TAKA Pertemuan4
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Transcript of TAKA Pertemuan4
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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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Kaplan & Roll (1972)
(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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Kaplan & Roll (1972)
(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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Kaplan & Roll (1972)
(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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Methodological Issues in Kaplan
& Roll (1972) Study (Contd)
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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Methodological Issues in Kaplan
& Roll (1972) Study (Contd)
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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Methodological Issues in Kaplan
& Roll (1972) Study (Contd)
Specification of the hypotheses tested(Contd)
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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Methodological Issues in Kaplan
& Roll (1972) Study (Contd)
Specification of the hypotheses tested(Contd)
Event study methodology
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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Methodological Issues in Kaplan
& Roll (1972) Study (Contd)
Specification of the hypotheses tested(Contd)
Event study methodology
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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Economic Consequences
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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Economic Consequences
Accounting policy choice is part of thefirms overall need to minimize its cost of
capital and other contracting costs