Unformatted text preview: ACCT3003 Issues in Accounting Theory 2009 Topic 9: Capital markets research Solutions to topic review questions 10.1 Capital market research explores the role of accounting and other information in equity (capital) markets. As shown in the chapter, one branch of capital market research explores the reaction of share prices to the release of particular information. The view taken is that if share prices change around the time of the release of particular information then (assuming the price reaction did not relate to other events) the information must have been useful in enabling the capital market to revise its expectations about the future earnings and cash flows of the organisation in question. The market is only expected to react to new information and hence a price change around the time of the release of the information indicates that the information is useful. A second branch of capital market research that we explored in this chapter related to research which considers how accurately accounting data reflects the information used by the market in determining share prices. This research, which has been described as ‘looking back the other way’, adopts the view (from the efficient markets hypothesis) that share prices reflect information gathered from many sources, one source of which is accounting. Accepting that the share market has correctly priced a security, the share price, and changes therein, are used as a basis, or benchmark, for evaluating accounting data. Under this branch of capital market research, accounting data that does not relate to, or correlate well with, share prices is deemed to have limitations. Capital market research typically adopts the assumption that equity markets are efficient, and accordingly, that they react swiftly to the public release of new information that relates to an entity’s future earnings and cash flows. This assumption is referred to as the efficient market hypothesis (EMH). There are different assumptions about market efficiency, these being the weak‐form assumption (which assumes that existing security prices simply reflect information about past prices and trading volumes); semi‐strong‐form efficient (which assumes that all publicly available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released); and, strong‐form efficient (which assumes that security prices reflect all 1 10.2 Issues in Accounting Theory 2009 Solutions: Topic 9 information known to anybody at that point in time, including information that is not publicly available). Capital market research typically adopts the semi‐strong‐form efficiency perspective. In the context of capital market research, efficiency means that the market reacts swiftly to new information. It does not mean that the market necessarily makes a correct assessment of future earnings and cash flows (which can only be determined with hindsight). However, it needs to be noted that in recent years there has been a great deal of research in the area of finance that has questioned assumptions about market efficiency. 10.3 As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the market does not also act in the same predictable manner. Nevertheless, the EMH has helped provide some useful predictions and no doubt will continue to be relied upon by many researchers for a considerable period of time. As Lee (2001, p. 238) states: A common assertion is that even if the EMH is not strictly true, it is sufficient to serve as a starting point for research purposes. Like Newtonian physics, it is more than good enough for everyday usage. Unfortunately, it has becoming increasingly more difficult to accommodate what we know about the behaviour of prices and returns within this traditional framework. At the present time there is a great deal of research into capital markets that does not rely upon market efficiencies. The consideration of ‘other forces’ that shape share prices and returns might eventually lead to a revolution in thought (Kuhn, 1962)—but it will arguably take a long time. 10.4 If it was assumed that capital markets were not efficient in assimilating information then the basis of efforts to link security price changes to information disclosures would be flawed. If they were not considered to be linked then there would be little reason to investigate the association. If information is useful then the market is expected to react because it can differentiate useful information from other disclosures. If it cannot Issues in Accounting Theory 2009 Solutions: Topic 9 2 10.5 differentiate between ‘new’ information and ‘old’ information then market reaction could relate to anything and any reaction, or lack thereof, could not be used as a basis for assessing whether particular information should be disclosed. In the branch of research which assesses accounting information on the basis of how well it relates to existing share prices (research that ‘looks back the other way’) the market is used as a basis for assessing the appropriateness of particular accounting disclosures. The market is assumed to provide the benchmark valuation. If the market is not deemed to be efficient then this type of research and evaluation would not be logical. The typical explanation from advocates of an efficient market would be that the disclosures provide no new information in relation to enabling investors to assess the future cash flows and profitability. The information being released by the organisation might have already been anticipated, or alternatively, the information might already have been gathered from an alternative source. As another possibility, the market might not believe the information is credible (perhaps it has not been subject to an independent review and/or the management releasing the information are not considered to be reliable). Typically, if an item of information is released and the market price of the firm’s securities does not change, then it is argued that the information is not being used by the market participants, otherwise there would have been a reaction. Conversely, if security prices change around the time of the release of particular information, and assuming that the information and not some other event caused the price change, then it is considered that the information was relevant and useful for investment decision making. It would be relevant because it allows market participants to reassess the future cash flows of the entity. That is, it is assumed that relevant information is not ignored by the market. Capital market research relies on the underlying assumption that equity markets are efficient. Market efficiency is defined in accordance with the EMH as a market that adjusts rapidly to fully impound information into share prices when the information is released (Fama et al. 1969). Capital market research in accounting typically assumes that equity markets are semi‐strong‐ form efficient. That is, that all publicly available information, including that available in financial statements and other financial disclosures, is rapidly and fully impounded into share prices in an unbiased manner as it is released. 10.6 Issues in Accounting Theory 2009 Solutions: Topic 9 3 10.8 As the chapter explains, the larger the organisation the more likely it is that there will be more information publicly available about the entity. Larger firms tend to attract more attention from parties such as security analysts who are likely to spend the necessary time to find out about various things such as earnings projections, the market position of the entity, the performance of its competitors, and so on. Because it is assumed, pursuant to the EMH, that share prices will reflect information from various publicly available sources, the larger the organisation (and hence the greater the alternative information sources) the relatively less the reaction of the market to accounting disclosures made by the entity. Research shows that the relationship between the information content in earnings announcements and changes in share prices tends to be relatively more significant for smaller firms. 10.9 Accounting standards, such as AASB 138 Intangible Assets (its international equivalent being IAS 38), restrict the recognition of many intangible assets. Internally generated intangibles which are unique in nature – such as many intangible assets relating to intellectual capital – are generally not recorded in an entity’s statement of financial position (balance sheet). This is despite the fact that the revenues being generated through the expertise and knowledge held by the entity might be significant. Because accounting standards fail to recognise many assets which nevertheless have value, and if we assume that share prices reflect expectations about future cash flows, then we would expect that there would be a low level of correspondence between the market capitalisation of an entity, and the net assets of the entity, if such an entity generates a great deal of its revenues through the use of its intangible assets. Many capital market researchers would use this low level of correspondence as an argument that the accounting standard on intangible assets needs to be revised. Conversely, we would expect a higher correspondence between the net assets of an entity, and its market capitalisation, for organisations that rely more heavily upon tangible assets. Many tangible assets can be valued at fair value, and these fair values will often represent expectations about future cash flows of the assets in question. 10.11 Assuming that there were no other relevant announcements on the day, either by the company or its competitors, then capital markets researchers would explain the rise in the share price on the basis that the profit announcement exceeded the market’s expectations and thereby allowed them to revise expectations about future cash flows associated with the organisation. The unexpected ‘good news’ would also probably lead to a rise Issues in Accounting Theory 2009 Solutions: Topic 9 4 in the price of other banks’ shares because the news might lead to revised expectations about profitability across the entire industry. 10.14 If we accept that the market is able to determine the appropriate price of a firm’s securities on the basis of information from a multitude of sources (the market has it ‘right’) then the role of accounting is to confirm these expectations. Of course, it is questionable whether markets can be expected to ‘get it right’ and as such it would typically be expected that there will be some unexpected information when financial statements are released. What must also be remembered is that the capital market is not the only user of accounting information and hence accounting has a role beyond informing or confirming the expectations of investors. An accountability is owed to other stakeholder groups, such as employees, customers, local communities, and so on, and one medium for providing information in response to this accountability is the annual report. 10.16 If we accept that markets are efficient then the price of Coca Cola shares changed around the date of the announcement of the new chairman because the information was unexpected, and further, that the information was considered to have negative implications for the future cash flows of Coca Cola. Because the share price declined, the announcement of the new chairman apparently was seen as providing bad news about the future prospects of the company. Perhaps because Daft was unknown the market perhaps considered that the appointment was risky and, accordingly, revised the value of the firm’s equity. In relation to the question of market efficiency we must remember that from the perspective of capital market research ‘efficiency’ means that the market adjusts rapidly and in an unbiased manner to the public disclosure of new information. Market efficiency does not mean that the market will make perfect predictions about future cash flows. Whether the market ‘gets it right’ will only be determined with hindsight. Because the market did react to new information which would have implications for future cash flows, it could be considered that the change in the price of Coca Cola shares is consistent with market efficiency. 10.17 Consistent with the results of many capital market studies we would expect the market to react to comments/disclosures which allow investors to reassess the future profitability and cash flows of an organisation. It is possible that because Alan Jones has such a wide audience, and because his views are respected by many within that audience, then his support for a project might increase community support for the project (in Chapter 8 of Issues in Accounting Theory 2009 Solutions: Topic 9 5 this book we considered media agenda setting theory which suggests that for many issues the media is able to influence public opinion). The increased support may have positive cash flow consequences for the organisations involved (perhaps increasing the demand for its products, increasing the interests of investors, and so forth) and this in turn could be reflected in the higher prices paid for the organisation’s securities. Explained in these terms, the market reaction could be construed as being efficient. 10.18 Capital market research indicates that share prices will react quickly and without bias when new information is publicly released which enables investors to revise expectations about the future cash flows of a company. As the newspaper article indicates, a significant event occurred—the ruling by the FDA that particular drugs could be sold—and this event could quite arguably have impacted expectations about future cash flows given that sales revenue would be expected to increase and related asset write‐downs would no longer be required. The extent of the share price change would seem to indicate that the FDA’s ruling was not anticipated by the market. Nevertheless, it is difficult to state with total certainty that a price change is related to any one specific event or news item. Issues in Accounting Theory 2009 Solutions: Topic 9 6 ...
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- Three '10
- Accounting, EMH, capital markets, future cash flows, Capital market research