Bloomfield[1] - 2002 American Accounting Association...

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© 2002 American Accounting Association Accounting Horizons Vol. 16 No. 3 September 2002 pp. 233–243 Submitted: August 2001 Accepted: April 2002 Corresponding author: Robert J. Bloomfield Email: [email protected] COMMENTARY The “Incomplete Revelation Hypothesis” and Financial Reporting Robert J. Bloomfield Robert J. Bloomfield is an Associate Professor at Cornell University. INTRODUCTION The most common form of the Efficient Markets Hypothesis (EMH) states that market prices fully reflect all publicly available information (Fama 1970). The EMH has been highly influential among academics, but practitioners and regulators appear unconvinced. Investors work hard to identify mispriced stocks on the basis of public data, or pay others to do so, even though the EMH asserts that such efforts are wasted. Managers seek to boost stock prices by hiding bad news in footnotes, and regulators work hard to defeat such efforts, even though the EMH asserts that information is reflected in prices no matter how obscure its presentation. Beliefs about inefficiency play a central role in the debate over recognizing expenses for incentive stock options. Opponents of expensing argue that the resulting lower net income will inappropriately reduce market prices, while proponents argue the market does not fully recognize compensation costs reported only in footnotes. In efficient mar- kets, however, expensing these costs has no direct effect on prices, as long as the details of the compensation are included in footnotes. The decision to expense option costs could reduce stock price indirectly, even in efficient markets, by affecting the terms of contracts between the reporting firm and other parties (Watts and Zimmerman 1986). However, few of the parties to the debate appear concerned about these effects. The academic community is showing increasing dissatisfaction with the EMH, swayed partly by evidence that prices underreact to large earnings changes, ratios of prices to fundamentals, and other statistics derived from fundamental accounting analy- ses. However, the EMH is still influential because there is no alternative theory that explains why we observe the inefficiencies we do. For example, why should the market underreact to large earnings changes, rather than overreact? Without a theory predict- ing how and why markets are inefficient, studies showing mispricing can be viewed as statistical flukes resulting from fishing expeditions (Fama 1998; Kothari 2001). This paper in an outgrowth of presentations at the 2001 P. D. Leake Lectures at Oxford University, the 2001 AAA Doctoral Consortium, the 2001 Conference on Experimental Methods at Harvard University, and Cornell University. Thanks to Paul E. Fischer, John Hand, David Hirshleifer, Mark Nelson, Maureen O’Hara, and Tom Dyckman for helpful comments.
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234 Accounting Horizons/September 2002 In this paper, I present an alternative to the EMH called the “Incomplete Revela- tion Hypothesis” (IRH). The IRH asserts that statistics that are more costly to extract
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Bloomfield[1] - 2002 American Accounting Association...

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