Question

In his article “The Impact of Accounting Regulation on the Stock Market: The Case of Oil and Gas Companies,” Lev (1979) examined the daily returns on a portfolio of oil and gas companies’ common shares affected by the exposure draft of SFAS 19. This standard required firms to use the successful efforts method of accounting for the costs of oil and gas exploration. Under successful efforts, costs of drilling unsuccessful wells are written off when the well is determined to be unsuccessful. An alternative policy is full cost accounting, under which the costs of unsuccessful wells are capitalized into the costs of successful wells. For firms with an active exploration policy, successful efforts reports lower net income than full cost, and also increases earnings volatility. Under the proposed standard, firms that were using the full cost method would be required to switch to the successful efforts method. The new standard became effective in December 1977.
SFAS 19 was objected to particularly strongly by small oil and gas firms, especially if they were actively exploring, who argued that successful efforts accounting would reduce their ability to raise capital, with consequent effects on oil and gas exploration and on the level of competition in the industry.
Lev found that there was an average decline of 4.5% in the share prices of firms that would have to switch to the successful efforts method, during a three- day period following the release of the exposure draft (July 18, 1977). This study is one of the few that have detected a securities market reaction to an accounting policy change that would have no direct impact on cash flows.

Required
a. Why did Lev examine share returns around the date of the exposure draft (July 18, 1977) rather than the date SFAS 19 was issued (December 5, 1977)?
b. Use contract theory and efficient securities market theory to explain why the stock market reacted as it did to the exposure draft of SFAS 19.
c. Suppose that, pursuant to the theory and evidence described in section 6.2, securities markets are not efficient. What reaction to SFAS 19 would you then expect? Explain



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  • CreatedSeptember 09, 2014
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