Chapter 12: Capital market research THEORY IN ACTION Theory in Action 12.1 Deregulation aids earnings at GrainCorp Instructors should use this question to consider an earnings valuation model and to analyse excess returns. Also questions are raised about market efficiency in the short term. What impact has the unexpected increase in earnings had on GrainCorp’s share price? Students are required to examine the impact of this news on share prices on or about the day of release on 4th August 2009. A simple exercise and an introduction to event studies is to ask students to gather the return on the market and then deduct it from GrainCorp returns to derive an abnormal return (alternatively use CAPM to derive expected returns). Are there any spikes in share price that can be observed that might indicate that the market (as a whole) has reacted to the increased earnings figures. Apart from higher than expected grain receivals, what other factors have had a positive impact on earnings? Earnings are not always the only indicator of an increase in share price as increased sales do not always translate into profit. In GrainCorp’s case, the company benefited from a deregulated wheat export market. As a result grain receivals increased and this underpinned increased export tonnages – both contributed to the improved earnings. GrainCorp’s interest expense decreased which was also a contributing factor in the improved earnings. GrainCorp also acknowledged that the continuing quality of its earnings is associated with normal rainfall patterns. Hence, analysts look to the quality of earnings. Does the article suggest market efficiency? Why or why not? The article certainly indicates market efficiency from the point of view of analysts. Analysts are able to quickly see through the impact of an increase in revenue and hence influence the impact on earnings. Whether the wider investment community is able to delineate to the same extent is an empirical question. Discussion should now revolve around analysts vs. wider market perceptions of firm value and which one is more important. Long run and short run perceptions should also be discussed and instructors could set an exercise for students to gather data and analyse the long run impact. Theory in Action 12.2 Managing costs doing business better Wattyl has announced that its debt is equivalent to 70 per cent of its outstanding shares and it aims to drastically cut costs in response to falling profits - yet its share price increased. Can you explain this? Share prices take into account information other than that published in financial reports. Share prices are determined partly by general market conditions and partly by firm-specific information (of which accounting information comprises a subset). Therefore, any share price movements experienced may be partly in response to fluctuating market conditions and partly in response to the release of new information about the firm itself. Firm-specific information that is price relevant may include accounting information (such as news about the firm’s earnings and/or cash flows) as well as non-accounting information (such as news about new product lines or markets, technological developments and management changes) that cause investors to revise their expectations about the firm’s future performance. Mentioned in the article are cost cutting measures, the expected reduction in staff numbers, the use of cheaper packaging materials, and a changed management focus. What other economic information besides the reported accounting profit does the market appear to be using to price shares in Wattyl? In addition to the factors mentioned in Solution 1 above, the market appears to be pricing in the change in management. The company has experienced a series of management changes, and the conclusion of two failed takeover attempts (of Wattyl) in recent years. The market might be perceiving a stable period ahead and the consolidation of new practices that could translate into improved earnings and returns. What is the likely impact on the share price of Wattyl if it were to become the target of a takeover bid as implied by the anonymous analyst? The analyst appears to be suggesting that Wattyl is faced with very tough operating conditions against very strong competitors in the same industry and that overcoming these will be a struggle. This could translate into a decrease in the share price. However, when considering the projected share price under takeover conditions one needs to consider the premium that might be offered in a takeover struggle. A takeover premium could result in an increased share price. Theory in Action 12.3 AIFRS – a work in progress On the evidence presented in this article, are financial analysts well equipped to efficiently factor into prices the impact of switching to international financial reporting standards? The evidence presented does not give one confidence that financial analysts are well equipped to factor into prices the impact of international financial reporting standards. There is mixed reaction over the impact, few agree that IFRS helps investment decision making or a strengthening of the capital markets (30/30, 40% undecided). What do you think will be the impact on share prices if analysts disagree on the information content? This question implicitly assumes that analysts are a major determinant on pricing or that they have to have considerable agreement in order to impact prices. Some points of debate: Analysts have never fully agreed on valuations Research by Beaver suggests that only very few smart analysts are required to make markets informationally efficient. This question also considers the role of financial analysts in the marketplace and the economic incentives they face. Recent research suggests that analysts are not arbiters or assessors of firm quality and do not provide independent advice. They are compensated by initial public offerings (IPOs) and merger and acquisition (M&A) capital raising deals and face certain economic conditions, which could compromise the advice given, such as: they function as an arm of investment banks they face competition from the Internet their rewards are mainly driven by the trading behaviour of clients (commissions) rather than the quality of advice they hold inventories of stock, which must be cleared from time to time they have close personal connections with some firms. What other methods could you use to assess the value relevance of AIFRS? Empirical evidence such as: before and after AIFRS association studies; event studies; impact of various valuations under AIFRS. Questions 1. What is positive accounting theory? How does it differ from normative accounting theory? What was/were the major dissatisfaction(s) with normative accounting theory which led to the development of a positive theory of accounting? Positive accounting theory is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historic cost accounting system. This approach can be compared with normative accounting theories which dismiss conventional historic cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. One technique which can be used to show students the different approaches is to contrast the assumptions used by each theory as follows: Normative Positive Objective of accounting Decision making Stewardship/Agency relationship Behavioural assumptions Functional fixation/fooled by cosmetic accounting Rational economic man-able to analyse and distinguish Economic assumptions Little comment costs Financial reports are an economic commodity. Information has a price. Semantic assumptions Accounting serves a measurement role Measurement role is a secondary function to monitoring and bonding Pragmatic assumptions Accounting is neutral/unbiased Accounting is a political economic/social commodity The dissatisfactions with normative accounting are: (i) To be normative one must specify an objective function, e.g., economic efficiency, decision usefulness, estimation of future share prices, improved quality of financial reports etc. However, many of the above objectives are conflicting and it is difficult to decide which one is a superior objective. It should be noted that the definition of an objective of accounting continues to be a contentious issue (note that the objective is usually defined in a very broad, non-specific manner). Popper also makes the point that no amount of empirical testing can prove or disprove the validity of normative accounting prescriptions — they are irrefutable — therefore they are weak hypotheses. (ii) There was usually no attempt to justify — empirically — that the prescriptions from normative theories are ‘better’ than the status quo. For example, the redefinition of the objective of financial accounting from the traditional stewardship role into a decision making role (usually to aid investors) was never justified by empirical research. (iii) Before condemning the usefulness of conventional accounting as a decision making tool it would be more scientific to analyse and compare the decision making processes induced by conventional accounting and the proposed alternatives. Part of this research would encompass whether cosmetic manipulations fooled market participants and the role that financial accounting played in economic decision making. 1. Normative inflation models have been widely known in the literature for over 30 years, and have not been readily accepted by the market place. Positive theories sought to obtain a rational explanation for the status quo. 2. This leads positivists to attempt to model the connection between financial accounting, firms and markets in a rational economic framework, rather than to take the stance of normative theorists who dismissed current practice and took a prescriptive attitude. 2. Explain the meaning of an efficient market. What is meant by the following terms: weak-form efficiency, semi-strong-form efficiency and strong-form efficiency? Which form is the most important to accounting research? Why? An efficient market, in the context of the share market, is a market which adjusts rapidly to new information and fully reflects the available information in an unbiased manner. The implication of this theory is that if share markets fully reflect all the available information in prices, then there is no marginal benefit in collecting and analysing information which bears on the price of any individual share. Market efficiency only refers to information efficiency and does not relate to exchange efficiency or production efficiency. Furthermore, it does not mean that all financial information has been ‘correctly’ presented by firms or ‘properly’ interpreted by individual analysts. Nor does it imply that managers make optimal management decisions or that investors can predict future events with certainty. EMH means that, in aggregate, all information which is relevant is impounded into security prices in an unbiased and rapid manner — hence the term — market prices are a fair game. To accommodate different types of information sets and to enable empirical testing (capital market research), Fama distinguished between three information sets (past price movements, publicly available information and all information, both public and private) as follows: (i) The ‘weak form’ of market efficiency implies that a security’s price at a particular time fully reflects the information contained in its sequence of past prices — that is, there are no trading strategies based on cycles in prices (Dow theory), price patterns (head and shoulders) or other rules such as oddlot behaviour, moving averages and relative strength which will give excess profits. (ii) The ‘semi-strong form’ asserts that a security’s price fully reflects all publicly available information which includes past prices. This means that there are no trading strategies available to make excess profits from analysing publicly available economic, political, legal or financial data. (iii) The ‘strong form’ suggests that a security’s price fully reflects all information, including information that is not publicly available — for example, insider and private information. Of the three, the semi-strong form is the one most directly related to the accounting profession, because accounting information, when released, is part of the subset of publicly available information. Normative accounting theorists and accounting standard-setting bodies give quite considerable effort to arguing the merits of the form in which accounting statements are disclosed to the public. However, if prices already reflect all publicly available information, which includes current values and general inflation, then their arguments for ‘proper’ measurement are considerably weakened. It is also important to distinguish the market related effects that different accounting standards may have on share prices. These effects may be caused by a higher cost structure (e.g., more complex accounting systems or regulation), or by the imposition of political, social or renegotiation costs by participants who are located outside the relatively efficient security market. Addendum: Relation between efficient markets and capital market research An article by Wyatt attempts to explain the impact of capital market research and the efficient capital market hypothesis on practising accountants. Wyatt gives a number of examples which he argues denies the propriety of the efficient market hypothesis (EMH). For example: (i) LIFO — accountants report higher profits by using LIFO even though (in the US) it has the economic consequence of a higher taxation payment. (ii) Off balance sheet finance — one of the predictions of EMH is that the form of accounting has no effect on share prices. However, Wyatt points out that some accountants use off-balance sheet lease financing even though it has a higher cost than on-balance sheet debt. (iii) Business combinations — EMH predicts that company share prices will be unaffected by the accounting method of merger accounting. However, one company Wyatt was aware of didn’t go ahead with a merger because it believed that the purchase method of accounting would knock down the market value of its shares to unacceptable levels. (iv) Foreign operations — Wyatt states that there is some evidence of managers changing their cash management and hedging operations to hedge accounting risks associated with foreign exchange accounting. Overall, Wyatt concludes that accountants, in general, ignore or dispute EMH. ‘If EMH is valid why do businessmen continue to act as if it isn’t?' Counter Arguments (a) Wyatt uses casual or anecdotal evidence. The value of such evidence is strengthened by expanding and analysing the evidence so that it is statistically acceptable. It is also questionable whether the behaviour of market participants (pragmatics) is appropriate evidence when analysing EMH and CMR. (b) Managers’ actions may be justified in choosing accounting techniques for rational reasons other than trying to fool the market. For example, to increase their own compensation, to meet debt or equity convenants, for political expediency or for other reasons which might affect the economic well being of the firm or managers. (c) The focus of EMH is to present an hypothesis about the reaction of share prices to information sets. CMR is statistically based research which examines the reaction of share prices — it is a semantic theory. Therefore, the question can be raised whether the beliefs and reactions of managers (pragmatics) is appropriate evidence to counter a statistical theory (semantics) about the movement of share prices. 3. Explain the importance of examining the impact of profits on share prices for financial analysis. Can this analysis be used to make abnormal returns from share markets? In general the empirical research on the information content of accounting earnings has the following implications: (i) historical cost income releases have significant information content for the marketplace in terms of CAR’s and the effect on volatility and trading volume (ii) there is a continuous information set which is employed by the market and, therefore, accounting reports are not the only source of information (iii) there are limited opportunities for abnormal returns after the release of earnings. Hence the analysis of financial reports well after the release of those reports is unlikely to result in abnormal returns for the analyst. empirical research on the mechanistic and no-effects hypotheses are inconclusive, but these tests were hampered by the lack of a well-formed predictive theory about accounting policy choice. current earnings are correlated with contemporary movements in share prices. Most of the research has been undertaken on large firms in the US stock market. There is evidence that financial analysts who concentrate on small firms may earn excess returns. Furthermore, there is no mention of the important role that financial analysts play in keeping the market efficient or in making the market when the stock is unlisted. Further, Beaver argues that CMR has the following implications for accounting standard setting: (i) many accounting issues are capable of a simple disclosure solution (for example, by footnote) (ii) the role of accounting data is to prevent superior returns accruing to insiders and can be achieved by a policy of fuller disclosure (iii) financial statements should not be reduced to the level of naive investors (iv) accounting policies should take into account excessive costs and their economic consequences. Additionally, Deitrick and Harrison believe that the EMH and CMR have important implications for practising accountants, such as: (i) counselling clients against making costly accounting changes if their sole purpose is to ‘fool’ share markets (ii) the fact that the substance of an accounting disclosure is more important than its form or location (iii) as a defence against claims for damages in courts of law and to quantify estimates of economic loss. 4. Does a study of the information content of profits announcements explain why firms use particular accounting practices? Does it help to predict which firms will use particular accounting practices? No. This is one of the major shortcomings of this type of research which simply looks at the aggregate effects of accounting practices (earnings) on share prices. There is no theoretical background to explain why firms use particular accounting techniques or no predictive theory as to the circumstances in which a firm would be expected to change its accounting policy (see Leftwich 1990 ). This leads into the second stage of positive theory — covered in chapter 10 — which encompasses rational economic models of voluntary and mandatory changes of accounting techniques. 5. Give reasons that non-linear models relating unexpected returns to share prices would provide a more precise estimate of the earnings response coefficient (ERC). Non-linear models would provide a more precise estimate for the ERC because: — high persistence earnings have a greater valuation impact (arctan model) — as surprise in earnings increases then the likelihood that earnings surprise is permanent will decrease (arctan model) — bad news and good news have differential impacts (exponential model). 6. Why would share prices have a greater reaction to the profit announcements released by small firms compared with those released by large firms? Do you think this research has any implications for ‘measurement’ issues in accounting or for the formulation of accounting standards? Large firms have greater potential information sources other than accounting reports from: — analyst research — information releases — media coverage — interim reports — private information trading — institutional investment. Therefore, small firm financial reports (earnings) will have greater impact on release because information from alternative sources is less. If small firm accounting reports contain more price-relevant information then there may be an argument for differential accounting standards. However, more detailed reporting may impose higher preparation costs on small firms. Instructors should encourage discussion for and against. 7. Outline the research that has been undertaken on the impact of permanent and temporary increases in profits. Why is this research important? Research is summarised in the chapter. Permanent and temporary earnings will have differential impacts on share prices in an efficient market. This has important impacts on research design (linear vs non-linear models) and assessing the sophistication of the market in analysing the impact of earnings on stock prices (see the next question). 8. How will risk and uncertainty affect the valuation of a firm and, through this valuation model, the ERC? Risk and uncertainty affect the value of the firm in two basic ways. First, increased risk affects the discount rate and therefore lowers the value of the firm. Increased uncertainty about current and future operations lowers the permanence of the earnings (cashflow) stream and also the value of the firm. This in turn reduces the ERC. 9. The impact of profits for valuation has diminished over the years. What is the impact? How has the research adjusted to reflect this fact? Over the years it appears that the relevance of historical cost income for valuation has declined in value relevance (see Francis and Schipper 1999, p. 425). The research has adopted by focusing more on the balance sheet (statement of financial position under IFRS) and estimating the value of goodwill and intangibles as a valuation concept. 10. Outline a research project which explains how share prices are determined. Would this project include factors other than accounting data? This question follows on from the one above. A typical example is to use the model of Lev and Thiagarajan (1993) where the income statement and balance sheet are decomposed. Other factor variables can be the quality of management, intangibles, analyst forecasts, industry growth, degree of monopoly power, barriers to industry, liquidity of the stock, corporate governance, and other macroeconomic variables that students can put forward. 11. Briefly explain and outline the research on the ‘mechanistic’ hypothesis. What are the implications of this research? ‘Mechanic hypothesis’ — the market is systematically deceived by accounting changes which increase reported profit. In other words the market is misled by cosmetic accounting techniques. ‘No-effects hypothesis’ — the market ignores accounting changes which have no cash flow consequences. That is, accounting changes which are carried out solely to window dress profit figures are discounted by the market place. This hypothesis accepts the market place as being economically rational and efficient; able to see through cosmetic accounting changes. The tests of the two hypotheses considered the behaviour of abnormal rates of return at and around the time of a change in accounting policy. According to the no-effects hypothesis, there should be no abnormal returns when there is a ‘cosmetic change’ in accounting policy, since there will be no effect on cash flows. This is because the creative accounting change is understood by capital market participants, and they are able to unravel and determine its effects at zero cost. On the other hand, if an accounting policy has an effect on cash flows, for example as a result of tax regimes, then we would expect to see positive abnormal returns at the date of announcement. Therefore, the no-effects hypothesis is a joint hypothesis of the EMH, the CAPM and zero monitoring costs. In contrast, under the mechanistic hypothesis we would expect to see positive abnormal returns at the date of announcing an accounting change even though the change has no effect on cash flows — that is, cosmetic or creative accounting can fool market participants. Empirical evidence cited in this text grouped under the hypothesis supported Inconclusive No Effects Mechanistic Kaplan & Roll, 1972 Sunder, 1975 Ricks, 1982 Biddle & Lindahl, 1982 Brown & Hancock, 1977 Brown, Finn and Hancock, 1977 Sharpe & Walker, 1975 DeBondt & Thaler 1985 Lakonishok et al, 1994 Sloan, 1996 Overall, the literature initially supported the ‘no effects’ hypothesis but more recent research supports a mechanistic argument. 12. Why would financial analysts be fooled by accounting numbers and provide optimistic and biased estimates of profits? Can you offer a positive economic reason for their actions? Financial analysts may not have an in depth knowledge of accounting procedures and accounting manipulations may garble the true underlying economic value. Financial analysts may have economic ties to produce positive reports (access to information), have less power than firm management, have incentives to hide in the crowd and not produce ‘bad’ reports. See also Theory in Action 12.3. 13. Outline the different procedures that can be used to determine whether accounts have quality accruals or whether they create more noise. Procedures or red flags to determine manipulations are: firms with debt covenants and high debt/equity ratios, insider trading, low cash flows to earnings, high levels of intangibles, corporate governance, and outside directors. See also Figure 12.7 page 431 and Figure 12.8 p. 432. 14. What are the two main explanations for the association between the choice of a high-quality auditor and a lower cost of debt or equity capital? The insurance hypothesis is that capital providers (equity or debt) rely on securities laws to protect them against misstatement by company managers in audited financial statements by allowing them to take action against the auditor who provided an opinion on those statements. Capital providers are willing to pay more (or charge less) based on their belief of the value of the insurance protection provided by the auditor. If they believe the auditor has ‘deeper pockets’, that is, have more resources available to pay successful claimants, they value the insurance protection more highly, and thus the company has a lower cost of capital. The information hypothesis, or brand name hypothesis, is that large or specialist auditors perform better audits and thus add greater credibility to the financial statements. This lowers the risk to capital providers that the audit is poor quality and therefore the risk of undetected material misstatement in the financial statements. 15. Why do we have to be careful drawing conclusions about casuality based on studies using archival data? Causality is a function of the research design and requires the elimination of all other possible explanations. The soundest (if not the only) method of ruling out other possibilities is to conduct a controlled experiment. In a study of auditing and cost of capital, this would require the researcher to control which auditors were engaged by all the companies studied. This is obviously not possible for existing companies. Therefore, the researcher must observe the actual auditor choices made by companies in the market, and also observe the share prices and loan interest charges that are the result of negotiation and transactions between the company and the capital providers. Even if you asked the company managers, auditors, and capital providers about the reasons for their actions, they may not be willing to tell you, or may not really understand all the reasons for their actions. Therefore, researchers rely on archival data, or data from the records. Researchers gather data on other factors that could explain the relevant outcomes and use this data to control for the alternative possible explanations to isolate the effect, if any, of their hypotheses or predictions which, in turn, are based on the theory. There are many possible sources of error in this process – faulty reasoning or theoretical development, corrupt or incomplete data, poor measurement by researchers, and inappropriate choice of statistical techniques to analyse the data. Even if the researcher takes extreme care, the results could still be due to chance or isolated to a particular set of circumstances. CASE STUDIES Case Study 12.1 DJ sales pick up but shares dive Why do you think David Jones’ shares have dropped in value when fourth-quarter profits have increased? According to the Ball and Brown model, share prices react to unanticipated increases or decreases in earnings, since these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. There are two types of new information: economy wide information affecting all firms and firm specific new information. Part of the fall could have been induced by a general share market fall, whilst the information about specific project non-performance would reduce future cashflows. Students should be encouraged to sift out both effects by using the CAPM. What other economic information is the market using besides accounting reports? Current market wide information (GDP, inflation, unemployment) Industry information Specific information about firm operations Regulations and political interference or support Expectations about future conditions Changes in risk levels Falling interest margins, slower consumer activity and housing investment, and the loss of market share in home lending are sometimes considered by investors as a better predictor of future returns than the current accounting report based on past financial performance. The question is, what is continuing or permanent income. The volatility of that income will change from industry to industry. One analyst suggests that there wasn’t enough ‘upside surprise or news to really keep the (share price) momentum going’. What does this comment suggest to you about market efficiency? The release of unanticipated news should cause a market reaction as investors adjust their expectations. As investors digest the news and revise their expectations regarding the firm’s future cash flows share prices tend to stabilise. This comment suggests that the market is relatively efficient. Given the analyst’s comment in question 3 how would you classify the market efficiency: weak-form; semi strong-form; strong-form? Explain your answer. The market appears to be semi-strong-form: it reacted to the release of new information suggesting that the news was unknown’. This reaction was followed by a stablising period where share price momentum dissipated – as the ‘informed’ market had digested the news and priced it in. Case Study 12.2 Nufarm buys US companies List the ways that you think Nufarm is changing its core operations. Addition of seed production to its operations Expansion of export markets in the US, Mexico, South America and Europe. If the acquisition is expected to deliver significant growth, why do you think the share price is falling? In your answer, consider the potential impact of both market-wide events and firm-specific information. This question requires further research on the market in general as well as the company. It may be that the wider market is falling and that relative to this general trend, Nufarm’s share price decrease is minor (or major). Some general observations regarding the company that may have an impact on the share price are: It is acquiring new assets – this carries risk Moving into new markets – this is also risky Exisiting management of the acquired organisation is being retained – this may (or may not) be viewed as positive by the market. Does this article suggest market efficiency? Explain your answer. The market has reacted to the announcement of an acquisition by reducing the share price of Nufarm. This would suggest that the market expects cash flows of the merged enterprises to diminish. This reaction suggests market efficiency. However, if the projected outcomes of the M&A activity are difficult to estimate, this suggests the market reaction is likely to be cautionary and negative. The market is likely to re-adjust if/when new information becomes available. Does the volatility hypothesis predict greater or less variance in the share price on the days following the announcement date? What other factors might affect the volatility of the share price following the announcement? The volatility hypothesis predicts that if there is information content in earnings announcements, we would expect to observe ‘larger’ price changes on the announcement date. The weeks/days immediately surrounding the announcement date are likely to be more volatile relative to an extended period (pre- and post- announcement). Other factors that might affect the volatility of the share following the announcement include whether there are other sources of information, and, the size of the firm. Case Study 12.3 Market cheers Axa’s Asian plan Axa’s share price increased by 2.3 per cent when its annual results were announced. What does this reaction suggest about market efficiency. The market is less than strong-form as it had a sizeable reaction to the news. Clearly there was information asymmetry, and once news became available the market interpreted the information and reacted. The article indicates that Axa experienced a sharp slump in sales, yet its share price increased. Explain why sales are not the most relevant indicator of Axa’s value. Sales are only one indicator of an increase in share price. In Axa’s case, the company was able to show that it was well-funded and this points to an increase in operating activities in the future. In this case analysts and investors looked to the predicted quality of future sales and earnings. List the factors that appear to have had an in impact on Axa’s share price and indicate the likely direction of that impact: that is, an increase or decrease. Factors that appear to have had an impact on Axa’s share price include: Sharp slump in sales –decrease Absence of negative news (no surprises) – increase Sales figures in line with analysts’/investors’ expectations – increase Earnings (profit) in line with expectations – increase Axa, first to report – increase Surplus capital level showing that it is well-funded – increase Asia directed growth prospects – increase Cost management – increase Diversification strategy – increase. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
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