6.2 Are Securities Markets Fully Efficient?

There is evidence that shares are misprices relative to their efficient market values, thus questions have
been raised about investor rationality and market securities. This is important to accountants because if
those questions are valid, this effect the effectiveness of supplementary information in delivering useful
information to investors. If shares are overpriced, improved financial reporting may help reduce
inefficiencies and make securities markets work better.

Average investor behavior may not correspond to the rational decision theory and investment models.
For example, individuals may have limited attention, meaning they do not have the time or availability
to process all available information causing them to only focus on the obvious and readily available
information and not take into consideration the other details. Also, individuals may be biased in their
reaction to information, relative to how they would react according to Bayes’ Theorem. For example,
they can be conservative in their reaction to new information, attaching them selves to prior beliefs.

Psychological Theory suggests that individuals can be overconfident – overestimating the precision of
information they have gathered or obtained themselves. Another individual characteristic from
psychology is representativeness – the individual focuses on evidence that is in line with the impression
or idea retrieved from the population from which the evidence is drawn. Another characteristic of many
individuals is self- attribution bias – the individual feels that good decisions are due to their abilities and
bad ones are not their fault. If an overconfident investor buys shares, and the share price rises, then the
faith in his investment rises. However if the share price falls, faith in ability does not fall. If all investors
acted this way, share momentum can develop. All these behavioral characteristics discussed are
inconsistent with market securities.

Motivated reasoning is a different behavioral characteristic – individuals accept at a face value

information consistent with their preferences. If information is inconsistent with their preferences, the
individual will attempt to discredit it.

In summary, behavioral characteristics can produce different share price behaviors over time. The study
of behavioral based securities market inefficiencies is called behaviorial finance.

6.2.2 Prospect Theory

This theory of Kahneman and Tversky provides a behavioral- based alternative to rational decision
theory. This theory suggests that an investor considering a risky investment will separately evaluate
gains and losses. This contrasts with decision theory. This separate evaluation of gains and losses is an
implication of narrow framing – analyzing problems in an isolated way to make decision making easier.
This will lead to limited attention. This theory assumes loss aversion – when individuals dislike even
small loses. This leads to investors having risk-taking behavior with respect to losses, leading to
disposition effect - where the investor holds on to losers and sells winners, and he may also buy more of
a loser security. Prospect theory also suggests that individuals under or overweight heir probabilities
when calculating the expected value of a prospect. Underweighting probabilities is a consequence of
overconfidence, because the individual will underweight the information not gathered by himself.
Overweighting is a consequence of representativeness – where the investor will overweight information
that is consistent. This separate evaluation of gains and losses can lead to irrational behaviors.
6.2.3 Is Beta Dead?

An suggestion of the capital asset pricing model is that A stocks beta is the sole firm-specific
determinant of the expected return on that stock. If the CAPM takes into consideration rational investor
behavior, then share returns shouldn’t be affected by other measures of firm related risks. However,
Fama and French found that beta and CAPM had little ability to explain stock returns. So instead of
looking at Beta as a risk measure, the market acts as if firm risk increases with book-to-market and
decreases with firm size. These findings are not necessarily inconsistent with rational investor behavior.
The results do threaten the CAPM since they imply that beta is not an important risk measure. This low
power for beta has led some to suggest that beta is “dead”. However, Kothari, Shanken, and Sloan found
that over a long period of time beta was an important predictor of return. B/M also predicted return,
but its effect was relatively weak.

Behavioral finance’s perspective is that share return behavior inconsistent with the CAPM is viewed as
evidence of market inefficiency. In result, a model presented by Daniel, Hirshfield, and Subrahmanyam
was presented assuming both investors, rational and overconfident. Rational investors cause a stock’s
beta to be positively related to its returns, just like the CAPM. However, overconfident investors
overreact to self obtained information driving prices too low or too high and the B/M as well.

A possible way for beta to be rescued is to recognize it may change over time. However changes in
interest rates, firms cost and capital structures, improvements in firms abilities to manage risks all may
affect the value of a firm’s beta.

Because of the mixed evidence, it can be concluded that beta is not dead, however it may change over
time and may have to “move over” to share its status as a risk measure with accounting-based variables.

6.2.4 Excess Stock Market Volatility

Shiller found the variability of the stock market index was greater than the variability of aggregate
dividends. He interpreted this as evidence of market inefficiency. A possible explanation for this
inefficiency is that behavioral factors increase stock market volatility. A different argument made by
DeLong, Shleifer, Summers, and Waldmann assumes a capital market with both rational and positive
feedback investors – those who buy in when share prices begin to rise, and vise versa. The authors
argues that rational investors instead take advantage of the price increase while it lasts. As a result,
there is excess volatility in the market. Another study by Ball, Sadka, and Sadka compares the variability
of earnings to the variability of stock market returns. They found that a large portion of earnings
variability is explained by economy wide factors and that aggregate earnings and stock market returns
are highly correlated, and that earnings variability explains a significant portion of returns variability.
These results, unlike Shiller’s, are more consistent with securities market efficiency.

6.2.5 Stock Market Bubbles

Stock market bubbles are when share prices increase above fundamental values. They represent an
extreme case of market volatility. Shiller argues that bubble behavior can continue for some time and it
is hard to predict when it will end, however it will eventually end because of recession or inflation. The
2007-2008 market meltdown Is generally recognized as a bubble. However the development of a bubble
does not contradict market efficiency. Because efficiency is relative to publicly available information, it is
important in terms of securities market efficiency to know whether the information at that time was
sufficient enough to diagnose the riskiness. If it was, then behavioral theories are supported and that at
least some information relevant to the collapse was in the public. However this information may have
not been sufficient to work against the general impression at the time that asset based securities wear a
better way to bear risk.

6.2.6 Discussion of Securities Market Efficiency vs. Behavioral Finance

The behavioral finance theory and evidence available raise questions about the extent of securities
market efficiency and rational investor behavior. Fama evaluated this evidence and concluded that while
there is evidence that market behavior inconsistent with efficiency, there is no theory that predicts and
integrates the atypical evidence. For example, evidence of overreaction of share prices to information is
just as common as underreaction. However Fama’s concern lacks a theory that predicts when the
market will overreact or underreact. Barberis, Shleifer, and Vishny drew on the behavioral concept of
conservatism to explain underreaction, and representativeness to explain overreaction. So according to
these authors, underreactions occurs when new evidence comes along on a one-time basis, and
overreaction occurs when there is a longer-term increase in earnings causing investors to assume this
continuation in growth. A study by Ahmed, Kilic, and Lobo found that there is no significant share price
reaction to the value of derivatives disclosed as supplemental information but a positive reaction when
disclosed on the balance sheet. This finding contrasts with efficient securities market theory. By setting
out the conditions under which different behavioral characteristics cause overreaction and
underreaction, behavioral researchers are responding to Fama’s concern.

6.3 Efficient Securities Market Anomalies

Recall that the evidence described in Chapter 5 generally supports efficiency and
the rational investor behaviour. However, other evidence suggesting that the
market may not respond to accounting information exactly as the efficiency theory
predicts. For example, share prices may not fully react to financial statement
information right away, so that abnormal security returns continue for some time
following the release of the information. Also, it appears that the market may not
always extract all the information content from financial statements. Statistically,
anomalies such as these imply that share returns are serially correlated, whereas,
under market efficiency, serial correlation is zero.
Cases such as these that appear inconsistent with securities market efficiency are
called efficient securities market anomalies.

We now consider two such anomalies.

1- Post-announcement Drift (PAD):

 Abnormal share returns drift upwards or downwards for several months following GN or BN in
quarterly earnings.
 Efficient securities market theory predicts immediate response to GN or BN in reported
earnings.

 Reasons for PAD:

1- Investors limited attention. (which investors do not exert the time and effort needed
to fully understand the serial correlation of quarterly earnings changes.)

2- Conservatism of financial reporting.

3- Effects of inflation on financial statements. (Instead of anticipating the effects of

inflation on future earnings growth, investors see waiting until the increased
or decreased earnings show up.)

4- Lack of timeliness of analyst forecast revisions.

5- Investors’ lack of confidence in management forecasts.

2- Accruals anomaly

Sloan (1996), separated reported net income into operating cash flow and
accrual components
 Net income = Cash flow from operation ± net accruals
 Accruals are more subject to errors of estimation and possible
manager bias than cash flows and argued that this lower reliability
should reduce the association between current accruals and next
period’s net income.

 The cash flow component of earnings is more persistent than

the accrual component.
The persistence is the extent to which the good or bad news in current
earnings is expected to continue into the future. Since accruals are
less reliable than cash flows, the good or bad news they contain in the
current period is less likely to continue into the next period than good
or bad news in cash flows.

 Reasons for accrual anomaly:

1- Low persistence, low reliability accruals may be ignored by investors.
2- Investors may ignore possibility of lower future returns for growth companies.
Some recent evidence that PAD & accruals anomalies has almost disappeared.

6.4 Limits to Arbitrage

• Reasons why anomalies may persist over time this is what called ‘’ limits to arbitrage’’

1- Behavioral biases between investors:

 E.g., limited attention, conservatism.
 As a result, investors continue to ignore full information content of financial
statements.

There are costs incurred by investors that limit their ability to fully exploit an
anomaly:

• Transactions costs (brokerage commission): It may not be worth exploiting anomalies if costs are
too high

• Idiosyncratic risk (i.e., firm-specific):

 To exploit anomalies, investors must depart from diversified investment strategy, thus
bearing idiosyncratic risk.
 Resulting risk may deter investors from exploiting the anomaly.

Persistence of anomalies may be due to unsophisticated, small trade, investors.

Why Do Anomalies Occur in First Place?

In face of estimation risk, rational investors learn over time, revising their beliefs as new information
comes along, this creates share price behavior similar to that of the anomalies.

6.5.1:

 The analysis of the financial statements may help the rational investor is unlikely to know the
answer with complete accuracy.

For example: to inside information, possibly compounded by poor disclosure.

 The investor faces estimation risk with respect to the underlying non-stationary firm parameter
of expected earning power.
  To reduce the estimation risk, investors will watch for additional information. If expected
earning power has in fact increased, new information that is on balance favorable will be
observed over time.

 For each information item, investors will revise their expected earning power estimate and will
buy additional shares.

 If expected earning power has not increased, unfavorable information will be observed over
time. Then, we would expect the share overvaluation to reverse as the overvaluation is
revealed.

 A related share mispricing argument is given by Lo’s adaptive market hypothesis (2004). Like
Brav and Heaton, Lo dropped the rational expectations assumption that underlies much of the
theory of market efficiency. Instead, investors are viewed as boundedly rational (Simon, 1955)
21 . That is, when their environment changes (e.g., higher reported firm profits, increased
awareness of firm risk).

 Callen, Khan, and Lu (CKL; 2013), who examined delayed share price reaction to new
information, based on a large sample of firms over the period 1981–2006.

Using several quality measures, including the accrual quality measure of Dechow and Dichev
( Section 5.4.1 ), they found the following:

o The higher accounting quality is significantly associated with lower delay.

o A significant positive relationship between a firm’s delay and its future abnormal share
returns, consistent with investors demanding a higher return on shares for which they
perceive greater estimation risk.
(These results are consistent with average investor rationality, even though the
existence of delay implies less-than-full market efficiency)

6.5.2:

 Higher order beliefs: When investors make decisions on the basis of their beliefs about the
beliefs of others, instead of solely on their beliefs about relevant states of nature.

 Our interest in higher order beliefs arises because such beliefs by rational investors can produce
share price behavior similar to that predicted by behavioral finance.
  As Allen, Morris, and Shin (AMS; 2006) modelled a market composed of overlapping generations
of rational, short-term, risk-averse investors, each generation “lives” for 2 periods.

 The source of the private messages could be from each investor’s more detailed examination of
the firm’s financial report.

 The AMS model has a number of implications:

o Serial correlation of security returns is interpreted by many behavioural finance-based
studies, such as the post-announcement drift and accruals anomalies.
o The initial noisy public message is, say, below fundamental firm value, price rises over
time.

 In addition, other investors (whose private message is bad news) will believe a security is
overvalued even though its price keeps rising.

 Elliott, Krische, and Peecher (EKP; 2010):

o They presented a group of 67 experienced financial analysts with financial information
about a firm and the ended with the result that the firm’s shares will be overpriced.
o Manipulated the transparency of disclosure of this earnings management.
o also manipulated the firm’s investor base by varying the type of sophisticated investor.

As a result, EKP predicted that when earnings management becomes more transparent, the
analyst subjects will expect greater share mispricing when transient investors have primary
influence on share price.

6.6:

 There are several possible reasons underlying the inefficiency implied by the inner circle:
o One reason derives from behavioral finance, under which behaviorally biased investors
do not take all publicly available information into account in their decisions.
o Second reason, suggested by Lee (2001), derives from behaviorally biased noise traders,
who may drive market price away from the efficient market ideal.

 The rational investor, unsure whether or not current increased earnings represent a persistent
increase, places some probability on both possibilities
6.7 Conclusion about securities market efficiency and investor rationality:

we can’t ask the market is efficient or not efficient, the right question is the extent of efficiency.

The market not always fully efficiency based on:

1- The development of liquidity pricing following a bubble.

2- Various lags in the convergence of price efficient values.
The market behavior is reasonably consistent with average investor rationality:

 Experimental studies supporting non – rational investor.

 The bubble leading up to 2007-2008 meltdown, that market tried to adjust for off balance sheet
risk, available information may not have been sufficient to fully diagnose this risk. Complex
financial instrument such as assets backed securities lacked transparency.
 Standard setters are introducing new standards for derecognition of securitized assets,
consolidation and expanded disclosures. Also, major audit agencies are reconsidering rules to
reinforce the objectivity and independence of the auditing profession and increased disclosure
by audit committees or auditors.
 Security price change fluctuate randomly on an efficient market, that is security returns don’t
predict unexpected events.
 Lack of transparency, complex financial instrument, inadequate reporting of off-balance sheet
obligations and sudden realization of the high correlation of market lead to increase in version
to risk.
6.8 Other reasons supporting a measurement approach:

 Investor need more information for firm performance than they obtain from historical cost
statements.
 clean surplus theory shows that the market value of the firm can be expressed in terms of
income statement and balance sheet variable. while clean surplus applies to any basis of
accounting, that firm value depends on fundamental accounting variable is consistent with a
measurement approach.

6.9 The low value relevance of financial statements information:

o Ball & Brown concluded “that most of the information in net income was built into share price
prior to its announcement date”
o This conclusion was investigated by Lev “that market response to the good / bad news in
earnings is really quite small.
o Value relevance is closely related to the concept of earnings quality. So, it uses the abnormal
change in share price surrounding earnings release to measure the extent to which financial
information assists investors to predict future firm value.
o Historical cost accounting and conservatism mean that net income lags in recognizing much
economically significant information
o Earnings quality could be improved by introducing a measurement approach into the financial
statements, thereby recognizing value relevant event sooner.

6.10 OHLSON’S CLEAN SURPLUS THEORY

6.10.1 Three Formula for Firm Value

- The Ohlson clean surplus theory provides a framework consistent with the measurement approach, by
showing how the market value of the firm can be expressed in terms of fundamental balance sheet and
income statement components.

- The theory assumes ideal conditions in capital markets,

- outline of the theory is based on a simplified version of Feltham and Ohlson

- The clean surplus theory model is also called the residual income model

- FO pointed out that the fundamental determinant of a firm’s value is its dividend stream

- The market value of the firm can also be expressed in terms of financial statement variables. Which is
BV + goodwill or Expect PV of expected future earnings

- Zero goodwill represents a special case of the FO model called unbiased accounting

6.10.2 Earnings Persistence

- FO then introduced the important concept of earnings persistence into the theory. Specifically, they
assumed that abnormal earnings are generated according to a formula which represent the Earrings
Dynamic

- The implications of the FO model with persistence are twofold. First, even under ideal conditions, all
the action is no longer on the balance sheet. The income statement is important too, since it reveals the
current year’s abnormal earnings

- Second, the formula (Equation 6.2) implies that investors will want informa- tion to help them assess
persistent earnings, since these are important to the future performance of the firm. Accountants can
help in this regard by appropriate clas- sification of items with low persistence

6.10.3 Estimating Firm Value

- The FO model can be used to estimate the value of a firm’s shares. This can then be compared to the
actual market value, to indicate possible over/undervaluation by the market, and to aid in investment
decisions

- Despite discrepancies between the estimated and actual share value, the FO model can be useful for
investment decision making

To Summarize:

- Clean surplus theory has had a major impact on financial accounting theory and research
- better earning predictions
- Better estimates of unrecorded goodwill which leads to better predications of firm value and
better investment decisions
 - less potential for investor mistakes in estimating this complex component of firm value since
most of the value is taken from the current values in balance sheet rather than estimating the
unrecorded goodwill

6.11 Auditors legal liability

Gains Trading/Cherry picking: Where investor portfolios were valued at cost basis and when at least
some securities have risen in value a firm can realize a gain by selling securities that have risen, while
continuing to hold securities that have fallen in value, so, no loss was was recognized on the held
securities.

Auditors/accountants can be put under pressure to bend or stretch GAAP but that could lead to legal
liabilities.

6.12 How can auditors protect themselves against pressures and potential liabilities?

Ethical behavior by unconditional conservatism and conditional conservatism.

Unconditional conservatism: is defined as an accounting bias towards reporting low book values of
stockholder equity.

Conditional conservatism: stresses the timeliness of loss recognition.

6.13 If auditors are penalized for investor losses arising from overstatements, why are they not also
penalized for investor loses arising from understatements?

While the amount of the misstatements could be the same, the investors loss of utility for an
overstatement is more than the loss for an understatement of the same amount. So, an auditor is more
likely to be sued for overstatement errors than understatement errors.

Early disclosure of BN tended to reduce the amounts of lawsuit settlements.