Group D Taylor Carson Nicholas Chow Michael Cheuk-Hei Yu Overview for Chapter 4 Meaning of efficiency Implications for financial reporting A capital asset pricing model Information asymmetry, insider trading, adverse selection Full Disclosure Efficient Securities Markets Under ideal conditions, information is free and investors use information to acquire and form subjective estimates of firms’ future performance Realistically, information is not free and it is up to investors to form their own subjective estimates of firms’ future performance Efficient Securities Markets (con’t) Information sources include: o o o o o Financial press Tips from friends and associates Changes in economic conditions Advice from analysts and advisors Quarterly and annual reports The Meaning of Efficiency Informed investors will quickly move on receipt of new information. If not, the market value of the security will adjust to reduce or eliminate the benefit Two definitions of efficient securities market: Semi-strong form: reflects publicly available information Strong form efficiency: reflects all information The Meaning of Efficiency (con’t) 4 important points about efficiency: 1) Market prices are efficient with respect to publicly known information. Thus, prices do not consider inside information 2) The market is efficient relative to a stock of publicly available information. 3) Investing is fair game if the market is efficient 4) Given market efficiency, a security's market price should fluctuate randomly over time Market prices reflect all available information Decision theory allows different investors to react to the same information differently, even though they all proceed rationally In the big picture, the differences in forecasting ability of individual forecasters tend to cancel out when the consensus is formed Most importantly, the security values must on average by unbiased Implications of efficient securities markets Accounting policies adopted by firms do not affect their security prices ii) If a firm’s management possesses relevant information about the firm that can be disclosed at little or no cost, management should then disclose this information on a timely basis iii) Financial statement information need not be presented in a manner so simple that everyone can understand it (naive investor) iv) Accountants are in competition with other providers of information i) Logical Inconsistency fully informative share prices allow investors to stop gathering information and rely on markets price as the best indicator of future security returns Price fully reflect available information Investors acquire information Investors loses motivation to acquire information Price doesn’t fully reflect available information Informativeness of Price Liquidity traders or noise traders buy/sell decisions coming at random coming from a hot tip Security prices are partially informative in the presence of noise trading How informative the price is depends on the quality of financial statement information and costs of analysis and interpretation Informativeness of Price (cont’d) Voluntary disclosure: disclosure of information beyond the minimum requirement of GAAP Rational investor will then look at what the manager does in terms of accounting policy choice and disclosure To increased the quality of financial statement disclosure, firms will include the management of discussion and analysis (MD&A) Capital Asset Pricing Models 3 Main Uses: Displays how share prices depend on expectations Separate expected and unexpected components of realized return Method to estimate a stock’s Beta Stock Prices Depend on Expectations ( + ) − 1 = 1 − + ( ) ,−1 is the price of the shares at the end of the period is the dividends paid by the firm ,−1 is the price of the shares at the beginning of the period New information changes ( + ), so ,−1 must change to balance out the formula Separate Expected and Unexpected Returns = + + + is the beginning of period expected return is the unexpected return Estimate a Stock’s Beta Obtain past data on and Perform a Least-squares regression and obtain the model’s coefficients The coefficient of will be a good estimate of Information Asymmetry Root cause of several market problems: Failure to launch Collapse Inefficiency Why is it important to accounting theory? Fundamental Value vs. Market Value Efficient Market Price of Firm Fundamental Value of Firm Publicly Available Information About Firm Inside Information Role of Financial Reporting The Social Significance of Securities Markets that Work Well Securities Markets = primary method of raising capital Information asymmetry creates problems Francis, Huang, Khurana, and Pereira (2009) Easier to obtain financing in countries with high quality financial reporting Promoting Reporting Quality There are two methods: Regulations (stick) Incentives (carrot) The right mix improves reporting quality Diminishing the Information Asymmetry Management Discussion and Analysis Used to convey more information to the public Summarize information from Financial Statements Can include strategies, plans, and prospects Objectives of the MD&A Financial Condition Company Performance Risks Future Prospects Investor Sun Airlines Inc. Operates primarily in the Eastern states and has been profitable during each of the last 6 years One of the first regional airlines to adopt a frequent flyer plan (FFP) -> Sun Travel Award Club (STAC) In 2002, approximately 45% of paid-for revenue passenger miles were eligible for FFP rewards to FFP members SAI has had a deteriorating current ratio and is approaching the minimum required by their lender’s covenants Sun Airlines Inc. After today’s textbook overview, what is one major implication of the possible covenant violation? Sun Airlines Inc. The FFP is causing a liability on the balance sheet and some VPs would like to see it removed Marketing is refusing to have it eliminated Investor relations is suggesting that this should be a contingency and therefore buried in the notes as opposed to set up as a liability What do you think? Sun Airlines Inc. 2 methods for accounting for FFPs - criteria Incremental cost method: assumes no displacement of revenue paying customers and that the earnings process is complete when the paid flight is taken, the no displacement is often shown by blackout periods and capacity controls, available excess capacity, and the FFP awards using a small portion of the excess Deferred revenue method: the free travel awards are essentially considered discounted tickets, it is suggested that this is used at least for the routes on which the load factor is high Sun Airlines Inc. 2 methods for accounting for FFPs – effects Incremental cost method: a liability is set up for the expected incremental cost of having the extra passengers on a future flight – takes into account an estimate of outstanding miles expected to be redeemed Deferred revenue method: a portion of the revenues received for current flights is deferred until the free flight is taken in the future in order to essentially spread the revenue across all flights taken Sun Airlines Inc. Given that Sun Airlines has current passenger load factors in the 60-70% range, that they provide a blackout period around holidays and other peak periods, what method should be used? One of the VPs mentioned that overall there is extra capacity, but certain routes operate close to 100% capacity, does this change your answer? Sun Airlines Inc. Given the current state, the current ratio has dropped to ~ 0.739 which is less than the required 0.8, causing a current covenant violation If the STAC liability were to be eliminated, the current ratio would move to ~ 0.864. However, this would require the elimination of the FFP program, which would cause many other issues, including potential lawsuits and loss of customers Sun Airlines Inc. Currently using a 75% expected redemption based on historical data However, VP Operations expects that in the future, only 70% of the miles flown by FFP members will qualify for rewards What concept previously discussed does this relate to? Sun Airlines Inc. Other issue facing the company is the revenue recognition surrounding bulk miles sold to other companies that can be returned. There is likely a marketing component as well as the travel portion, and therefore a travel portion should be removed if possible. Mid-Term Prep Questions 6. What market efficiency means? 7. 8. 9. 10. 11. Why the term “market efficiency” is important to financial accounting? How market efficiency occurs? How Market inefficiency can have impacts on financial accounting? What are the market anomalies? What they indicate? What information asymmetry means? What consequences can it cause? How is it related to market efficiency?