The Economic Determinants of the Market Reaction to Proposed Mandatory Accounting Changes in the Oil and Gas Industry

Abstract

This paper examines the economic reasons for the observed negative abnormal common stock performance of firms whose reported earnings and stockholders' equity were negatively affected by the proposed elimination of full cost accounting in the oil and gas industry. Four explanations of the market effects of this mandatory accounting change are examined: (1) naive investor theory, (2) modified naive investor theory, (3) contracting cost theory, and (4) estimation risk theory. These hypotheses are developed in detail and used to generate variables for a cross-sectional model which explains observed return behavior. The effect of the accounting change on total stockholders' equity, the existence of financial contracts denominated in terms of accounting numbers and, to a lesser extent, firm size are shown to be important explanatory variables. The importance of these variables is consistent with both the contracting cost and estimation risk theories.

Keywords: contracting cost, full cost accounting, oil and gas industry, mandatory accounting change

JEL Classification: M40, M41