Abstract
This study discusses the relationship between accounting information and capital market. It first provides a discussion on the theory of market efficiency. Next, this study examines empirical researches that conclude that capital markets are inefficient. Then, the study reviews the issue of how accounting standard shift to fair value method and how it will affect capital markets and market efficiency.
Introduction
To undercover the relationship between capital market research and accounting, let’s consider a classic event from security market. Share prices change around the date of information releases. ( give some examples of how big the change is). Intuitively, the release of accounting information has impacts on security prices. It is reasonable to include accounting financial report information as one of the factors that inherent in security price movements.
Broadly speaking, capital market research focus on the relation between accounting statement information and capital market (Kothari, 2001). For instance, the value of a firm is always the central of asset pricing researches. Under neoclassical economy theory, when capital market is efficient, a firm’s value is equal to the present value of expected future new cash flows, discounted by appropriate risk-adjusted rate of return (cohoren, 2008). There are three key factors in this statement: An efficient market; expected future cash flows and risk-adjusted rate of return. An efficient market is the background. The expected future cash flows however, is closely related to current and historical financial statement of a firm. The risk-adjusted rate of return is beyond the discussion of this assignment. Financial Accounting Standard Board’s (FASB’s) conceptual framework empersis that financial statements should help investors and creditors in assessing the amounts, timing, and uncertainty of future cash flow (FASB, 1978).
Pioneered by Graham and Dodd and their famous book Security Analysis in 1934. Fundamental analysis entails the use of information in current and past accounting statements, in conjunction with industry and macroeconomic data to arrive at a firm’s intrinsic value. A difference between the current price and the intrinsic value is an indication of the expected rewards for investing in the security.
However, Fama (1970, 1991) proposed the theory of market efficiency. By Fama’s definition, in an efficient market security prices fully reflect all available information. Such a theory connects the financial information and capital market through security prices. If market efficiency theory states true, the fundamental analysis would be useless. In either view, financial statement information is the very important as these data serves as basics inputs.
Empirical evidence
Early capital market researches largely supported market efficiency. Researchers test the market efficiency in two aspects: security price movements around announcement dates and effects of changes in accounting methods. Ball and Brown (1968) and Beaver (1968) find positive evidence of market efficiency according to first aspect. On the other hand, Archibald (1972) and Ball (1972) conclude similar results from the second aspect.
Link to accounting practices
Several studies have examined market efficiency based on some key feature of financial reporting. Sloan (1996) is an excellent example of research that exploits one key accounting treatment: accrual accounting. Sloan (1996) concludes that capital markets overestimate the persistence of accruals and underestimate the persistence of cash flows from operations, because accruals are more subject to uncertainty of estimation and more subject to management and manipulation. Xie (2001) supports this conclusion by showing the mispricing documented by Sloan (1996) is largely due to abnormal accruals.
Issues in accounting practice
Questions to regulators then arise as to whether altering the presentation of the data could mitigate or improve the market efficiency.
The methods of forming accounting data can have huge impact on capital markets. The empirical evidence about accruals accounting is only one example of such influences. Another important aspect of accounting rule is fair value accounting.
In December of 2001, accounting standard-setters around the world published a consultation paper that proposes fundamental changes to the way financial instruments are reported in the financial reports of firms. A financial asset for which an active market exists should be carried in the balance sheet at its market bid price and changes in that bid price should be recognized immediately in the profit and loss account. FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition abandons a long-standing practice of using the transaction price for an asset or liability as its initial fair value. In other words, fair value will no longer be based on what you pay for something; it will now be based on what you can sell it for.
The world of accounting practice is implicated in the current financial crisis in a number of ways. The most obvious is through financial reporting requirements governing asset valuation and off-balance sheet entities (Ryan, 2008).
The FVA continues to produce a passionate and interesting debate about its impact on the Global Financial and Economic Crisis despite the widespread adoption of International Financial Accounting Standards (IFRS) by accounting regulatory committees in many countries. While fair value has come under scrutiny and was blamed, the main critical flaw does not lie in the accounting standards but in the fact that companies take measures to partially withhold information. Financial reporting is not always prepared specifically for delivering the needed information to investors, and third parties such as analysts, investors, standard setters (Menicucci, 2015).
Financial reporting rules governing off-balance sheet structured investment vehicles (SIVs), including rules on special purpose entities (SPEs), qualified special purpose entities (QSPEs), and variable interest entities are equally, if not more, significant. In the 1980s, US accounting standards setters began allowing banks to move securitized loans and related debts off their balance sheets and onto the books of these off-balance sheet entities (Turner, 2008). This obviously flawed rule which enabled the creation of the shadow banking system has been modified several times since the 1980s, but never satisfactorily. The practice of using structured investment vehicles to move banking operations off-balance sheets in order to evade accounting rules and regulatory capital standards, together with the potential impact on capital adequacy ratios of forcing banks to consolidate off-balance sheet vehicles remains a crucial issue facing accounting and regulatory authorities (Group of Thirty, 2009).
Accounting research lagged behind this burgeoning world of accounting practice. While accounting practitioners were involved in the securitization schemes that ultimately led to the crisis, accounting scholars were largely unaware of their activities or the troubles brewing in the credit market and shadow banking system (Arnold, 2009). The premier academic accounting journals did not address the dangers of structured investments, securitization and off-balance sheet entities until 2008 when the credit crisis was in full swing.
Issues to transparency
Therefore, the change of accounting standards disrupted the information transparency channel of capital market instead of improve market efficiency. Moreover, the problems by using fair value accounting enforces the idea of market prices reflect information from many sources and if the accumulated data provide a particular signal, the accounting disclosures should provide similar signals. It is a circular reasoning.
The idea that markets will efficiently allocate capital and risk under conditions of perfect competition and perfect information, of course, derives from neoclassical economic theory. It follows that financial accounting and auditing have an essential role to paly by ensuring that relevant and reliable information is disclosed to investors. This is the theoretical rationale, but what are the actural historical and political origins of the quasi-regulatory role that financial reporting and auditing have come to play I the governance of capital markets?
Capital markets research on fundamental analysis has become extremely popular because of many evidence in the financial economics literature against the efficient markets hypothesis.
Before we take a deeper analysis on those events, it is worth to take a detour on the theory of market efficiency. The link between accounting and capital market research can start from the theory of market efficiency.
Therefore, it is important to discuss what information does accounting reports contain? Expectations and history of earnings and a firm. Individual investors can have different expectations based on those accounting informations and the market has an aggregate believe or the best guess as a whole.
The event of enron collapse in 2001.
That example is a closer look at how accounting earnings information can related with share prices and the market as a whole.
Modern asset pricing theory proposes that a share price can determined as the sum of expected future cash flows from dividends, discounted to their present value using a rate of return commensurate with the company’s level of risk. The dividend itself is a function of accounting earnings.
Here is worth to mention the fundamental of economy that developed by adam smith. The break down of the trust of the system is
The accounting rules and standards are the fundamentals to create those financial reports. Recently, fair value accounting rules are
References
Menicucci E. (2015) The Role of Fair Value Accounting (FVA) in the Financial Crisis. In: Fair Value Accounting: Key Issues Arising from the Financial Crisis. Palgrave Macmillan Studies in Banking and Financial Institutions. Palgrave Pivot, London