Chapter 03

The predictive and

positive
approaches
 The predictive approach
• According to Beaver and others:
– ‘The measure with the greatest
predictive power with respect to a
given event is considered to be the
“best”method for that particular
purpose’
• The predictive approach arose from the
need to solve the difficult problem of
evaluating alternative methods of
accounting measurement alternatives
 Research based on the
predictive approach
There are two streams of research:
1. that which is concerned with the ability
of accounting data to explain and
predict economic events
2. that which is concerned with the ability
of accounting data to explain and
predict market reaction to disclosure
 Time-series analysis
• Time-series analysis is a structural
methodological approach by which
temporal statistical dependencies in a
data set may be examined
• Time-series analysis research focuses
on:
– time series properties of reported
earnings
– prediction issues in time-series
analysis
 Time-series properties of
reported earnings
Research has examined both reported earnings
and models that describe quarterly earnings:
• Findings on the annual-earnings series present a
moving-average process, a submartingale, or
one of two processes:
1. martingale
2. moving averages regressive
• Findings on the quarterly-earnings series show
that it follows an autoregressive process
characterised by seasonal and quarter-to-
quarter components
 Predicting future accounting
earnings
• Sophisticated autoregressive processes do not
forecast significantly better than the random-walk
method
• Models of quarterly earnings have better
predictive ability than annual models and Box
and Jenkins’ ‘individually identified’ models
• Disaggregated sales and earnings provide good
forecasting ability, but this is not demonstrated
for models based on components such as interest
expense, depreciation expense and operating
income before depreciation
 Distress prediction
• A relevant application of the predictive
approach is in distinguishing financially
distressed firms from non-distressed firms
• Most models use a paired-sample technique:
– part of the sample contains data from
firms that failed, while the other part
contains data from firms that did not fail
– the researcher searches for a formula
based on ratios that best discriminate
between firms that failed and firms that
remained solvent
Studies in bankruptcy prediction
• Beaver’s univariate study revealed cash-flow-
to-total-debt ratios to be the best predictors,
followed by net-income-to-total-assets ratios
• Altman’s multivariate study resulted in a model
with five variables:
– net working capital/total assets
– retained earnings/total assets
– earnings before interest and taxes/total
assets
– market value of equity/book value of total
debt
– sales/total assets
 Ohlson’s model
• Ohlson proposed a logit model to examine
the effects of the following four factors on
the probability of bankruptcy:
1. size of firm
2. measures of the firm’s financial
structure
3. measures of performance
4. measures of current liquidity
• Nine financial ratios were chosen to
represent these factors
 Advantages of discriminant
analysis based models
• Can process information more quickly
and at a lower cost than loan officers
and bank examiners
• Can process information in a more
consistent manner
• Can facilitate decisions about loss
function being made at more senior
levels of management
 Limitations of discriminant
analysis based models
• The absence of a general economic theory
of financial distress that can be used to
specify variables for inclusion in models
• All of the studies examined observable
events such as legal bankruptcy and loan
default, rather than financial distress per se
• The results of the superior predictive ability
of some accounting ratios may not be
generalised to permit the formulation of an
accounting theory
 Predictions of bond
premiums and bond ratings
The following factors create bond risks
and therefore affect yields to maturity:
• default risk
• marketability risk
• purchasing-power risk
• interest-rate risk
 Fisher’s model
Fisher used four variables to explain the
differences in risk premiums of industrial
corporate bonds:
1. earnings variability, measured as the
coefficient of variation on after-tax earnings of
the most recent nine years
2. solvency, measured as the time period since
the latest of the following occurred: the firm
was sounded, emerged from bankruptcy, or
made a compromise with creditors
3. capital structure, measured by market value
of equity/par value of debt
4. total value of the market value of the firm’s
bonds
 Studies on bond ratings
• Studies on bond ratings at first tried to
develop a bond-ratings model from an
experimental sample of ratings on the
basis of selected accounting and
financial variables
• In the second stage of studies on bond
ratings, the model obtained was applied
to a holdout sample to test its
predictive ability
 Problems with bond-rating
models
• All bond-rating models but one lack an explicit
and testable statement of what a bond rating
represents, and an economic rationale for the
variables
• No bond-rating model accounts for possible
differences in the accounting treatments used
• Studies using regression models treat the
dependent variable as if it were on an interval
scale
• All but one study confused ex-ante predictive
power with ex-post discrimination
 Belkaoui’s model
• Recent bond-rating models have shown
the importance of profit-based
measures and other measures of
financial fitness in the explanation and
prediction of bond ratings
• Belkaoui’s discriminant-analysis-based
bond-rating model is an example
 Corporate restructuring
• Includes mechanisms such as mergers,
consolidations, acquisitions,
divestitures, going private, leveraged
concerns and buyouts
• Their purpose is to:
a. maximise the market value of
equities held by existing
shareholders
b. maximise the welfare of existing
management
 Corporate restructuring
behaviour
Analyses based on share valuation:
• Marris’ study showed that companies
acquired are those that are
undervalued by the market
• Gort hypothesised that the level of
takeover activity varies with the
degree of share undervaluation
 Other analyses
• Chambers examined the undervaluation
of net assets as a key factor for
predicting takeovers
• Taussig and Hayes rejected these
findings based on the absence of a
control group
• Both of the above studies were
univariate and considered only
voluntary mergers
• Palepu developed a multivariate logit
model based on ten variables
 Credit and bank lending
decisions
• Research on the predictive approach
consists of replicating or predicting the
credit evaluation based on accounting
and other financial information
• The bank lending decision has also been
the subject of empirical and predictive
research. There have been three areas
of research, which deal with:
1. efforts to simulate aspects of a bank’s
investment and lending processes
 Credit and bank lending
decisions (cont’d)
2. reduction of the loan classification
decision
3. the estimation and prediction of
commercial bank financial distress
 Forecasting financial
statement information
Choice of techniques may be mechanical
or non-mechanical and univariate or
multivariate:
• mechanical univariate forecasting
includes moving average and Box-
Jenkins univariate models
• mechanical multivariate forecasting
includes regression models, Box-
Jenkins transfer function models and
econometric models
Forecasting financial statement
information (cont’d)
• Nonmechanical models include
univariate models such as visual
curve extrapolation and multivariate
models such as security analyst
approaches
Forecasts of earnings versus
statistical models
There is great disagreement as to whether
forecasts of earnings are superior to
statistical models. Various unanswered
issues include:
• relevance of forecast data
• value of non-accounting information in
forecasting
• randomness of earnings time series
• cost of alternative forecasting procedures
• respective motives of management and
security analysts in making forecasts
Capital markets and external
accounting
• Observations of capital-market reaction
may be used as a guide for evaluating
and choosing among various accounting
measurements
• The predictive approach favours the
adoption of accounting numbers that
have the highest association with
market prices
 The efficient market model
• Fama defines an efficient market as one in which
prices ‘fully reflect’ the information available,
and where the market reacts to new information
instantaneously and without bias
• According to a second definition, correct
expectations are formed on the basis of all
available information, including prices, meaning
that more-informed individuals reveal
information to less-informed ones through
trading actions etc.
• A third definition distinguishes between market
efficiency with respect to a signal and with
respect to an information system
The efficient market hypothesis
Fama distinguishes three levels of
market efficiency:
1. weak form efficiency, in which
expected returns ‘fully reflect’ the
sequence of past events (prices)
2. semi-strong form efficiency, in
which expected returns ‘fully reflect’
all publicly available information
3. strong-form efficiency, in which
expected returns ‘fully reflect’ all
information
The capital asset pricing model
 The arbitrary pricing theory
The abitrary pricing theory (APT) assumes
that security returns are related to an
unknown number of unknown factors, a
multifactor model being:

The securities will be priced as follows:

where:
Ri = returns on riskless asset
bij = sensitivity of security i to factor j
Yj = security return premium
The arbitrary pricing theory (cont’d)
• According to APT, the security expected
returns are linearly related to the securities
of the pervasive factors, with a common
intercept equal to the riskless rate of
interest
• Various studies have attempted to identify
the factors
 Factors of the APT
• Chen, Roll and Ross identified four factors:
1. growth rate in industrial production
2. rate of inflation
3. spread between long-term and short-term
interest rates
4. spread between low-grade and high-grade
bonds
• The Salomon Brothers identified five factors:
1. rate of inflation
2. growth rate in gross national product
3. rate of interest
4. rate of change in oil prices
5. rate of growth in defence spending
 Equilibrium theory of option
pricing
The following formula was proposed by Black and
Scholes to value options:

where:
Ps = current market price of the underlying stock
E = exercise price of the option
Equilibrium theory of option pricing
(cont’d)
R = continuously compounded risk-free rate
of return expressed on an annual basis
T = time remaining before expiration,
expressed as a fraction of a year
[theta] = risk of the underlying common
stock, measured by the standard deviation
of the continuously compounded annual
rate of return on the stock
 The market model
The Markovitz and Sharpe market model
is used as a test of the efficient market:
 The market model (cont’d)
• The market model asserts that the
return of each security is linearly
related to the market return
• The market model has been used in
most studies evaluating the relation
between market return and accounting
return
• To estimate the parameters alpha and
beta, research has generally relied on
the ordinary least-squares approach,
which assumes that the parameters are
consistent during the event period
 Beta estimation
• Various corrections have been proposed to
account for the potential problem of error, or
systematic risk, in estimating beta.
• The generalised Scholes–Williams correction
provides the following estimator:

where
B+1, B0, B–1 = leading, contemporaneous, and
lagged betas
P1 = first-order serial correlation of the index
 Event study methodology
E(Rit) = Rft + [E(Rmt) – Rft]b
where: 
E(Rit) = the expected return of security i in
period t
Rft = the return on a riskless asset in period t
E(Rmt) = the expected return on the market
portfolio in period t
s (Rit, Rmt) = the covariance between Rit and
Rmt
s 2(Rmt) = the variance of the return on the
market portfolio
b = }ss(R2(itR9 Rmtm)t)} = risk coefficient
 Residual earnings model
In the dividend discount model (DDM) the
value of the firm is that present value of the
future dividend stream to equity holders:

where:
Vt = the equity value of the firm at time t
dt = dividend at time t (all capital flows to
equity holders net of contributions)
r = cost of equity capital
E(.) = expectations operator
Residual earnings model (cont’d)
Substituting accounting variables into
the DDM, Ohlson and Feltham
developed the following expression
relating firm value to accounting values:

The value of the firm (Vt) at time t is

the sum of net book value (bt) plus the
discounted expected future abnormal
earnings (xat)
Models of the relation between
earnings and returns

• Price and book values are related as

follows:

Pjt = BVjt + Ujt (1)

where Pjt is the price per share of firm j at

time t and BVjt is the book value per share
of firm j at time t
 Models of the relation between
earnings and returns (cont’d)
• Accounting earnings and security returns can be
derived by taking first differences of the variables
in equation (1) as follows:

(2)
where:

(3)
Ajt = accounting earnings of firm j over the time
period t-1 to t
Ajt = the dividend of firm j over time period t-1
to t
 Models of the relation between
earnings and returns (cont’d)
• The relation between earnings and returns is
obtained by substituting equation (3) into
equation (2) and dividing by Pjt–1 as follows:

(4)
where:

This equation shows that if stock price and

book value are related, then earnings
divided by beginning-of-period price explains
returns
 Evaluation of the market-
based research in accounting
The available evidence for market-
based research in accounting can be
classified into four categories:
1. information content studies
2. difference in discretionary
accounting techniques
3. consequences of regulation
4. impact on related disciplines
 Information content studies
• This approach is used to examine whether
the announcement of some event results in
a change in the characteristics of the stock-
return distributions
• Impetus was created by the Ball and Brown
study in which unexpected earnings changes
were found to be correlated with residual
stock returns
• These studies are consistent with the
hypothesis that accounting information
leads to changes in equilibrium prices
 Voluntary differences and
changes in accounting techniques
• What is the impact of differences and changes
on investors?
• The issue is whether the market is
‘sophisticated’ enough not to be fooled by
cosmetic differences or accounting changes
• The naive investor hypothesis assumes that
some investors cannot perceive the cosmetic
nature of certain accounting changes
• The efficient market hypothesis, on the other
hand, stipulates that rational investors should
see through such changes
Market impact of accounting
regulation
Research in this area has created convergent
results:
• mandated line-of-business information has
affected investor assessment of the return
distributions of multiproduct firms
• the FASB and SEC regulation on the ‘full
cost’/‘successful effects’ issue are associated
with significant reactions of oil and gas stock
prices
• price-adjusted estimates of earnings as well as
replacement cost data did not generate any
noticeable market reaction
 Implications for financial
reporting
According to Copeland:
• relevant new information should be announced as
soon as it is available
• the most important information is forward-looking
• the market can evaluate information regardless of
whether cash flow effects are reported in the
balance sheet, income statement or footnotes
• the market reacts to the cash flow impact of
management decisions, and not to the effect on
reported earnings per share
• the SEC should conduct a thorough cost-benefit
analysis of all proposed changes in disclosure
requirements
 Capital markets and
accounting information
Some argue that capital markets are not
efficient handlers of accounting information:
• Gonedes and Dopuch argue that stock-price
associations are not sufficient grounds on
which to evaluate alternative information
systems and suggest the need for social-
welfare considerations
• the efficient market hypothesis and empirical
evidence supporting it are silent concerning
the ‘optimal’ amount of information
Capital markets and accounting
information (cont’d)
• a qualifier has been omitted in the studies
cited, in that market efficiency may be
implied only if no change in stock price and
the firm’s decision-making are observed
• finding out what information is used and
should be provided to investors may be
difficult
• most of the research cited lacks a theory to
predict who should be better or worse off
from accounting policy changes, and which
changes if any might include changes in
management behaviour to offset the effect of
a change in accounting policy
 Arguments against the
predictive approach
• Users individually or in aggregate react
because they have been conditioned to react
to accounting data rather than because the
data have any informational content
• Observations of users’ reactions should
therefore not guide the formulation of an
accounting theory
• Sometimes recipients of accounting
information react when they should not react,
or do not react in the way that they should
Adequacy of methodology used
Most of the empirical evidence rests on research
designs and methodological assumptions that
are influenced by:
• anomalous evidence regarding market
efficiency
• self-selection bias and omitted variables
• confounding effects arising from the release
of other unrelated and relevant informational
items
• the timing of capital-market impact
• the choice of control group
• behavioural finance
• factors raised in chaos theory
 The positive approach
• The subject matter of the anthropological/
inductive positive approach is:
– existing accounting practices
– management’s attitudes towards those
practices
• Proponents of the positive approach argue
that the techniques can be derived from
and justified on the basis of their tested
use, or that management plays a central
role in determining the techniques to be
implemented
 Information/economics
• Feltham’s framework relies on the individual
components required to compute the payoff of
a particular information system, being:
– a set of possible actions at each period within
a time horizon
– a payoff function over the events that occur
during the periods
– probabilistic relationships between past and
future events
– events and signals from the information
system
– a set of decision rules as functions of the
signals
 Information/economics (cont’d)

• Basic subject matter:

– information is an economic commodity
– acquisition of information amounts to a
problem of economic choice
• Accounting information is evaluated in terms
of its ability to improve the quality of the
optimal choice in a basic-choice problem that
must be resolved by an individual
• The information system with the highest
expected utility is preferred
 Analytical models proposed
1. Decision-theory model
2. Syndicate-theory model
3. Informational-evaluation-decision-
maker model
4. Team-theory model
5. Demand-revelation model
The analytical-agency paradigm
• The analytical-agency paradigm is
characterised by two types of paradigms:
1. analytical or principal-agent paradigm
2. positive-agency paradigm
• The agency relationship is said to exist
when a contract between a person (a
principal), and another person (an agent),
to perform some service on the principal’s
behalf involves a delegation of the
decision-making authority to the agent
 The agency problem
The basic agency problem is enriched by
different options concerning:
1. the initial distribution of information and
beliefs
2. the description of the number of periods
3. the description of the firm’s production
function in terms of:
• amount of capital supplied by the
principal
• agent’s level of effort
• an exogenously determined, uncertain-
state realisation
 The agency problem (cont’d)

4. the description of the feasible set of

actions from which the agent chooses
5. the description of the labour and
capital markets
6. the description of the feasible set of
information systems
7. the description of the legal system that
specifies the type of behaviour that can
be legally enforced, and what is
admissible evidence
8. the description of the feasible set of
payment systems
The agency problem (cont’d)

9. the description of the solution to the

basic agency model
10.the role of self-interest
11.the solution concept and the nature
of optimality
 Income smoothing
Gordon’s propositions on income
smoothing
1. The criterion a corporate management
uses to select among accounting
principles is the maximisation of its
utility or welfare
2. The utility of management increases
with:
• job security
• the level and rate of growth in
management’s income
• the level and rate of growth in the
corporation’s size
 Income smoothing (cont’d)
3. The achievement of the
management goals stated in
proposition 2 depends in part on the
stockholders’ satisfaction with the
corporation’s performance
4. Stockholders’ satisfaction increases
with the average rate of growth in
the corporation’s income
 Gordon’s Theorem
Given that Gordon’s four
propositions are true, management
would within the limits of its power:
1. smooth reported income
2. smooth the rate of growth in
income
 Motivations for smoothing
• According to Heyworth, motivations for
smoothing include improvements of relations
with creditors, investors and workers, as well
as dampening of business cycles through
psychological processes
• Beidelman’s two motivating reasons:
1. a stable earnings stream is capable of
supporting a higher level of dividends,
having a favourable effect on the value of
the firm’s shares
2. smoothing counters the cyclical nature of
reported earnings and reduces the
correlation of a firm’s expected returns with
returns on the market portfolio
 Constraints leading to
smoothing
Three constraints are presumed to lead
managers to smooth:
1. the competitive market mechanisms,
which reduce options available to
management
2. the management compensation
scheme, which is linked directly to
the firm’s performance
3. the threat of management
displacement
Dimensions of smoothing
Barnea and others distinguished
between three dimensions:
1. smoothing through events’
occurrence and/or recognition
2. smoothing through allocation over
time
3. smoothing through classification
Positive theory of accounting
• The positive theory of accounting is
based on the propositions that
managers, shareholders and
regulators/politicians are rational and
attempt to maximise their utility
• Their choice of accounting policy rests
on comparing the relative costs and
benefits of alternative accounting
procedures so as to maximise their
utility
 The central ideal of the
positive approach
1. To enhance the reliability of prediction,
based on the observed smoothed series of
accounting numbers along a trend
considered best or normal by management
2. To reduce the uncertainty resulting from
the fluctuations of income numbers in
general and the reduction of systematic
risk in particular by reducing the
covariance of the firm’s returns with
market returns
 The central problem in
positive theories
• The central problem is to determine how
accounting procedures affect cash flows, and
therefore management’s utility
• Theoretical assumptions guiding resolution of the
problem are:
– the agency theory evolves to a view of the firm
as a ‘nexus of contracts’
– given this ‘nexus of contracts’ perspective, the
role of accounting information is to monitor
and enforce these contracts to reduce the
agency costs of certain conflicts of interest
 Contracting costs
Contracting costs include:
• transaction costs
• agency costs
• information costs
• renegotiation costs
• bankruptcy costs
 The accounting choice
• The accounting choice rests on variables
that represent management’s incentives
to choose accounting methods under
bonus plans, debt contracts and the
political process
• There are three hypotheses:
1. The bonus plan hypothesis maintains
that managers of firms with bonus
plans are more likely to use
accounting methods that increase
current-period reported income
The accounting choice (cont’d)

2. The debt/equity hypothesis

maintains that the higher the firm’s
debt/equity, the more likely
managers are to use accounting
methods that increase income
3. The political cost hypothesis
maintains that large firms rather
than small firms are more likely to
use accounting choices that reduce
reported profits
 Accounting paradigms
1. Anthropological paradigm
2. Behaviour-of-the-markets paradigm
3. Economic-event paradigm
4. Decision-process paradigm
5. Ideal-income paradigm
6. Information-economics paradigm
7. User-behaviour paradigm