Lecture 4ACCT 332 Accounting Thought and PracticeACCT 332 Accounting Thought and Practice

Efficient Securities Markets

- Chapter 4p- Concept No. 6 Elements of Financial Statements- Beaver (1973) What should be the FASBs objectives?

S (1978) Th i t f i i th- Sprouse (1978) The importance of earnings in the conceptual framework

Objectives for Todays Class

Concept of Market Efficiency

D d f A ti I f ti i Effi i t Demand for Accounting Information in Efficient Markets

Implications of Market Efficiency for Financial Implications of Market Efficiency for Financial Reporting (Beaver)

Where are we?

No true incomeHow do we make accounting choices about financial reporting?How do we make accounting choices about financial reporting?

Look at decision usefulness- Focus on investors and creditorsFocus on investors and creditors

What is decision usefulness?- Revision of subjective probabilities by the decision makerj p y- Improvement of main-diagonal probabilities in the information system

How would revision of subjective probabilities manifest itself?j p- Potential changes in investment decisions

What visible impact would changes in investment decisions have?- Possible changes in security prices

What drives security prices and how are price changes related to information? - Chapter 4

Amos Lim

Amos LimThe subjective probabilities formed by the decision maker are adjusted based on the objective information provided by the financial statements.

Efficient Markets

Markets are quick and efficient processors of information even though individuals are fallibleinformation even though individuals are fallible.

It can be visualized as individuals continuously revising their probabilities as new information comes in from pany source.

Individual errors cancel out- Provided that there is no systematic bias.

Example: GDP forecasts for four largest economies in p gEurope

Amos Lim

Amos Lim

Amos LimBlue Dots: Individual forecastsRed Dot: Consensus ForecastGreenline: Actual GDP return

Amos LimSystematic bias (e.g. everyone is optimistic), evident in difference between consensus forecast and actual return

Share Price in an Efficient Market

CAPM required return E(R ) = R + (E(R ) R )E(Rjt) = Rf+ j(E(RMt)- Rf)

Market sets share price so that expected return E(Rjt) (i e firms cost of equity capital) is given by right side of(i.e., firm s cost of equity capital) is given by right side of equation.

Note that only firm-specific component is jy p p j- How is the expected return defined?

Expected priced at t plus any dividends expected, divided by the current price p p p y p , y pin t-1.

Or, jt jtjt

j 1

E(P +D )E(R )= -1

P

In an efficient market where prices reflect all publicly available information the req ired ret rn sho ld eq al the e pected

j,t-1P

information, the required return should equal the expected return.

Amos Lim

Amos Lim

Numerical Example

Current situation- Current price per share: $10; assume no dividendsCurrent price per share: $10; assume no dividends- = 1.2, Rf = .03, E(Rmt) = .05- by CAPM, the expected return E(Rjt) will be: ?by C , t e e pected etu ( jt) be- Everything else constant, the expected price at the end of the period will

be: ?

Changes:- Then some firm-specific financial report is released, an investor

assesses it as good news and changes her expectation of the futureassesses it as good news and changes her expectation of the future price to $11

- The expected return will still be 5.4%. Why?- The new price - $X will be such that ($11 - $X)/$X = .054, or

We have now established a link between information (through its impact on t ti ) d i texpectations) and price movements

What about information related to the cost of capital?

Amos Lim0.03 + 1.2 (0.05 - 0.03) = 0.054

Amos Lim10 * (1 + 0.054) = $10.54

Amos LimExpected return does not as a result of this new information. Rf, Beta, and Rm remain the same. All that changes is therefore that the current stock price is adjusted.

Amos Lim$10.43

The Informativeness of Price

Fully informative share pricesy p- If share prices are fully informative, no one would bother to gather

information, since no one can beat the market

- If no one gathers information, share prices will not reflect all publicly available information

- If share prices do not reflect all publicly available information investorsIf share prices do not reflect all publicly available information, investors will gather information. Share price will quickly become fully informative

- Then, none would bother to gather information, etc., etc.- Hence the logical inconsistency

The Informativeness of Price (contd)

A way out of the logical inconsistencyN i t di- Noise trading Expected value of noise = 0 Share prices still efficient, but in an expected value

sense

Sh i ti ll i f ti i f- Share prices are partially informative in presence of noise trading

Share price may deviate from its efficient value due to Share price may deviate from its efficient value due to noise trading

Restores incentive of investors to gather informationRestores incentive of investors to gather information Dynamic concept of market efficiency

e g gravity and the oceane.g. gravity and the ocean

Amos LimOcean should be flat due to gravity. But this doesnt mean there arent waves.

Amos LimTrading w/o the use of fundamental data.

Amos Limi.e. they are expected to be efficient, not that they always are

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

EfficientSecuritiesMarkets

A relative conceptEffi i i d fi d l ti t bli l il bl- Efficiency is defined relative to publicly available information.

- If the information that is available is of poor quality if- If the information that is available is of poor quality, if there is not enough of it, or if it is simply wrong, then prices will reflect this poor information.

- Thus, accounting has a role to play even in efficient markets, by improving the quality of information, and

ti i id i f ti t bli i f ticonverting inside information to public information

Amos Lim(semi-strong)

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos LimI.e. to move the market from semi-strong form efficiency to strong form efficiency.

Amos LimSemi-strong efficient market

Social Significance of Markets that Work Well

In a capitalist economy, allocation of scarce capital is accomplished by market pricesp y p- Firms with productive capital projects should be rewarded

with high share prices (low cost of capital) and vice versa

Capital allocation is the most efficient if share prices reflect fundamental valuefundamental value

Social role of financial reporting- To help markets work well

Maximize amount of publicly available information Subject to a cost-benefit constraint

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Amos Lim

Implications for Financial Reporting

W. Beaver, What Should Be the FASBs Objectives,, j ,Journal of Accountancy (1973) Full disclosure, including acc. policies Accounting policies do not matter (unless with cash flow

effects).Nave investors are price protected Nave investors are price-protected.

Accountants are in competition with other information providers .p

Amos Lim

Amos Lim

Some Examples

Letsreflectonsomeexamplesoffinancialreportinginefficient markets:efficientmarkets:

- MD&A,Footnotes

What role do they play Whatroledotheyplay

Voluntary/Mandated

h l ? OtherExamples?

Earnings Opacity Around the World (Bhattacharya et al. TAR 2003)

Earnings Opacity Around the World (Bhattacharya et al. TAR 2003)

Earnings Opacity Around the World (Bhattacharya et al. TAR 2003)

Summary

Effi i t iti k t i l ti t hi h Efficient securities market is a relative concept, which allows for informative financial reporting to play a role in improving the accuracy, timing, and amount of a p g y, g,companys stock.

Full disclosure allows investors to make better decisions and improves the ability of securities markets to allocate resources more efficiently.

Fi ti li h i h ld t ff t th i Firms accounting policy choices should not affect their cash flows or their stock prices, provided they are applying the full disclosure principle.pp y g p p

Amos Lim

Group Questions

40 minutes to complete group questions A i t f di i l di Assignment of discussion-leading groups