Accounting Theory

CASE STUDY

Prepared by Lutfiana Hermawati 023091076

Excellent Class Program Faculty of Economy Trisakti University May 2012

Case 2.5 Alumina Jumps on Bad News

1. Alumina reported an 86.3 per cent fall in first half-year profit, and suspended its final dividend. Why did its share price rise by 9.79 per cent on the announcement date? Although the situation in Alumina was extraordinarily difficult, Alumina firmly believed that the worst reason behind them is the impact of the global crisis, and Alumina were quietly confident that market will begin to improve. In between last November and April, Aluminium prices had since rebounded trade above $US2000 a tone, then Aluminas share price rose by 9.79 per cent on the announcement date. In my opinion, from this problem we can analyze that a share's perceived value is a huge player in its price change. Pleasant surprises can help a company's stock move up in price because it ameliorates the investor's opinion of the company and therefore encourages more people to buy. This increases demand, which increases price. Accordingly, a disappointment can trigger the opposite effect. The more speculation there is regarding a particular stock, the more volatile its price per share becomes. Actually, several factors can cause a share price to rise. For example, one of factor that influences whether or not a share price will rise is supply and demand, simply put, if the number of people who want to buy a share increases, so will the price of share. The price of share can also increase if enough investors feel strongly about it, as explained in case of Alumina. 2. In trying to explain the positive response to Aluminas reported earnings, explain whether and/or how you could use the following approaches to accounting theory construction (a)decision usefulness; (b)normative; and (c)scientific. Decision usefulness is an approach to the preparation of financial accounting information that studies the theory of investor decision making in order to infer the nature and types of information that investors need (concentrated on users of accounting reports, their decisions, information needs, and information-processing abilities). In my opinion, in case of Alumina, this approach is a way of conceptualizing the information content of financial statement, represented the conditional on each state of nature and each possible financial statement evidence item, such as we can define a rational investor in relation to risk, define the principle of portfolio diversification, define beta (the comovement between changes in market prices of a security and changes in market value of market portfolio), calculate expected return, make the optimal investment decision, analyze the relationship between the decision theory to conceptual frameworks of standard-setting bodies, etc. Normative approach is where theorists tend to advocate their opinions on accounting based upon subjective opinion, deductive logic, and inductive methods. In the final analysis, nearly all standards are based upon normative theory. Generally we can conclude that some accounting rule is better or worse than its alternatives. Normative theorists tend to rely heavily upon anecdotal evidence (e.g., examples of fraud) that generally fails to meet tests of academic rigor. In my opinion, in case of Alumina, we can use this approach to describe how a process of accounting in Alumina should be done, this approach is not based on observation, and may suggest radical changes to current practices in accounting. For example, how Aluminas profit should be calculated. Scientific approach refers to the formal procedures used to derive the laws and principles that govern the hard scientific discipline. Accountants who believed in a scientific approach want empirical evidence and logical explanation to support accounting practices so that practitioners can

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recommend the most appropriate methods for given situations based on evidence. For example, when the statistical tests show that the results obtained have less than a 5 per cent probability of occurring by chance. 3. Which of the approaches described in the answer to question (2) do you believe is most useful? Why? In my opinion, the most useful approach is decision usefulness approach, because this approach demonstrates that major professional accounting standard-setting bodies have adopted the theory as a guide to the preparation of useful financial accounting information. 4. Explain the importance to investors of developing a theory to explain the relationship between earnings announcements and share price movements? A theory must be based on a careful and rational examination of the facts, a clear distinction needs to be made between facts. A theory is based upon a hypothesis and backed by evidence. Developing theory will help investors to make decision in expanding their investment, for example, the random walk theory states that market and securities prices are random and not influenced by past events (referred as the weak form efficient-market hypothesis), this theory will help investors in predicting the future growth, it means that, momentum doesnt generally exist and calculations of past earnings growth doesnt predict future growth and all methods of predicting share prices are futile in long run. Share prices usually rise, in days around earnings announcement and when firms announce their quarterly earnings, as they are required to do, considerable price volatility and increases in trading volume are evident. They hypothesize that the predictable rise in stock prices is driven by the predictable rise in volume generated by earnings announcements. They go on to show that the premium is strongly correlated with the concentration of trading activity around previous earnings announcements, and that stocks with high volume around earnings announcements in particular subsequently have both high premiums and high imputed buying by individual investors. This suggests that, at least for some stocks, prices are boosted around announcement dates by demand from individual buyers

Lutfiana Hermawati / Trisakti University