wiedmanl@ show that in new equity offering
cases, fiims panicularly manage eamints through higher accounts receivables, whereas
in management buyouts, accounts rcceivable arc mana8ed lower. For firms avoiding an
earnings decrease, only the unoeected pan ofspecial-item acanrals differs siSnificanrly.
Finally. if we examine insider tradinS according to incom€ incleasing and deffeasin8
accmals, we are able to predict future r€turns and earnings more accuntely because of
insid€rs' specialis€d knowled8e of the fum and t}Ie implication! of specific acdxals. r Io

Financial anal)sts and their mixed reaction to swilching to international accounting

rl,rndards

AIFRS - a work in progress

ln a Catch 22 scenario, increased underrtanding of Australia's equivalent of lnternational
Financial Reporting Standards (AIFRS) has caused mixed reactions amon8Australian finarcial
analysts as to its potential to help in!€stment decision-making, accordinS to a KPMG report.
The report, A Work /r P/ogress assesses Austhlian financial analysts' response to the fkst
financial resuits publjshed under AIFRS since its jnception in January 2005. lt replicated a
similar repon conducted in late 2004 on the same subject.
While it showed an encouraSinS uplift in analyst undeulanding, increased analyst
knowledSe around AIFRS has also led to debate on its value wilh 30 per cent saying lt
facilitated a strcnSth€ning of the capital markets, 30 per cent saying it didnl and 40 per cent
slill undecided.
Additionally, a 17 per cent incrcase in lhe number of analysts who are confident in
distinguishing a change resuhing from eilher business pe ormance or accountin8 changes
underAIFRS, coincided with an I I p€r cent drop in those sayingA|FR5 provided mo.e insiSht
inlo a company's tue tinancaal perfomarrce.

412 PART 3 Accounring.nd research

 "This hiShlights one of ihe most significanr challenSes for countries tike Australia who are
adopting IFRS: how to ensure the benetiis are real ised," sa id Ceoff Wi lson, KpMC,s parrner in
charge ofaudit and risk advirory.
"While the analyst response is someu/hat concerning, there were many positives to draw
from the report, inciuding the increased quality of company communication and reduced
fears of market volatility because of AIFRS.
At thetime ofAlFRS'inception, analysts were calling for company briefings on its expected
impact. Nearly ha f the analysts surveyed sald all or most companies they follow provided
brielinSs or additlonal information explaining how AIFRS is afiectingthefinancial informatlon
they report. Whi e this is a signlficant improvement s ince our first report, there is still work to
be done as the remaining analysts (56 per cent), said they received briefings trom just a few,
one or none of the companies they track," Wilson said.
Andrea Wateft, KPMC partner in charge of IFRS conversion services concluded: "ln 2004,
our report identified lhat analysts expected there to be market volatility when resuks under
AIFRS were released. To date, this anxiety app€ars to have been quclled. ln 2004 a majority
of analysts said they would mark down a company's shares if they didn't undentand rvhy
its results looked ditferent under AIFRS- ln 2006, ana ysts appear io be less likely to mark
do$,n shares oi companies showing volatility after switching to AlFR5. However, business
should see this time as an opportunity to ensure communications are hitting the mark with
stakeholders and the AIFRS impacts are well understood by the nrarke!" she said.
so!/.ei Alstra ia. rnstitute ol Compnny DirecloE, 'A Work in Progre$', Ihe B k1tuon Repod. rai A,
is!. I l, llne 6, 2006, F.

Questions
1. Ontheevidencepresentedinthisarticle,aretinancialanalystsw€llequippedtoefficieftly
faclor inio prices the impact of switching to international financial reporting standards?
2. What do you think willbe the impact on share prices if analysts disagree on the information

3. What other methods could be used to assess the value relevance of AIFRS?

@- ISSUES FOR AUDITORS

The empirical evidenc€ r€viewed in this chapter shows that accounling earnings have
information content, and lhat market reactions to accruals tend to be biased because
iDvestors do nol appear to fully appre.iate the rsersing nature of accruals. Research
also shows Gal *te nature of the long tenn association belwe€n accountiDg eamings
and share prices is influenced by a number of factors. The eamings response coefficient
studies shoi{ thal qualified audit repons and SEC sanctions againsr audilors signal
Lower qualily €arnings and result in lower ERCS.
There is some €vidence of an association berween auditing and the cost of capiaal.
Black{'ell, Noland and winters irvestigated the elfect of purcbasing an audit on dre
cosl of debt capilal for a sampLe of companies that are nol legally required to be
audited.'rr They found thar small privale firms that purchase audirs are charged lou€r
interest rates. However, nlost economic activity occurs in fims that are required to
purduse an audit, so researchers have investigated the cost ofcapital effecrs associared
with ditrerent quality aLdiiors. As discussed in chapter 11, it is generally believed
that large or 'Big'auditors ar€ higher quality than other auditors. Also, audito.s that
specialise in ceiaiD indust es or conincts are higher quality aft€I coDtrolling for the
Big auditor effect. Mansi, Max$'el] and Miller prcvide eviderce ihat higher quality
audning lowers the cost of debt capital.rt'] They found thar the effect on the cost of
debt is mosr pronounced in firms lhal have lower quality debt, which suggesrs that
auditors provide value to lirms through bo$ their information and insumnce roles.

CHAPTER l2 aa.iral market resear.h 433

 This means that Ienders appear to believe that higher quality auditors are associated
wirh hi8he! quality financial information and that the larger auditor provides greater
insurance agaiAst debt default. securities laws provide recours€ for i ,'estoB against
auditors, so the .esults suggeat lerders value being able to sue a well-resourced large
auditor instead ofa smaller auditor.
The association ofhighei quality auditors with the cost of equity capital has also been
investrgated. Khurana and Rarnan studied the association ofBig auditors with €quity prices
across several countries (iftluding the Uniled States, Ausualia, Canada and d€ United
Kingdom).ll3 They also found information and insuranc€ efiects, but only in the United
stat€s. They attdbuted this result to the higher litigation environment in the United states
relauve rc the other countries. Li and Stokes investigated th€ Australian €nvironment
further and fourd that rhe choice of a Big auditor is associated with a lower cost of capital
wh€n a f-rm switches from a non-Big auditor to a Big auditor.lta They interpreted their
fiBdingp as supporting the information, or brand'nam€ rcPutatio& argument ln addition,
they found evidence of a lower cost of equity capital for climo where there had been
Sreatet audit effort, and those dients were audited by an industry sPecialist.
Researchers investigated the effecl on equity prices when there is an exogenous, or
extemal, sho& to the system. These shocks include the rare event of the failure of an
audil 6rm. In 1990, the s€venth largest accounting firm in the United States, laventhol
& Horwath, filed for bankBptcy. The main reason oted for its demise was the large
amount of litiSation against it.rrt Thes€ events meant that the insurance protection
provided by the audit firm (o its clients was suddenly withdrawrl If the piotection
was valuabl€ to investors, we would expect to see a drop in laventhol & Horwath's
cli€nts share prices. Menon and Williams found evidmce lhat the share prices did fall
on avemge, and the effec! was greater for inilial public oferings than seasoned public
offerinSs because securities laws prcvided more Protection for the audftors in the latter
case. Th€ fall ofAnhur Andersen LLP in 2002 following the Enron collaPse appea$ to
hav€ had an advers€ €fTect on its clients' share prices
tt6 Because the'Andersen effect'
was more severe for clients audited from the same offic€ as Enron (i.e Houston),
the results seem to indicate that investors had concerns about the quality of audits
performed by certain panners and staff of the audit firm.
Many of the studi€s examining the association berwe€n auditor choice and cost
of capital (reviewed in this chapter) and the demand for audit quality (reviewed in
chapter 11) face a similar methodological problem. The researchers are unable to
conduct controlled eeeriments to Prove a causal link between auditor choice and cost
ofcapital. Evidenc€ ftom archival dataru that a client using a larger auditor is likely to
' have a losrer cost ofcapital could be exPlained in thr€e dilferent way!:
l. Investors value €ft}Ier the quality of the audit work and/or the insurance prctection
provided by the large auditor, and therefore pay more for shares or charge lower
interest.
2. The company is Perceived as being a good investm€nt for oth€t reasons, and the
e.onomic bmefts ftom th€ lower cost of capital enable the manage$ to Pay the higher
fees charged by a larS€ auditor. ln this case the cost of capiul causes auditor choice'
3. The audilor choice and cost of €apital could borh be caused by other factors, such as
the quality ofthe companyt management or investmenl oPponuniti€s.
The researchers are careful to alt€mPt a contlol of these alt€mative exPlanations'
and use techniques such as control vaiables, simultan€ous equations and complex
statistical analysis, as well as conducting numerous sensirivity tests. Finally, th€ process
of research involves many separate attempts to inv€stiSat€ theory using different
merhods and samPles, and in differeni contex$, to build confidence in the results'

434 PARI 3 AccountinBand research

E- I" Ol']:'ophy oi posiri\e accountinS rheory
The philosophical objective of positiv€ accounting theory is to explaiD and predict
th€ application of accounting practic€- It also s€eks to explain how and rvhy capital
marke$ react ro accounting rcpons. ln contrast, normadve or inflation theorists ofien
argue for a change in accounring medrod withour putting forward any supponing
empirical evidence and withoul trying !o understand lhe rationale for current and pasl
use ofaccounting principl€s and rules. Positive theory has an empirical economic focus.
It assumes investors and financial accounaing users and preparers are rational u(ility
maximisers. Positive fi€orists reject argunrents based on anecdotal evidence, and call for
$c tening of notnrarivF d.sumption..
Itrrll- ii'" ,,r"ngrhs oi posirrve rheory
The srrengths of posirive th€ory lie in the fact that hypotheses are framed in such a lvay
that they ar€ capable of falsification by empirical research. Resea(hers aim to provid€
an understanding of how the world works rather than prescribing how the world
should rvork. In capilal market res€arch tha( D€aDs uDderstandins the associalion of
accounringnumbersand stock prices- Researche6 attempt to Lrnderstand theconn€ction
between accountinB information, managers, 6rms and markets and to analys€ lhose
relationships.
The scope of positive accounting theory
Positive theory developed in two stages. The first stage involved research into the impacl of
accounting and the activityofcapilal markets. The second-stage literature soughl to explajn
and predict the application ofaccountingpractices across 6rms.

@t c,citat -urkel reeearch and lhe etfir ient market5 hvpothesis

Two qpes of capiral market research ar€ particularly important to positive accounling
theory: ( 1) those studies that attempr to determin€ the inrpact ofa.cotlnting informalion
on drare retums, and (2) those sludies that consider the effects ofchanges in a(courttrng
policy on share prices. Most research in these areas has been conducl€d by testirlg the
semistrong form of lh€ efficient markels h!?othesis (lMH). Evenl sttrdies, asso{iation
studies and the mechanistic bchavioural approaches ar€ examples of research, $,hich
rests relationships in (apital nrarkets.

The influence of accountinB information on investor behaviour and share prices

'the maior results suggest fie follorving:
. llistorical cost profit releases hav€ information content for the marketplac€ in terms
oFCARs and the effect on volitility and trading volume.

CHAPTTR l2 CJ!,r11 mirlet rF\r,in lr 435

 . Information asymm€uy (which is affected by 6rm size) afiects the r6ponsiv€n6s of
price chant€s, th€ nature of price chantes, and the volume ofrrade following profii
anDolncements,
. There is a continuous infomadon set which is used by the market and, therefore,
accountint r€ports are nol the only 6ources of information.
. longer term association studies show that a numb€r of faclors indudiDg risk and
uncenainty, frrm size, industry interest rates, financial leverage, potential growth,
and permanent and temporary prcfi1s have a role in determining firm value.
. Adding profit levels (as well as (hang€s in pro6t), decomposing profits into separar€
componeDts, addinS cash flows, accruals and balance sheet componens, as well as
ukiDg inio accounl broader macoeconomic facto$ further inqeases the ercplanatory
power of ac(ounting variables,

Trading strat€gles and mechanistic behavioural effects

There is ins€asing €vidence ihat rnarkets can be fooled by accounting numbers, evidenced
by post-announcement drift, tradin8 rules ftom financial stat€ment information, changes
in accounting t€chniques, accrual levels, winnerlos€r strategi$ and financial analrst
opdmism. The r€lationship tretween accounting methods and the impact of behaviour
on shar€ markets is an ongoing research area in accounting which will play a significant
role in the research literature in the years to com€.
|llE- tr.u", fo.
"uditoo
The empirical research provide. evidence of b€nefits to companies through lower cost
of equity and debt capital when they volunta ly purchase an audit or purchase a high-
qrality audit. Inv€stors value the insurance prot€ction provided by the possibility of
taking legal aclion aSainst a lar8e auditor who has deep resourc€s. In addition, inv€stoB
valu€ the assurance provided by the auditor about the quality ofthe company's financial
information. Researchers are unable to run controlled experiments on auditor choice
and face methodoloSical challen$s in desitning studies usint archival data that enable
these condusions to be drawn with confidence.

Questions
1. What is positive accounting theory? How does it differ from normative accounting
theory? what was/were the rDaior dissatisfaction(s) with normative accounting
lheory which led to the development ofa positive theory ofaccounting?
2. Explain the meaninB of an effrcient market- What is meant by the following terms:
weak-form efficiency, s€mistrong'form efnciency and stron8-form €fncien.t? Which
form is the most important 1o accounting research? why?
3. Explain the imponance of€xamiding the impact ofprofits on share prices for financial
analysis. can this analysis be used to make atrnormal retums Fom share markets?
4. Does a sludy ofthe information content of profits announcements explain why
firms use particular accountin8 practices? Does it help to predictwhidr frrms will
use particular accounting practic€s?
5. Cive reasons that non-linear models r€lating unacpect€d retums to sharc prices
would provide a more precis€ $timate of the earnings respons€ coefncienl (ERC).
6. why would share prices have a greaier reaction to ihe profit announcements
released by small firms compared with those rcl€ased by large 6rms? Do you think
(his research has any implications for'measuremenC issu€6 in accounting or for the
formulation of accounting standards?

4?6 PART 3 A.counti.B and re*arch

 7. Outline ihe research that has been undenaken on rhe impacr of permane[r and
temporary increases in pronts. Why is this reseaKh impo(ant?
8. Howw nskand uncertainty affect the valuation ofa firm and, rhrough rhis
valuation mod€I. the ERC?
9. The impact ofprofiis forvaluation has diminished ov€r ihe y€ars. What is the
impact? Ho$' has the research adiusred to reflect lbis fact?
r0. Outlhe a researd proiect whid explains how share pric€s are delemined. \^'ould
this project in(lude factors other than accouniing daht
11. Bri€fly ej.plain and outline 1he research on the'mecha[istic'hypothesis. what are
the implicalions of this research?
12. Why rvould 6nancial analysts be fooled by acrounting numbers and provid€
optimistic and biased estimates ofprontsl Can you offer a posilive economic
reason for iheir actionsl
13. Ou ine the differ€nt procedures that can be used to d€termine lvhether accounts
have qualiq accruals or whedrer they (reJte more noise
t4. ['hat are the two main explarations for dre association between th€ choice ofa
high quality audiror and a lower cos! ofdebi or eqli1y capiial?
15. why do we have to be careful drarvinS conclusions about causaliqr based on
studies using archival daiai

Additional readings
Bror\'n, P 1970, The impact ofrhe annual ner pro6t repon on th€ stock mai<er', Auscalian
Accountaflt, lrly, pp. 27 3 -83.
D€itick, Jw & Harrison. wl 1984, 'EMIJ, CMR and the accoun!in8 profession', ./orrrndl
of Ac.ountanc)', t:ebmary, pp. 82 94.
l\tafi, AR r983,'llf6dent markel theory: lts inrpad or accountin8', /orrrndl of Ac@untanq .
Febrllary, pp.56-65

Thh case sludy discusses the impact olan increas€ in accounting melrics bul a
share price.

Dl sales pick up but shares dive

David Jones sharcs yesreda), sufrered their biggest one-day drop thls year, desp te
thc retailer unveilng a beiter iourth qLrader sales result. The shares were hammered
I
more than per cent 1o $4.81
- the bit$st ftll since Novembe. last year as the
depanment store chain booked a 6.9 per cent d;ve in full-year like-loFlike sales.
Holv€ver, after ialling allnost ll
per cent in th€ third quart€r, comparable sales
rebounded in the fourth. to be down iust 1.2 per cent on the back of stronger trading.
David jone, chiei Mark Mclnnes refused to say lhe worst was over lor deparlment
slores, w?rnin8lh€ economy was stillopen to "an externalshock". "lt's not about being
less confident, it's mo€ about recognising that the jury's out . .. as lo the recov$y and
the pace of recovery of the cconomy," he said.
Mr Mclnnes said the folrlh quarter sales of $512.3 rnilliof lverc much betler
than expected "and aftcr the previous three quarters, \a'hich lvere terible, it was a

tt

CHAPTER r2 CiDitil marker rescir.h 437

 Crcdit Suisse retaii analyst Crant Saligari said the result was "fairly weli in line" with
ma*et expectations. He attributed the slide in the sharc price to a strong run over the
past month. "l think you're just seeing a little bit of profit-taking off the back of that "
Mr Sali8a.i said. He saad the stront cyclical rally in the rnarket over several months
wa5 reflected in the share prices of retailers such as David jones and JB HiFi, while
"some of the more staple slocks such as Woollvonhs, which have lower risk profiles,
are comint back lo the field a little bit."
Austock securities analyst Thomas Hodson compared David Jones' recent share
performance to Harvey Normanrs, 'where lhere was a slrong run up in the share price
hopint that the Sood news and stronS momentum wolld continle". The DJs sales
resuhwasn't a disaster, but there probably wasnt enough in terms ofupside surpriseor
news to really keep the momentum goin&" Mr Hodson said.
Other relail stocks also took a hit yglerday. with Harvey Norman down 4-28 p€r
cent to $3.13 and JB Hi-Fi off 3.82 per cent to $16.1l Dj's shares have doubled since
March, and surged 10.17 per cent on June 30 after lvlr Mclnnes upgraded the slorct
full-year profitguidance to beween 9 and l2 per cent growth.
Mr Mclnnes yesterday reafiirmed this year's profit tuidance and said the company's
neK fina ncial year, in which it expecis to deliver flat to 5 percent profit growth, would
b€ one of "stability" before a return to rctail growth. We?e not predicting any sales
8rcwth in FYl0 - we don,t se€ tha( coming until FY]1 and FY12," he said.
The retailer oullined a new focus on online marketinS, with former marketing 8enelal
mana8er CeorSia ChewinS appointed to the new role of h€ad ofditital marketint and
e-tail business. Mr Mclnnes said thet over the next year David Jones would focus on
improving its communications networks online.
"Twitter is only like 12 rnonths old and Facebook thre€ yeaa old, and those are
completely chan8inglheway people are communicatin& and so we want to make surc
ourbrand has a presence in those newtechnology distribution markets," he said.'And
if there's an oppo(unity for e{ailexpansion and we can 8et a return on investment then

DJ's latest full-year sales totaled $1.986 billion. Co6metics continued to be lhe
store's best performer, achievlnB double-digit growth dudng the fourth-quarter. Young
men/s and women's fashion, children's wear, manchester, kitchenware, home office
electronics and small appliances were among other silong pedormers. However,
tradinB in big items such as rclevisions remained tou8h.
Like Myer chief Bernie Brooke5 a day earlier, Mr A4clnnes was bemused at this
lveek's retail trade fitures which showed depanment slores' sales fell 8.8 per cent in
June compared with May. "our sales both at a total level and a likejorlike level in
Jun€ were up on last year, so it has to b€ lhe discount depanment stores that have had
a difficult month - but it certainly wasn't us," Mr Mclnnes said.
He did notbelieve the flagged relistintofMyer influenced yesterdayt DJsharc price
plunge.
Sou.@: He,ald Sun,6 Asgust 2009, pp.37-8, ww.heraldsun,com.au-

Que6tions
r. Why do you think David Jones' sharcs have dropped in value when founh'quarter
prof its have increasedl
2, What other€conomic information is the market usint besides accounting rcports?
3. One analyst suggests that there wasn't enough in 'upside surprhe or news to really
keep the (sharc price) momentum going'. What does this commen! suggest to you
about markel elf iciency?
4. Civen the anabat's comment in question 3 how would you classify the ma.ket
efficiencyr weak-form; semistrong-fom; strong-form? Explain your answer.

438 PARI3 Ac(ounrins and research

rh€ Iollowint article dhcusses the situation oI a firm expanding its core oPerations
offshore.

Nufarm buys US companies

Agricultural chemicals group Nufarm has bought two US'based sorghum comPanies
to h"Lp gro- its see.is division into a $50 milljon business The companv will add
Texas-based Richardson Seeds and MMR Cenetics to its sorghum platform, which
was started with the acquisition last year of Queensland sorghum specialist lefroy

Brent Zacharias, the head of Nufarm's seeds division, said the acquisitions would
deliver significant grolvth and complenrent Nufarm's sorghum bLrsiness.
Nufarm managing director Doug Rathbone said Richardson and MMR would
strengthen Nufarm'iseeds platform. "solghum has been a target crop for our seeds
business," Mr Rathbone said, noting that Nufarm would gain a range ol benefls ftom

Richardson Seeds produces and markets sorghLrm seed hybrids lr is a market leader
in the US and holds expanding market posltions in Mexlco, South Am€Iica, Europe,
Japan and the Middle East.
MMRCenetics, prcvioLrsly 47 percentowned by Richardson Seeds, isa global leader
in the development of elite sorghunr Sermplasm
Combined sales of Richardson seeds and MMR in 2008 totalled about $US22
miilion.
Mr Zacharias said he considered it impo(ant that Nufarm was retaining the existinS
management and employees of Richardson Seeds, includjng company pretident Larry
Richardson of MMR.
Nufarm fell 7 c to $10.90.
sou/.e: He.a/d sun, 6 AuBUsl 2009, P 60, sww heraldsun.cod au.

Que\tion\
1. List dre ways that you think NLrfarm is changing its core operatlons.
2. lf ihe acqulsitlon i, expected to deliver signlticant growth, why do you lhink the
share price is tall rg? ln your answer, consider the potential impact of both market
wide events and firm specific lnformation.
3. a(icl€ suggest market efficiency? Exp aln yo!r anslver'
Does this
4. Does the volatility hypothesis predict greater or less variance in dre share prlce on
the days following the announcemenl date? What olher factors might affect the
volatility of the share price following the anno!ncement?

This case study considers lhe market reaction to information released by a firm that
has div€rsified ils operations.

Market cheers Axa's Asian Plan

The fund manaSer got off lightly vesterday derpite a sharp slump in sales, thanks to
its diversificatio; pLns. Axais Andy Penn yesterday showed that the stockmarket is
in a fo€lving mood. Just getting close to expectatjons with no negative surprises was
enough lo win market backing.

cHAPTER l2 Cap ta nr!rlict iescarch

 It doesn't work for everyone, as David ,ones leamed, with expectations running
ahead of actual returns. s€ndin8 its stock prace down 8.4 per cent to $4.81 . lt was partly
caught in a general sell-off of the so-called high beta sbcks, which have run hard on
hopes of an economic bounce because, as with Axa. the 5ales fi8ures were in line. The
mistake was not sa srying hopes of another profit uptrade.
Axa eased butstillclosed up 2.3 per cent at $4.42 a shareafterdisclo5ingasharpslump
in sales and a pmfit that was no better than in line with estimates. Penn's advantage is
that he was the fiEt to report frcm the funds management sector.
But the good news for AMP'5 Craig Dunn et al is that Penn didn't set the bar very
high. Those with a much better domestic franchise should jump over it easily.
As always, how analysts r€sponded depended on theh estimates. So news that sulplus
capitalstood at $1.5 billion pleased those exp€cting lessand disappointed those tipping
more- The bottom line is that it shows Ara is well funded.
As for groMh, well thats another question altogether, and had to find in this
environment. ln Axa's case, it's all in Asia, which accounb for two{hkds of operating
earnings and a pladorm for groMh, onceallthe problems are ironed out.
Overall operating earnings were down 13 per cent, with funds under managemert
down some 28 per cent. This shows Ar(a's Andy Penn is keeping a close eye on costs,
and diversitication is once again provinS to be the best line of defence.
Source: rhe Austalian, 6 Augld 2009, p. 26 www.the.ustlalian.com-au.

Qu€stions
1 , Axa's share price increased by 2.3 per cenl when ils annual r€sults were announced.
What do€s this reaction sugSest about ma et efficiency?
2, The article indicates that Axa experienced a sharp slump in sales, yet its share price
increased. txplaih why rales is notthe moet relevant indicator of Axa's value?
3. list the factors that appear to har€ had an impact on Axa's share price and indicate
the likely direction ol that impact that is, an increase or decrease.

Endnotes
1 M Friedman, The detbodoloEyof as it involve cnoosinS bdwe€n nsk , Ioumal al Finance, septembet
poskive e.onomi.s', in M. Friedman individuals. 1964, pp. 425-42; I Linher, The
@4.), Esl,s in Witiw econoaics, 9. K Popp., rhe loSie of scientif. valMtion of nsk Nec dd ihe
Chicato: Univecily of chicago dt.or?ry, London: Hutchinson, sel<tion of nsb inve(m€nls
Pr€sr r953,p.7. r96a in sto& ponfolios and cpilal
2. R wats and t Zimmeman, Pori,i4 10. , HiBchliefer Ih@ thsorl atd btdAes', Faietu of E.o@ni6 and
amuntins thuty, Er.glewood cliffs, 4rplicnliorr 2nd edn, EnSlewood Sra&ncr, FebNary 1955, pp. l3-37,
Nr: Pr€nti(e-Hall, 1986, p.2. Clifii, NJ: Prcnlice-Hall, lt80 or ro any tdt in inrodudory
3. ibid. 1t. ibid.. p. 1.
4. M,eoseo Oryaniration theory and t2. I Fama, 'Eff.ient apital markeB: 16.
methodologt', Ac.ounting Retiao, A review of th€ory and .npirical 17, R Ball and P Brown, An mpidcal
April 1983, pp.3t9-39- eolk' , louftol ol Financz, May r9?o, evaluation of accounting income
5. ibid., p- 320. pp.183-{r7, p.383). nt'nberf', Jour,at oJAa nrinI
6. ibid. 13. ibid., p. 389. Raar.h, vol. 6, no. 2, A!tumn
7- Wa s and amm€rman, op. <ir., E fama" Founddriors oJ lkdw, Na 1968, pp. 1s9-73-
York Bas'c Book, 1976, pp.63-8. t8 ibid. p. 160.
8. ibid., p.8, watts and ziEm€rman l5 W€ will notpr4ent an in-deplh 19. P Brcwn, Th€ impacl oflh€ annual
su8g*t that the adoption ofany dbc6ioo of rhe CAPM. InteEsted ner profit r€pon on the sto.k
objecliv€ oihd than economic reades are rcfered ro th€ seminal m tuet' , Ausnalidn Accountant.
efficiency,such6amore anides: W sha.p€, 'Capital ,uly 1970, pp.273-83.
equitable distibution of weakh, aset pric€r: A rheory of narket wata and ammemal! op. cit.,
is a rubjedik value judsenel €quilibrium under coqdilions of Dp. 48-9.

4n PART 3 AccourtinS and research

21. C Fosier, 'Quanerly ac.ounljDg
dara:Time sedes propenies and
pRdictive'abiliry 6olts', A.@!nlrn8
Rei@, 1977, pp.686-98.
22. Evamples indlde: P Brown and
'anuary
P HancocL 'Proit r€pons and th.
sbar€mi*ei. in l'telley and P lubb
(eds), Carnal, incone and deeision-
ndhinS: nthotluctary readings i
e.dlrrrrrS, Sydnel Hol( Rinchan
and Winsro., 1977, pp.28l-8;
S Easbn and NA Sinclair, Tte
impacr of unqpect€d eamiogs and
dividends on abnomal rerurns to
.gliV , ArcounrinB and Finan.e,
May 1989, pp. I -19.
23. w B.ave. RClarke and
w Wnth! The associarion berwen
unqstemat'c security r€ru.ns
and the masnitude oieartrints
roftcasr em6 , Iounot ol Accounnns
R5enrch, A!fumn 1979,
Pp.3l6-40
24. W Beaver Rlimben and D Morse,
'Ihe infomarion .ontem of
sotiry Dtices , Iolnol of
dnd Edonontrr, Ma(h 1980,
pp- 3-38.
25. The t€m 'earnings response
coefncien( and tbe aaonym 'ERC'
w.r. iisr rs.d in PD tasron.nd
ME Zmij€\vski, 'Cro$ sedional
rdiarion in rh€ sro.k marker
respons€ io accountin8 €aminSs
announr€mer1r" ro!ndl o/
Ac@u nt9 af,d E.onontics,
1989, pp. r17-42
26. RN Freeman, 'Ihe a$o.iation
be$veen a.countinE errDirys and
s..unr)_ R(urns for larse and small
l
6n$, u al ol Accountins d d
!.nno,rli.i, !ol. 9, 1987,
Pp. 195-228.
27. EB Cranr.'Nla*er implicalioDs of
diffe.ential amo!nts of interih
infornrarion', /orD'di ot,4..orrn,A
Rsrdlr.,r. vol. 18, no. 1, 19a0.
28 R Atiase- 'Pre dirlcure
inlorm.tion, nrm.apnaliz.tion
and securir-v price belraviout
around €arnnrss announcements"
lountl of Accounhts Researh,
vol. 23, 1985, pp 2l 16
30. D ShoRr The.so(iarion berween
interim intorm.rion and security
Ie1un$ suroundinS earoings
anoouncenenrs" tdlmzl o/
Arcdtnfit9 Reiearch, lol 28, io r,
G Fosr.r,'lntra"induslry
infornadon transfers associated
wilh eaminss rdass, Ioridl
ol Acconnns and E o onics,
Decehb{ 1981, pp. 201-32
32. cl Clinch and NA Sid.lair,'lnta
industry infom.tion relea*s: A
recurcjve systems approach , .lolrnal
aJ Actauntiag dnd Ecotonk\, Aptil
1987, pp.89-106.
33.
'lnrerconp yinformation
xans{$', Joutnal of A..o ntinl
E orosis, JrneAepkmber 1 992,
Pp. 509 23.
34 W Bea!P.. 'IIt informdrion
conlem ofannual eaminSs
announ.emenc" Eft p'nddl r6.ar.lr
in a.conting: selected stulies 1968,
supplemenr to.lormdl ol A.:..!ntrS
R6eath, !ol. 6, 196A, pp.67-92-
The apparc advanb8e ofsuch
a hethod is that it avoids the
nece$ity otspeciryiDs a hod€l
for expdred profiG rhis is
At.outtin, n€cesary in the srudies usinS meln
abnornal returns siIlc€ tbe.e is
-
do need lo panhion th€ s.mple
inlo ?ood .ews' and'bad ns'
I Parell and M WolfsoD.
ADlicipated inlodarion release
refl€sedtu.all option pd.6',
Iawndt oI Aceountins and Ecanontes,
Augusr 1979. pp. r17-40i I Patell
ltlt in.t lll $Iolfron 'TlrP €x abr..nd
ex posr price €ffeds ofquinerlv
eainings anDounc€me c tenect€d
in opdoD and (ock pricei, /ouma/
,/ A..o,'rir8 R4.4r.r, Nrfumn
r98l, pp.434-58.
P Btoqi, Copitdl indtlrk,
basa.l esdtch in a..owtit\: afl
irrrolrdioi, Coope6 & Lybnnd
F Modigliani ind Mll
Nliller,
'Coeorate in.omc tdes and
rhe.osr ofcaPilal: A corr€crion',
Arrcrn n l.otrorri. R.ri0{, vol
oo. 3, r963, Pp.433-113.
34. Easton and Zmiisski. op .ir
DW Collins and SP Kothari, 'An
atr.ltsis ofinte empo6l and (oss.
sectional d.reminanG of {amioAs
resPonse (oetfrcieDa" .10!,ral o/
Ac.orntin| d d E.onottie!, eol 1r,
1989, pp. 143-ali R Lipe,'The
relarion betweetr sro.k returrs
and a.couniing €arniogs Eiv€n
alt€rnative infomation', Aroln.ing
Ref iw, \ol. 65, 199A, pp. 49 -? 1.
DW Collins lod L De^ngelo,
'Accoundng informarion and
coQorale 8ov€rnan.er Market and
analy$ reactions ro earDhgs of
fms eo8aSed in prory cont6rs'.
loundt aJ Accotntins t d Econahtics,
!ol. 13, r990, pp.213-47.
41. Bcarer rrnrbedand Molse, op. cn.:
Nornadve rheorisrs would argle
this is done to obseRede6cienr
d^11 accountinE staDdards, whereas
atetrC' theorisls would argue lhat
it is done iD ord€rroenhance
conf a.rin8 n)echanisns
42. B Lev, 'on the usetulo€ss of
eaminSs and eamings Rsearch:
kssons and d'recdons f@m two
decades of empiical lcsearch',
Ioutual of Accountins Resurcn,
vot.27, Suppl., 1989, p, 155.
43. DC IeE and PK Chan€y, An
empincal investisation of fadom
affeclinA ihe earnines associarion
coeftciqt, louf,ol oJ BtBi'6
Finana ahrl Accohti S,val. i9,
Do.6, 1992, pp. 839-63.
M Pinds, 'Accountine methods
and difier€nrial nock marker
respodse to the announc.freDr
al earninAs , larmdl ol Ae.olflIri+,
Andilirt an l Fina@, rol. A, io- 3,
1993, pp. 221 46.
AUS 202 Objrcdv. and Ceneral
Principlc ColemnrA in Audn
ofa Financial Repofl srat€s,
piragdph 02: '... tle audilor's
opinion.nhan.es rhc oedibility ol
th. financinl repo( ...'
L D€Angelo, 'Auditor size and
a udil quality , .louddi 4 rt'8
^-o!,
anl !.onofli.r, vol. 3, 1981,
PP.183 99.
N Dopu.h and D Simtrni.,
'Conperilior in aldirjngr An
assessnenf i Paper Presenred
nr Ih€ sy'nPosium on AudninS
R€search lV, univenity of lllinois,
53, atUrbaDa.ChaNpaien, 1982.
48. RA Da{idson and D Neo, A
nok on dE &so.iarion between
audit frnD size and audir quahy',
Cohte lpotr)' A.cauttits R.sca'rh,
vol.9, no- 2, 1993, pp 479 a8;
H,ans ard C li.,'Audir qlality
and ftdnrg volune reicdor: A
srudy olinirial p{blic oflerinss ,
Ioumdl oI Accounfiv Mn Publi.
Atiry, vol. 12, no.3, 1991, p.263;
CHAPTER 12 Cnpital mrrker ctearch 441

LPnno,r 'Ate larS€ audnoB moR
c worhlE Paps, Univesity of
a.crrrate tlEn small auditoB?'.
Acc'untinS an l Bdinest RB.4rh,
vol. 29, no.3, 1999, PP.217-77
49. MC f.napp, 'Factols that audn
@mmitlee fiembeB qse ac
slirogat6 for audit qualiti,'.
Auditirs: A lottul ol Pracnce and
Tftrory vol. 10, no. 1, 1991,
w.35-52.
50. X is ar8ued that iodusty
sPecialiston confibutes to
auditoB' .redibility ard audh
quality by €nhancin8lhe level of
a$uranc€ provided by lhe audi!
51. , (rkhDd and lS Yar& 'Audnor
ind8l.y spedalballon aqd the
eamidSs r6pons. (oeffi ci.nt',
Temple University Worling Paper.
Philad€lpbia 1999.
t1. sK choi and Dc lerer. The eff€(s
of qualified audir opinions on
edninSs Epon* coefii<i€nB',
Iolnat of Accounnn9 Md E ononi6s,
aol. 15, t992, W. 22947 .
53. K Moreland, 'Crn'ckms of auditoB
d lhe dsociadon berw€eD
eamins and reoms of.lient
frnd , AtAititrS: A loutul of tuacdce
atuI The.ry, \ol. 1,4, no. 1,. rr9s,
pp.94'r04.
54 leter and Chaney, op. cit.
E fama and C Schr*.r 'A!s€t
elttns ad inflation', .Iolnal o/
Financial E@nodi*, eol. 2, 1977,
115-46; E. Fana. 'Sto.k r€$ms,
rel acriEty, inflation, d honey',
t,
Andicad Econonic Reitu, vol. 7 PP_ 249-64.
1981, pp.545-65.
dd K ftend, 'Permaoenr
56. E Fama
dd lemponry compooenls of
srGk pdc€s', .Io,rnai ofloJin:tal
E o^otif, aol. 96, l9AA, W- 246-
73: E Fam. and K Frcnch.'Business
condirioft and opected rerums
on 3ro.k and bondd,lolnal ,/
Fitun idl Econo ics.\ol.25, 19A9,
pp. 23-49; R 8alv€rr T Cdimano
and B McDonald, 'Pr€dictin* sto.k
r.lurns in an €f6cient ma*et"
Iormal ol Financ., lol 45, 1990,
pp, 1109-28.
S Kothdi, 'Capilal markec re.arch
in , loumat ol Acco"ntias
ard^Kotnti,^t
Ecoranis, aol.3t, 2AO1-
58. I,eld and Chan y, op. <i..
59. D Dhaliwal and s Reynoldt The
€ff.rt of the 6nnt capital struclur€
on rh€ (latio$hip belwlen
€amin8s chan8es and stock relu.ns'.
442 PART 3 Accounling and.€search
ri
m. A@tnairy R@i.w. \ol.7t,
Arizona, 1989i DS Dhaliwal. KI k€ no.3, r996, pp, 289,315.
md NL Fr.gher, 'rhe assodatio! 72. YK Chia, R CzemkoBki ard
b€tween unexpeced earnings and i Loftus, The association ofaggretate
abnormal sea,rily r€tum3 in fie and disaggregared €amin$ eidr
Pre3€nc€ of financial l*eage, annttal dock relum8', Icrolrrii8
Conrenwary Atcouning Retufth. and Fitun ., !ol. 3?, no- L lt97,
vol- 8, no. l, 1991, pp- 20-41. PP,llr-28.
60. N4odigliani lnd Miller op. ci!. 73. RM 8ow€n, D Burgsrahler and
61. S Ross, 'The detemiMtion of lA Dal€y 1987, The ins€menhl
fi nancial strudurer The inc€ntiv€- informatior contentofacc al
si$allinS approach'. Bell ,anal ol v€rsus c.lhiows, AdoutirS
E oniB, vol. A. 1977, pp. 23-40. Retitu. vol. 42, no. 4, \9A? ,
62. A Hodgson and P SteveNon-
Pp. ?23-47.
Clarke, Ac.outrtinS qriabls 74_ ibid.
and stock returns: The impa( of 75. ILG Board and tFS Dar The
leeeraae', Pacife Accounting Rdiew, irlomation corleot of carhflow
vol. 12, no. 2, 2000, pp.37-64. frg!ft!, A@ntin8 atul Buils
63. collins and Kothan, op. cit. Rdr4r.h vol. 20, 1989, pp.3-lt.
64- I Anihony and I( Iam6tr 76. A Ali. ThG indemental infomadon
'Asso.iation beMern account'ng
contem of eaminSs, workinS capital
perfomance m€asures and src€k
from operations, and cashflows',
p.ice.: A re$ of lhe life cyde
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r,orld b€ obtained by. leadra
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datr is obi.in€d tt,. r€lafthd
froln obeNins whi.h bowl of food
is pr€f€ned by a captiv€ animal
ih.r hd thc Choie bdwe a
number of food bowls proeid.d by

444 PART 3 Accounrint and research