CAPITAL MARKET RESEARCH

Septian Bayu Kristanto, SE, MSAk, CPMA

Source: Godfrey et al. (2010). Accounting Theory. Chapter 12

Outline
The philosophy of PAT The strength of positive theory The scope of PAT Capital market research & EMH The influence of accounting information on investor behavior & share prices Trading strategies & mechanistic behavioral effects Issues for auditor

The philosophy of PAT

Researcher view: Friedman, Watts & Zimmerman

The objective of PAT is to explain & predict accounting practices ... Explain (provide reasons) and predict (predicts unobserved phenomena)

Economic focus on PAT

Cost & benefit using alternative accounting methods Cost & benefit of regulation & standard setting process Effect of reported financial statements on share prices Accounting valuation models to predict future

The philosophy of PAT

Behavior/individuals assumptions on PAT

Individuals user are assumed to be rational Managers have discretion to choose accounting policies Managers take actions to maximize the value of the firm

PAT proposed normative accounting model to be tested & verified before made an accounting standard

The strength of positive theory

Skipped.....

The scope of PAT

Firts stage
Historical cost method financial statements capital market valuation (EMH & CAPM)

Second stage
Predict accounting practices across firms
Ex post (choosing accounting policies after the fact) Ex ante (cost reduction/efficiency reasons/opportunistic)
6

Capital market research & EMH

Types of market research

Impact of accounting information on share returns Effects of changes in accounting policies on share prices

market adjusts rapidly to new information EMH

Weak form (sequences of past prices). Exp: Dow theory, Head & Shoulders, Moving Average Semistrong form (past price & public information)
Proper measurement using accounting information

Strong form (past price, public & privat information)

Capital market research & EMH

Market model (Fama) R i ,t ai i ( Rm,t ) i ,t

Raw return = average/constant + market + firm news (see pg. 411)

Implications
Predicting returns
Normal vs. Abnormal Average unique return (AR) & Cumulative average abnormal unique return (CAR)
8

The influence of accounting information on investor behavior & share prices

Direction
Ball & Brown, Watts & Zimmerman, Foster tested in US and Australia with replication Implications:
1. Content of historical profit was significant information 2. Market information was continuous release 3. Market reaction reasonably consistent (see pg. 413)

The influence of accounting information on investor behavior & share prices

Magnitude
Conducted by Beaver, Clarke, & Wright; Beaver, Lambert, & Morse Find sensitivity & relationship between abnormal returns & unexpected profits Earnings Response Coefficient (ERC)

10

The influence of accounting information on investor behavior & share prices

Information asymmetry & firm size

Different information proposition relies on fact/source, cost of information, & incentive for information Large firms provide greater variety & exposure about financial press than small firms (Freeman)

11

The influence of accounting information on investor behavior & share prices

Magnitude of profit release from other firms

Conducting by Foster, Clich & Sinclair, Freeman & Tse Confirm hypothesis price reactions & early announcers

Volatility
Announce the stability of profit

Association studies & ERC

Determinants of firm value
MM model: sustainable EBIT, tax-adjusted earning, cost of capital, growth opportunities
12

The influence of accounting information on investor behavior & share prices

Association studies & ERC

Factors can affect ERC
Risk & uncertainty (-) Audit quality (+) Industry (+) Interest rate: charge (-), risk-free (+) Financial leverage: above ideal (-) , below ideal (+) Firm growth (+) Permanent & temporary profits (+) Non-linear modelling (+) Disagregating profit: based on proxies Cash flow: good signal Balance sheet components: based on proxies
13

Trading strategies & mechanistic behavioral effects

Post announcement drift

Predicting following year using current year financial statement

Winner/losers & overconfidence

Winner/losers is unregular anomaly Overconfidence is overreaction based on analysts optimism

14

Trading strategies & mechanistic behavioral effects

Mechanistic/behavioral effect
Cosmetic accounting/creative accounting Manipulating accounting numbers
Opportunistic: fraud, industry regulations, equity offerings, debt covenants, management compensation Informational: signalling, fair value

Earning management
Share price reactions, firm-specific, independence, CG, discretionary accruals, inside trading
15

Issues for auditor

ERC as a audit signal Associations between audit quality & cost of capital Associations between audit quality & equity prices (after Andersen effect)

16

The strength of positive theory

Please discuss and share in writing paper Read the source at pg. 405 - 407

17