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

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 (contd):
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 Browns 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

Positive accounting theory

EMH
CAPM
CAR
Information asymmetry
Market efficiency
Impact of behaviour

Where to get more

information

Other courses
List books
Articles
Electronic sources