Chapter 11

The predictive and positive approaches

The predictive approach

• According to Beaver and others:– ‘The measure with the greatest

predictive power with respect to a given event is considered to be the “best”method for that particular purpose’

• The predictive approach arose from the need to solve the difficult problem of evaluating alternative methods of accounting measurement alternatives

Research based on the predictive approach

There are two streams of research:1. that which is concerned with the ability

of accounting data to explain and predict economic events

2. that which is concerned with the ability of accounting data to explain and predict market reaction to disclosure

Time-series analysis

• Time-series analysis is a structural methodological approach by which temporal statistical dependencies in a data set may be examined

• Time-series analysis research focuses on:– time series properties of reported

earnings– prediction issues in time-series

analysis

Time-series properties of reported earnings

Research has examined both reported earnings and models that describe quarterly earnings:

• Findings on the annual-earnings series present a moving-average process, a submartingale, or one of two processes:1. martingale2. moving averages regressive

• Findings on the quarterly-earnings series show that it follows an autoregressive process characterised by seasonal and quarter-to-quarter components

Predicting future accounting earnings

• Sophisticated autoregressive processes do not forecast significantly better than the random-walk method

• Models of quarterly earnings have better predictive ability than annual models and Box and Jenkins’ ‘individually identified’ models

• Disaggregated sales and earnings provide good forecasting ability, but this is not demonstrated for models based on components such as interest expense, depreciation expense and operating income before depreciation

Distress prediction

• A relevant application of the predictive approach is in distinguishing financially distressed firms from non-distressed firms

• Most models use a paired-sample technique:– part of the sample contains data from

firms that failed, while the other part contains data from firms that did not fail

– the researcher searches for a formula based on ratios that best discriminate between firms that failed and firms that remained solvent

Studies in bankruptcy prediction

• Beaver’s univariate study revealed cash-flow-to-total-debt ratios to be the best predictors, followed by net-income-to-total-assets ratios

• Altman’s multivariate study resulted in a model with five variables:– net working capital/total assets– retained earnings/total assets– earnings before interest and taxes/total

assets– market value of equity/book value of total

debt– sales/total assets

Ohlson’s model

• Ohlson proposed a logit model to examine the effects of the following four factors on the probability of bankruptcy:1. size of firm2. measures of the firm’s financial

structure3. measures of performance4. measures of current liquidity

• Nine financial ratios were chosen to represent these factors

Advantages of discriminant analysis based models

• Can process information more quickly and at a lower cost than loan officers and bank examiners

• Can process information in a more consistent manner

• Can facilitate decisions about loss function being made at more senior levels of management

Limitations of discriminant analysis based models

• The absence of a general economic theory of financial distress that can be used to specify variables for inclusion in models

• All of the studies examined observable events such as legal bankruptcy and loan default, rather than financial distress per se

• The results of the superior predictive ability of some accounting ratios may not be generalised to permit the formulation of an accounting theory

Predictions of bond premiums and bond ratingsThe following factors create bond risks and therefore affect yields to maturity:• default risk• marketability risk• purchasing-power risk• interest-rate risk

Fisher’s modelFisher used four variables to explain the differences in risk premiums of industrial corporate bonds:1. earnings variability, measured as the

coefficient of variation on after-tax earnings of the most recent nine years

2. solvency, measured as the time period since the latest of the following occurred: the firm was sounded, emerged from bankruptcy, or made a compromise with creditors

3. capital structure, measured by market value of equity/par value of debt

4. total value of the market value of the firm’s bonds

Studies on bond ratings

• Studies on bond ratings at first tried to develop a bond-ratings model from an experimental sample of ratings on the basis of selected accounting and financial variables

• In the second stage of studies on bond ratings, the model obtained was applied to a holdout sample to test its predictive ability

Problems with bond-rating models

• All bond-rating models but one lack an explicit and testable statement of what a bond rating represents, and an economic rationale for the variables

• No bond-rating model accounts for possible differences in the accounting treatments used

• Studies using regression models treat the dependent variable as if it were on an interval scale

• All but one study confused ex-ante predictive power with ex-post discrimination

Belkaoui’s model• Recent bond-rating models have shown

the importance of profit-based measures and other measures of financial fitness in the explanation and prediction of bond ratings

• Belkaoui’s discriminant-analysis-based bond-rating model is an example

Corporate restructuring

• Includes mechanisms such as mergers, consolidations, acquisitions, divestitures, going private, leveraged concerns and buyouts

• Their purpose is to:a. maximise the market value of

equities held by existing shareholders

b. maximise the welfare of existing management

Corporate restructuring behaviour

Analyses based on share valuation:• Marris’ study showed that companies

acquired are those that are undervalued by the market

• Gort hypothesised that the level of takeover activity varies with the degree of share undervaluation

Other analyses• Chambers examined the undervaluation

of net assets as a key factor for predicting takeovers

• Taussig and Hayes rejected these findings based on the absence of a control group

• Both of the above studies were univariate and considered only voluntary mergers

• Palepu developed a multivariate logit model based on ten variables

Credit and bank lending decisions

• Research on the predictive approach consists of replicating or predicting the credit evaluation based on accounting and other financial information

• The bank lending decision has also been the subject of empirical and predictive research. There have been three areas of research, which deal with:1. efforts to simulate aspects of a bank’s

investment and lending processes

Credit and bank lending decisions (cont’d)

2. reduction of the loan classification decision

3. the estimation and prediction of commercial bank financial distress

Forecasting financial statement information

Choice of techniques may be mechanical or non-mechanical and univariate or multivariate:• mechanical univariate forecasting

includes moving average and Box-Jenkins univariate models

• mechanical multivariate forecasting includes regression models, Box-Jenkins transfer function models and econometric models

Forecasting financial statement information (cont’d)

• Nonmechanical models include univariate models such as visual curve extrapolation and multivariate models such as security analyst approaches

Forecasts of earnings versus statistical models

There is great disagreement as to whether forecasts of earnings are superior to statistical models. Various unanswered issues include:• relevance of forecast data• value of non-accounting information in

forecasting• randomness of earnings time series• cost of alternative forecasting procedures• respective motives of management and

security analysts in making forecasts

Capital markets and external accounting

• Observations of capital-market reaction may be used as a guide for evaluating and choosing among various accounting measurements

• The predictive approach favours the adoption of accounting numbers that have the highest association with market prices

The efficient market model

• Fama defines an efficient market as one in which prices ‘fully reflect’ the information available, and where the market reacts to new information instantaneously and without bias

• According to a second definition, correct expectations are formed on the basis of all available information, including prices, meaning that more-informed individuals reveal information to less-informed ones through trading actions etc.

• A third definition distinguishes between market efficiency with respect to a signal and with respect to an information system

The efficient market hypothesis

Fama distinguishes three levels of market efficiency:1. weak form efficiency, in which

expected returns ‘fully reflect’ the sequence of past events (prices)

2. semi-strong form efficiency, in which expected returns ‘fully reflect’ all publicly available information

3. strong-form efficiency, in which expected returns ‘fully reflect’ all information

The capital asset pricing model

The arbitrary pricing theory The abitrary pricing theory (APT) assumes

that security returns are related to an unknown number of unknown factors, a multifactor model being:

The securities will be priced as follows:

where:Ri = returns on riskless asset

bij = sensitivity of security i to factor j

Yj = security return premium

The arbitrary pricing theory (cont’d)

• According to APT, the security expected returns are linearly related to the securities of the pervasive factors, with a common intercept equal to the riskless rate of interest

• Various studies have attempted to identify the factors

Factors of the APT

• Chen, Roll and Ross identified four factors:1. growth rate in industrial production2. rate of inflation3. spread between long-term and short-term

interest rates4. spread between low-grade and high-grade

bonds• The Salomon Brothers identified five factors:

1. rate of inflation2. growth rate in gross national product3. rate of interest4. rate of change in oil prices5. rate of growth in defence spending

Equilibrium theory of option pricing

The following formula was proposed by Black and Scholes to value options:

where:

Ps = current market price of the underlying stock

E = exercise price of the option

Equilibrium theory of option pricing (cont’d)

R = continuously compounded risk-free rate of return expressed on an annual basis

T = time remaining before expiration, expressed as a fraction of a year

[theta] = risk of the underlying common stock, measured by the standard deviation of the continuously compounded annual rate of return on the stock

The market model

The Markovitz and Sharpe market model is used as a test of the efficient market:

The market model (cont’d)

• The market model asserts that the return of each security is linearly related to the market return

• The market model has been used in most studies evaluating the relation between market return and accounting return

• To estimate the parameters alpha and beta, research has generally relied on the ordinary least-squares approach, which assumes that the parameters are consistent during the event period

Beta estimation• Various corrections have been proposed to

account for the potential problem of error, or systematic risk, in estimating beta.

• The generalised Scholes–Williams correction provides the following estimator:

whereB+1, B0, B–1 = leading, contemporaneous, and

lagged betasP1 = first-order serial correlation of the index

Event study methodologyE(Rit) = Rft + [E(Rmt) – Rft]b

where: E(Rit) = the expected return of security i in

period tRft = the return on a riskless asset in period tE(Rmt) = the expected return on the market

portfolio in period ts (Rit, Rmt) = the covariance between Rit and

Rmts 2(Rmt) = the variance of the return on the

market portfoliob = }ss(R2(itR9 Rmtm)t)} = risk coefficient

Residual earnings modelIn the dividend discount model (DDM) the value of the firm is that present value of the future dividend stream to equity holders:

where:Vt = the equity value of the firm at time t

dt = dividend at time t (all capital flows to equity holders net of contributions)

r = cost of equity capitalE(.) = expectations operator

Residual earnings model (cont’d)

Substituting accounting variables into the DDM, Ohlson and Feltham developed the following expression relating firm value to accounting values:

The value of the firm (Vt) at time t is the sum of net book value (bt) plus the discounted expected future abnormal earnings (xa

t)

Models of the relation between earnings and returns

• Price and book values are related as follows:

Pjt = BVjt + Ujt (1)

where Pjt is the price per share of firm j at time t and BVjt is the book value per share of firm j at time t

Models of the relation between earnings and returns (cont’d)

• Accounting earnings and security returns can be derived by taking first differences of the variables in equation (1) as follows:

(2)where:

(3)Ajt = accounting earnings of firm j over the time

period t-1 to tAjt = the dividend of firm j over time period t-1

to t

Models of the relation between earnings and returns (cont’d)

• The relation between earnings and returns is obtained by substituting equation (3) into equation (2) and dividing by Pjt–1 as follows:

(4)where:

This equation shows that if stock price and book value are related, then earnings divided by beginning-of-period price explains returns

Evaluation of the market-based research in accounting

The available evidence for market-based research in accounting can be classified into four categories:1. information content studies2. difference in discretionary

accounting techniques3. consequences of regulation4. impact on related disciplines

Information content studies

• This approach is used to examine whether the announcement of some event results in a change in the characteristics of the stock-return distributions

• Impetus was created by the Ball and Brown study in which unexpected earnings changes were found to be correlated with residual stock returns

• These studies are consistent with the hypothesis that accounting information leads to changes in equilibrium prices

Voluntary differences and changes in accounting

techniques• What is the impact of differences and changes

on investors?• The issue is whether the market is

‘sophisticated’ enough not to be fooled by cosmetic differences or accounting changes

• The naive investor hypothesis assumes that some investors cannot perceive the cosmetic nature of certain accounting changes

• The efficient market hypothesis, on the other hand, stipulates that rational investors should see through such changes

Market impact of accounting regulation

Research in this area has created convergent results:• mandated line-of-business information has

affected investor assessment of the return distributions of multiproduct firms

• the FASB and SEC regulation on the ‘full cost’/‘successful effects’ issue are associated with significant reactions of oil and gas stock prices

• price-adjusted estimates of earnings as well as replacement cost data did not generate any noticeable market reaction

Implications for financial reporting

According to Copeland:• relevant new information should be announced as

soon as it is available• the most important information is forward-looking• the market can evaluate information regardless of

whether cash flow effects are reported in the balance sheet, income statement or footnotes

• the market reacts to the cash flow impact of management decisions, and not to the effect on reported earnings per share

• the SEC should conduct a thorough cost-benefit analysis of all proposed changes in disclosure requirements

Capital markets and accounting information

Some argue that capital markets are not efficient handlers of accounting information:• Gonedes and Dopuch argue that stock-price

associations are not sufficient grounds on which to evaluate alternative information systems and suggest the need for social-welfare considerations

• the efficient market hypothesis and empirical evidence supporting it are silent concerning the ‘optimal’ amount of information

Capital markets and accounting information (cont’d)

• a qualifier has been omitted in the studies cited, in that market efficiency may be implied only if no change in stock price and the firm’s decision-making are observed

• finding out what information is used and should be provided to investors may be difficult

• most of the research cited lacks a theory to predict who should be better or worse off from accounting policy changes, and which changes if any might include changes in management behaviour to offset the effect of a change in accounting policy

Arguments against the predictive approach

• Users individually or in aggregate react because they have been conditioned to react to accounting data rather than because the data have any informational content

• Observations of users’ reactions should therefore not guide the formulation of an accounting theory

• Sometimes recipients of accounting information react when they should not react, or do not react in the way that they should

Adequacy of methodology usedMost of the empirical evidence rests on research designs and methodological assumptions that are influenced by:• anomalous evidence regarding market

efficiency• self-selection bias and omitted variables• confounding effects arising from the release

of other unrelated and relevant informational items

• the timing of capital-market impact• the choice of control group• behavioural finance• factors raised in chaos theory

The positive approach

• The subject matter of the anthropological/inductive positive approach is:– existing accounting practices– management’s attitudes towards those

practices• Proponents of the positive approach argue

that the techniques can be derived from and justified on the basis of their tested use, or that management plays a central role in determining the techniques to be implemented

Information/economics• Feltham’s framework relies on the individual

components required to compute the payoff of a particular information system, being:– a set of possible actions at each period

within a time horizon– a payoff function over the events that occur

during the periods– probabilistic relationships between past and

future events– events and signals from the information

system– a set of decision rules as functions of the

signals

Information/economics (cont’d)

• Basic subject matter:– information is an economic commodity– acquisition of information amounts to a

problem of economic choice• Accounting information is evaluated in terms

of its ability to improve the quality of the optimal choice in a basic-choice problem that must be resolved by an individual

• The information system with the highest expected utility is preferred

Analytical models proposed

1. Decision-theory model2. Syndicate-theory model3. Informational-evaluation-decision-

maker model4. Team-theory model5. Demand-revelation model

The analytical-agency paradigm

• The analytical-agency paradigm is characterised by two types of paradigms:1. analytical or principal-agent paradigm2. positive-agency paradigm

• The agency relationship is said to exist when a contract between a person (a principal), and another person (an agent), to perform some service on the principal’s behalf involves a delegation of the decision-making authority to the agent

The agency problemThe basic agency problem is enriched by different options concerning:

1. the initial distribution of information and beliefs

2. the description of the number of periods3. the description of the firm’s production

function in terms of:• amount of capital supplied by the

principal• agent’s level of effort• an exogenously determined, uncertain-

state realisation

The agency problem (cont’d)

4. the description of the feasible set of actions from which the agent chooses

5. the description of the labour and capital markets

6. the description of the feasible set of information systems

7. the description of the legal system that specifies the type of behaviour that can be legally enforced, and what is admissible evidence

8. the description of the feasible set of payment systems

The agency problem (cont’d)

9. the description of the solution to the basic agency model

10.the role of self-interest11.the solution concept and the nature

of optimality

Income smoothingGordon’s propositions on income

smoothing1. The criterion a corporate management

uses to select among accounting principles is the maximisation of its utility or welfare

2. The utility of management increases with:• job security• the level and rate of growth in

management’s income• the level and rate of growth in the

corporation’s size

Income smoothing (cont’d)

3. The achievement of the management goals stated in proposition 2 depends in part on the stockholders’ satisfaction with the corporation’s performance

4. Stockholders’ satisfaction increases with the average rate of growth in the corporation’s income

Gordon’s Theorem

Given that Gordon’s four propositions are true, management would within the limits of its power:

1. smooth reported income2. smooth the rate of growth in

income

Motivations for smoothing• According to Heyworth, motivations for

smoothing include improvements of relations with creditors, investors and workers, as well as dampening of business cycles through psychological processes

• Beidelman’s two motivating reasons:1. a stable earnings stream is capable of

supporting a higher level of dividends, having a favourable effect on the value of the firm’s shares

2. smoothing counters the cyclical nature of reported earnings and reduces the correlation of a firm’s expected returns with returns on the market portfolio

Constraints leading to smoothing

Three constraints are presumed to lead managers to smooth:

1. the competitive market mechanisms, which reduce options available to management

2. the management compensation scheme, which is linked directly to the firm’s performance

3. the threat of management displacement

Dimensions of smoothing

Barnea and others distinguished between three dimensions:

1. smoothing through events’ occurrence and/or recognition

2. smoothing through allocation over time

3. smoothing through classification

Positive theory of accounting

• The positive theory of accounting is based on the propositions that managers, shareholders and regulators/politicians are rational and attempt to maximise their utility

• Their choice of accounting policy rests on comparing the relative costs and benefits of alternative accounting procedures so as to maximise their utility

The central ideal of the positive approach

1. To enhance the reliability of prediction, based on the observed smoothed series of accounting numbers along a trend considered best or normal by management

2. To reduce the uncertainty resulting from the fluctuations of income numbers in general and the reduction of systematic risk in particular by reducing the covariance of the firm’s returns with market returns

The central problem in positive theories

• The central problem is to determine how accounting procedures affect cash flows, and therefore management’s utility

• Theoretical assumptions guiding resolution of the problem are:– the agency theory evolves to a view of the firm

as a ‘nexus of contracts’– given this ‘nexus of contracts’ perspective, the

role of accounting information is to monitor and enforce these contracts to reduce the agency costs of certain conflicts of interest

Contracting costs

Contracting costs include:• transaction costs• agency costs• information costs• renegotiation costs• bankruptcy costs

The accounting choice

• The accounting choice rests on variables that represent management’s incentives to choose accounting methods under bonus plans, debt contracts and the political process

• There are three hypotheses:1. The bonus plan hypothesis maintains

that managers of firms with bonus plans are more likely to use accounting methods that increase current-period reported income

The accounting choice (cont’d)

2. The debt/equity hypothesis maintains that the higher the firm’s debt/equity, the more likely managers are to use accounting methods that increase income

3. The political cost hypothesis maintains that large firms rather than small firms are more likely to use accounting choices that reduce reported profits

Accounting paradigms

1. Anthropological paradigm2. Behaviour-of-the-markets paradigm3. Economic-event paradigm4. Decision-process paradigm5. Ideal-income paradigm6. Information-economics paradigm7. User-behaviour paradigm