Introduction

The purpose of this paper is to summarize theories and implications related to the efficiency
of securities markets. We begin with an explanation of the theory of market efficiency followed by a
brief evaluation of the capital asset pricing model. Next, some anomalies in the securities markets
are described, particularly with respect to the issues of post-announcement drift, the predictive
power of financial ratios and market response to accruals. After considering the implications of
market efficiency on financial reporting, the concept of information asymmetry and the significance
of full disclosure, we discuss the social importance of properly working securities markets.
The Theory of Efficient Securities Markets
According to the semi-strong form definition, an efficient securities market is one “where
the prices of securities traded on that market at all times properly reflect all information that is
publicly known about those securities.” (Scott 85) This definition yields a number of points worthy
of further elaboration. First, it should be stressed that the market is efficient only with respect to
information available to the public. Thus, persons who possess and take advantage of insider
information may be able to earn excess profits on their investments. Second, market prices are not
“all-knowing” reflections of real underlying firm value. In other words, the market is only efficient
relative to a set of publicly known information. This interpretation of market efficiency does imply,
however, that upon release of new or revised data to the public, security prices quickly adjust to the
information through the buy-and-sell decisions of investors. Third, under an efficient market,
investing is fair game; investors cannot expect to earn abnormal profits on risk-adjusted securities
and portfolios. The implication of such a definition is that market securities fluctuate randomly over
time, reacting in an unbiased manner to new and unexpected information. Often such market
efficient securities are described as exhibiting a random walk.
That being said, how can the market correctly reflect all available information when
individual investors differ in their prior beliefs and/or may interpret the same data differently? The
answer to such a problem lies in the idea that the market’s reflection of the value of a security is on
average correct or unbiased. There are, in fact, a sufficient number of knowledgeable and adept
investors that are able to interpret information objectively. Furthermore, the biased reactions of

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some investors effectively “cancel each other out”, so that the market price has superior quality
when compared to the information processing of any given individual.
The Capital Asset Pricing Model
The net rate of return on a security is calculated as follows: Rjt = [(Pjt + Djt)/Pj,t-1] –1.
Thus, returns are a function of the dividends paid by and changes in the price of a security. In an
economy with a large number of investors, the relationship between the efficient market price
of a security, its risk and its expected market rate of return is described by the capital asset
pricing model. Given that there is a risk free asset in the economy, security markets are efficient
and transaction costs are zero, CAPM shows that E(Rjt) = Rf (1- βj) + βj E(RMt).
Efficient Securities Market Anomalies
Research in behavioral finance has noted instances of investor behavior that appears to
challenge the theory of efficient securities markets. Thus, an alternative to the rational decision
theory has been developed—namely, prospect theory. Under prospect theory, an investor
contemplating an investment containing risk will evaluate possible gains and losses separately.
Moreover, the utility curve for losses is assumed to be convex, so that the investor exhibits “risk
taking” behavior with respect to losses, unlike the “risk aversion” behaviour with respect to gains.
This theory also states that investors tend to overweigh low payoff probabilities and underweigh
high payoff probabilities, and the resulting weighted probabilities need not sum to one.
Such an evaluation of investment prospects can lead to a wide variety of “irrational”
behavior. Widespread “irrational” behavior can lead the market to exhibit anomalies with respect to
what is predicted by efficient securities market theory. An overview of these anomalies follows:
Post-Announcement Drift
In a number of studies, it has been documented that abnormal returns persist for a period of
time in an upwards or downwards direction following the release of good or bad news respectively.
In fact, investors on the whole appear to underestimate the implications of current earnings for
future earnings, thus allowing certain astute individuals to earn arbitrage profits by purchasing
shares of good news firms on the day these companies announce their earnings and, similarly, short
selling shares of bad news firms. Counter to the theory of efficient markets, post-announcement

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drift seems to indicate that the market takes substantial time to incorporate news of current earnings
into stock prices.
Market Efficiency and Financial Ratios
The results of several studies suggest that the market waits until certain balance sheet
information appears in the income or cash flows of subsequent periods before reacting. If this is
indeed the case, it should be possible to devise an investment strategy that uses balance sheet data,
particularly financial ratios, to earn excess returns on the market. A number of researchers have
tested this theory and have found that the market can take as much as two years or react to
information evident in financial ratios, allowing investors to earn more than the market-wide return
in the mean time. Consequently, the theory of market efficiency is called into serious question.
Market Response to Accruals
Since accruals include such items as amortization and allowance for doubtful accounts, the
efficient market should react stronger to a dollar of good or bad news if that dollar comes from
operating cash flows, rather than if that dollar was the result of accruals. In other words, operating
cash flows provide better predictive values of a firm’s future earnings than do accruals. Research
evidence, however, suggests that investors do not distinguish between cash flows and accruals; once
again, this phenomenon runs counter to the theory of efficient markets.
A number of researchers have attempted to explain such anomalies in the context of efficient
securities market theory. For example, some have concluded that risk effects were driving the
results of these studies, whereas others suggested that previous research did not properly account for
the effects of firm size on expected returns. Another possible explanation presented was that
investment strategies required to earn arbitrage profits are quite expensive in terms of investor time
and effort and are, therefore, not cost-effective. Nevertheless, the anomalies presented above are
difficult to dismiss. In the end, one should conclude that the market is reasonably efficient – certain
anomalies may occur, but, generally, the market can be viewed as fairly efficient.
Implications on Financial Reporting
The theory of efficient securities market has a number of implications for financial
reporting. First, battles among accountants and managers over the use of alternative accounting
policies should be of no consequence unless different accounting policies have different cash flow

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effects. Second, the greater amount of cost-effective information a firm discloses about itself, the
greater is investor confidence in the market. Third, since the efficient securities market reflects all
that is publicly known about those securities, naïve investors are price protected; moreover,
financial mediums such as analyst reports and investment funds allow investors to utilize
sophisticated information without fully understanding it themselves. Finally, the efficient market is
not only interested in relevant information from financial reports, but from other sources as well,
such as the media and various company officials.
It should be noted here that the term “properly reflects” used in the definition of efficient
securities market should not be interpreted to mean that security prices are fully informative with
respect to all public information at all points in time. In fact, perfectly informative stock prices
would create somewhat of a logical inconsistency. Instead, security prices can be thought of as
partially informative, with some trades being driven by rationally informed investors and others
made by the random actions of liquidity or noise traders.
Information Asymmetry and Full Disclosure
Securities markets are subject to information asymmetry, which is the result of one type of
market participant knowing something about the asset being traded that another type of market
participant does not know. Information asymmetry exists in securities markets, as evidenced by the
excess returns that investors with inside information can make. Because they are aware of insider
trading, the majority of investors will lower the amount that they would otherwise be willing to pay
for shares to reflect their expected losses from the actions of insiders. This adverse selection
problem leads to a security market that does not work as well as it might in the absence of
information asymmetry. Thus, the importance of full and timely disclosure in financial reporting
cannot be overly stressed. Such disclosures make financial reporting more useful, thereby
improving the working of securities markets. Of course, since full reporting can be both financially
and strategically costly, the inside information problem cannot be eliminated completely.
The Social Significance of Properly Working Securities Markets
It is important that one recognize the social significance of properly working securities
markets. If investors are unable to obtain relevant and reliable security information, buyers and
sellers will withdraw from the market, leaving it thin or, equivalently, without depth. Social welfare

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will be reduced if scarce capital is not allocated to the most productive alternatives. To avoid this
type of “domino effect”, capitalist economies often impose penalties on companies that engage in
insider trading or avoid disclosure of materially significant events. Often, however, the natural
operation of the market can provide incentives for full disclosure. For example, a firm that signals
the high quality of their projects to the market by having insiders retain substantial equity positions
in the firm may be rewarded by greater prices for their shares.
Management Discussion and Analysis (MD&A) and Future-Oriented Financial Information
(FOFI) are examples of accounting standards that firms may adopt to enhance the quality of their
financial disclosures. MD&A’s are required for all companies that are registered with the Ontario
Securities and Exchange Commission or the U.S. Securities and Exchange Commission. Such
disclosures emphasize assisting the user with assessing the future prospects of a particular firm. An
MD&A may include information on such topics as a firm’s consumer environment, immediate
competition, risk factors and the prevailing interest rate. Similarly, FOFI is an incentive mechanism
available to those companies who wish to reflect a reputation for full and timely disclosure. Not
only do MD&A’s and FOFI’s aid the investor with investment decisions, but they also improve the
ability of securities markets to direct investments to their most productive uses.
Conclusion
The discussion and analysis of market efficiency presented above has a number of important
implications for the accounting profession. Namely, accountants need not concern themselves with
the interpretation of financial information by novice investors, nor should they argue about the
application of different accounting policies. Perhaps, most importantly, however, one should realize
that accounting will remain useful only if it provides relevant, reliable and timely information in a
cost-effective manner. After all, accounting is only one source of security information; if investors
deem such data to be worthless, many in the profession may find themselves unemployed. Thus, it
is crucial that the integrity and reputation of accounting be protected through the independence,
competence and honesty of its professionals.

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CHAPTER 4 QUIZ (Out of 20 marks)

Section I: Multiple choice (1 mark each)

Select the one best answer for each of the following questions.

1) Security market efficiency implies that which one of the following would be true?
a) Information can be released more easily in financial statements than in footnotes.
b) Information can be released more easily in supplementary disclosures than in
footnotes.
c) Information can be released less easily in supplementary disclosures than in financial
statements.
d) Information can be released equally as easily in financial statements, footnotes, and
supplementary disclosures.

2) Suppose that an insurance company offers life insurance without requiring a medical exam
of its clients. Consequently, HIV-infected people flock to buy insurance from this company.
The problem faced by this insurance company is most aptly described as the
___________________ problem.
a) Moral hazard
b) Adverse selection
c) Misinformation
d) Ethical danger
e) Information separation

3) Bob purchases a share of security XXX at the beginning of the year for $20. Over the course
of the year, he expects to receive $2 in dividends from holding that security. At the end of
the year, Bob expects that he will be able to sell his share of security XXX for $25. Ignoring
tax effects, what is Bob’s one-year expected return?
a) 0%
b) 10%
c) 20%
d) 35%
e) 45%

4) Which of the following is not an assumption made in the Sharpe-Lintner CAPM model?
a) There is a risk-free asset in the economy.
b) Security markets are efficient.
c) Transaction costs are zero.
d) There is no uncertainty.
e) All of the above are assumptions made in the Sharpe-Lintner CAPM model.

5) Ivan has just lost $10,000 on an investment. There is an opportunity for him to gamble
another $10,000; with this second gamble, there is a 40% probability that he will win back
the $10,000 he lost (and come out even) and a 60% probability that he will lose the
additional $10,000 (for a total loss of $20,000). Despite the negative expected value of

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 taking this second gamble, Ivan decides to take it. Ivan’s risk taking behavior would best be
explained by
a) Rational decision theory.
b) Prospect theory.
c) Personal decision theory.
d) Irrationality theory.
e) None of the above.

6) An investor faces uncertainty in holding a diversified portfolio because of the randomness of

the market return. This uncertainty is best described as
a) Exogenous uncertainty.
b) Extreme uncertainty.
c) Endogenous uncertainty.
d) Random uncertainty.
e) None of the above.

7) According to Sloane, other things equal, efficient markets should react most strongly to
which of the following scenarios?
a) Net income increases $100,000 as a result of a $50,000 increase in operating cash
flows and a $50,000 increase in net accruals.
b) Net income increases $100,000 as a result of a $100,000 increase in operating cash
flows and a $0 increase in net accruals.
c) Net income increases $100,000 as a result of a $0 increase in operating cash flows
and a $100,000 increase in net accruals.
d) Efficient markets would react equally strongly to each of the above scenarios.

8) Which of the following is not one of the implications of efficient securities markets for
financial reporting according to Beaver (1973)?
a) Accounting policies adopted by firms do not affect their security prices.
b) Efficient securities markets go hand in hand with full disclosure.
c) Firms should not be overly concerned about the naïve investor.
d) Accountants are in competition with other providers of information, such as financial
analysts and the media.
e) All of the above are implications of efficient securities markets for financial
reporting according to Beaver.

9) The primary objective of the Management Discussion and Analysis disclosure requirement
is to enhance which of the following characteristics?
a) Representational faithfulness
b) Relevance
c) Reliability
d) Comparability

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 10) Which of the following statements about future-oriented financial information is false?
a) Section 4250 does not require that FOFI be presented.
b) FOFI applies to forecasts, but not to projections.
c) According to Section 4250, the period covered by FOFI would normally not extend
beyond one year.
d) FOFI should be prepared in accordance with the accounting policies to be used in
presenting historical financial statements for the future period.
e) All of the above are true.

11) Under ideal conditions, the firm’s market value reflects_______________ information.
When conditions are not ideal, but the security markets are semi-strong efficient, then the
firm’s market value reflects _________________ information.
a) all publicly available; insider
b) all; insider
c) historical; all publicly available
d) all publicly available; historical
e) all; all publicly available

12) One explanation for the post-announcement drift is that investors appear to ____________
the implications of current earnings for future earnings. In the context of the information
system relating current earnings to future earnings, this means that the average investor
evaluates the main diagonal probabilities as ______________ they really are.
a) Overestimate; greater than
b) Underestimate; less than
c) Accurately estimate; equal to
d) Underestimate; greater than
e) Overestimate; less than

13) Joe Student sells his shares of security X because he needs the cash to pay his tuition. Joe
would be most accurately described as what type of trader?
a) Noise
b) Value
c) Random
d) Unbiased
e) Irrational

Section II: Short Answer (number of marks is given in parentheses)

14) Explain the concept of information asymmetry. Describe, with reference to examples, the two
major types of information asymmetry (3).

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15) Read the attached article “Mad Catz Director Not So Mad When It Comes to Timing.”
According to the article, are insiders able to earn excess profits? If so, how? Comment on the
implications of insider trading on the efficiency of securities markets (I.e. Assuming that insiders
can earn excess profits, does this mean that securities markets are not efficient?) (4)

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SOLUTION TO CHAPTER 4 QUIZ

Section I: Multiple Choice

1) d (page 83)
2) b (page 106)
3) d (page 89)
4) d (page 89)
5) b (page 94)
6) a (page 92)
7) b (page 97)
8) e (pages 100 to 102)
9) b (page 110)
10) b (page 118)
11) e (page 108)
12) b (page 95)
13) a (page 93)

Section II: Short Answer

14) Explain the concept of information asymmetry. Describe, with reference to examples, the two
major types of information asymmetry (3).

 Information asymmetry occurs when one type of participant in the market knows
something about the asset being traded that another type of participant does not know. (1)
 The first major type of information asymmetry is moral hazard. (0.5)
Example: Suppose that an insurance company reimburses students for their full income loss
if they fail to attain a university degree due to poor health. The insured student has an
information advantage over the company because only the student knows whether his failure
is due to health reasons. A moral hazard occurs because the student would be tempted to
cheat the company by shirking his studies, failing, and then getting the proceeds from the
insurance.
(0.5 for any credible example)
 The second major type of information asymmetry is adverse selection. (0.5)
Example: Suppose that an insurance company reimburses students for their full income loss
if they fail to attain a university degree due to poor health. Students with poor health would
flock to enroll in university programs (and then collect on their policies when their health
fails). An adverse selection problem occurs because people whose health is adverse to the
insurance company’s best interests self-select themselves to buy insurance.
Example: Insiders know more than outsiders about the true quality of their firms. Insiders
will be tempted to use their information to earn excess profits, which is adverse to the
interests of investors.
(0.5 for any credible example)

15) Read the attached article “Mad Catz Director Not So Mad When It Comes to Timing.”
According to the article, are insiders able to earn excess profits? If so, how? Comment on the

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implications of insider trading on the efficiency of securities markets (I.e. Assuming that insiders
can earn excess profits, does this mean that securities markets are not efficient?) (4)

 Yes, insiders are able to earn excess profits according to the article. (1)
 As illustrated in the article, Mr. McWhinnie of Mad Catz was able to save himself from a
sizeable loss by selling his company’s stock shortly before announcing that the firm lost its
Sony contract.
(1 for any illustration with reference to the article)
 Insiders are able to earn excess profits by taking advantage of information asymmetry.
They have an information advantage over the general public, which only has access to
publicly known information. Insiders can time their trades to take advantage of information
about the company before it becomes publicly announced. (1)
 This article implies that securities markets are not strong-form efficient, since strong-form
efficiency implies that prices properly reflect all information, including insider information.
If this were the case, then insiders would not be able to make excess profits. (1)
 The securities markets are probably semi-strong efficient—securities prices properly reflect
all information that is publicly known about the firms. For markets to be semi-strong
efficient, it is not assumed that prices incorporate the knowledge that insiders possess. (1)
 Market efficiency is a relative concept. The markets may be efficient relative to a stock of
publicly known information; this does not mean that securities prices have to always reflect
underlying firm value. Consequently, insiders can use their information to benefit from
mispricings in the market (1).
 Full and timely disclosure will reduce the problem of insider information, thereby making
financial reporting more useful to investors and improving the efficiency of securities
markets. (1)

(1 mark for each of the above points or any other credible points, to a maximum of 4)

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