BMAN 71132

Financial statements analysis

Lecture 6
Financial statement and security mispricing
 Overview

• Basic concept of efficient market hypothesis (EMH):

– Market is efficient with respect to a piece of information if trading
strategy based on that information earns a zero abnormal return
• Rationale:
– Numerous profit-maximizing investors compete to exploit arbitrage
opportunities by trading on all available and relevant information
– On aggregated level, investors’ trading adjust security prices quickly
to reflect the news, security prices are driven close to their intrinsic
(or fundamental) values, and expected returns implicit in the current
price of a security should reflect its underlying risk
• Implications:
– Since new information reaches market randomly, changes in
security prices occur in random walk and returns are unpredictable
– Since security prices are close to their intrinsic value, there is no
exploitable mispricing opportunities 2
 Overview

http://financeunleashed.blogspot.co.uk/2007/12/market-efficiency-and-financial.html 3
 Factors that influence security mispricing

• Why do we see security mispricing against EMH prediction?

Behavioural Investor
biases rationality

Incomplete Security Information

information mispricing quality

Limits to Investor
arbitrage arbitrage

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 Factors that influence security mispricing
• Behavioural bias
– Human are susceptible to similar psychological biases and on
aggregated level induce systematic overpricing or underpricing
– Information not fully impounded into security value, which is
determined both by fundamentals and investor irrationality
• Examples of cognitive biases
– Investor sentiment effect:
• People’s belief about future cash flows and investment risks can be driven by
mood or emotion, rather than by the facts or economic rationale
– Overconfidence:
• People tend to feel that their predictions are more accurate than they actually
are and unrealistically overestimate their abilities and prospects
– Conservatism:
• People tend to revise belief slowly and underweight new of evidence, possibly5
due to the cost of new information and the reluctance to change beliefs
 Factors that influence security mispricing

• Incomplete information effect:

– Investors prefer familiar stocks due to information uncertainty and
information cost
• underweight signals perceived to have lower precision or quality, which leads to
temporary mispricing
• adjust their original valuation upon arrival of new and more accurate information,
which leads to abnormal returns
– Security pricing anomalies can arise even if the market is
dominated by rational agents
• temporary mispricing or market inefficiency should be more pronounced among
companies with higher degree of information obscurity
• improvements in the quality and availability of information in the capital market
should lead to decrease in asset pricing anomalies
• this is where accounting information affects the efficiency of capital markets
through its affect on information asymmetry and environment
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 Factors that influence security mispricing
• Limits to arbitrage effect:
– Uncertainty
• Investment horizon of arbitrageurs can be shorter than the actual time needed for
price correction
• Arbitrageurs prefers to avoid bearing risk of loss
– Implementation cost
• Exploiting some opportunities such as overpricing requires short-selling which
entails cost
• Discourages arbitrageurs from fully exploiting overpriced securities
– Model risk
• The inaccuracy of valuation or asset pricing models
• Causes wrong recommendation and decisions

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 Factors that influence security mispricing
• Interaction between different factors that affect market
information efficiency (Baker and Wurgler, 2007, JEP)

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Factors that influence security mispricing

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Factors that influence security mispricing

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 Accruals anomaly – behavioural bias
• Sloan (1996, TAR):
– Overview:
• Examines if stock prices reflect information about future performance contained in
accruals and cash flow components of current earnings
– Motivation:
• While academics suggest that accruals and cash flow components of earnings
can have differential valuation implications, investors often fixate on reported
earnings
• Such functional fixation bias could cause the mispricing of security with regard to
accounting information, leading to information inefficiency in the capital market
– Empirical findings:
• Confirms that earnings performance is less persistent when driven by accruals
rather than cash flows
• Provides evidence of a negative relationship between current accruals and future
stock returns, which suggests that firms with higher accruals are systematically
overvalued 11
Accruals anomaly – behavioural bias

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Accruals anomaly – behavioural bias

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Accruals anomaly – behavioural bias

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Accruals anomaly – behavioural bias

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Accruals anomaly – behavioural bias

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 Accruals anomaly – behavioural bias
– Implications:
• Investors appear to fixate on reported earnings and neglect the differential
valuation implications between the accruals and cash flows component
• As such, investors systematically overvalue (undervalue) firms associated with
higher accruals (cash flows)
• It appears possible to formulate profitable trading strategy based on the level of
accruals
– Long stocks with higher level of cash flows relative to accruals
– Short stocks with higher level of accruals relative to cash flow
• Stock market is not informationally efficient with regard to accounting information
associated with accruals
• Challenges semi-strong form EMH, which argues that all publicly available
information are fully and quickly impounded to share prices

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 Accruals anomaly – incomplete information
• Do analysts and auditors alert investors about high accrual
firms (Bradshaw, Richardson, and Sloan, 2001, JAR)?
– Individual and less sophisticated investors are expected to be more
vulnerable to incomplete information
– Analysts and auditors, however, should be able to help reduce the
information barrier
• Analysts are sophisticated end-users of financial statement information and
serve as financial information intermediaries
• Auditors are supposed to help monitor and ensure the quality of financial
statement information issued by firms
– Problem:
• Analysts may collude with firms to increase investors’ expectations of future
earnings by inflating current accruals, current earnings, and forecasts of future
earnings
• Auditors may understand that inflated accruals imply greater likelihood of future
earnings declines and GAAP violations, but not required to communicate this
information to investors through audit opinion, i.e. earnings quality issues of 18
this
type may be beyond the scope of audit
Accruals anomaly – incomplete information

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 Accruals anomaly – limits to arbitrage
• Do institutional investors arbitrage away the mispricing of
accruals (Lev and Nissim, 2006, CAR)?
– Individual and less sophisticated investors are expected to be more
vulnerable to behavioural bias like functional fixation, which is
assumed to drive mispricing of accruals
– Institutional investors, however, should be able to exploit and
arbitrage away such mispricing opportunities
• Assumed to be more sophisticated than individual investors
• Should have the expertise to distinguish earnings persistence implication of
accrual and cash flow
• Could arbitrage and profit from the judgemental error of individual and/or less
sophisticated investors
– Problem:
• Extreme accrual stocks are associated with characteristics that are unattractive
to institutional investors
• Information and transaction cost deter individual investors from fully exploiting
such strategy 20
Accruals anomaly – limits to arbitrage

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 Incomplete information and security mispricing
• Lee, Strong, and Zhu (2014, JAR)
– Examines if disclosure regulations curbing abusive financial reporting
and analyst behaviour strengthen information environment
– Motivation:
• Dot.com bubbles and financial reporting scandals such as the case of Enron
causes capital market regulators to implement disclosure regulations
• However, there are debates among academics and practitioners over whether the
costs and benefits of these regulations, and whether they can really achieve the
purpose of improving capital market information efficiency
– Empirical findings:
• Provide evidence of significant reduction in mispricing as indicated by the decline
in price continuation after earnings announcements and analyst forecast revisions
• These effects are more pronounced in firms with higher information uncertainty
that are supposed to be more sensitive to changes in disclosure regulations

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 Incomplete information and security mispricing
– Hypotheses:

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 Incomplete information and security mispricing
– Research design:
• Sample:
– U.S. firms listed on NYSE, AMEX, and NASDAQ over the period of 1983 to 2011
– IBES, CRSP, and Compustat databases
– 459,546 and 435,834 firm-month observations during pre-regulation (1983-2000) and
post-regulation (2003-2011) periods respectively
• Abnormal returns tests:

• Mispricing effects tested:

– Post-earnings announcement drift
– Post-analyst forecast revision drift

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Incomplete information and security mispricing

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Incomplete information and security mispricing

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Incomplete information and security mispricing

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Incomplete information and security mispricing

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Incomplete information and security mispricing

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Incomplete information and security mispricing
– Implications:
• Disclosure regulations contributed to the reduction of security mispricing and
improved capital market information efficiency.
• Security mispricing is not only caused by cognitive bias of investors (demand side
of information) but also by the information environment of firms (supply side of
information).
– Limitations:
• The evidence does not imply disclosure regulations can solve all problems
associated with corporate information environment, and other factors such as
regulatory enforcement as well as voluntary disclosure incentives matters as well

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 Main lecture slides of this topic
ends here

Supplementary materials for this

topic coming up next
(will not be assessed and will only
be discussed if time allows)
 Supplementary materials

• Incomplete information and mispricing of accruals (Chan,

Lee, and Lin, 2009, JAPP)
– Overview

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 Supplementary materials
– Portfolio-based analysis

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 Supplementary materials
– Conditional effect of accounting information quality

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 Supplementary materials
– Comparison of discretionary vs non-discretionary accruals

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 Supplementary materials
– Accounting quality effects

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 Main readings and other references
• Main readings (primary focus and priority for final assessment revision)
– Lee, E., Strong, N., Zhu, Z. 2014. Did Regulation Fair Disclosure, SOX, and other analyst
regulations reduce security mispricing? Journal of Accounting Research 52, 733–774.
– Sloan, R. 1996. Do stock prices fully reflect information in accruals and cash flows about future
earnings? The Accounting Review 71, 289-315

• Other references
– Baker, M., Wurgler, J. 2007. Investor sentiment in the stock market. Journal of Economic
Perspectives, 21:2, 129-152.
– Bradshaw, M., Richardson, S., Sloan, R. 2001. Do analysts and auditors use information in
accruals? Journal of Accounting Research, 39:1, 45-74
– Chan, A., Lee, E., Lin, S. 2009. The impact of accounting information on mispricing of accruals:
The case of FRS 3 in UK. Journal of Accounting and Public Policy 28, 189-206.
– Lev, B., Nissim, D. 2006. The persistence of the accruals anomaly. Contemporary Accounting
Research, 23:1, 193-226

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 Thank you and
enjoy your study