THE EFFICIENT MARKET HYPOTHESIS AND ITS IMPLICATIONS FOR FINANCIAL REPORTING by Robert Lipe Statement of Financial Accounting

Concepts No. 1 states that financial reporting should provide information "that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions ... about the economic resources of an enterprise..."1 Investors in stocks and bonds are perhaps the most often mentioned users of financial reports, so it is helpful to understand how information impacts capital markets. This brief note discusses the Efficient Market Hypothesis and how it relates to accounting issues.

THE EMH The word "efficient" here refers to the processing of information. As Gene Fama put it, stock prices in an efficient market "are based on 'correct' evaluation of all information available at that time. In an efficient market, prices 'fully reflect' available information."2 And this efficiency has benefits for both individual investors and the firms in which they invest. For the investor, since the price reflects all available information, he/she will buy and sell shares at "fair" prices. Also, firms that sell securities to raise capital will receive "fair" prices. "In short, if the capital market is to function smoothly in allocating resources, prices of securities must be good indicators of value."3 So in general, the EMH implies that security prices reflect information quickly and without bias. However, there are actually three versions of the EMH which differ depending on the underlying information sets. The first is weak form efficiency, in which current stock prices fully reflect the information in past prices. Thus knowledge that a share of IBM sold for $16 last month cannot predict tomorrow's stock return. But information such as current period earnings could potentially be used to earn abnormal returns. In the semi-strong form, prices are assumed to reflect all publicly available information. In such a case, prices should reflect earnings when it is first announced to the public. Therefore, using earnings information a week after announcement should not produce abnormal returns. However, if someone has access to the earnings number before it is announced to the general public, then abnormal returns may be possible by using this inside information. The final form is referred to as the strong form. In this case, all existing information, both publicly and privately held, is assumed to be reflected in prices quickly and without bias. Of these three, semi-strong form is the the most popular.
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FASB, Statement of Financial Accounting Concepts No. 1, FASB, Stamford, CT: 1978. Eugene Fama, Foundations of Finance, Basic Books, Inc. New York: 1976, p. 133. Fama, 1976, p. 133.

IMPLICATIONS FOR ACCOUNTANTS While the EMH is a fairly simple concept, understanding what the EMH implies for accountants is not. If one accepts the strong form, then financial reporting is of little or no use as a source of information to the capital markets because prices will have responded to any relevant information long before the annual report is released. However, most observers put more faith in the semi-strong form, and certainly financial reports such as earnings announcements can be informative under this form of the EMH. But, as Bill Beaver points out, even the semi-strong EMH has important implications. Some of the points he makes are as follows:4 1. In creating accounting rules and policies for the benefit of investors, the focus should be on substance rather than form. Either recognizing a transaction in the balance sheet or disclosing it in the notes makes it public information, and as such it will be reflected quickly and without bias in security prices. However, this only addresses recognition versus disclosure from the stand point of investors; for other users, the form of the disclosure could be of paramount importance. Investors receive information from many sources other than financial statements. Perhaps certain items may be better left out of the financial statements. For example, few corporations include earnings forecasts in their annual report for fear of litigation. Yet investors receive a multitude of forecasts from companies such as Value Line and Standard & Poor's. The role of accrual accounting is ambiguous. If everyone agrees with the underlying accrual rules, then accounting aggregates millions of separate transactions into a manageable set of financial statements. In this case, accrual accounting is beneficial to society. But, if different users would have aggregated the raw transaction data in substantially different ways, then society may be harmed because information is lost by using accrual accounting. The FASB and SEC should probably aim financial disclosures at sophisticated rather than naive investors. First, actions of sophisticated investors, such as stock analysts, are more likely to affect prices. Second, even though a naive investor cannot easily understand an annual report, since the information is reflected in price, the investor is assured of encountering a fair price whenever he/she makes a transaction. Only if the firm makes less than full disclosure of pertinent details can the investor be seriously harmed by another
William Beaver, Financial Reporting: An Accounting Revolution, Prentice-Hall, Englewood Cliffs, New Jersey: 1981, p. 163-167.

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trader who uses information that is not yet reflected in the price.

Of course, some people read more into the EMH than is there. For example, the EMH does not imply that the market can unambiguously predict future events. The world is uncertain, and when new information becomes available, stock prices will react. Thus the EMH does not imply that the market is clairvoyant, only that past information should not be useful in predicting future "abnormal" returns. Also, the EMH does not imply that market participants must act as if the EMH is true. For example, Arthur Wyatt, a former member of the FASB, presented a series of "transactions that dispute the validity of EMH".5 Specifically, he reports that firms use a form of LIFO accounting that increases current income and tax payments, spend real dollars to construct financing agreements which keep additional debt off of the balance sheet, and expend extra effort to get business combinations classified as poolings of interests to avoid future goodwill amortization. If the stock market is efficient, it should see through these accounting "gimmicks" and not reward these firms. Thus Wyatt feels businesses make real decisions that appear to deny the EMH. Based on this evidence, he reaches a conclusion regarding standard setting that differs substantially from Beaver's. He does not view disclosure as an adequate substitute for formal recognition of assets, liabilities and equities in the balance sheet. "Either the balance sheet should report all liabilities or financial statements should be dispensed with completely and financial reporting should be limited to narrative disclosures."6 In a response to Wyatt, Deitrick and Harrison point out that the EMH is not invalidated by the beliefs or actions of certain managers.7 Whether stock prices reflect information or not does not depend on the observance of accounting gimmicks. And Deitrick and Harrison report on several capital market research studies that are consistent with prices reflecting information. Further, several studies show that accounting gimmicks do appear to be "undone" by the market. In the end, they reiterate the conclusions of Beaver, particularly that substance of the disclosure is paramount while form is secondary.

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Arthur Wyatt, "Efficient Market Theory: Its Impact on Accounting," Journal of Accountancy, (February, 1983) pp. 56-65. Wyatt, p. 62. James Deitrick and Walter Harrison, "EMH, CMR and the Accounting Profession," Journal of Accountancy, (February, 1984) pp. 82-93.

RECENT EVIDENCE Few concepts have been so broadly embraced as the EMH. In fact, some have embraced it to such an extent that they view the stock market as an infallible machine; if it reacts (does not react) to a piece of information, that information must have been relevant (irrelevant). But research methods have improved over time. Whereas prior studies generally failed to refute the EMH, now there are several papers which raise serious doubts about its validity. Perhaps the clearest challenge to the EMH comes from two papers by Victor Bernard and Jacob Thomas.8 Previous papers have shown that when firms report favorable earnings, stock prices increase both at the time of announcement and for several months thereafter. This continued rise in price is known as the "post-announcement drift" in stock prices. If the market is efficient, there should be no measurable post-announcement return related to earnings. Bernard and Thomas set out to determine the origins of the drift. First, they examined previous findings that quarterly earnings changes are related across time. The evidence shows that if earnings for quarter 1 of 1990 are larger than earnings for quarter 1 of 1989, then earnings for quarter 2 of 1990 will probably increase relative to last year's. Similar phenomena will occur in quarters 3 and 4 of 1990. But, for quarter 1 of 1991 (i.e., four quarters ahead), earnings will most likely decrease. Next, Bernard and Thomas looked closely at "abnormal" daily stock returns, and they found that firms with positive earnings surprises in the current period have positive returns when earnings are announced one and two quarters ahead, but have negative returns four quarters ahead. In essence, the return behavior matches the time-series properties of earnings. Bernard and Thomas conclude that their evidence "is consistent with stock prices partially reflect[ing] a naive earnings expectation; that future earnings will be equal to earnings for the comparable quarter of the prior year." In other words, the market appears surprised by predictable earnings patterns. How big is the inefficiency? Bernard and Thomas show "that the three-day announcement-period returns on portfolios constructed with only prior-quarter earnings information are approximately half as large as the return portfolios constructed using the contemporaneous earnings information.... [I]f market prices fail to reflect fully the implications of information as freely available as earnings, how well do they reflect information that is not as well-publicized?"9

"Post-Earnings-Announcement Drift: Delayed Price Reaction or Risk Premium?" Journal of Accounting Research (Supplement, 1989) pp. 1-36, and "Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings," Journal of Accounting and Economics, (December, 1990) pp. 303-340. Bernard and Thomas, 1990, p. 338-339.

CONCLUSION Bernard and Thomas's last sentence suggests that EMH proponents may need to soften their positions. In light of the evidence, how can one presume that prices can fully and unbiasedly reflect all of the information in detailed footnote disclosures? At present, some studies find that prices appear to reflect the economic substance underlying reported accounting numbers, while other studies reach the opposite conclusion. How efficient is the market? If efficiency were plotted on a ten point scale, it is safe to conclude that the stock market is more efficient than "0" and less efficient than "10." Based on the all of the evidence to date, I would rank it above 5 but no higher than 8. This means that some managers who put bad news in footnotes instead of the balance sheet may fool the market some of the time, but such gimmicks will fail more often than not. However, inefficiencies do exist, and therefore, the price of a given firm at a given point in time can deviate from the "correct" price based on all available information. More concrete conclusions will have to await further research.