CHAPTER 8

Capital market research

and accounting
LEA RN IN G OBJE CTIVE S

After studying this chapter, you should be able to:

8.1 explain the role of capital market research for accounting
8.2 differentiate between an event study and an association study
8.3 outline the relationship between accounting measures of financial performance and share prices
8.4 identify findings of capital market research relevant to accounting
8.5 explain the role of information and information intermediaries in capital markets
8.6 distinguish between behavioural finance findings and mainstream finance findings
8.7 discuss how behavioural research contributes to an understanding of decision making.
 Capital markets

Efficient market hypothesis

Corporations Governments
Signalling theory

Agency
International
theory
standards

Management Shareholders Debtholders

Australian
Dividend Interest Competition
Information
asymmetry and Consumer
Commission

Share prices

Risk

Earnings

Behavioural

Australian
Mergers/ Securities
acquisitions and Investments
Commission

CHAPTER 8 Capital market research and accounting  237

Share markets have been popularised over the past two decades. This is reflected in regular media reports
on the state of the daily markets. Share markets have particular importance to accounting because of the
generally held assumption that accounting informs capital or share market participants. In Australia, this
assumption is embedded in the Conceptual Framework. According to that framework, accounting aims
at providing investors with relevant information for investment decision making, enabling investors to
predict future cash flows and assess future risk and returns associated with particular shares.
The assumption that accounting provides information useful to participants in share or capital markets
raises the issue of whether those participants actually use accounting information in their decisions. This
is an important issue for accounting because if capital market participants do not use accounting infor-
mation when making decisions related to share transactions, what then is the purpose of accounting?
Since the development of a conceptual framework for accounting, its policy makers have concentrated
on improving this kind of information, so finding that it does not inform capital markets would be dev-
astating for accounting and its policy makers.

8.1 Capital market research and accounting

LEARNING OBJECTIVE 8.1 Explain the role of capital market research for accounting.
Capital markets have been extensively researched, more so in the context of the United States than any
other country. Since the seminal study by Ball and Brown,1 more than 1000 papers have been pub-
lished covering various aspects of capital markets. Because the important issues for accounting are
whether accounting information informs capital markets and whether capital market based research can
inform the standard‐setting process, the focus in this chapter is on research investigating the relation-
ship between the two. However, there are limitations to the value of capital markets based research to
accounting. First, accounting standards require the specification of social preferences — that is, how to
measure and weigh the net benefits to some capital market participants and the net costs to others. No
capital market based study does this.2 Second, because the research concentrates on the United States,
the results of capital market research should be viewed with caution as the findings may not be relatable
to countries such as Australia.
Capital market research adopts either an information perspective or a measurement perspective. The
information perspective focuses on accounting providing information to users of financial statements
about a firm’s financial position and performance. In short, how well do accountants summarise infor-
mation related to economic events? This is consistent with the Conceptual Framework’s objective to pro-
vide useful information to users of financial statements to help them make economic decisions relating
to the reporting entity. The measurement perspective focuses on accounting amounts as measures of the
firm’s resources (assets), claims to those resources (liabilities) and components of performance (revenues
and expenses) — in short, how well accounting income numbers measure economic income, and how
well an accounting asset number or liability number measures the associated economic asset or liability.3
This perspective is consistent with the Conceptual Framework’s criteria for recognition and measure-
ment — that is, an item, after meeting the asset definition, is suitable for financial statement recognition
if it is probable that future economic benefits will flow to the entity and these benefits can be measured
reliably.
How do accounting earnings numbers relate to share returns? The theoretical framework to answer this
information perspective question has been developed by Beaver and reworked by Nichols and Wahlen,
and this section relies heavily on that framework.4 Beaver identified three links between earnings and
share prices:
1. earnings of the current period provide information to predict future periods’ earnings, which
2. provide information to those interested (shareholders and analysts) to develop expectations about divi-
dends in future periods, which
3. provide information to determine share value (the present value of expected future earnings).5
This theoretical framework is outlined in figure 8.1.

238  Contemporary issues in accounting

 FIGURE 8.1 Links relating earnings to share returns

Link 1
Current period earnings Expected future earnings
This link assumes that current
period earnings provide
information about current
wealth creation and future
earnings so that shareholders This link assumes
can form expectations about that current and
Test: future earnings. expected future
How do earnings profitability
Link 2
numbers relate to determines the
share prices? firm’s expected
future dividend-
paying capacity.

Link 3
Current share price Expected future dividends
This link views share value as
the present value of all
expected future dividends.
Source: Adapted from Nichols & Wahlen.6
To understand this framework, some clarification is necessary. There are two measures of firm
performance. There is the measure termed ‘earnings’ which refers to accounting profit (the ‘bottom‐
line’ accounting measure of a firm’s performance), which is measured by accrual accounting over an
accounting period. The second measure is the firm’s share return (the change in the firm’s market value
over a period of time plus any dividends paid), which represents the capital market’s measure of the
firm’s performance. These two measures of the firm’s performance are rarely, if ever, equivalent. Much
research focuses on how the two measures relate. Three important assumptions underlie this research.
They are:
1. that the accounting measure provided by financial reporting can be used by shareholders to form
expectations about current and expected future profitability
2. which in turn provides shareholders with information about dividends, both current and expected
3. these expectations will influence shareholders’ decisions to retain or sell their shares, so determining
the market price of the shares.
A share price represents the present value of future dividends to shareholders.
While the linkage model, shown in figure 8.1, provides an intuitive framework for understanding the
relation between earnings and share prices, it also demonstrates the importance of whether the earn-
ings are expected to continue. Earnings that are expected to continue into future periods, will contribute
more to share value than earnings which are expected to be short‐lived. This model implies that if earn-
ings exceed expectations, share prices increase; if earnings fall short of expectations, share prices fall.
However, this is too simple an explanation because the capital market’s use of information is a ‘complex
and dynamic process’.7 The four factors that are commonly considered by capital market researchers are
accounting information in the form of earnings/profitability, expectations about earnings, asset pricing
and market efficiency. But these factors cannot be isolated individually so capital market researchers use
statistical and econometric tests to examine the association (not the cause) between share prices and
unexpected earnings numbers.
The first factor, accounting information in the form of earnings, may not provide useful information
to capital markets because earnings announcements may have been pre‐empted by other sources such

CHAPTER 8 Capital market research and accounting  239

as the financial press, or accounting standards do not allow a firm to recognise certain information (for
example, research and development expenditures), or capital market participants may suspect earnings
management. Researchers using expectations about earnings rely heavily on analysts’ forecasts and, if
they are not available, on prior period earnings. The difference between the reported accounting numbers
and the forecasts about those earnings is assumed to be new information.
The second factor is unexpected earnings — that is, new information conveyed by the earnings
number. How do researchers know what information is new? They take the earnings that were predicted
by a consensus of analysts’ forecasts and the difference between the earnings announcement and the
consensus number is assumed to be ‘unexpected’ or new information.
Asset pricing, the third factor, uses models that assume that shares should provide a rate of return
sufficient to compensate their holders for forgoing consumption and bearing the risk associated with the
shares. Share purchases come with opportunity costs: purchasing shares means that the purchaser has
less money to spend on other purchases. To entice the purchase of particular shares, the shares need to
offer an expected rate of return that will supposedly place the purchaser in a better position than if they
had purchased other items, or saved their money.
The fourth factor is market efficiency, which refers to the efficiency with which markets handle infor-
mation. Definitions of market efficiency are linked to assumptions about what information is available
to investors and thus reflected in the price. The efficiency with which the market uses information gives
rise to three forms of market efficiency. Under weak form efficiency, the current share price reflects all
the information contained in past prices, suggesting that technical analyses that use past prices alone
would not be useful in finding undervalued stocks. Under semi‐strong form efficiency, the current price
reflects the information contained, not only in past prices but all public information (including financial
statements), and no approach that was based on using and manipulating this information would be useful
in finding undervalued stocks. Under strong form efficiency, the current share price reflects all infor-
mation, public as well as private or hidden, and no investors will be able to consistently find undervalued
stocks. An efficient market is one in which share prices reflect fully all available information, including
accounting information. Under this hypothesis, corporate disclosure is critical to the functioning of
capital markets. But not all corporate disclosure is accounting based. Firms disclose using annual reports,
including the financial statements and notes, management discussion and analysis, regulatory filings,
and voluntary disclosures such as management forecasts, press releases, websites and so on. Information
arising from firms is supplemented by financial analysts, industry experts and the financial press.
Accounting’s policymakers, particularly standard setters, rely on the assumption of market efficiency
because decisions relating to matters such as changes in accounting policies should not affect share price. An
alternative view is that capital market efficiency provides justification for using the behaviour of share prices
as an operational test of the usefulness of information provided by financial statements.8 Market efficiency,
however, is being challenged. Some findings of capital market research and the causes of the global financial
crisis suggest that markets are not efficient. Behavioural finance research also contradicts the assumption that
capital markets are efficient. Contemporary issue 8.1 outlines some of these issues.

8.1 CONTEMPORARY ISSUE

Economists and the global financial crisis

John Maynard Keynes famously remarked on the importance of ideas:

The ideas of economists and political philosophers, both when they are right and when they are
wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any intellectual influences, are
usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are
distilling their frenzy from some academic scribbler of a few years back. I am sure that the power
of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

240  Contemporary issues in accounting

 The global financial crisis of 2008–09 has proved him right, albeit in a manner that he would have
hated: the financial crisis and the ensuing recession in the real economy were both made by the political
influence of erroneous economic ideas.
The age of neoliberalism is most often interpreted in microeconomic terms, as an epoch of privat-
isation, public–private partnerships and market‐mimicking arrangements of many different types, all
based on the assertion that ‘state failure’ was invariably a more serious problem than market failure
. . . beginning in the early 1970s, neoliberalism conquered academic economics . . . The discipline was
becoming more mathematical, and therefore — supposedly — more scientific, at precisely the same
moment as its practitioners were becoming neoliberal.
There was also, and crucially, a macroeconomic dimension to this process. Or, rather, there were two
macroeconomic dimensions. The first was a belief in the underlying stability of the (private) capitalist
economy, if it was not disturbed (‘shocked’) by mistaken government intervention. The second was
a belief in the efficiency of financial markets, which therefore required only the lightest of government
regulation, if any at all . . .
First, the ‘efficient market hypothesis’: according to the classic definition by Eugene Fama, ‘A market
in which prices always “fully reflect” available information is called “efficient”’. . . Now ‘efficiency’ is obvi-
ously a good thing, and having ‘the right price’ is evidently socially beneficial. Hence theorists already
favourably disposed towards free markets on ideological grounds could not resist the fatal elision from
the true statement that financial markets are subject to random disturbances and therefore impossible
to predict, to the false statement that they should be left to regulate themselves . . . The consequent
far‐reaching deregulation of national and international financial transactions was fundamental to the
subsequent global financial crisis . . . the efficient market hypothesis did a great deal of harm, both in
encouraging foolhardy behaviour on a massive scale by large corporate players in financial markets and
in discouraging any serious attempt at governmental regulation . . .
So what should non‐economists do, in order to make sense of the global financial crisis? First, they
should take a deep breath and learn some mainstream economics, if only . . . to avoid being deceived by
economists. Second, they should also learn some heterodox macroeconomics . . . since this will throw
at least some light on existing economic reality. Third, they should encourage interdisciplinary contacts,
including links between the disciplines of international political economy and (heterodox) economics.
Source: Excerpts from JE King, ‘Economists and the global financial crisis’, Global Change, Peace & Security.9

QUESTIONS
1. Who was John Maynard Keynes?
2. To what does the author attribute the causes of the global financial crisis?
3. How did the efficient market hypothesis contribute to the crisis?

8.2 Research methods: event studies and value

relevance
LEARNING OBJECTIVE 8.2 Differentiate between an event study and an association study.
Because of the complexity of the relationship between accounting information and share prices, researchers
can never be certain that accounting information causes share price reactions. The common aim is to test
whether accounting information in the form of earnings numbers reflects information that capital markets
believe is relevant and faithfully represented, two of the qualitative characteristics for accounting information
promoted by the Conceptual Framework. To do so, researchers rely on statistical and econometric tests to
examine the association between unexpected earnings and share returns, assuming capital market efficiency.
If capital markets are efficient, share prices must accurately and quickly reflect new information, including
accounting information. New information causes market participants to revise their expectations of future
cash flows. Their revisions cause them to act so that share prices change.
There are two main methods that are used to examine whether share prices react to accounting infor-
mation: an event study and an association study.

CHAPTER 8 Capital market research and accounting  241

 An event study examines the changes in the level or variability of share prices or trading volume over
a short time around the release of accounting or other information. Information is assumed to be ‘new’
if the release revises the market’s expectation, as evidenced by changes in level of prices or in the vari-
ability of prices around the disclosure date.
An association study does not assume a causal connection between an accounting performance measure
and share price movements. Rather, this type of study aims to see how quickly accounting measures cap-
ture changes in the information that is reflected in share prices over a given period. Accordingly, an associ-
ation study looks for correlation between an accounting performance measure (such as earnings or income)
and share returns where both are measured over relatively long, contemporaneous time periods. Association
studies are used to assess the value relevance of accounting information.

8.3 What the information perspective studies tell us

LEARNING OBJECTIVE 8.3 Outline the relationship between accounting measures of financial
performance and share prices.
Most event studies focus on earnings announcements. The general intuitive assumption underlying the
research is that an earnings announcement with good news should cause a share price to increase; one
with bad news should cause a share price to decrease. Observing the volatility of returns on announce-
ment days can indicate whether earnings convey information to investors. Releases of earnings numbers
should also result in significant increases in trades if they are a source of information for investors.
Ball and Brown, and Beaver were the first to show that earnings announcements lead to significant
share price changes, or increases in trading volumes.10 Subsequent research, such as that by Hew et al. in
the United Kingdom, shows that disclosures of earnings have information content since positive (nega-
tive) unexpected annual earnings announcements caused significant positive (negative) returns.11 These
results have been confirmed in countries as varied as the United States, Finland, Spain, Malaysia and
China. The assumption of some studies that the greater the surprise in disclosures, the larger will be the
investor reaction has also been confirmed, with trading volumes, volatility of returns or mean abnormal
returns all positively related to the size of unexpected earnings.12
Association studies also show that accounting earnings capture part of the information set that is
reflected in share prices. Although this is good news for accounting, there is some bad news. The evi-
dence suggests that much of the information is captured from non‐accounting sources that compete with
the earnings number. This means that annual financial statements are not a timely source of information
for the capital market.
Interim disclosures of accounting information may help investors predict the annual earnings number.
Share price reactions to half‐year releases are statistically significant, but their information content
appears to be less than that of the annual report.13
Certain factors such as firm size and the ability of investors to use accounting information seem to
modify results. The larger the market value of the firm, the smaller its abnormal returns at announcement
dates. For large firms, information disclosed at typical announcement dates is usually pre‐empted by the
attention given to large firms by investment analysts and fund managers. Sophistication of investors also
accounts for the positive association between price changes and unexpected earnings. Unsophisticated
investors are defined as those who react mechanically to reported earnings. A positive investor sophisti-
cation effect has been observed. Less sophisticated investors react to good news but underreact to nega-
tive unexpected earnings in comparison with their sophisticated counterparts.14

Prices lead earnings

As mentioned above, not all of the information captured in share prices is accounting information.
Beaver, Lambert and Morse put forward the idea that the information reflected in prices is richer than
the information in accounting earnings.15 This idea is called prices lead earnings, which means that the
information set reflected in prices contains information about future earnings.

242  Contemporary issues in accounting

 So why do earnings numbers lag prices? The fundamental principles in the calculation of earnings
relate to revenue realisation and expense matching. These principles are conservative. According to
Kothari, accounting ‘garbles’ an otherwise ‘true’ earnings signal about firm value.16
The divide between accounting measures of earnings and share prices is referred to as the deficient‐
GAAP argument. This argument suggests that financial statements are slow to incorporate all of the infor-
mation that investors use to value shares, including information about human capital and other intangibles.
There is information asymmetry between managers and outsider investors. This information asymmetry,
together with the threat of litigation against managers by outsiders, produces a demand for, and supply of,
conservative accounting numbers. The generally accepted accounting principles (GAAP) have responded
by having different timings for good and bad news: bad news is disclosed more timely than good news. In
other words, accounting recognition criteria are less stringent for losses than for gains.
Because of the differences in accounting’s recognition criteria, accruals and cash flows are the two
most commonly examined components of earnings.17 Accruals are the means by which accountants
attempt to transform operating cash flows into an earnings figure that is more informative about firm
performance. From positive accounting theory, it is known that managers might use accounting infor-
mation opportunistically and so manipulate accruals for their own ends, distorting the earnings figure as
a measure of firm performance.

Post‐earnings announcement drift

Much evidence indicates that the stock market under‐reacts to earnings information. This means that the
market does not recognise accounting earnings information as soon as the figure is released. Instead, the
market recognises its full impact gradually. This evidence is inconsistent with the assumption of capital market
efficiency. An efficient market should react instantaneously and completely to value‐relevant information.
This gradual adjustment in prices makes it seem that investors underreact to the information. This
phenomenon is termed post‐earnings announcement drift. According to Nichols and Wahlen, post‐
earnings drift is one of the most puzzling anomalies in accounting (and finance and economics) based
tests of capital market efficiency in relation to earnings information.18 It was one of the first areas to
suggest that markets may not be efficient with respect to accounting data.19 The drift seems to be related
to the extent of good news in an announcement. Unexpected good news causes the market to react as pre-
dicted by the efficient market hypothesis, but drift follows bad news announcements. Contrary evidence
has been found — for example, in Finland, post‐announcement drift is higher following positive earnings
surprises.20 Johnson and Schwartz show that the drift persists in the United States among small firms and
among firms with little analyst coverage.21 In Australia, Chan et al. found that both growth and value
firms have significant negative post‐earnings announcement drift following non‐routine bad news fore-
casts.22 Truong shows that a post‐earnings announcement drift exists in the New Zealand equity market.23
Not all studies concentrate on the association between share prices and earnings. Some studies have
used inflation‐adjusted earnings, residual earnings and operating cash flows as measures. Recently, per-
formance measures such as comprehensive income compared with earnings per share, economic value
added against earnings, or measures specific to particular industries have been used. Evidence from
these studies is important to accounting because it suggests that performance measures that have evolved
in an unregulated environment are more informative than those mandated by regulation.24

Cosmetic accounting choices

Because accounting allows management to make some choices about accruals and methods, manage-
ment is likely to have incentives to convey self‐serving information when preparing financial statements.
When accounting choices are used to achieve a particular goal, the choice is described as earnings man-
agement. According to Beaver, although earnings management appears to be widespread, it may not be
management discretion but a proxy for some other factor.25
Earnings management occurs when managers use judgement in financial reporting and in structuring
transactions to alter financial reports to either mislead some stakeholders about the underlying economic

CHAPTER 8 Capital market research and accounting  243

performance of the company or to influence contractual outcomes that depend on reported numbers.26 In
an earlier definition, Schipper emphasised the purposefulness of the process order to obtain some private
gain to managers and perhaps shareholders.27 The discretion they use may not be necessarily opportun-
istic. Healy and Palepu, for instance, view earnings management as the means by which management
conveys either its private information about the firm’s prospects or a more accurate picture of the firm’s
performance.28 For example, informed management imparts information to less informed users about the
timing, magnitude and risk of future cash flows. For earnings management to be successful, users of the
financial statements must be either unable or unwilling to unravel the effects of earnings management.29
Recent research has focused on whether management compensation contracts provide incentives
for managers to achieve desired financial reporting objectives. Managers are hypothesised to select
accounting methods to increase their compensation or to reduce the likelihood of violating debt cov-
enants. The debt covenant hypothesis predicts that when a firm is close to violating an accounting‐based
debt covenant restriction, its managers are expected to make income‐increasing accounting choices to
relax the debt covenant restriction and lower the expected costs of technical default, such as renegotia-
tion costs or bankruptcy costs.
Managers seem to take advantage of discretion in methods to manage reported earnings to increase
their compensation.30 Some contradictory evidence suggests that an income‐smoothing hypothesis better
explains the evidence. Other evidence suggests that management may engage in ‘big bath’ accounting.
When earnings for a period are below expectations, managers may write off as many costs as poss-
ible in that period to allow improved performances in subsequent periods. Similar actions have been
observed with changes in executives or CEOs. The evidence suggests that investors react positively to
such actions.31 Additionally, managers seem to manipulate discretionary accruals in the period before
announcing a management buyout, presumably to reduce the share price.

Capital markets and their participants’ reaction to

accounting disclosures
In an efficient market, firm value is defined as the present value of expected discounted future net
cash flows.32 An important input into the market’s assessment of value is a firm’s current performance,
reflecting the Conceptual Framework’s focus on financial statements providing information useful in
assessing the amounts, timing and certainty of future cash flows.
Disclosures of accounting earnings numbers lead to share price changes or increases in the volume
of trading, providing evidence that capital market participants do use accounting information, reacting
more quickly to bad news than good. However, the conservative principles that govern the calculation of
accounting earnings ‘garble’ the signal sent to the capital market.
The good news for accounting is that participants use accounting information; the bad news is that
accounting earnings numbers are poor measures of the relevant events that are incorporated into share
prices. Forecasts of future revenues, expenses, earnings and cash flows are the core of valuation. Financial
statements, with their backward focus, are poor indicators of value. Accounting’s reliability and recog-
nition principles are blamed for financial statements not providing forward‐looking information.
Managers’ behaviour suggests that they believe accounting information is used by capital market par-
ticipants. The reaction of investors to voluntary disclosures by management and to some earnings man-
agement strategies confirms that accounting information is used by them.

8.4 Do auditors or intermediaries add value to

accounting information?
LEARNING OBJECTIVE 8.4 Identify findings of capital market research relevant to accounting.
Capital providers require firms to employ an independent auditor as a condition of financing, even
when it is not required by regulations. Although little or no research has examined the reasons capital

244  Contemporary issues in accounting