capital market and behavioural research in accounting

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)


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


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


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


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

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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


PRICES

Magnitude

Information asymmetry and firm size

Magnitude of profit releases from other firms

Volatility


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


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

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TRADING STRATEGIES

Detecting the quality and probability of accounting management

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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


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


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


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


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


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 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


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

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LIMITATIONS OF BAR

SOURCE:GODFREY, HODGSON, HOLMES, AND TARCA

(2012) ACCOUNTING THEORY 7TH EDITION