Decision-useful financial reports in efficient securities markets

Table of contents

1. Overview

2. Efficient securities markets
2.1. Definition
2.2. Forms of Efficiency
2.3. Inefficient Markets
2.3.1. Naïve traders
2.3.2. Information asymmetry
2.4. Conclusions

3. Decision-usefulness of accounting information
3.1. Economic relevance of financial reporting
3.2. Legal aspects
3.3. Significance of financial reporting for different constituencies
3.3.1. Investors
3.3.2. Management
3.4. Conclusions

4. Financial reporting and their implications
4.1. Information dilemma
4.2. Solutions out of the information quandary
4.2.1. Penalties/ Incentives
4.2.2. Change of legal standards
4.3. Conclusions

5. Summary

Bibliography

List of abbreviation

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1. Overview

This paper studies the decision-usefulness of accounting information and the implications of financial reports, especially against the background of efficient securities markets.

The decision-usefulness of financial statements gained in importance in the literature of accounting research due to the decline in helpfulness for decision taking of traditional financial statements like earnings, cash flows and stock returns.^[1] This deterioration is accompanied by a deficit of future-oriented indicators, in particular intangible assets, which are not integrated in the actual financial reporting requirements.^[2] These outstanding problems lead to incompleteness of capital markets, which are tried to be solved by different mechanisms, e.g. penalties, incentives and voluntary disclosure, to attain to efficient securities markets, the social advantageous solution.^[3]

Section 2 describes the requirements of efficient securities markets, its various forms and the origin of inefficient working securities markets. Chapter 3 illustrates the usefulness of financial statements for different constituencies, especially for investors and management, and the legal standards for mandatory disclosure. Division 4 expresses the information dilemma and presents diverse solutions for an approximation to social optimal allocations, i.e. allocations that diminish securities markets inefficiencies. Chapter 5 gives a short summary of this paper.

2. Efficient securities markets

2.1. Definition

The theory of efficient markets respectively the efficient market hypothesis (EMH) is generally valid to every market.^[4] This implies that EMH is also applicable for securities markets. Accounting research deals with two different types of definition about efficient markets. One is a more a verbal explanation, the other one tries to find a formal structure.

FAMA established the verbal definition of efficient markets with his statement that “in an efficient market prices fully reflect available information”, but he admitted that this definition is too universal, so that there is no possibility to carry out empirical evidence.^[5] The second problem of this description is a circular because if the definition is turned around what implies that accessible information is total reflected in market prices then every security market is efficient by explanation.

To solve these problems BEAVER improved this definition with the limitation that in an efficient market prices “act as if” each market participant has knowledge about all available information.^[6]

The formal structure invented the term “abnormal rate of return”, which is defined as the difference of “realized rate of return” and “expected rate of return”. If after many periods the “abnormal rate of return” on a capital market is approximately zero, then one can say that this market is efficient. Every capital market can be analyzed empirically with this definition whether it is efficient or not.^[7] The surveyed information data will be divided in three classes, which is part of the next section.

2.2. Forms of Efficiency

Possible information subsets were divided in three main categories to make a distinction between capital markets with high efficiency and those with a bad working information system.

The worst efficiency form is the weak one. A capital market is efficient in the weak form if the whole subset of past information, like past prices and earnings, is reflected by market prices.

If market prices reflect any available information, equal whether it is private or public information, then this capital market is efficient in the strong form. That means that every market participant has insider information.

The midcourse is efficiency in the semi-strong form. That implies that market prices contain all public available information.^[8]

Tests on the evidence of these three different efficiency forms conclude that the semi-strong form and so the weak form also, classified on an lower level than the semi-strong form, can be empirically verified, while the strong form is in general^[9] incompatible with practical observations.^[10]

The EMH in the semi-strong form is the most interesting form for accounting research because the substantial part of public information is accounting data and so every reference in this paper relating to market efficiency relates to the semi-strong form.

2.3. Inefficient Markets

In this chapter possible origins of inefficient markets are examined. As described above these markets are determined through prices not acting as if every applicant has facts of all public existing information. Potential reasons are non-rational traders, called naïve traders, and differences in knowledge between market participants, called information asymmetry.

2.3.1. Naïve traders

EMH makes an assumption of rational market participators who make a decision on the basis of information content and to maximize their value. However this assumption is very unrealistic because some of the participants decide non-rational or their private situation forces them to take a decision, for instance to sell their shares for extraordinary costs. These people are called noise or naïve traders.^[11]

The result of this mixed society is a relationship between rational and noise trading. This correlation can result in a price with a higher unpredictability and a price that is mispriced in stability.^[12] As a consequence a market allocation exists in which the possibility of an abnormal rate of return different from zero. Such a market is an inefficient market.

2.3.2. Information asymmetry

The second alternative of a market’s inefficiency is an unfair distribution of information content relevant for decisions. Two main areas are well known in accounting research, adverse selection and moral hazard.

Adverse selection, also described as hidden information, occurs when one person has a better information set than his trading partner so that the better informed one has the opportunity to get some extraordinary earnings. The result of adverse selection is that products with good quality won’t survive on the market.^[13]

Moral hazard respectively hidden action arises because some participants cannot observe individual actions of others while these actions influence the benefit of all. So moral hazard leads to a benefit, caused by information advantage, for those who cannot be obeyed.^[14]

Accounting can help to reduce information asymmetry in two key cases. The adverse selection one is insider trading which can be decreased by financial reporting disclosure mechanisms. One important case of moral hazard is the division of possession and power. These hidden actions can be trimmed down by observing the accounting net income.^[15]

2.4. Conclusions

In this chapter the literature on EMH is reviewed, its different figures and the possibility of inefficient markets. The major results are that the EMH is valid for the semi-strong form, which is the most important type for financial accounting. Because there is only evidence for the semi-strong division and not for the strong there is always an opportunity of inefficiency as shown in the last section.

The next chapter studies how accounting information can be used for decision-making and therefore cure market’s inefficiencies and how professional accounting bodies take care of a decision-useful accounting environment.

3. Decision-usefulness of accounting information

3.1. Economic relevance of financial reporting

Accounting data claimed from financial reports has an important nature because it is a cost-effective source intended for nearly every constituency for decision taking in the surrounding of a firm, which is listed on a security market. So investors have to optimize their portfolio, creditors have to decide about the creditworthiness of companies, financial analysts have to solve the problem which firm will pay the highest stock return and so on.^[16]

While gathering information about the observed firm the constituencies use different sources^[17] and so beside other resources also accounting data. In the group of financial analysts accounting data, in particular annual and quarterly reports, occupies one of the front places besides one-to-one communication. This statement is not only valid for this group since investors, the major group of these above announced constituencies, have not the alternative to use one-to-one communication.

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^[1] See LEV / ZAROWIN (Boundaries of Financial Reporting 1999), pp. 354 – 362.

^[2] See GÜNTHER / BEYER (Value Based Reporting 2001), pp. 1627 – 1629.

^[3] See SCOTT (Financial Accounting Theory 1997), pp. 81 – 82.

^[4] See DYCKMAN / MORSE (Efficient Capital Markets 1986), pp. 1 – 2.

^[5] See FAMA (Efficient Capital Markets 1970), p. 384.

^[6] See BEAVER (Market Efficiency 1981), pp. 27 – 28.

^[7] See WATTS / ZIMMERMAN (Positive Accounting Theory 1986), pp. 17 – 18.

^[8] See FAMA (Efficient Capital Markets 1970), pp. 383, 388, 404, 409 – 410, 414 – 415.

^[9] See FAMA (Efficient Capital Markets 1970), pp. 409 – 410, who emphasized two variations that give evidence for the strong form of EMH, which are not important for carrying on this paper.

^[10] See WATTS / ZIMMERMAN (Positive Accounting Theory 1986), p. 19.

^[11] See DYCKMAN / MORSE (Efficient Capital Markets 1986), p. 8.

^[12] See LEE (Market Efficiency 2001), pp. 243 – 247.

^[13] See AKERLOF (Market for “Lemons“ 1970), pp. 488 – 492, who described the used car market as such a market for lemons.

^[14] See HOLMSTRÖM (Moral hazard 1979), pp. 74 – 75.

^[15] See SCOTT (Financial Accounting Theory 1997), pp. 3 – 4. See section 4 for solutions out of inefficient markets.

^[16] See SCOTT (Financial Accounting Theory 1997), p. 61 and WATTS / ZIMMERMAN (Positive Accounting Theory 1986), pp. 2 – 4.

^[17] See ACHLEITNER et al. (Kapitalmarktkommunikation 2002), pp. 35 – 36.