Prepared by Arabella Volkov
University of Southern Queensland
References
•Text – Chapter 9
Positive theory and capital
market research
Learning Objectives
At the conclusion of this lecture, you
should have an appreciation of:
• the philosophy of positive
accounting theory
• the strengths of positive accounting
over normative accounting
• the scope of positive accounting
theory
Learning Objectives
At the conclusion of this lecture, you
should have an appreciation of:
• capital market research and the
efficient market hypothesis
• the influence of accounting
information on investor behaviour
and share prices
• trading strategies and mechanistic
behavioural effects
Philosophy of positive
accounting theory
• seeks to explain observed accounting
phenomena
• economic focus
• more scientific in methodology
• Assumptions about the behaviour of
individuals
• underlies most empirical studies
in economics
Strengths of positive theory
over normative theory
Dissatisfactions with normative
accounting:
– Prescriptions not based upon identified,
empirical observations or methods
– Theories are not falsifiable
– Does not explain and predict accounting
practice
– Do not assess existing accounting
practices
Scope of positive accounting
theory
Two stages of development:
1. Capital market research
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Did not explain accounting practice
Connection
EMH
Market model
2. Explaining and predicting
accounting practice
Capital Markets Research & the
Efficient Markets Hypothesis
• Two types of capital markets research:
– Impact of the release of accounting
information on share returns
– The effects of changes in accounting
policy on share prices
• Most research in these areas relies
upon the efficient markets hypothesis
(EMH)
Capital Markets Research & the
Efficient Markets Hypothesis
Efficient market: one ‘in which prices
‘fully’ reflect available information’
3 Forms of Information Efficiency:
1. Weak form
(past price information)
2. Semi-strong form
(publicly available information)
3. Strong form
(all information – public and private)
Capital Markets Research & 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
Capital Markets Research & the
Efficient Markets Hypothesis
Sufficient conditions of an efficient market
(Fama):
• There are no transaction costs in trading
securities
• All information is available cost-free to all
market participants
• All agree on the implications of current
information for the current price and
distributions of future prices of each
security
Capital Markets Research & the
Efficient Markets Hypothesis
Market efficiency does not assume:
• Other forms of efficiency recognised in
economics
• Every investor has knowledge of all
information
• All financial information is correctly
presented or interpreted by individual
investors
• Managers make the best decisions
• Investors can predict the future precisely
Capital Markets Research & the
Efficient Markets Hypothesis
CMR:
• Empirical research
• Tests hypotheses about capital market
behaviour
Market Model:
• Derives from CAPM
• Used to estimate abnormal returns on
shares when profits announced
Capital Markets Research & the
Efficient Markets Hypothesis
Capital Markets Research & the
Efficient Markets Hypothesis
Figure 9.1: Sample market model for i = BHP and t = quarter ending
June 2001
Impact of Accounting Profits
Announcements on Share Prices
Ball & Brown (1968):
• Seminal work in positive accounting
and finance literature
• Tested the usefulness of historical
cost profit figure to investment
decisions
• If historical cost profit figure is useful
share price will react (EMH)
Impact of Accounting Profits
Announcements on Share Prices
Impact of Accounting Profits
Announcements on Share Prices
Ball & Brown (1968) Results:
• Most of the information contained in
the earnings announcement (85-90%)
was anticipated by investors
• Evidence of Information content at
time of (historical cost) earnings
announcement
Impact of Accounting Profits
Announcements on Share Prices
• Magnitude
• Information asymmetry and
firm size
• Microstructure extensions to
firm size
• Magnitude of profit releases of other
firms
• Volatility
Association Studies & Earnings
Response Coefficients
Association studies
• impact of accounting measures on share
prices over a longer event window
• Earnings response coefficient (ERC) is a
subset of this literature
ERC:
• Ordinary least-squares regression
• Dependant variable: returns
• Independent variable: profit
• R2 (goodness of fit) and slope (sensitivity
of returns to profit) used to assess
informativeness of profits
Association Studies & Earnings
Response Coefficients
Factors which can affect the ERC:
• Risk and uncertainty
• Audit quality
• Firm size
• Industry
• Interest rates
• Financial leverage
• Firm growth
• Permanent and temporary profits
Association Studies & Earnings
Response Coefficients
Determinants of firm value:
• Industry
• Interest rates
• Financial leverage
• Audit quality
• Firm size
• Firm growth
Association Studies & Profit
Response Coefficients
Determinants of firm value (cont’d):
• Magnitude of profit releases of other firms
• Volatility
• Permanent and temporary earnings
• Omitted variables
• Changes versus levels in earnings
• Profit components
• Cash flows
Methodological issues
• Ball and Brown’s original paper
– Positive theory of accounting
• Williams and Findlay
– Argue the results of the research are
supportive of EMH
• Watts and Zimmerman
– No attempt to differentiate EMH
Trading Strategies
• Post-announcement drift
• Winner/loser effect
– Long-term association anomaly
• Past winners tend to be future losers
and vice versa
• Debondt and Thaler
– Long-term return reversals to investor
overconfidence and
– Biased self-attribution
Mechanistic or
behavioural effect
• Cosmetic accounting
– Leftwich
• Two hypotheses
– Market reacted mechanistically to changes in
accounting numbers, regardless whether they
were cosmetic or whether they had cash flow
implications
– Market ignored accounting changes which had
no cash flow consequences
Mechanistic or
behavioural effect
Manipulating accounting numbers:
Mechanistic or
behavioural effect
Detecting the quality and probability of
accounting management:
Summary
• Philosophical objective of positive
accounting theory is to explain and
predict current accounting practice
• Positive theory developed in two
stages
– Capital market research
– Contracting theory
Key terms and concepts
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Positive accounting theory
EMH
CAPM
CAR
Information asymmetry
Market efficiency
Impact of behaviour
Where to get more
information
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Other courses
List books
Articles
Electronic sources