ACCOUNTING THEORY
price.
Chapter 4
Efficient Securities Markets
 An efficient market is one where security prices
accurately reflect the collective knowledge of
investors.
 Investors will seek information, but they must
balance the cost of information against the benefits
received.
 Accounting reports communicate inside
information to outside users.
 This process improves decision making and the
efficiency of the market.
 Informed investors will spend considerable time
and money gathering information.
 If enough investors act this way, the market should
become efficient.
 The semi-strong form of efficiency suggests that
market prices reflect all public information.
 Insider trading is still possible, however, is due to
information asymmetry.
 Efficiency is relative to the amount of information
available. There is no absolute measure of
efficiency.
 Thus, the price of any security may still not reflect
true economic value.
 In an efficient market, excess returns shouldn’t be
possible in the long term. Efficiency implies that
the market is a fair game.
 In an efficient market, security prices should
fluctuate randomly over time.
How Does E.S.M. Work?
 Review football forecasting example on page 112
of the textbook.
 The consensus decision outperformed individual
forecasts.
 Individual errors tend to cancel each other out with
the consensus.
 Although E.S.M. does not guarantee accurate
prices, it does suggest that prices react quickly to
new information.
Capital Asset Pricing Model
 Under CAPM, the market price reflects what the
market expects about the firm’s future
performance.
 The share price will be adjusted so that the
expected return will equal the return demanded by
the market.
 If beta is high (systematic risk), investors will
demand a higher return, or else the market price
will drop.
Implication of E.S.M. on Financial Reporting
1) Accounting policy choice should not affect share
o However, full disclosure is required
2) All relevant information should be disclosed.
oThe market will make use of all information
oIncreased disclosure improves investor
confidence
oHowever, the benefits of additional disclosure
must exceed the costs
3) Companies should not be concerned with naïve
or uninformed investors
oInformed investors will drive price to correct
level
oNaïve investors can mimic the informed
investors, and are thus price protected
4) Accountants compete with other information
sources
oAccountants must strive to provide relevant,
cost effective information
Informativeness of Price
 If the market is efficient and security prices are
fully informative, then why would investors gather
more information?
 This logical inconsistency can be explained by the
presence of “noise traders”
Noise Traders
 Some people trade shares for irrational reasons.
 The presence of noise traders means that the
market prices are not fully informative.
 Therefore, investors will gather further information
to filter out the “noise” and revise their
expectations appropriately.
 Carl Icahn – recent articles related to Apple –
noise???
Social Significance of E.S.M.
 Securities markets are important for raising and
allocating scarce capital to the most productive
alternatives
 Therefore, it is important that stock prices reflect
the fundamental values of companies
 However, information asymmetry may hinder the
efficient operation of securities markets
Information Asymmetry and E.S.M.
 Insiders may withhold, delay or bias information
 Investors will then lose confidence in the market
because share prices do not reflect fundamental
value
 Investors may lower the price offered for all
securities, as they are unable to distinguish
between good and bad economic prospects. The
process is known as pooling
 If investors lose too much confidence, they may
withdraw completely from market
 Securities markets may then collapse, which would
hinder economic development.
Responses to Prevent Market Collapse
 Penalties can be used to prevent insider trading
and enforce full disclosure.
 Agencies such as securities commissions enforce
regulations by applying penalties.
 However, regulation may not always be fully
effective at reducing information asymmetry.
 Incentives may provide motivation for companies
to voluntarily disclose information
 A company may develop a reputation for full and
fair disclosure which would increase investor
confidence in that company and thus increase
share price and reduce the cost of capital
 However, these benefits will not be realized in the
short term.
Conclusions
 Supplementary information is just as useful to
investors as information contained within the
financial statements
 Market efficiency is relative to the amount of
publicly available information
 Financial reporting can increase the amount,
timing and accuracy of public information, and thus
improve market efficiency
Chapter 5
The Value Relevance of Accounting Information
 Research has shown that stock prices do respond
to net income and other accounting information.
 When security prices respond to accounting
information, it is known as value relevance.
 The information approach recognizes that
investors want to make their own predictions about
future firm performance.
 This approach concentrates on providing useful
information for decision making.
 Thus, full disclosure and not valuation is the focus
of financial reporting.
 This is the approach that has historically
dominated accounting standard setting. Although
still relevant, the approach has begun giving way
to the measurement approach, which will be
discussed in Chapter 6.
Outline of the Research Problem
 The following predictions about investor behavior
can help us understand the research that has been
conducted to assess the usefulness of financial
reporting:
oInvestors have prior beliefs about risk, return,
future earnings and cash flow.
oUpon release of the current period financial
information, investors will decide to become
more informed.
oInvestors who revise their beliefs upward will
be inclined to buy more shares.
oThe volume of shares traded will increase
when the firm reports its income.
Overall:
oInvestors will analyze net income.
oIf net income is interpreted as good news,
investors will revise their beliefs upward.
oInvestors will then buy more shares.
oThis should increase both trading volumes and
share prices.
oIf bad news received, the share price should
go down, but trading volumes will still
increase.
 William Beaver completed study in 1968 that
confirmed increased trading activity after Net
Income was released.
 However, decision usefulness can be better
demonstrated by examining share price reaction to
financial information, and not just trading volumes.
 When examining changes in share price, however,
one must consider:
When did net income actually become known?
Good or bad news is relative to investor
expectations.
There are many factors affecting share price
other than net income.
Ball and Brown Study
 This 1968 study looked at 261 NYSE companies
over a 9 year period.
 Prior year earnings were used as the proxy for
investor expectations.
 Companies reporting good news had positive
securities returns the month after earnings release.
Likewise, bad news companies reported negative
returns.
 Subsequent studies found the market anticipated
news up to a year before the earnings release.
 Investors were thus getting information from other
sources.
 This implies that accounting information is
associated with abnormal share returns above the
market, but is not the cause of those returns.
Earnings Response Coefficients (ERC)
measures the extent of a security’s abnormal
market return in response to the unexpected
component of reported earnings.
 Why does the market react differently to the same
news from different companies?
 ERC research suggests the following:
High beta stocks are less responsive to good
news.
Highly leveraged stocks are less responsive to
good news.
Earnings persistence increases investor
response.
Earnings quality increases investor response.
Growth opportunities increase investor
response.
A similarity of investor expectations will
increase the market’s response.
Price informative (highly visible) companies
have lower ERCs.
Implications of ERC Research
 Less visible companies should increase
disclosure.
However, some argue that only large
companies should be required to fully
disclose, due to cost constraints.
 Highly leveraged companies should increase non-
earnings disclosure (i.e. off balance sheet items
and financial instruments).
 Segment information will help investors assess
growth opportunities.
 Full disclosure of the components of net income
will help in the assessment of earnings
persistence.
Extraordinary Items (EI)
 Full disclosure is important, as these items are not
persistent.
 3 criteria for classification as an EI
The event is infrequent.
The event is not typical of normal business
activities.
The event was not due to a management
decision.
 IAS 1 prohibits the disclosure of extraordinary
items.
 The third criteria was introduced to alleviate the
problem classificatory earnings management.
 However, the standard resulted in some non-
persistent items being reported in operating
income.
 Since IFRS prohibits disclosure of EI, which may
make the evaluation of persistence more difficult.
Caveat About Best Accounting Policy
 Although information may be useful to investors,
the quantity and quality of the information
disclosed may not produce the best result for
society.
 This is because accounting information is a public
good (i.e. its consumption cannot be measured).
 Thus, the forces of supply and demand will not
determine the correct amount of information
production.
 As a result, there may be a need for regulation of
the information industry to promote the production
of the socially correct quantity and quality of
information.
 However, accountants still need to be aware of the
market response to information as they compete
with other information sources.
 Note that information costs can be the cost to
report or cost of disclosure to competition.
Information Content of RRA
 RRA should be relevant, as it provides information
about future earnings potential.
 However, several studies have found only a weak
market reaction to RRA.
 The lack of precision in the estimates and the
relatively untimely disclosure of RRA information
has likely resulted in the muted investor response.
Conclusions
 Research suggests that financial statements are
useful.
 Investors use financial statements to estimate risk
and future returns.
 The market hasn’t responded well to some non-
earnings information, such as RRA.
 This could be due to reliability problems and the
use of alternative information sources.
 The information approach suggests that investors
will use all relevant information.
 Accountants must thus be aware of what
information is useful.
 Accountants must convert this inside information to
external information.
 However, the accountant should not assume that
the most market-responsive information is
necessarily the best for society.
CHAPTERS 6
Measurement Approach to Decision Usefulness
 Investors are more interested in the values of
assets than their historical costs.
 The measurement approach incorporates market
value and fair value information directly into the
financial statements, as long as it can be done with
reasonable reliability.
 This approach recognizes the accountant’s role in
assisting investors to make decisions.
Are securities markets efficient?
 It has been asserted that security prices respond
to financial statements
 However, research by Lev concluded that only 5-
6% of security price changes were due to earnings
information.
 Lev suggested the reason for this was poor
earnings quality, leading to the need for more
value oriented information.
 Investors make irrational decisions due to:
Limited attention
Overconfidence
Representativeness
Self attribution bias
Motivated reasoning
 These behaviours can lead to extreme situations
like stock market bubbles.
Limited Attention
Investors may not have the time, or ability to
process all information related to the security.
Inly concentrate on information that is readily
available.
Overconfidence
Overestimation of the precision of the information
that they collect themselves.
Underreact to information that the did not collect
themselves.
Representativeness
Assigning too much weight to evidence that is
consistent with the individuals impression of the
population that it comes from.
Too much weight to recent events, rather than also
reflecting on historical information.
Self-Attribution Bias
Where individuals feel that the good decision
outcomes are a result of their abilities
Bad decision outcomes are a result of external
sources.
 Self-Attribution Bias can lead to momentum, where
reinforced confidence results in the purchase of
more shares
Motivated Reasoning
Individuals accept at face value information that is
consistent with their preferences
E.g. Good news is received well, however bad
news is received with skepticism and the individual
attempts to discredit it.
Prospect Theory
 This theory suggests that investors evaluate gains
and losses differently for a risky investment.
 This is behaviour is consistent with the concept of
narrow framing (analyzing problems in an overly
isolated manner).
 Investors react more strongly to small gains and
losses.
 Management will thus try to manage earnings to
avoid a loss.
 Even if a prospect has a positive expected value,
fear of losses may keep an investor out of the
market.
 The disposition effect can also occur, whereby
investors hold onto losing stocks to avoid realizing
a loss.
 Research supports these behavioural views that
seem contrary to rational decision theory. See
Theory in Practice 6.2.
Efficient Market Anomalies
 Research suggests that investors aren’t always
rational and need help interpreting financial
statements.
 This results in anomalies and market inefficiency.
 There are many examples of anomalies. Two that
will be examined are post announcement drift and
market response to accruals.
Post Announcement Drift
 The market seems to take some time to respond to
the release of information – often up to a month.
 This observation suggests that arbitrage (profit
being the difference between the market prices)
profits should be possible, as investors could take
advantage of this slow response.
 Bernard & Thomas studied this phenomenon and
were able to earn returns that exceeded the
market-wide return by 18%.
 This seems to indicate that investors
underestimate the effects of current earnings on
future earnings.
 The market thus takes time to absorb and process
the information.
Market Response to Accruals
 The market should respond more positively to
income from cash flow rather than income from
accruals.
 This is because accruals reverse.
 Sloan’s study found no difference in market
response, and he was able to earn returns that
exceeded the market by 10%.
 This result suggests market inefficiency.
Why Doesn’t Arbitrage Eliminate Anomalies?
Arbitrage behaviours are limited by:
 Transaction Costs:
oFinancial
oTime and effort required
 Idiosyncratic Risk
oArbitrage behaviours lessen diversification,
which may be undesirable to investors
Adaptive Market Hypothesis
 Instead being rational, investors may be viewed as
being boundedly rational (when environment
changes, reaction is over time).
 This implies that investors take time to respond to
a change in the environment.
 Investors will seek other evidence to confirm the
change observed. Some research suggests this
process may take up to 3 years.
Conclusions About Market Efficiency
 Despite the presence of anomalies, the market is
still reasonably efficient and there is evidence of
rational investor behaviour.
 However, behavioural models still persist.
 Whether investors are rational or not, disclosure of
fair value information could help as more relevant
information will become available for decision
making purposes.
Ohlson’s Clean Surplus Theory
 Traditionally, a company is valued using a
discounted cash flow approach.
 This theory attempts to value the company using
balance sheet and income statement components
exclusively.
 Assumptions:
oDividend stream determines a company’s
value.
oGoodwill = expected present value of future
abnormal earnings
oIf the accounting is unbiased, all value should
appear on balance sheet
oAccounting policies won’t affect the company’s
value
 Calculation:
oAccretion of discount = cost of capital x opening
book value
oPredicted actual earnings = ROE x opening
book value
oAbnormal earnings = predicted earnings –
accretion of discount
 Review example on pages 221-224.
 The theory predicted a value for Canadian Tire
shares of $85.91, while the actual market price
was $72.
 Although the theory could be flawed or the market
inefficient, it is more likely that investors simply
anticipated greater persistence of earnings than
was assumed in the example.
Auditor Liability
 An audit opinion provides no information on
company value.
 A company can fail even with an unqualified audit
opinion.
 The loss of utility for investors is greater when
asset values are overstated compared to when
they are understated.
 Thus, more valuation information could be useful,
but could also lead to greater liability.
 However, auditor liability issues will likely lead to
greater conservatism in the accounting profession,
which will result in one-sided applications of the
measurement approach.
 It will be interesting to see the long term impact of
the growth of IFRS, as these standards allow for
greater use of measurement approach
applications.
CHAPTER 7
Current Value Accounting
 Value-in-use
oAlso called amortized cost
oValued at discounted present value of future
receipts
oRelevance: high
oReliability:
 Error and possible bias in estimating
 Management may opportunistically change
intended use to increase present value or
avoid impairment writedown
 Fair value
oDefinition under IFRS 13
 The price that would be received to sell an
asset or paid to transfer a liability in an
orderly transaction between market
participants at the measurement date
oAlso called exit price
oExit price measures opportunity cost of
retaining asset/liability in firm
 Hence a stewardship aspect in addition to
valuation aspect.
 If manager cannot earn at least cost of
capital on asset, should be sold
 Market price does not exist for many assets
oFair value hierarchy; IFRS 13, ASC 820-10
 Level 1: market price exists
 Level 2: market price of similar asset exists
  Level 3: no market price, fair value must be criteria, they do represent an attempt to value
estimated internally generated goodwill.
oEffect on reliability as move from level 1 to  Purchased goodwill is reported at fair value at the
levels 2 and 3? time of purchase. Subsequent impairment testing
represents a partial application of the
Revenue recognition measurement approach.
oValue-in-use: changes in value recognized as
present value changes Derivatives
oFair value: changes in value recognized as  Derivatives are financial instruments
value changes occur  Definition
 Recognition is sooner than under historical cost oA contract, the value of which depends on some
oIncreases in value recognized when realized underlying price, interest rate foreign exchange
under historical cost or other variable
oMay not require an initial cash outlay
Measurement Approach Applications oGenerally settled in cash, not in kind
 GAAP/IFRS already include numerous examples  Derivatives valued at fair value under IFRS 9
of the fair value concept:  Unrealized gains and losses included in net
oThe revaluation model for capital assets under income, except certain hedging contracts
IFRS is a full application of the measurement
approach.
oThe short collection/payment period for A/R and
A/P essentially creates a cash equivalent
amount on the balance sheet. As well, using an
allowance for doubtful accounts provides a fair
value estimate of receivables.
oBonds with discounts/premiums are presented
at the present value of future cash flows .
oCapital leases are initially established at an
amount equal to the present value of future
minimum lease payments.
oPart of the reported pension liability/asset
includes an estimate of the present value of
future cash flows for payments to retirees.
oLower of cost and net realizable value rule for
inventory is a partial application of the
measurement approach.
oCeiling test for recording impairment of capital
assets represents a partial application of the
measurement approach.
oReporting of certain financial instruments at fair
value is an application of the measurement
approach, although the use of OCI makes the
presentation less clear.
 Fair value standards for financial instruments were
revised after the 2007-2008 market meltdowns.
 More value-in-use and amortized cost applications
are allowed, but this leads to questions of
reliability.
 Standards regarding derecognition and
consolidation are also being revised.
 Variable Interest Entities (VIE’s) are being
removed from the handbook.
 Research and development costs are generally
expensed, but to the extent that they can be
reliably measured and meet certain feasibility