AN EMPIRICAL INVESTIGATION OF THE STOCK MARKET'S RESPONSE TO CHANGES IN INVENTORY AND DEPRECIATION METHODS

KAREL ANN DAVIS, Purdue University

Abstract

The purpose of this thesis is to provide empirical evidence with respect to how specific accounting changes are perceived by the capital market. In particular, the security prices of firms which made changes in inventory or depreciation methods are examined around the date on which the changes were publicly disclosed, in order to determine whether a market reaction (as evidenced by price fluctuations) occurred in response to the switch in accounting methods. Since information production is costly, the accounting profession would like some assurance that the financial data which is distributed to the securities market is useful, in that it aids in decision making. In this context, information may be considered to be useful if it causes investors to revise their previous expectations regarding security prices, as signalled by changes in security prices. The research question addressed in this thesis is whether the public disclosure of a change in either inventory or depreciation methods leads investors to cause a change in security prices. To this end, the two-parameter market model is employed in order to isolate the unexpected portion of a security's return during the two-day period in which the accounting change was publicly disclosed. Since investors are believed to react only to events associated with cash flow implications, inventory changes, which have related cash flow implications due to reduced taxable income, should lead to security price revisions, while depreciation changes, which have no such cash flow impact, should not. The major findings of this study coincide with previous research as well as the stated hypotheses: when publicly disclosed, LIFO changes appear to be associated with increases in security prices, while depreciation changes are not associated with price variations. Therefore, the study concludes that accounting changes, at least LIFO and depreciation changes, cause price revisions only if the change has related cash flow implications.

Degree

Ph.D.

Subject Area

Accounting

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