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LECTURE 12
CAPITAL MARKET AND BEHAVIOURAL RESEARCH
ARTHIK DAVIANTI, SE. MSI. AK. CA.
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
Positive theory is based on assumptions about the behaviour of individualsassumes 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
PHILOSOPHY OF POSITIVE ACCOUNTING THEORY
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
Positive hypotheses are capable of falsification by empirical research
Provides an understanding of how the world works rather than prescribing how it should workobtain 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
STRENGTHS OF POSITIVE THEORY
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
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
2. Sought to explaining and predict accounting practices across firms– ex post opportunism– ex ante efficient contracting
SCOPE OF POSITIVE ACCOUNTING THEORY
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
Efficient market: one ‘in which prices fully reflect available information’
3 Forms of Information Efficiency1. Weak form
(past price information)2. Semi-strong form
(publicly available information)3. Strong form
(all information – public and private)
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
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
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
Market efficiency simply means that share prices reflect the aggregate impact of all relevant information, and do so in an unbiased and rapid manner
CAPITAL MARKET RESEARCH AND THE EFFICIENT
MARKETS HYPOTHESIS
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
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
MARKET MODEL
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
19
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
Magnitude of profit releases from other firms
Volatility
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
IMPACT OF ACCOUNTING PROFITS ANNOUNCEMENTS ON SHARE
PRICES
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)
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
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
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
ASSOCIATION STUDIES AND EARNINGS RESPONSE
COEFFICIENTS
TRADING STRATEGIES
Post-announcement drift
Winners/losers and over-confidence
Mechanistic or behavioural effectno-effects hypothesis
cosmetic accounting
Two viewpoints of accounting manipulation
28
TRADING STRATEGIES
Detecting the quality and probability of accounting management
29
TRADING STRATEGIES
BEHAVIOURAL RESEARCH IN ACCOUNTING
BEHAVIOURAL ACCOUNTING RESEARCH: DEFINITION AND
SCOPE
‘Positive’ research encompassesCapital markets researchasks how do securities markets react to accounting information
Agency theory researchasks what are the economic incentives that determine the choice of accounting methods
Behavioural accounting researchasks how do people actually use and process accounting information
Capital markets research looks at the macro level of aggregate securities markets
Agency and behavioural research both focus on the micro level of individual managers and firms
BEHAVIOURAL ACCOUNTING RESEARCH: DEFINITION AND
SCOPE
Capital markets and agency research are both based on economics and assume everyone is a rational wealth maximiser
Behavioural research is based on psychology, sociology and organisational theory and generally makes no assumptions about how people behave
BEHAVIOURAL ACCOUNTING RESEARCH: DEFINITION AND
SCOPE
Definition
The study of the behaviour of accountants or the behaviour of
non-accountants as they are influenced by accounting functions
and reports. Hofstedt & Kinard
The study of the behaviour of accountants or the behaviour of
non-accountants as they are influenced by accounting functions
and reports. Hofstedt & Kinard
BEHAVIOURAL ACCOUNTING RESEARCH: DEFINITION AND
SCOPE
The major type of BAR is Human judgement theory (HJT) or Human information processing (HIP)
Looks at the judgement and decision making of accountants and auditors and the influence their output has on users’ judgements and decision making aim is to explain and predict behaviour and
improve decision making
BEHAVIOURAL ACCOUNTING RESEARCH: DEFINITION AND
SCOPE
WHY IS BAR IMPORTANT?
It discovers how people use and process accounting information
It provides valuable insights into the ways different types of decision makers produce, process and react to particular items of accounting information and communication methods
It provides useful information to accounting regulators
It leads to efficiencies in the work practices of accountants and other professionals
DEVELOPMENT OF BEHAVIOURAL ACCOUNTING
RESEARCH HJT research began in 1954
The term BAR appeared in 1967
Last 30 years has seen an explosion in BAR especially auditing importance of judgement the ‘Brunswik lens model’
AN OVERVIEW OF APPROACHES TO UNDERSTANDING INFORMATION
PROCESSING
Three major research approachesBrunswik lens modelthe dominant approach
process tracingbuild representative decision trees
probabilistic judgementprobability statements based on Bayes’s theorem
THE BRUNSWIK LENS MODEL Used as an analytical framework and the basis for most judgement studies involving prediction (e.g. bankruptcy) evaluation (e.g. internal control)
Example – a model of a bank loan officer’s judgements in the form of a simplified equation:
Likelihood of default/non-default =
A constant term – 0.15 profit + 0.25 cash flow + 0.50 debt to equity ratio + other information cues … + error
THE BRUNSWIK LENS MODEL
THE BRUNSWIK LENS MODEL
Has provided valuable insights regarding patterns of cue use evident in various tasks weights that decision makers implicitly place
on a variety of information cues the relative accuracy of decision makers of
different expertise levels in predicting and evaluating a variety of tasks
the circumstances under which an expert system and/or ‘model of human behaviour’ outperforms humans
Valuable insights (continued) the stability (consistency) of human
judgment over time the degree of insight decision makers
possess regarding their pattern of use of data
the degree of consensus displayed in a variety of group decision tasks
THE BRUNSWIK LENS MODEL
The model usually has good predictive powers it removes much of the random error due to
human things such as tiredness, illness or distraction
An important limitation is that it is not a good descriptor of how people actually make decisions so process tracing methods developed
THE BRUNSWIK LENS MODEL
PROCESS TRACING METHODS
Provides an explanation about how a decision is made ‘process tracing’ or ‘verbal protocol’ produces a ‘decision tree’ to represent the
decision process ‘classification and regression trees’ (CART)
PROBABILISTIC JUDGEMENT
Useful where initial beliefs about a prediction or evaluation need to be revised as new data arrives
Posterior odds = Likelihood ratio x Prior odds
Found use of rules of thumb to simplify complex judgment tasks
LENS MODEL STUDIES – THE EVIDENCE
accuracy of humans’ predictions of business failure
model of human behaviour
information overload literature
judgement confidence literature
PROCESS TRACING STUDIES – THE EVIDENCE
Brunswik lens models and process tracing style studies are different technologies with the same objective of modelling decision processes as completely as possible
FORMAT AND PRESENTATION OF FINANCIAL STATEMENTS
Libby (1976) – 3 options for improved decision making changing the presentation and amount of
information educating decision makers replacing decision makers with a model of
themselves or with an ideal cue-weighting model
Little research has been undertaken regarding ideal presentation formatse.g. graphs versus tablese.g. colour versus black & white
Mixed results
No well developed and tested theory
FORMAT AND PRESENTATION OF
FINANCIAL STATEMENTS
PROBABILISTIC JUDGEMENT STUDIES – THE EVIDENCE
Three rules of thumb (heuristics) representativeness availability anchoring and adjustment
Expert judgement and rules of thumb
Representativeness
When judging the probability that a particular item comes from a particular population of items, people’s judgement will be determined by the extent to which the item is representative of the population
Availability
The assessment of the probability of an event is based on the ease with which instances of that event come to mind
Anchoring and adjustment
An initially given response serves as an anchor, and other information is used to adjust that response
ACCOUNTING AND BEHAVIOUR
The techniques adopted and the subsequent interpretation of reported information are matters of perspective
Accounting is a direct function of human behaviour and activity
Two-way influence
LIMITATIONS OF BAR
Frequent contradictions between the findings of similar studies
Human information processing is far more complex than the development of current research theories and methods
Research settings fail to adequately replicate real-world settings
Should policy be influenced by research on individual decision makers
The major limitation is the lack of a single underlying theory to unify diverse research questions and findings has borrowed from a multitude of disciplines
and contexts and so no common framework
A single theory is unlikely in the foreseeable future
54
LIMITATIONS OF BAR
SOURCE:GODFREY, HODGSON, HOLMES, AND TARCA
(2012) ACCOUNTING THEORY 7TH EDITION
SOURCE:GODFREY, HODGSON, HOLMES, AND TARCA
(2012) ACCOUNTING THEORY 7TH EDITION