Group D
Taylor Carson
Nicholas Chow
Michael Cheuk-Hei Yu
Overview for Chapter 4
Meaning of
for financial
A capital
asset pricing
Information asymmetry,
insider trading, adverse
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:
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
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
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
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
Investors acquire
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
 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 −  +  ( )
  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
 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
About Firm
Role of Financial
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
 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
 Summarize information from Financial
 Can include strategies, plans, and
Objectives of the MD&A
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
 SAI has had a deteriorating current ratio and is
approaching the minimum required by their lender’s
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
Mid-Term Prep Questions
6. What market efficiency means?
Why the term “market efficiency” is important to
financial accounting?
How market efficiency occurs?
How Market inefficiency can have impacts on financial
What are the market anomalies? What they indicate?
What information asymmetry means? What
consequences can it cause? How is it related to market

similar documents