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CHAPTER 4DISCRIMINATING

BETWEEN COMPETINGHYPOTHESES


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The Competing

Hypotheses

EMHNo-effects hypothesis

Competing hypothesisMechanistic

hypothesis


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The Competing

Hypotheses (Contd)

The No-Effects Hypothesis CAPM: the market value of the firm is a

function of the firms expected future cash-

flows and the expected rate of returnAccounting change has no implications for

stock prices

Unless it had implications for taxes

Accounting change has to be unexpected by

the market


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The Competing

Hypotheses (Contd)

The Mechanistic Hypothesis Changes in accounting procedures affect

stock prices even if those changes have no

effect on the firms cash flowsAssumption: accounting reports are the sole

information on the firm

Also called: monopolistic hypothesis,

functional fixation hypothesis


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Discriminating between

the Hypotheses

3 sets of accounting changes:All accounting changes whether they affect

taxes or not

Accounting changes that do not affect taxesAccounting changes that affect taxes


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Kaplan & Roll (1972)

Investigate accounting changes that donot affect taxes

Accounting for investment tax credit

From deferral method to flowthrough methodAccounting for depreciation

From accelerated depreciation to straight-line

depreciation


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(Contd)

Methodology: Calculate abnormal returns around the

earnings announcement week

Mechanistic hypothesis predicts: CAR > 0 No-effects hypothesis predicts: CAR = 0


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(Contd)

The Investment tax credit:Abnormal rates of return > 0 for change

sample and = 0 for control sample.

Support the mechanistic hypothesis ratherthan no-effect hypothesis


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(Contd)

The Depreciation switchback:Abnormal rates of return = 0.

Support the no-effect hypothesis.

Contradict with results for investment taxcredit.


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Methodological Issues in

Kaplan & Roll (1972) Study

Two issues: Specification of the hypotheses tested

Event study methodology


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Methodological Issues in Kaplan

& Roll (1972) Study (Contd)

Specification of the hypotheses tested The concentration is on the competing

hypothesis the hypothesis that the market is

misled Problem: Do not specify exactly when the stock

price reacts to the earnings effect of an

accounting change.


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Specification of the hypotheses tested Specifying the mechanistic hypothesis

Kaplan & Roll (1972) fail to make powerful test

when they use two-tail test on the abnormal

returns

Should be one tail: H0 = e0 < 0, Ha: e0 > 0


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Specification of the hypotheses tested(Contd)

Specifying the mechanistic hypothesis(Contd) Another way to increase the power of test is to

calculate the earnings effect of the accountingchange and then investigate the abnormalreturns associated with the largest effects

Kaplan & Roll use the 1st annual earningsnumber, which is not necessarily the firstearnings disclosed using the changedaccounting method


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Testing the no-effect hypothesis

The acceptance of EMH led early accountingresearchers to accept readily no-effect hypothesis

when it was not rejected

There are infinite number of alternative

hypotheses to the null hypothesis


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There are two reasons to believe that therandomization of other variable has not been

achieved in Kaplan & Roll: clustering and

selection bias


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Clustering: investment tax credit changes occur in1 year and depreciation switchback occur

predominantly in 3 years and over represented in

several industries

Selection bias When a sample is selected on the basis of one variable

and it is latter found that the sample differs from the

population of observation on the basis of some other

variable


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Ball (1972)

Investigates all types of accountingchanges

Does not restrict his sample to changes

that do not affect taxes He argues that under the no-effectshypothesis, accounting changes has noobservable effects on the stock price at

the time an accounting change isannounced


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Ball (1972) (Contd)

Reasons: Changes in the optimal tax inventory method

are induced by changes in other variables

affecting the managers decisions Tax effects are too small to be observed

The changes in other variables occur before

the accounting change enabling the market to

predict the accounting change


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Ball (1972) (Contd)

Sample: Samples are relatively spread over the 14-

year period, reducing the clustering problem

encountered by Kaplan and Roll


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Ball (1972) (Contd)

Results:Abnormal returns unadjusted for risk changes

for the whole sample

There appears to be no price change associatedwith the earnings announcement consistent

with the no-effects hypothesis


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Ball (1972) (Contd)

Results: Tests for risk changes and abnormal returns

adjusted for risk changes

Average estimated for switches to LIFOincreases

Lack of any stock price effect in month 0 is

consistent with the no-effects hypothesis


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Ball (1972) (Contd)

Results:Abnormal returns adjusted for risk changes

for particular accounting changes:

Stock price do not react to earnings changes thatresult only from accounting changes that have no

cash flow effect


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Ball (1972) (Contd)

Like Kaplan & Roll, concentrates ontesting the mechanistic hypothesis

Fails to account for selection biases

Contemporaneous unexpected earnings

A more powerful test using non zero

stock price effect predictions

Changes in inventory methods because theyaffect taxes


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Sunder (1973, 1975)

Realizes the potential of the LIFOchanges to discriminate between the two

hypotheses (no effects and mechanistic)

Sunder (1973 1975)


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Sunder (1973, 1975)

(Contd)

Sample: Firms switching to LIFO andfirms abandoning LIFO

Results:

Observe abnormal price increasesassociated with switches to LIFO


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Sunder (1973, 1975) (Contd)

Problems: Doesnt identify the switchs announcement

date and investigate the abnormal returns at

that time. Has a clustering problem

Does not allow for the contemporaneous

earnings selection bias.


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Ricks (1982)

Attempts to control for the unexpectedincrease in earnings associated with LIFO

switches


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Biddle & Lindahl (1982)

Results: The larger the tax savings, the larger the

change in value of the firm

The larger the unexpected earnings, thehigher the value of the firm

Consistent with no-effects hypothesis

Methodological problem: clustering (1974changes)


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Economic Consequences

Economic consequences: a concept thatasserts that, despite the implications of

efficient securities market theory,

accounting policy choice can affect firmvalue


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Accounting Policy

Accounting policy any accountingpolicy, not just one that affects a firms

cash flows

E i C &


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Economic Consequences &

Efficient Market Theory

Economic consequences theaccounting policy will matter, despite the

lack of cash flow effects

Efficient market theory the change willnot matter because future cash flows are

not directly affected


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Essentially, the notion of economicconsequences is that firms accounting

policies and changes in policies, matter

Matter to management But if matter to management, accounting

policies matter to the investors


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Accounting policy choice is part of thefirms overall need to minimize its cost of

capital and other contracting costs

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