Question

1)Provide an example of an efficient market’s response to financial accounting information. Was the direction of the response predictable given an efficient market? Explain.

2)The IFRS Conceptual Framework’s purpose for reporting financial accounting information focuses on the primary decision makers and their need for information relevant to decision making.  One of the implications of an efficient market is “more information is better”. How is the implication for more information incorporated into the CPA Handbook (of standards)? Explain.

Answer 1

1)Provide an example of an efficient market’s response to financial accounting information. Was the direction of the response predictable given an efficient market? Explain.

A quest for abnormal returns by using accounting information plays an important role in 'price discovery' in investment practice. it provides valuable counter-evidence for the traditional framework and theory in the academic fields. However, it is a mistake to emphasize the inefficiency of the market and irrationality of investors based on those observed anomalies immediately. Originally, the efficient market is the ideal type. Therefore, we cannot test it directly. The efficient market hypothesis as an ideal type implies that investors can understand accounting information accurately and respond quickly and correctly and that, by investors' rational behavior, accounting information should be perfectly reflected in stock prices as soon as it is released. However, in the real world, accounting information does not always present the evident information, which investors can distinguish into good news and bad news instantaneously. Therefore, it is also a mistake to attribute all of the anomalies to the decision biases of investors though such a type of conclusion is often adopted in behavioral finance. Investors receive various accounting information in a complicated information environment. It is necessary for investors to obtain ex-ante and ex-post information for interpreting accounting information. We should investigate the market response to accounting information considering their decision process. Moreover, accounting information has inherent attributes (or characteristics) such as conservatism. Those attributes may be obstacles for investors to understand accounting information accurately and quickly.

An Example of an Efficient Market

While there are investors who believe in both sides of the EMH, there is real-world proof that wider dissemination of financial information affects securities prices and makes a market more efficient.

For example, the passing of the Sarbanes-Oxley Act of 2002, which required greater financial transparency for publicly traded companies, saw a decline in equity market volatility after a company released a quarterly report. It was found that financial statements were deemed to be more credible, thus making the information more reliable and generating more confidence in the stated price of a security. There are fewer surprises, so the reactions to earnings reports are smaller. This change in volatility pattern shows that the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient. This can be considered a confirmation of the EMH in that increasing the quality and reliability of financial statements is a way of lowering transaction costs.

Other examples of efficiency arise when perceived market anomalies become widely known and then subsequently disappear. For instance, it was once the case that when a stock was added to an index such as the S&P 500 for the first time, there would be a large boost to that share's price simply because it became part of the index and not because of any new change in the company's fundamentals. This index effect anomaly became widely reported and known and has since largely disappeared as a result. This means that as information increases, markets become more efficient and anomalies are reduced.

The financial theory describes risk assessment as one of the most important parts of an investment decision-making process. However, for a risk to be known, it is important for investors to interpret information flowing on the market. This is aimed to examine the association between accounting information and the market risk over time. It also evaluates how far the beta value and accounting variables can be useful for investors in Mauritius. Beta estimates are calculated using Capital asset pricing model and accounting risk variables are derived from theoretical foundations and prior empirical findings. The relationship between the financial ratios and the level of systematic risk is obtained by regressing the variation in the beta against changes in the accounting variable.

The use accounting as means of estimating the systematic risk will allow the user of the financial statement to assess the investment alternative in terms of risk, return and the value of the firms.

The volatility of market betas over time indicates that the ex post measure of systematic risk is does not provide meaning full information in estimating the future risk. As such, understanding the relationship between accounting variables and systematic risk could indeed be useful in measuring and predicting the actual and upcoming market risk.

Accounting risk model overcome the conventional problem were ex post measure of risk can not be applied due to the fact that historical security returns is not available or insufficient like in the case not listed entities and for initial public offering

2)The IFRS Conceptual Framework’s purpose for reporting financial accounting information focuses on the primary decision makers and their need for information relevant to decision making.  One of the implications of an efficient market is “more information is better”. How is the implication for more information incorporated into the CPA Handbook (of standards)? Explain.

The revised Conceptual Framework for Financial Reporting (Conceptual Framework) issued in March 2018 is effective immediately for the International Accounting Standards Board (Board) and the IFRS Interpretations Committee. For companies that use the Conceptual Framework to develop accounting policies when no IFRS Standard applies to a particular transaction, the revised Conceptual Framework is effective for annual reporting periods beginning on or after 1 January 2020, with earlier application permitted.

The Conceptual Framework sets out the fundamental concepts for financial reporting that guide the Board in developing IFRS Standards. It helps to ensure that the Standards are conceptually consistent and that similar transactions are treated the same way, so as to provide useful information for investors, lenders and other creditors.

The Conceptual Framework also assists companies in developing accounting policies when no IFRS Standard applies to a particular transaction, and more broadly, helps stakeholders to understand and interpret the Standards.

The 2018 revised Conceptual Framework sets out:

• the objective of general-purpose financial reporting;
• the qualitative characteristics of useful financial information;
• a description of the reporting entity and its boundary;
• definitions of an asset, a liability, equity, income and expenses and guidance supporting these definitions;
• criteria for including assets and liabilities in financial statements (recognition) and guidance on when to remove them (derecognition);
• measurement bases and guidance on when to use them;
• concepts and guidance on presentation and disclosure; and
• concepts relating to capital and capital maintenance.