ACT301 Week 9 Tutorial

Chapter 10: Reactions of capital markets to financial reporting

10.1 Capital markets research explores the role of accounting and other information
in equity (capital) markets. As shown in the chapter, one branch of capital
markets research explores the reaction of share prices to the release of particular
information. The view taken is that if share prices change around the time of the
release of particular information then (assuming the price reaction did not relate
to other events) the information must have been useful in enabling the capital
market to revise its expectations about the future earnings and cash flows of the
organisation in question. The market is only expected to react to new
information and hence a price change around the time of the release of the
information indicates that the information is useful.

A second branch of capital markets research that we explored in this chapter

related to research which considers how accurately accounting data reflects the
information used by the market in determining share prices. This research, which
has been described as ‘looking back the other way’, adopts the view (from the
efficient markets hypothesis) that share prices reflect information gathered from
many sources, one source of which is accounting. Accepting that the share
market has correctly priced a security, the share price and changes therein, are
used as a basis (or benchmark) for evaluating accounting data. Under this branch
of capital market research, accounting data that does not relate to, or correlate
well with, share prices is deemed to have limitations.

10.3 As Chapter 10 questions, if further evidence continues to surface that capital

markets do not always behave in accordance with the efficient market
hypothesis, then should we reject the research that has embraced the EMH as a
fundamental assumption? In this regard we can return to earlier chapters of this
book in which we emphasised that theories are abstractions of reality. Capital
markets are made of individuals and as such it would not (or perhaps, should
not) be surprising to find that the market does not also act in the same
predictable manner. Nevertheless, the EMH has helped provide some useful

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 predictions and no doubt will continue to be relied upon by many researchers for
a considerable period of time. As Lee (2001, p.238) states:

A common assertion is that even if the EMH is not strictly true, it is sufficient
to serve as a starting point for research purposes. Like Newtonian physics, it
is more than good enough for everyday usage. Unfortunately, it has
becoming increasingly more difficult to accommodate what we know about
the behaviour of prices and returns within this traditional framework.

At the present time there is a great deal of research into capital markets that does
not rely upon market efficiencies. The consideration of ‘other forces’ that shape
share prices and returns might eventually lead to a revolution in thought (Kuhn,
1962)—but it will arguably take a long time.

10.8 Typically, if an item of information is released and the market price of the firm’s
securities does not change, then it is argued that the information is not being used
by the market participants; otherwise there would have been a reaction. Conversely,
if security prices change around the time of the release of particular information,
and assuming that the information and not some other event caused the price
change, then it is considered that the information was relevant and useful for
investment decision making. It would be relevant because it allows market
participants to reassess the future cash flows of the entity. That is, it is assumed that
relevant information is not ignored by the market.

Capital markets research relies on the underlying assumption that equity markets
are efficient. Market efficiency is defined in accordance with the EMH as a
market that adjusts rapidly to fully impound information into share prices when
the information is released (Fama et al. 1969). Capital markets research in
accounting typically assumes that equity markets are semi-strong-form efficient.
That is, that all publicly available information, including that available in
financial statements and other financial disclosures, is rapidly and fully
impounded into share prices in an unbiased manner as it is released.

10.18 The research shows that the earnings announcements of firms within an industry
can impact the share prices of other firms in the same industry. This effect has

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been labelled as the ‘information transfer effect’. The ‘information transfer
effect’ highlights the belief that share prices react to public information
emanating from various sources—including information emanating from the
entity’s competitors. Research shows (for example, Clinch and Sinclair 1987)
that within an industry, the ‘information transfer effect’ tends to be more
significant in relation to those entities that make the earlier earnings
announcements. Once a number of firms within an industry report their earnings
then most of the industry-wide information would have been incorporated in
competitors’ share prices. Accounting Headline 10.7 provides an example of the
information transfer effect.