ACCT 90013:
Market Efficiency
and Value Relevance
of Accounting
Information
1. Capital market efficiency
2. Value relevance of accounting information
3. Capital market inefficiency
2
Structure of Today’s Lecture
Learning Objectives
• To explain the efficient market hypothesis
and its implications for financial reporting
• To understand how to test the value
relevance of accounting information
• To explain why security market may not be
efficient
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Readings
• Chapter 4.1-4.3, Scott
• Chapter 5.1-5.4, Scott
• Chapter 6.2.1 & 6.3, Scott
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Usefulness of Accounting Information
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Adverse Selection
Persons with information
advantage exploit this advantage
Moral Hazard
Manager knows his/her actions
but investors do not
Capital Markets Perspective
Role of accounting reports to
value the firm
Contracting Perspective
Role of accounting reports to
motivate the manager
Valuation Role Stewardship Role
Capital
Market
Efficiency
7Efficient Market Hypothesis (EMH)
2013 Nobel Prize in Economics
“for their empirical analysis of asset prices”
-Royal Swedish Academy of Science
- “… their findings showed that markets were moved by a mix of rational
calculus and human behavior.”
8• Fama (1970, 1991): The market price “incorporates” all
“currently available information”
Quickly and
without biasDepending on the information, there
are three forms of market efficiency
What Is Market Efficiency?
Three forms of efficiency
• Weak form: reflect data on past prices
• Strong form: reflect all information, public &
private
• Logic inconsistency on information acquisition
• Semi-strong form:
An efficient securities market is one where the prices of
securities fully reflect all information that is
publicly known about those securities.
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How do market prices fully reflect
all available information?
When a sufficient number of informed investors react to
new information, the market becomes efficient.
• Investors’ estimates of security values must be, on
average, unbiased.
• Any one individual may not be correct, but on average
the market uses all available information
• Assume individual decisions are independent
• Therefore, the market price fully reflects all publicly
available info
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The meaning of efficiency
Market prices are semi-strong form efficient:
• Does not rule out the possibility of inside
information
• Prices not necessarily reflect ‘real’ value
• Market prices follow a random walk
– Today’s price tells you nothing about tomorrow’s
price
– Price changes randomly because it is only driven by
unexpected information
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Implications for Financial Reporting
Scott 2015
Implications for Financial Reporting
1. Accounting policies adopted by the firms do not affect
security prices (assuming no differential cash flow
effects and full disclosure)
• e.g. depreciation method
• Investors are pricing expected future cash flows and
dividends
• Only accounting information that affects expectations of
future cash flows is priced.
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Implications for Financial Reporting
2. Full disclosure enhances efficiency
• All info will be used, managers should disclose as much
as cost-effective
• More disclosure, less concern about inside information
3. “Naïve” investors are price-protected
• Financial report does not need to be presented in an
extremely simple manner
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Implications for Financial Reporting
4. Accountants in competition
• Compete with other providers of information
• Must provide relevant, reliable, timely and cost-
effective information (relative to other sources)
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Implications for Financial Reporting
Why is this important for the purpose of
financial reports?
• Market efficiency has implications for how financial
reports should be prepared
• If investors are fully efficient, then the market
reaction, is a good way to measure whether financial
information is useful
– i.e. to examine the value relevance of accounting info
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The Value
Relevance of
Accounting
Information
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• Accounting information is value relevant when
market prices do respond to accounting information
• Central Questions
• Whether accounting information is useful to the
capital market?
• What accounting information should be reported in
financial reports?
Value relevance
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Empirical studies on value relevance:
• Ball and Brown (1968)
• Earnings response coefficient (ERC)
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Value relevance
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THE Example: Ball and Brown (1968)
• Whether accounting earnings contain information
of use for market investors.
– Are accounting data, derived from a mixture of
historical costs on transactions occurred at
various points in time, useful to investors?
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THE Example: Ball and Brown (1968)
• The first study to document statistically a
share price response to reported net income
• Foundation of empirical financial accounting
research
• Methodology still used today
https://www.intheblack.com/articles/2018/11/01/australian-academics-
changed-global-accounting
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THE Example: Ball and Brown (1968)
For Each Sample Firm:
• Estimate investors’ earnings expectations
(proxied by last year’s actual earnings)
• Classify each firm as GN (actual earnings >
expected earnings) or BN (vice versa)
• Estimate abnormal share return for month of
release of earnings (month 0)
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THE Example: Ball and Brown (1968)
GN (good news):
Actual
E>Expected E
BN (Bad news):
Actual
E24
Ball & Brown Results
The narrow window results remain, thereby
supporting the value relevance of accounting
information
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Ball & Brown Results
• Around 85%-90% of the information was already
built into share price by the time annual earnings were
announced.
• Post-earnings announcement drift
Take-away points:
• Stock market reacts to accounting information;
• Begins to anticipate the GN or BN in earnings 12 months
prior to month of earnings announcement Prices
lead earnings
• Contrary to critics, historical cost based statements are
decision-useful!
• Consistent and inconsistent with securities market
efficiency
• Consistent: market use public information to value a firm
• Inconsistent: post-earnings announcement drift
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Ball & Brown conclusion
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Unanswered Questions
Many other questions followed
• Market response to information contained in new
accounting standards, auditor changes, other
forces that vary accounting numbers.
• Does the amount of abnormal share price change
correlate with the amount of GN/BN?
– BB’s study was based only on the sign of
unexpected earnings
Earnings
Response
Coefficient
(ERC)
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Earnings response coefficient [ERC]:
• The extent of share price return in response to
unexpected earnings (UE)
AR jt = αjt + λ jtUE
• λ = the response of Abnormal Share Return (AR) to
one unit of UE
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Searching for the Determinants of ERC
When (or for what types of firms) earnings
information is more important.
• Accountants can improve their understanding of how
accounting information is useful to investors.
• Preparation of more useful financial statements.
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Why explore the determinants of ERC?
Differential market response to reported earnings:
• Earnings persistence: Higher persistence →
Higher ERC
• Capital structure: Higher leverage → Lower ERC
• Growth opportunities: Higher growth
opportunities (GN or BN in current earnings may
suggest future growth prospect of the firm) →Higher
ERC
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Determinants of ERC
More value-relevant financial reporting:
(a) make growth opportunities explicit –e.g. segment info
and a detailed discussion of growth opportunities
(b) display all components of net income to allow
investors to assess what will and will not be permanent
effects
(c) expand disclosure of the magnitude and nature of
debt financing
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Implications of ERC research
Capital
Markets
Inefficiency
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Structure
1. Evidence of inefficiency with accounting information
(a) the “post-earnings announcement drift”
(b) the “accruals anomaly”
2. Potential reasons of inefficiency
• Irrational behavior
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Post-earnings announcement drift
• Efficient securities market theory predicts immediate
response to good news and bad news
• Abnormal share returns drift upwards or downwards for a
period of time (e.g. several months) following good news
or bad news announced in quarterly earnings (Bernard
and Thomas 1989)
• Buy shares with high unexpected earnings at
announcement date
• Sell short shares with low unexpected earnings at
announcement date
• Earns abnormal returns with no risk
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Trading strategy based on Post-
earnings announcement drift
‘Money
Machine’
Accruals anomaly
Sloan [1996]
Net income = OCF ± net accruals
Accruals have lower persistence than cash flows
• If markets are efficient, ERC should be greater the
higher the proportion of OCF relative to accruals, and
vice versa
• But investors fail to distinguish the OCF and accrual
components of net income
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Trading strategy based on
Accruals anomaly
• Buy shares of “low accrual firms”
• Sell shares of “high accrual firms”
• Strategy earned 10.4% above market return over 1
year
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‘Money
Machine’
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Market Inefficiency and
Behavioral Finance
• Evidence of anomalies is inconsistent with the efficient
market hypothesis
• Anomalies as a pre-cursor to behavioral finance
• Challenge in developing a behavioral finance theory of
markets
– Evidence of both over- and under-reaction to events
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Why may the security market be
inefficient
Individuals are not perfectly rational
1. Limited attention
2. Investors exhibit information processing
biases that cause them to over- and under-
react
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Individuals are conservative
• Put excess weight on prior beliefs, less weight on
new information than Bayes’ theorem implies
Individuals are overconfident
• overestimate the precision of information they
collect themselves
Why may the security market be
inefficient
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Motivated reasoning
• Accept at face value information that is consistent
with preference, receive with skepticism information
inconsistent with preference.
Self attribution bias
• Individuals feel that good decision outcomes are due
to their abilities, whereas bad outcomes are due to
unfortunate realization of state of nature, hence not
their fault.
Why may the security market be
inefficient
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Conclusion
1.Market Efficiency Hypothesis
•Semi-strong form
•Implication for financial reporting
2.Value Relevance of Accounting Information
•Ball and Brown (1968)
•Determinants of ERC
3.Market Inefficiency
•Evidence of market inefficiency
•Investors’ behavioral biases that cause market inefficiency
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Conclusion