Chapter 4:Efficient Securities Market

Group DTaylor Carson

Nicholas ChowMichael Cheuk-Hei Yu

Meaning of

efficiency

Implications for

financial reporting

Full Disclosure

A capital asset

pricing model

Information asymmetry, insider

trading, adverse selection

Overview for Chapter 4

Efficient Securities MarketsUnder ideal conditions, information is free

and investors use information to acquire and form subjective estimates of firms’ future performance

Realistically, information is not free and it is up to investors to form their own subjective estimates of firms’ future performance

Efficient Securities Markets (con’t)Information sources include:

o Financial presso Tips from friends and associateso Changes in economic conditionso Advice from analysts and advisorso Quarterly and annual reports

The Meaning of EfficiencyInformed investors will quickly move on

receipt of new information. If not, the market value of the security will adjust to reduce or eliminate the benefit

Two definitions of efficient securities market:Semi-strong form: reflects publicly available information

Strong form efficiency: reflects all information

The Meaning of Efficiency (con’t)4 important points about efficiency:

1) Market prices are efficient with respect to publicly known information. Thus, prices do not consider inside information

2) The market is efficient relative to a stock of publicly available information.

3) Investing is fair game if the market is efficient

4) Given market efficiency, a security's market price should fluctuate randomly over time

Decision theory allows different investors to react to the same information differently, even though they all proceed rationally

In the big picture, the differences in forecasting ability of individual forecasters tend to cancel out when the consensus is formed

Most importantly, the security values must on average by unbiased

Market prices reflect all available information

Implications of efficient securities marketsi) Accounting policies adopted by firms do not

affect their security pricesii) If a firm’s management possesses relevant

information about the firm that can be disclosed at little or no cost, management should then disclose this information on a timely basis

iii) Financial statement information need not be presented in a manner so simple that everyone can understand it (naive investor)

iv) Accountants are in competition with other providers of information

Logical Inconsistencyfully informative share prices allow

investors to stop gathering information and rely on markets price as the best indicator of future security returns

Investors acquire information

Investors loses motivation to acquire

information

Price fully reflect available information

Price doesn’t fully reflect available

information

Informativeness of PriceLiquidity traders or noise traders buy/sell

decisions coming at random coming from a hot tip

Security prices are partially informative in the presence of noise trading

How informative the price is depends on the quality of financial statement information and costs of analysis and interpretation

Informativeness of Price (cont’d)Voluntary disclosure: disclosure of

information beyond the minimum requirement of GAAP

Rational investor will then look at what the manager does in terms of accounting policy choice and disclosure

To increased the quality of financial statement disclosure, firms will include the management of discussion and analysis (MD&A)

Capital Asset Pricing Models3 Main Uses:

Displays how share prices depend on expectations

Separate expected and unexpected components of realized return

Method to estimate a stock’s Beta

Stock Prices Depend on Expectations

is the price of the shares at the end of the period

is the dividends paid by the firm is the price of the shares at the beginning of

the periodNew information changes , so must change

to balance out the formula

Separate Expected and Unexpected Returns

is the beginning of period expected return is the unexpected return

Estimate a Stock’s BetaObtain past data on and Perform a Least-squares regression and

obtain the model’s coefficientsThe coefficient of will be a good estimate of

Information AsymmetryRoot cause of several market problems:

Failure to launchCollapseInefficiency

Why is it important to accounting theory?

Fundamental Value vs. Market Value

Publicly Available

Information About

FirmInside

Information

Fundamental Value of Firm

Efficient Market Price of Firm

Role of Financial Reporting

The Social Significance of Securities Markets that Work WellSecurities Markets = primary method

of raising capitalInformation asymmetry creates

problemsFrancis, Huang, Khurana, and Pereira

(2009)Easier to obtain financing in countries with high quality financial reporting

Promoting Reporting QualityThere are two methods:

Regulations (stick)Incentives (carrot)

The right mix improves reporting quality

Diminishing the Information Asymmetry

Management Discussion and AnalysisUsed to convey more information to the public

Summarize information from Financial Statements

Can include strategies, plans, and prospects

Objectives of the MD&A

Investor

Company Performan

ce

Financial Condition Risks

Future Prospects

Sun Airlines Inc.Operates primarily in the Eastern states and has

been profitable during each of the last 6 yearsOne of the first regional airlines to adopt a

frequent flyer plan (FFP) -> Sun Travel Award Club (STAC)

In 2002, approximately 45% of paid-for revenue passenger miles were eligible for FFP rewards to FFP members

SAI has had a deteriorating current ratio and is approaching the minimum required by their lender’s covenants

Sun Airlines Inc.After today’s textbook overview, what is one

major implication of the possible covenant violation?

Sun Airlines Inc.The FFP is causing a liability on the balance

sheet and some VPs would like to see it removed

Marketing is refusing to have it eliminatedInvestor relations is suggesting that this

should be a contingency and therefore buried in the notes as opposed to set up as a liability

What do you think?

Sun Airlines Inc.2 methods for accounting for FFPs - criteria

Incremental cost method: assumes no displacement of revenue paying customers and that the earnings process is complete when the paid flight is taken, the no displacement is often shown by blackout periods and capacity controls, available excess capacity, and the FFP awards using a small portion of the excess

Deferred revenue method: the free travel awards are essentially considered discounted tickets, it is suggested that this is used at least for the routes on which the load factor is high

Sun Airlines Inc.2 methods for accounting for FFPs – effects

Incremental cost method: a liability is set up for the expected incremental cost of having the extra passengers on a future flight – takes into account an estimate of outstanding miles expected to be redeemed

Deferred revenue method: a portion of the revenues received for current flights is deferred until the free flight is taken in the future in order to essentially spread the revenue across all flights taken

Sun Airlines Inc.Given that Sun Airlines has current

passenger load factors in the 60-70% range, that they provide a blackout period around holidays and other peak periods, what method should be used?

One of the VPs mentioned that overall there is extra capacity, but certain routes operate close to 100% capacity, does this change your answer?

Sun Airlines Inc.Given the current state, the current ratio has

dropped to ~ 0.739 which is less than the required 0.8, causing a current covenant violation

If the STAC liability were to be eliminated, the current ratio would move to ~ 0.864. However, this would require the elimination of the FFP program, which would cause many other issues, including potential lawsuits and loss of customers

Sun Airlines Inc.Currently using a 75% expected redemption

based on historical dataHowever, VP Operations expects that in the

future, only 70% of the miles flown by FFP members will qualify for rewards

What concept previously discussed does this relate to?

Sun Airlines Inc.Other issue facing the company is the

revenue recognition surrounding bulk miles sold to other companies that can be returned. There is likely a marketing component as well as the travel portion, and therefore a travel portion should be removed if possible.

Mid-Term Prep Questions6. What market efficiency means?7. Why the term “market efficiency” is important

to financial accounting?8. How market efficiency occurs?9. How Market inefficiency can have impacts on

financial accounting?10. What are the market anomalies? What they

indicate?11. What information asymmetry means? What

consequences can it cause? How is it related to market efficiency?