Discussion on research in accounting based on capital market and behavioural aspect of accounting.

1. LECTURE 12
CAPITAL MARKET AND
BEHAVIOURAL RESEARCH
ARTHIK DAVIANTI, SE. MSI. AK. CA.

2. CAPITAL MARKET RESEARCH

3. 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

4. Positive theory is based on assumptions about
the behaviour of individuals
assumes 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

5. 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

6. Positive hypotheses are capable of
falsification by empirical research
Provides an understanding of how the world
works rather than prescribing how it should
work
 obtain 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

7. 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

8. 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

9. 2. Sought to explaining and predict accounting
practices across firms
– ex post opportunism
– ex ante efficient contracting
SCOPE OF POSITIVE
ACCOUNTING THEORY

10. 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

11. 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 MARKET RESEARCH AND
THE EFFICIENT MARKETS
HYPOTHESIS

12. 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

13. 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

14. 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

15. 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

16. MARKET MODEL

17. 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

18. 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. 19
IMPACT OF ACCOUNTING PROFITS
ANNOUNCEMENTS ON SHARE PRICES

20. 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

21. Magnitude
Information asymmetry and firm size
Magnitude of profit releases from other firms
Volatility
IMPACT OF ACCOUNTING PROFITS
ANNOUNCEMENTS ON SHARE PRICES

22. 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

23. 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)

24. 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

25. 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

26. 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

27. TRADING STRATEGIES
Post-announcement drift
Winners/losers and over-confidence
Mechanistic or behavioural effect
no-effects hypothesis
cosmetic accounting

28. Two viewpoints of accounting manipulation
28
TRADING STRATEGIES

29. Detecting the quality and probability of accounting
management
29
TRADING STRATEGIES

30. BEHAVIOURAL RESEARCH IN
ACCOUNTING

31. BEHAVIOURAL ACCOUNTING
RESEARCH: DEFINITION AND SCOPE
‘Positive’ research encompasses
Capital markets research
asks how do securities markets react to
accounting information
Agency theory research
asks what are the economic incentives that
determine the choice of accounting methods
Behavioural accounting research
asks how do people actually use and process
accounting information

32. 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

33. 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

34. 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
BEHAVIOURAL ACCOUNTING
RESEARCH: DEFINITION AND SCOPE

35. 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

36. 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

37. 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’

38. AN OVERVIEW OF APPROACHES TO
UNDERSTANDING INFORMATION
PROCESSING
Three major research approaches
Brunswik lens model
the dominant approach
process tracing
build representative decision trees
probabilistic judgement
probability statements based on Bayes’s
theorem

39. 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)

40. 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

41. 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

42. 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

43. 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

44. 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)

45. 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

46. LENS MODEL STUDIES –
THE EVIDENCE
accuracy of humans’ predictions of business
failure
model of human behaviour
information overload literature
judgement confidence literature

47. 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

48. 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

49. Little research has been undertaken regarding
ideal presentation formats
e.g. graphs versus tables
e.g. colour versus black & white
Mixed results
No well developed and tested theory
FORMAT AND PRESENTATION OF
FINANCIAL STATEMENTS

50. PROBABILISTIC JUDGEMENT
STUDIES – THE EVIDENCE
Three rules of thumb (heuristics)
 representativeness
 availability
 anchoring and adjustment
Expert judgement and rules of thumb

51. 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

52. 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

53. 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

54. 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

55. SOURCE:
GODFREY, HODGSON, HOLMES, AND TARCA (2012)
ACCOUNTING THEORY 7TH EDITION

56. SOURCE:
GODFREY, HODGSON, HOLMES, AND TARCA (2012)
ACCOUNTING THEORY 7TH EDITION