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ACCT 90013:
Market Efficiency
and Value Relevance
of Accounting
Information
1. Capital market efficiency
2. Value relevance of accounting information
3. Capital market inefficiency
2
Structure of Today’s Lecture
Learning Objectives
• To explain the efficient market hypothesis
and its implications for financial reporting
• To understand how to test the value
relevance of accounting information
• To explain why security market may not be
efficient
3
Readings
• Chapter 4.1-4.3, Scott
• Chapter 5.1-5.4, Scott
• Chapter 6.2.1 & 6.3, Scott
4
Usefulness of Accounting Information
5
Adverse Selection
Persons with information
advantage exploit this advantage
Moral Hazard
Manager knows his/her actions
but investors do not
Capital Markets Perspective
Role of accounting reports to
value the firm
Contracting Perspective
Role of accounting reports to
motivate the manager
Valuation Role Stewardship Role
Capital
Market
Efficiency
7Efficient Market Hypothesis (EMH)
2013 Nobel Prize in Economics
“for their empirical analysis of asset prices”
-Royal Swedish Academy of Science
- “… their findings showed that markets were moved by a mix of rational
calculus and human behavior.”
8• Fama (1970, 1991): The market price “incorporates” all
“currently available information”
Quickly and
without biasDepending on the information, there
are three forms of market efficiency
What Is Market Efficiency?
Three forms of efficiency
• Weak form: reflect data on past prices
• Strong form: reflect all information, public &
private
• Logic inconsistency on information acquisition
• Semi-strong form:
An efficient securities market is one where the prices of
securities fully reflect all information that is
publicly known about those securities.
9
How do market prices fully reflect
all available information?
When a sufficient number of informed investors react to
new information, the market becomes efficient.
• Investors’ estimates of security values must be, on
average, unbiased.
• Any one individual may not be correct, but on average
the market uses all available information
• Assume individual decisions are independent
• Therefore, the market price fully reflects all publicly
available info
10
The meaning of efficiency
Market prices are semi-strong form efficient:
• Does not rule out the possibility of inside
information
• Prices not necessarily reflect ‘real’ value
• Market prices follow a random walk
– Today’s price tells you nothing about tomorrow’s
price
– Price changes randomly because it is only driven by
unexpected information
11
12
Implications for Financial Reporting
Scott 2015
Implications for Financial Reporting
1. Accounting policies adopted by the firms do not affect
security prices (assuming no differential cash flow
effects and full disclosure)
• e.g. depreciation method
• Investors are pricing expected future cash flows and
dividends
• Only accounting information that affects expectations of
future cash flows is priced.
13
Implications for Financial Reporting
2. Full disclosure enhances efficiency
• All info will be used, managers should disclose as much
as cost-effective
• More disclosure, less concern about inside information
3. “Naïve” investors are price-protected
• Financial report does not need to be presented in an
extremely simple manner