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Capital Market Efficiency and Its Implication for Financial Reporting

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Capital market efficiency has been a widely debated topic since the term was introduced. The efficient market hypothesis was introduced by Eugene Fama in 1970 and is one of the most important topics that is covered in financial accounting theory. There have been many papers and studies that have backed the efficiency market hypothesis.

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There have also been many others that have tried to show that the markets are inefficient. Are securities markets efficient or not? I believe that they are, and because they are efficient, there are multiple implications of efficient securities markets for financial reporting.

In 1970, Eugene Fama introduced the efficient market hypothesis. Since there are many definitions and forms of an efficient securities market, I will focus my attention on the semi-strong form. In the semi-strong form, a market is considered efficient when security prices traded on that market at all times fully reflect all information that is publicly known about those securities. This hypothesis or theory has had many proponents for and many against it in recent years. These people have done their own studies and research on the market trying to either prove or disprove that the markets are efficient.

An important statement in the definition of an efficient securities market is publically known. It focuses on the theory that the market prices are efficient and include all publicly known information. It does not rule out that some people will have inside information, and they will know more about the company than the market. Since these people know more than the market, they may be able to earn excess profits on their investments if they choose to take advantage of their inside information.

While most insider trading is legal, it is illegal for insiders to trade when they trade with information that is not publicly known to further their own profits. By enacting trading laws, like insider trading, it just further solidifies that the markets are efficient. Market efficiency is a relative concept. This means that the market is efficient relative to the quality and quantity of the publicly known information. Nothing in the definition suggests that the current market prices reflect the real firm value. Due to the possible presence of inside information, for example, the market prices may be incorrect.

What the definition does imply is that once new or corrected information comes along the market will adjust the prices quickly. This adjustment happens because rational investors will revise their beliefs. They will start buying and selling securities due to their new beliefs which in turn will change prices. Another important point of the theory is that investing is fair game if the market is efficient. In an efficient market there is an expected return on that security, and one way to establish the expected or normal return is by using the capital asset pricing model.

In an efficient market, the investors cannot expect to earn excess returns on a security over and above the expected return of the capital asset pricing model. Under the efficient market hypothesis, a security’s market price should fluctuate randomly over time. The reason that prices will fluctuate is that anything about the firm that can be expected will be properly reflected in the price by the efficient market as soon as the expectation is formed. The only reason that prices in an efficient market will change is if some unexpected and relevant information comes along.

By examining a time series form by the sequence of price changes, the time series should fluctuate randomly. A random walk is a time series of price movements that will not follow any patterns or trends and that these past movements cannot be used to predict future price movements. There seems to be an increasing number of people against the theory of market efficiency including Professor Charles Lee (2010). He states that the market efficiency has its limitations. He uses the United States housing market as an example of a market that seems to have been dominated by greed.

He believes that emotions now dominate the markets and assist in setting the prices in the securities market. The other emotion that he points out is that of fear. The unwillingness to grant credit and to take risks are direct results of fear. Since these emotions dominate people’s actions, the markets are not as efficient as originally thought. Shiller (1984) created a model which featured two types of agents. The two types of agents are “smart-money” investors and noise traders (ordinary investors).

The smart-money investors focus on fundamental information and react quickly to news about fundamental information in an unbiased manner. Noise traders are vulnerable to fads and may also overreact to news. Noise traders may also trade for consumption-based or liquidity reasons. Since there are noise traders in the market that assist in driving prices, the markets are not completely efficient. Critics of market efficiency also point out that there are several recent instances where the market prices must have been set by psychological considerations instead of by rational investors.

The first example is the stock market crash of October 1987. During this crash, the general economic environment stayed the same, but the stock market lost about one-third of its value. A second example is the Internet “bubble” of the late 1990s. The values assigned to high-tech and Internet related companies were inconsistent with rational valuation. In looking at market efficiency, any large swings upwards or crashes downward that do not have related unexpected information can be signs that the market is not efficient.

Despite these cases and examples of reasons that the market is inefficient, I believe that for the most part the market is efficient. It is not completely efficient, nor will it ever be, but for the most part the securities are properly priced. I believe that if the market was not efficient, there would be more professional investors that would be able to beat the market as a whole. I believe that with the information and the speed with which it is available today it is more efficient than in 1970 when Fama first introduced market efficiency.

I do agree with the notion that there are some people who invest with emotions. When you talk to people about a company such as Apple, you will find just as many people who “love” the company as you will who dislike it. My feeling is that most of the emotion trading will for the most part cancel out and will not represent enough trading to dramatically adjust market securities prices. There are many fund managers who believe that they can outperform the market. Efficient markets depend on these participants who think that the market is inefficient and trade in the market in an attempt to outperform the market.

Jensen (1968) performed the first study of mutual fund performance. He found that active fund managers underperformed the market and were unable to add value. In my personal research, I have found that when looking at “professional” analysts opinions, they are all over the board. My belief is that fund managers should focus more on correctly diversifying people’s portfolios than suggesting and trying to get them to invest in securities that they feel are undervalued. In order for the market to be efficient, the arket must be able to quickly analyze and adjust prices for new information.

Nowadays with the Internet, investment journals that come out daily, and television shows and channels related to securities markets, the markets are more efficient than in the past. An example of the market being able to react quickly was in the article “The Stock Price Reaction to the Challenger Crash: Information Disclosure in an Efficient Market. “ Maloney and Mulherin found that “the market pinpointed the guilty party within minutes. Regardless of whether you agree with the efficient securities markets theory or not, there are many implications of efficient securities markets for financial reporting. In W. H. Beaver’s article “What Should Be the FASB’s Objectives”, he outlines four implications. The first implication is accounting policies adopted by firms do not affect their security prices, as long as policies are disclosed. The accounting policies have no differential cash flow effects, and the information is given so readers can easily convert across different policies.

The policy that is chosen will affect the reported net income, but it will not directly affect future cash flows and dividends. The efficient market is not fooled by different accounting policies when securities of firms are compared. The second implication is that efficient securities markets go hand in hand with full disclosure. Management should report firm information if the benefits are greater than the costs. Investors use information that is available to them to improve decisions in market efficiency. Confidence in the securities market will increase because of the information available.

An important standard of full disclosure is Management Discussion and Analysis. The objective of MD&A is to enhance investor understanding of the issuer’s business by providing supplemental analysis and background material to allow a fuller understanding of the nature of an issuer, its operation, and known prospects for the future. The third implication is that market efficiency implies that financial statement information does not need to be presented in such a form that everyone is able to understand. The majority of investors are educated and will understand the information as presented.

They are the ones who buy and sell and will move market prices to an efficient level. Naive investors are then price-protected since they can trust the efficient market to price securities. The final implication is that accountants are in competition with other information providers. With new pertinent information investors will change their beliefs. This revision of beliefs is a continuous process. If accountants did not provide useful, cost-effective information, the usefulness of this function would decline to other information sources.

Accounting information is generally useful to investors. The theory of efficient securities markets has been around for more than forty years. The concept should be around for many years to come. As in all theories, there are people that will continue to try to further prove the theory and people that will work to disprove the theory. From all available information and from my experience, I believe that securities markets are efficient. Due to the efficient securities markets, there are many implications for financial reporting.

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