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Financial Accounting Theory

by: Rocio West

Financial Accounting Theory ACC 6013

Rocio West
GPA 3.92

Jeffery Boone

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Jeffery Boone
Class Notes
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This 5 page Class Notes was uploaded by Rocio West on Thursday October 29, 2015. The Class Notes belongs to ACC 6013 at University of Texas at San Antonio taught by Jeffery Boone in Fall. Since its upload, it has received 17 views. For similar materials see /class/231441/acc-6013-university-of-texas-at-san-antonio in Accounting at University of Texas at San Antonio.

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Date Created: 10/29/15
Summary of Key Ideas from 91608 Class There are two key ideas from the 9 16 class meeting The idea of informationally efficient capital markets EMHIRH and the role of information asymmetry The early version of the Efficient Market Hypothesis EMH asserts that at all times stock prices re ect all publicly available information Hence stock prices are fully informative and there are no undervalued securities The logic behind the EMH is the presence of arbitrageurs who quickly act on any piece of value relevant information about a security buying if the information is good news selling if it is bad news Their act of buying selling puts upward downward pressure on stock prices causing them to gravitate toward fullinformation value However this poses a logical inconsistency if stock prices fully re ect all public information what incentive is there for information search Lacking such incentive arbitrageurs would cease their information search efforts and stock prices would no longer fully re ect all publicly available information The way out of this logical inconsistency is to recognize the role of noise traders Noise traders are those investors who trade on the basis of liquidity needs liquidate a position to get cash for some consumption purposes or take a position to invest excess cash pseudosignals a hot tip or on the basis of some whim Trades executed by noise traders can cause stock prices to temporarily deviate from full information value creating an incentive for the arbitragers to engage in information search If the information search reveals that noise trade has moved stock prices above full information value stock is overvalued the arbitrageur will sell short Alternatively if the arbitrageur concludes that an increase in stock price is due to some other arbitrageur buying based on newly discovered information the arbitrageur will buy the stock Given the presence of both arbitrageurs and noise traders we say that stock prices are partially informative That is investors can expect that on average stock prices fully re ect all publicly available information but further investigation may reveal this is not the case The cost of arbitrage is an important determinant of the extent to which stock prices will re ect publicly available information Arbitrage costs include transaction costs the cost of placing the order the spread between bid and ask prices etc holding costs and information acquisition and processing costs In settings where arbitrage costs are high stock prices in general will re ect a smaller portion of publicly available information than when arbitrage costs are low This is the Incomplete Revelation Hypothesis IRH which is essentially a tweak on the original EMH This insight has important implications for accounting policyimost notably the issue of recognition versus disclosure If one ignores arbitrage costs and adopts a simplistic view of market efficiency ie the early version of EMH then the issue of recognition versus disclosure is moot whether an item is recognized in the nancials proper or merely disclosed in the footnotes is irrelevant because the market will properly act upon the information causing the information to be impounded in stock prices However once we recognize that information disclosed in footnotes may be more costly to acquire and process then it is possible that information disclosed in the footnotes may be less fully incorporated in stock prices than information that is recognized in the nancial statements So policymakers might want to opt in favor of recognition disclosure rather than disclosure recognition if an issue will disproportionately affect rms in which arbitrage costs are high low The issue of recognition versus disclosure has at least three other implications too First investors may perceive footnote information as somehow less reliable than information that is incorporated into the financial statements The lower perceived reliability of the disclosed information may dampen investors response to the information causing it to be less fully incorporated into stock prices Second many of a firm s contracts are denominated in terms of accounting numbers eg executive compensation contracts lending agreements etc Thus recognizing a piece of information into the financial statements may in turn cause changes in the terms of the accountingdenominated contract triggering potentially costly consequences For example recognizing operating leases as capital leases would increase debtequity ratios which might cause firms with large operating leases to violate debtequity constraints stipulated in their lending agreements resulting in technical default on the loan Third in those few instances in which a firm has a choice between recognition versus disclosure the decision of the manager to relegate information to the footnotes may reveal something about the credibility of the firm e g Why is this firm burying bad news in the footnotes In addition to the idea of efficient markets information asymmetry is a second key idea from this class meeting Information asymmetry eXists when there is unequal distribution of valuerelevant information between two parties to a transaction one party knows something of importance that is unknown to the other party Two problems arise from information asymmetry the problem of moral hazard and the problem of adverse selection Moral hazard arises when one party to a transaction shirks on hisher responsibilities and the shirking cannot be detected by the other party due to information asymmetry Adverse selection arises when information asymmetry prevents buyers from distinguishing quality differences among products resulting in a migration of inferior products to the market and withdrawal of quality products from the market Your textbook gives a great example to illustrate these two sorts of information asymmetry related problems The example is insurance to protect against the possibility that you might not successfully complete your college education As we all know there is no market for this type of insurance Why The answer is the problem of moral hazard and adverse selection Moral hazard is a problem because a student buying such insurance would have an incentive to shirk on hisher studies not complete the course of study and file an insurance claim Adverse selection is a problem because only the weaker students would tend to buy the insurance the good students wouldn t buy the insurance because they know they have the ability and motivation to compete the course of study Thus because of the severity of information asymmetry and its related problems of moral hazard and adverse selection the market for graduation insurance has never developed In other instances the problems arising from information asymmetry may not be severe enough to prevent markets from forming but these problems do impair the functioning of the market A good example is the used car market where the seller of a car knows more than the buyer about the car s condition Here the buyer knows there are two states of nature 1 the car is a lemon or 2 the car is not a lemon The buyer aware of the information asymmetry will assign a nonzero probability to the state of nature car is a lemon and accordingly will reduce his offer price for the car Owners of quality cars will be unwilling to sell their cars for less than true value and will avoid the used car market So the used car market should contain a disproportionate number of lemons Adverse selection arising from information asymmetry has reduced the quality and quantity of the used cars offered for sale A similar problem can arise in capital markets Here investors analogous to buys of used cars know there are two states of nature 1 the stock is strong or 2 the stock is weak The investor aware of information asymmetry will assign a nonzero probability to the state of nature the stock is weak and reduce the offer price accordingly Entrepreneurs of highquality fums wanting to go public will be unwilling to sell their fum for less than its true value and thus will remain privately owned So under conditions of information asymmetry the market for IPOs potentially contains a disproportionate number of weak rms Accounting can enhance the functioning of securities markets by fully disclosing all valuerelevant information about the rm Full disclosure will help reduce the information asymmetry and the related problem of adverse selection resulting in lower lemons discounts for securities and a higher quality and quantity of securities trading in the marketplace As an aside I note that hiring a high quality auditor also can help reduce information asymmetry how


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