Discuss whether alternative accounting policies have a systematic effect on security prices and what this implies about the information content of accounting policy changes. Include a discussion of previous research in this area.

Question

What will be an ideal response?

Answer 1

ANSWER:
If security prices do not respond to artificial book-income differences, then there is evidence that investors are sophisticated and are able to see through superficial book-keeping differences. If security prices do respond to income levels that differ solely because of alternative accounting methods, with no cash flow consequences, then there is support for the naive-investor hypothesis.

Most of the initial research in this area supported rejecting the naive-investor hypothesis. Research studies have examined security-price responses to a reported change in accounting policy by a company, and they have compared companies using different accounting methods. The evidence from this research supports the claim that there is no information content in accounting policy changes, at least where there are no apparent underlying changes in cash flows. This finding has also been interpreted as a rejection of the naive-investor hypothesis. Investors appear to adjust accounting income to compensate for artificial book-keeping differences with no real substance.

One type of change in accounting policy that does produce a security-price response is a change from FIFO to LIFO inventory accounting. Changes to LIFO have been associated with a positive security-price movement. The suggested reason for the price response is that a change to LIFO does generate real cash flow consequences by lowering taxable income, and thus income taxes. Other studies, however, contradict these findings, showing no evidence of price response or a negative price response. If these studies are correct, there may be some support for the naive-investor hypothesis. A negative price response could be interpreted as a mechanistic response to a lower accounting number, ignoring the real positive cash flow consequence due to lower taxes. However, another reason for the negative price reactions could be that investors are considering the potentially high adoption costs relative to LIFO such as accounting system changes and higher probability of violating debt contract provisions, possible diluting presumed future tax savings.

Research studies have also investigated the effect on security prices of indirect cash flow consequences, such as a reduction of dividend paying ability because of restrictive debt covenants. Studies in this area have found negative security-price responses in the case of such indirect consequences.