Question

1. How do you think the efficient-markets hypothesis impacts the drafting of accounting standards? Bear in mind that many questions have been raised about the efficient-markets hypothesis itself.

Answer 1

Efficient market hypothesis is a hypothesis which states that share price or assets of firms reflect all the information and consistent alpha generation is possible. According to this, stocks always trade at their fair value on exchanges making it really impossible for the investors to buy a share which is undervalued or sell stocks for inflated price. So it should not be possible to outperform the overall market through expert stock selection or market timing and the only way an investor can obtain higher returns is by purchasing the stock which have high risk.

EMH impacting the drafting of accounting standards :

It is the EMH that influences today's accounting and auditing standards. Beaver's critique to FASB action relate to the five implications of EMH for standard setting. They are:

I) Standard setters should realize that financial report is not the only supplier of information to investors. Accountants must therefore stop acting as if they are the only suppliers of information about the company.

2) A role of accounting data is to prevent superior returns accuring from inside information. To achieve this he suggested that there should be full disclosure.

3) Standard setters should sponsor a full scale research problem in most of the trivial areas found in accounting today, so that it may have some evidence of the consequences of their choices among different sets of financial accounting standards.

4) Financial statements should not be reduced to the level of understanding of the naive investor who can get hurt by presuming that they can trade on published data and earn abnormal profit.

5) Many reporting issues are capable of a simple disclosure solution and do not warrent an expenditure of FASB time and resources in attempting to resolve them.

Other benefits from this to accounting are:

A) EMH is used as a basis for advising clients by the accounting professionals or practitioners. Often these accountants advice clients that changing an accounting policy to manipulate reported income for the purpose of supporting stock price cannot fool the market since the market is sophisticated to see through such attempts to increase earnings artificially or to conceal an underlying negative shift in a company. In short we can say that using EMH assertion, clients can be advised that the stock market reacts to underlying economic phenomena rather than to cosmetic accounting appearances. Finally by being well informed about EMH, accountants can assist clients in anticipating the reaction of the stock market to various types of financial disclosures.

B) EMH and the capital market research in accounting: Another very important area in accounting where EMH has had a very important implication is the accounting research. More specifically the EMH has given rise to a line of research in accounting called as capital market research or paradingm. The commonest of these studies is the value relevance studies. Most of these studies were market reaction to accounting releases of good or bad news.

Usually there is a cost to disclose. An attempt should be made to determine the value of additional disclosure in relation to the additional cost. Disclosure should be made when the perceived benefits exceed the additional cost to provide the disclosure.