Topic 7 Guidance on self-study 2020 PDF

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Accounting Theory III Topic 7 Capital Markets Research Guidance on self-study questions SQ. 1 Distinguish between the three forms of market efficiency? Which form is more relevant for financial reporting? Justify your answer. A market is efficient if it adjusts rapidly to new information and fully reflects the available information in an unbiased manner. The implication of this theory is that in an efficient market security prices fully reflect all the available information so there is no systematic benefit in collecting and analysing information which bears on the price of individual shares. The weak, semi-strong and strong forms of efficiency are used by Fama (1970) to distinguish between three information sets (past price movements, publicly available information and all information, both public and private) that prices may impound. (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. If the market for a security is efficient in the weak form, there are no trading strategies based on cycles in prices, price patterns or other rules such as odd-lot behaviour, moving averages and relative strength that would systematically yield excess returns.

(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 returns 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.

The semi-strong form is more relevant for financial reporting because financial statements, when released, are part of the set of publicly available information. SQ. 2 What is a cosmetic change of accounting policy? Discuss the ambiguity of a share price increases in response to cosmetic changes in accounting policies. A cosmetic accounting policy changes affects profit but has no direct cash flow consequences. Some accounting policies changes may affect the firm’s cash flows through their effect on the calculation of income tax payable. However, this is not the case for changes in depreciation policies because the depreciation method used for tax purposes does not need to correspond to the depreciation method used for accounting purposes. Accordingly, a change of depreciation policy has no cash flow effects and is, thus, an example of a cosmetic accounting policy change. The ‘mechanistic hypothesis’ is that the market is systematically deceived by accounting changes that affect reported profit. This hypothesis assumes investors are naïve and ignore the effect of different accounting policies on the calculation of profit. If the mechanistic hypothesis were correct, the market would be misled by cosmetic accounting policy changes. Accordingly, we would expect share prices to react positively to cosmetic accounting policy changes that increase profit. The mechanistic hypothesis is inconsistent with the semi-strong form of market efficiency. If the market were efficient in the semi-strong form, share prices would reflect all publicly available information, including information about the nature of the change of accounting policy. The theory behind this view is that creative accounting change is understood by capital market participants, and they are able to unravel and determine its effects at zero 1

Accounting Theory III Topic 7 Capital Markets Research cost. Thus, in accordance with the efficient market hypothesis we would expect the market to “see through” cosmetic accounting policy changes and only respond to those changes in profit that give rise to changes in cash flows (including future cash flows). This can also be described as the ‘no-effects hypothesis’, that the market ignores accounting changes that have no cash flow consequences. The tests of the two hypotheses consider the behaviour of share prices. They focus on event studies that look for the presence 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. In contrast, under the mechanistic hypothesis we would expect to see positive abnormal returns in response to a profit-increasing accounting policy change even though the change has no effect on cash flows — that is, cosmetic or creative accounting can fool market participants. The research generally supports the ‘no effects’ hypothesis. Some studies find evidence consistent with the mechanistic argument. A possible interpretation of an abnormal return in response to cosmetic changes is that it reflects sophisticated investors who are considering indirect benefits of accounting changes, such as avoiding the breach of a debt contract. In conclusion, a positive share price reaction to a cosmetic accounting policy change is ambiguous. It might indicate that the market is misled, but it might reflect the market’s adjustment for the reduced risk of a costly breach of a debt contract. Capital markets research is unable to distinguish between these two interpretations because it only observes a price reaction; it does not observe actual human behaviour and decision making. Capital markets research focuses on the change in price that resulted from people trading shares but it doesn’t tell us why they bought or sold their shares. SQ.3 Text chapter 8, review question 2, page 255 An event study examines the changes in the level or variability of share prices or trading volume around the time when information is released. The information is interpreted as new and relevant information to the market if the share price or trading volume responds to the information. In contrast, an association study looks at the correlation between accounting measures of performance, such as earnings (profit), and market-based measures of performance, such as share returns, to see how well accounting measures capture the richer information set reflected in share prices over a given period. SQ. 4 Text, chapter 8, review question 3, page 255. Accounting earnings do not capture all the information contained in share prices because they are calculated using conservative principles which do not recognise all the events that are incorporated into share prices. E.g., a company might be awarded a valuable contract to supply goods to the government. Management would likely be keen to announce the contract, perhaps by a press release, and we would expect the share price to increase to reflect revised expectations of future cash flows. However, the event would not be reflected in financial statements until the goods are supplied (satisfaction of the performance obligation, per AASB 15). Additionally, accounting principles result in bad news being disclosed in a more timely manner than good news (e.g., recognising a loss on onerous contracts before it has been realised). This shows that accounting standards more readily permit recognition of expenses than income. 2

Accounting Theory III Topic 7 Capital Markets Research SQ.5 Limitations of Capital Markets Research Capital markets research is often referred to as a “black box” approach. The researcher observes inputs, such as the disclosure of accounting profit, and outcomes, namely changes in share prices or stock returns. The actual process by which prices changes (i.e., the decision models and decision processes behind the share trades) is not observed. Capital market research does not explain the reasons and human behaviour that underlies the price reaction, or lack thereof. For example, if there share price did not react, was it because the information was ignored, dismissed as unreliable, dismissed as irrelevant or perhaps, already known and reflected in the share price. Another limitation is that capital markets research only investigates capital market responses and thus ignores the potential value and relevance of accounting information to other uses, such as creditors. SQ.6 What is off-balance-sheet financing? Off-balance sheet (OBS) financing refers to any form of borrowing that is not recognised on the statement of financial position. E.g., the use of long-term operating leases to finance investment in assets; the lease liability would not be recognised under AASB 117.

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