ACCT90013 · Financial Accounting Theory And Practice
Efficient Markets and Capital Markets
This chapter owns the valuation half of the subject. The organising question is simple: when an accounting number is released, does the market move, and why? The answer runs through the Efficient Markets Hypothesis (EMH) — prices reflect an information set, in three nested forms (weak ⊂ semi-strong ⊂ strong) — and its sharp accounting implication: in an efficient market a cosmetic policy change with no cash-flow effect moves no price, so what is disclosed matters, not where it sits (substance over form). It then turns to the evidence: Ball & Brown (1968) showed earnings carry information, and the Earnings Response Coefficient (ERC) measures how much price moves per unit of unexpected earnings — governed by persistence, growth, risk and earnings quality. Finally, the behavioural cracks (post-earnings-announcement drift, the accruals anomaly, over/under-reaction) show efficiency is an approximation, not a law. The engine to remember: prices react to the unexpected, persistent, reliable part of an accounting signal.
What this chapter covers
- 01The three nested forms of the EMH (weak ⊂ semi-strong ⊂ strong)
- 02What efficiency does NOT claim; substance over form
- 03The information perspective on decision-usefulness
- 04Ball & Brown (1968): earnings have information content
- 05The Earnings Response Coefficient (ERC) and its determinants
- 06Value relevance; behavioural cracks (PEAD, accruals anomaly, over/under-reaction)
Worked example: read the price reaction
- +1Establish the trigger: in an efficient market price reacts only to the unexpected component of earnings — both firms beat by the same amount, so the surprise is equal.
- +1(a) Persistence: Firm A's surprise is persistent (it should recur), so it revises expected future earnings more → a larger price reaction. Firm B's beat is transitory (one-off), so it revises the future little.
- +1(a) Risk: Firm B is highly leveraged — higher risk raises the discount rate and dampens the reaction. Both factors push Firm A's reaction above Firm B's.
- +1(b) Name it: the size of the price response per unit of unexpected earnings is the Earnings Response Coefficient (ERC), higher for persistent, lower-risk, higher-quality earnings.
Key terms
- Efficient Markets Hypothesis (EMH)
- The proposition that security prices fully reflect an information set, in three nested forms: weak (past prices), semi-strong (all public information, including accounting reports) and strong (all information, public and private). Accounting research mostly tests the semi-strong form.
- Substance over form
- The EMH implication that an efficient market sees through cosmetic accounting: a policy change with no cash-flow effect moves no price. What is disclosed (and its economic substance) matters, not the label or location in the statements.
- Information content
- The idea, established by Ball & Brown (1968), that earnings announcements convey new information — abnormal returns cluster around the announcement and move with the sign of the earnings surprise. It is the empirical foundation of capital-markets research.
- Earnings Response Coefficient (ERC)
- The slope linking abnormal return to unexpected earnings — how much price moves per dollar of surprise. It is higher for persistent, growing, lower-risk, higher-quality earnings and lower for transitory or risky earnings.
- Post-earnings-announcement drift (PEAD)
- The anomaly that abnormal returns continue to drift in the direction of an earnings surprise for weeks after the announcement — evidence that the market under-reacts, a crack in semi-strong efficiency.
Efficient Markets and Capital Markets FAQ
If markets are efficient, why does accounting policy matter at all?
Because not all policy is cosmetic. The EMH says a policy change with no cash-flow consequence won't move an efficient price — so “managing the optics” via pure presentation fails. But policy that affects cash flows (e.g. via taxes or contract triggers), or that reveals private information, does move price. The exam reward is distinguishing cosmetic changes (no reaction) from substantive or informative ones (reaction).
Why does the same dollar of earnings move two firms' prices differently?
Because price reacts to the unexpected part scaled by its persistence and risk — that scaling is the ERC. A persistent surprise revises the whole stream of future earnings (big reaction); a one-off surprise barely changes the future (small reaction). High risk or high leverage raises the discount rate and shrinks the reaction. So identical surprises produce different price moves through different ERCs.
Do the anomalies (PEAD, accruals) mean the EMH is wrong?
Not wrong, but incomplete. The anomalies show efficiency is an approximation: PEAD says the market under-reacts and information is impounded with a lag; the accruals anomaly says investors over-weight earnings and under-weight the lower persistence of the accrual component. The exam wants you to name the anomaly, say which form of efficiency it dents, and explain the behavioural mechanism — not to declare the EMH dead.
What's the difference between ‘value relevance’ and ‘information content’?
Information content (Ball & Brown style) asks whether a number triggers a price reaction around its announcement — a short-window event study. Value relevance asks whether an accounting number is associated with market value or returns over a longer window — an association study. Both test whether the number is decision-useful; they differ in research design and window.
Exam move
Memorise the engine sentence — price reacts to the unexpected, persistent, reliable part of an accounting signal — and run every price-reaction scenario through it. Build a two-line ERC checklist: (1) isolate the surprise (actual − expected), then (2) scale it by persistence (recurring vs one-off), growth, risk/leverage and earnings quality to predict the size of the move. Keep the three EMH forms straight (weak ⊂ semi-strong ⊂ strong) and know that accounting research targets the semi-strong form. For the anomalies, learn each as a triple: name → which efficiency form it dents → the behavioural mechanism (under-reaction for PEAD; mispriced accrual persistence for the accruals anomaly). Always conclude with the applied sentence, not the definition.
