Master in Industrial Economics &
Markets

Business &
Finance I:
Business
Economics &
Financial
Analysis
Professor:
Juan Manuel García Lara

Lecture 2: Accounting & capital markets
What’s the role of accounting in a context of capital markets? (think in terms of the market for lemons)

Are capital markets efficient?

(What do

we mean by efficient?)

2

The market efficiency hypothesis
A market is efficient… if security prices fully reflect the information available
(Fama, 1970). with respect to some specified information system, if and only if security prices act as if everyone observes the information system.

Forms of market efficiency (Fama,
1970)
Weak form: prices fully reflect information regarding the past sequence of prices.
Semi-strong: prices fully reflect all publicly available information, including financial statement data.
Strong: prices fully reflect all information, including inside information.
3

From the front page of “The Economist”, 7 November 1997

4

Accounting and capital markets
Relevance of accounting information and capital market efficiency:
- The association between earnings and change in price is small. Why? Does it mean earnings are not relevant?
- Large association between shareholders’ equity (as reflected in the balance sheet) and market capitalisation.

5

Relevance of accounting information
Ball and Brown (1968):

6

Accounting and capital markets
Information content:
- Does the capital market react to accounting information?
- This is,…, Is accounting providing information the market did not know?

7

Information content of earnings
Beaver (1968):

8

Information content of earnings
Beaver (1968):

9

Information content of earnings

Morse (1981)
10

Information content of earnings

Patell and Wolfson (1984)
11

Information content of earnings

12

Information content of earnings

13

Information content of earnings

14

Information content of earnings

15

Accounting and capital markets
Does the market fully understand all accounting information?:
- Apparently not, there are anomalies in the formation of prices.
• Post earnings announcement drift
• Anomalies in accounting ratios
• The accrual anomaly

16

Post earnings announcement drift
There’s evidence that share prices show abnormal returns during approximately 60 days after the earnings announcement (Foster et al. 1984;
Bernard and Thomas, 1989 y 1990).

If the anomaly exists, there are arbitrage opportunities: (buy firms with good news and short sell firms with bad news).

Why there is this postannouncement drift?

17

Anomalies in accounting ratios
Ou and Penman (1989):
- They calculate a number of ratios and select those that explain better next period’s earnings.
- They use them in a linear model to predict the
increase