GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 12
CAPITAL MARKET RESEARCH
Philosophy of positive
accounting theory
• Seeks to explain and predict accounting practice
• Seeks to explain how and why capital markets react
to accounting reports
• Does so by observing practice – empirical evidence
• Explanation means providing reasons for observed
practice
– e.g. why do firms continue to use historic cost
• Prediction means that the theory predicts
unobserved phenomena
• Has an economic focus

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Philosophy of positive
accounting theory
• Positive theory is based on assumptions about
the behaviour of individuals
– assumes investors and financial accounting users
and preparers are rational utility maximisers
– rejects arguments based on anecdotal evidence
and naïve acceptance of political or academic
prescriptions

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Strengths of positive theory
• In order to prescribe an appropriate
accounting policy, it is necessary to know how
the world actually operates
• We can then normatively prescribe accounting
practice

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Strengths of positive theory
• Positive hypotheses are capable of falsification by
empirical research
• Provides an understanding of how the world works
rather than prescribing how it should work
– obtain an understanding about how value-relevant
accounting numbers are for share prices
– attempt to understand the connection between
accounting information, managers, firms and markets, and
analyse those relationships

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Dissatisfaction with prescriptive
standards
• Normative standards
• Prescriptions not based upon identified,
empirical observations or methods
• Theories are not falsifiable
• Do not explain and predict accounting practice
• Do not assess existing accounting practices

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Scope of positive accounting
theory
Two stages of development
1. Capital market research – into the impact of
accounting and the behaviour of capital
markets
– did not explain accounting practice
– investigated connection between the accounting
data and share prices/returns
– efficient markets hypothesis (EMH)
– capital asset pricing model
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Scope of positive accounting
theory
2. Sought to explaining and predict accounting
practices across firms
– ex post opportunism
– ex ante efficient contracting

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Capital market research and the
efficient markets hypothesis
• Two types of capital markets research
– the impact of the release of accounting
information on share returns
– the effects of changes in accounting policy on
share prices
• Most research in these areas relies upon the
EMH

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Capital market research and the
efficient markets hypothesis
Efficient market: one ‘in which prices fully
reflect available information’
3 Forms of Information Efficiency
1. Weak form
(past price information)
2. Semi-strong form
(publicly available information)
3. Strong form
(all information – public and private)
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Capital market research and the
efficient markets hypothesis
• Capital markets research in accounting
assumes semi-strong form efficiency
• Financial statements and other disclosures
form part of the information set that is
publicly available

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Capital market research and the
efficient markets hypothesis
• Based on dubious assumptions
– there are no transaction costs in trading securities
– information is available cost-free to all market
participants
– there is agreement on the implications of current
information for the current price and distributions
of future prices

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Capital market research and the
efficient markets hypothesis
Market efficiency does not assume, mean or
imply
– that every, or any, investor has knowledge of all
information
– that all financial information has been correctly
presented or interpreted by individual investors
– that managers make the best decisions
– that investors can predict the future precisely

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Capital market research and the
efficient markets hypothesis
• Market efficiency simply means that share
prices reflect the aggregate impact of all
relevant information, and do so in an unbiased
and rapid manner

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Market model
Market Model:
• Derives from CAPM
• Used to estimate abnormal returns on shares
when profits announced
• Share prices and returns are affected by both
market-wide and firm-specific events
• Market-wide events must first be controlled
for

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Market model

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Market model
• Based on dubious assumptions
– investors are risk averse
– returns are normally distributed and investors
select their portfolios on this basis
– investors have homogeneous expectations
– markets are complete
• all participants are price takers
• there are no transaction costs
• there are no taxes
• there are rational expectations by investors
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Impact of accounting profits
announcements on share prices
Ball & Brown (1968):
• Seminal work in positive accounting and
finance literature
• Tested the usefulness of historical cost profit
figure to investment decisions
• If the historical cost profit figure is useful the
share price will react

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Impact of accounting profits
announcements on share prices

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Impact of accounting profits
announcements on share prices
Ball & Brown (1968) Results:
• Most of the information contained in the
earnings announcement (85-90%) was
anticipated by investors
• Evidence of information content at time of
historical cost earnings announcement

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Impact of accounting profits
announcements on share prices
• Magnitude
• Information asymmetry and firm size
• Magnitude of profit releases from other firms
• Volatility

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Impact of accounting profits
announcements on share prices
• Profit release event studies showed that accounting
profit does capture a portion of the information set
that is reflected in security returns
• The evidence also shows that competing sources of
information pre-empted the information in annual
profits by about 70-85 per cent
• Annual accounting figures are not timely
• Led to an another approach – association studies

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Association studies and earnings
response coefficients
• The objective is to test the impact of
accounting variables and a wider information
set that is reflected in securities returns over a
longer period
– earnings response coefficient (ERC)

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Association studies and earnings
response coefficients
Factors which can affect the association
between profits and share prices:
– risk and uncertainty
– audit quality
– firm size
– industry
– interest rates
– financial leverage
– firm growth
– permanent and temporary profits
– non-linear modeling
– disaggregating profits
– cash flows
– balance sheet and balance sheet components
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Methodological issues
• To argue that the results of the research are
supportive of EMH and that the form of
accounting is not that important for valuation
purposes derives, in part, from the fact that
the EMH is assumed to be descriptively valid
• This assumption may not be warranted
• There is increasing evidence that markets can
be fooled by accounting numbers

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Methodological issues
• No attempt to discriminate EMH from
competing hypothesis
– mechanistic hypothesis
• managers use accounting to deliberately mislead the
share market
• market participants can be fooled
– no-effects hypothesis
• the market ignores accounting changes that have no
cash flow consequences

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Trading strategies
• Post-announcement drift
• Winners/losers and over-confidence

• Mechanistic or behavioural effect

– no-effects hypothesis
– cosmetic accounting

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Trading strategies
Two viewpoints of accounting manipulation

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Trading strategies
Detecting the quality and probability of
accounting management

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Issues for auditors
• There is some evidence of an association
between auditing and the cost of capital
• Lower cost when firms voluntarily purchase an
audit or purchase a high quality audit
– investors value the deep resources of a large
auditor
– investors value the quality assurance regarding
accounting data provided by the auditor

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Summary
• Philosophical objective of positive accounting
theory is to explain and predict current
accounting practice

• Positive theory developed in two stages

– capital market research
– contracting theory
• Significant issues relating to the validity of
capital market research
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Key terms and concepts
• Prescriptive standards
• Positive accounting theory
• Capital market research
• EMH
• CAPM
• CAR
• ERC
• Information asymmetry
• Market efficiency
• Impact of behaviour
• Mechanistic hypothesis
• No-effects hypothesis

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