Accounting Information and Market Efficiency – Theory and Evidence 1

Efficient Markets Hypothesis Three forms of market efficiency – Weak – Semi-strong – Strong What are the definitions of the above? 2

Semi-strong market efficiency Market is semi-strong efficient when the stock price reflects all publicly available information This is the one most relevant for accounting, since accounting information is publicly available 3

Implications of semi-strong efficiency for accounting information If market is semi-strong efficient with respect to accounting information, the following should hold true – Market should react immediately and completely to earnings announcements No opportunity for profitable trading strategies based on the earnings announcements – No opportunity for profitable trading strategies using information in the financial statements – Market should not react to changes in accounting method, as long as the change in method is disclosed by the company and there is no cash flow effect 4

Empirical Evidence – Earnings Announcements Market underreacts to earnings announcements. – Takes one whole quarter for the market to react completely. – This is called the post earnings announcement drift anomaly. Opportunity to make trading profit. – Investors have created Earnings Momentum Strategy (to be discussed later) Overall, this evidence is inconsistent with semi- strong market efficiency (not semi-strong efficient) 5

Empirical Evidence – Trading Strategies Using Information in F/S Financial ratio based fundamental analysis can be used to earn abnormal returns – Resulting fundamental strategies pay double digit abnormal returns in a 12-month period following the portfolio formation date Residual Income Model can be combined with analysts’ forecasts to earn abnormal returns Overall, this evidence is inconsistent with semi-strong market efficiency (not semi- strong efficient) 6

Empirical Evidence – Market Reaction to Accounting Method Changes or Differences Accounting Method Changes – No Cash Flow Effect (e.g., Depreciation Method Change) Market is not fooled when a firm switches its depreciation method and increases earnings. No increase in stock price. Investors read the footnotes and know that the increase in earnings is due to depreciation method change. Consistent with semi-strong market efficiency. – With Cash Flow Effect (e.g., FIFO to LIFO) When firm switches from FIFO to LIFO, net income goes down but cash flow goes up (due to lower taxes) [assume inflation] If market is fixated only on earnings, and ignores the positive cash flow effect, we would expect stock price to go down But if market takes into consideration the positive cash flow effect, we would expect the stock price to go up Research has found that stock price goes up, which is consistent with semi-strong market efficiency Accounting Method Differences – Market values R&D Costs as an Asset even though they are expensed for reporting purposes – P/E ratios of accelerated depreciation firms are higher than those of straight line depreciation firms Overall, the evidence is consistent with semi-strong market efficiency (IS semi-strong efficient) 7