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.
What will be an ideal response?
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.
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