1-1Copyright?2015PearsonCanadaInc.1-2FinancialAccountingTheory

SeventhEdition

WilliamR.ScottPurpose:Tocreateanawarenessandunderstandingofthefinancialreportingenvironmentinamarketeconomy1-3Chapter1

Introduction1.2SomeHistoricalPerspectiveEarlydevelopmentGreatdepressionof1930sreinforcedhistoricalcostaccountingAlternativestohistoricalcostCurrentvalueaccountingValue-in-useFairvalue(alsocalledexitprice,opportunitycost)Mixedmeasurementmodel1-41.2CollapseoftheStockMarketBoomofLate1990sEnronWorldComCollapseofpublicconfidenceincapitalmarketsEffectsonfinancialreportingIncreasedregulationandcorporategovernanceSarbanes-OxleyActTightenrulesreoff-balancesheetentities1-51.3MarketMeltdowns,2007-2008TerminologySecuritizationFinancialinstrumentsAsset-backedsecuritiesCollateralizeddebtobligationsAsset-backedcommercialpaperCreditdefaultswapsExpectedlossnotesLiquidityriskLiquiditypricingCounterpartyrisk

>>Continued1-6MarketMeltdowns,2007-2008(continued)

FinancialaccountingissuesleadinguptothemarketmeltdownsFairvalueaccountingforfinancialinstrumentsLiquiditypricingFairvaluelessthanvalue-in-useSeverecriticismoffairvalueaccountingHighleverageoffinancialinstitutionsOff-balancesheetliabilitiesUseofexpectedlossnotestoavoidconsolidationofstructuredinvestmentvehiclesWasdisclosureofoff-balancesheetliabilitiesadequate?

>>Continued1-7MarketMeltdowns,2007-2008(continued)

ResponseofstandardsettersStopgapmeasuresinresponsetogovernmentpressureFairvalueaccountingguidanceduringliquiditypricingIncreaseduseofinternalestimates(value-in-use)Increaseduseofcost-basedvaluationNewaccountingstandardsConsolidationDerecognitionIncreaseddisclosureResponseofstandardsettersconsideredingreaterdetailinChapter7

>>

Continued

1-8MarketMeltdowns,2007-2008(continued)

ResponseofotherregulatorsIncreaseddisclosureofmanagerialcompensationMovetransactionstosecurityexchangesandclearinghousesfromshadowbankingsystemIncreasedcapitalreservesforfinancialinstitutions

>>Continued1-9MarketMeltdowns,2007-2008(continued)

ImplicationsforaccountantsNeedfortransparencyValue-in-usev.fairvalueaccountingFulldisclosureofoff-balancesheetactivitiesNewaccountingstandardstohelppreventfutureabuses?1-101.4EfficientContractingAdifferentviewofthepurposeoffinancialreportingthanthecurrentvalueorientationofstandardsettersBasiccharacteristicsofefficientcontractingviewEmphasisoncontracts.AfirmcanbedefinedbythecontractsitentersintoE.g.,debtcontracts,compensationcontracts…EmphasisoncorporategovernanceThosefirmpoliciesthatalignthefirm’sactivitieswiththeinterestsofinvestorsandsociety1-11EfficientContractsForgoodcorporategovernance,contractsshouldbeefficientContractingpartiesmusttrusteachotherE.g.,afirmcangeneratelenders’trustbyincorporatingacovenantintoaborrowingcontract.CovenantsareacostofcontractingLendersrewardfirmwithlowerinterestrate.ThisisabenefitofcontractingAnefficientcontractisthebesttradeoffbetweencontractingcostsandbenefits>>Continued1-12EfficientContracts(continued)EfficientcontractingemphasizesmanagerstewardshipCompensationcontractsshouldmotivatemanagerstoworkinthebestinterestsoffirmownersAnefficientcompensationcontractdoessoatlowestcompensationcost.1-13AccountingPolicyImplicationsofEfficientContractingFinancialreportingshouldbereliableReliablereportinggeneratesinvestortrustFinancialreportingshouldbeconservativeE.g.,writeassetsdownifcurrentvaluelessthanbookvalue.But,writeassetsuponlyifcanbedonereliably.Rationale:encouragesstewardshipPreventsmanagersfromincreasingreputationandcompensationbyincreasingreportedprofitsthroughnon-reliableassetwriteupsThesepoliciesoftenconflictwithcurrentvalueaccountingCurrentvalueaccountingsacrificesreliabilityforrelevance1-141.5EthicalBehaviourbyAccountants/AuditorsWasaccountant/auditorbehaviourleadinguptoEnron,WorldCom,and2007-2008marketmeltdownsepisodesethical?Servetheclient(shortrunview)orservesociety(longrunview)?Whywouldyouservetheclientorservesocietyinsimilarcircumstances?EthicalprinciplesrequireyoutodotherightthingLongruninterestsofprofessionrequireyoutodotherightthingButmindsetsdiffer1-151.6Rules-Basedv.Principles-BasedAccountingStandardsDorules-basedaccountingstandardswork?Enron,WorldComExpectedlossnotesWillmorerulesinnewaccountingstandardsworktopreventabuse?Principles-basedstandardsImportantroleofConceptualFrameworkReliesonethicalaccounting/auditingprofession1-161.7TheComplexityofInformationIndividualreactionstosameinformationmaydifferReportingtoinvestorsv.reportingonstewardshipcomplicatesreportingCurrentvaluev.efficientcontractingviewsInformationalsoaffectshowwellmarketswork1-171.9InformationAsymmetryRoleofInformationinaMarketEconomyToimproveoperationofcapitalmarketsAdverseselectionproblemToimproveoperationofmanageriallabourmarketsMoralhazardproblemBothrolescrucialifmarketsaretoworkwellE.g.,2007-2008marketmeltdownsLackoftransparencyofasset-backedsecuritiesExcessiveriskencouragedbyoff-balance-sheetactivitiesExcessiveriskencouragedbymanagercompensationstructure

>>Continued1-18InformationAsymmetry(continued)RoleofaccountinginformationtocontroladverseselectionConvertinsideinformationintooutsideSupplyusefulinformationtoinvestors

RoleofaccountinginformationtocontrolmoralhazardControlmanagershirkingImprovecorporategovernance

1-191.10TheFundamentalProblemOfFinancialAccountingTheoryThebestmeasureofnetincometocontroladverseselectionnotthesameasthebestmeasuretomotivatemanagerperformanceInvestorswantinformationaboutfuturefirmperformanceCurrentvalueaccounting?Goodcorporategovernancerequiresthatmanagers“workhard”Doesmorereliableinformationandconservatismbetterreflectmanagereffortthancurrentvalueinformation?1-201.11RegulationasaReactiontotheFundamentalProblemofStandardSettingStandardsettingisaformofregulationIsstandardsettingneeded?MarketforcesmotivatefirmstoproduceinformationButmarketforcessubjecttofailureAdverseselectionMoralhazardRegulationstepsintotrytocorrectmarketfailuresRegulationiscostlyContinued1-21RegulationasaReactiontotheFundamentalProblemofStandardSetting(continued)StandardsettingmediatesbetweenconflictinginterestsofinvestorsandmanagersInvestorswantlotsofusefulinformationManagersmayobjecttoreleasingalltheinformationthatinvestorsdesireDueprocessinstandardsettingmediatesbetweeninvestors’andmanagers’interestsRepresentationofdiverseconstituenciesSuper-majorityvotingExposuredrafts1-221.12.5TheProcessofStandardSettingStructureIASBInternationalstandardsFASBUnitedStatesstandardsSecuritiescommissionsRoleinenforcingfirmstofollowstandardsMaysetstandardsthemselvesWhydotheydelegatemoststandardsetting?1-23TheoriesRelevanttoFinancialAccountingTherationalinvestorAmodelofhowaninvestormayusenewinformationtorevisebeliefsaboutfuturefirmperformanceRationalityholdsonaverage,notnecessarilyforeachindividualEfficientsecuritiesmarketsEfficiencyisamatterofdegreeSharepricesreasonablyreflectallpubliclyavailableinformationEfficiencyisrelativetoastockofinformationRoleoffinancialreportinginimproving/expandingthestockofinformationContinued1-24TheoriesRelevanttoFinancialAccounting(continued)BehaviouraltheoriesInvestorsdonotusealltheinformationinfinancialstatements→securitiesmarketsnotfullyefficientAgencytheoryEfficientcontractstomotivatemanagerperformance(stewardship)andachievegoodcorporategovernance1-252-26Chapter2

AccountingUnderIdealConditions2-27AssumptionsKnownfuturecashreceiptsGiveninterestrateBasisofaccountingPresentvalue(ormarketvalue)IncomerecognitionAschangesinpresentvalueoccur

2.2IdealConditionsofCertainty

2-282.3IdealConditionsofUncertaintyAssumptionsStatesofnatureThesetofpossiblestatesofnatureispubliclyknownStaterealizationpubliclyobservableStateprobabilitiesobjectivepubliclyknownGiveninterestrate

>>Continued2-29IdealConditionsofUncertainty(continued)Basis

ofaccountingExpectedpresentvalueIncomerecognitionAschangesinexpectedpresentvalueoccur2-302.4.1EmbeddedValueApartialapplicationofpresentvalueaccountingwhenidealconditionsdonotholdShowsnetpresentvalueofbusinessinforceRelevance?Reliability?WhyisManulife’sembeddedvaluepershare($20.02)lessthanshareprice($13.96)?2-312.4.2ReserveRecognitionAccountingAnapplicationofpresentvalueaccountingwhenidealconditionsdonotexistSFAS69ofFASBAppliestoprovedreservesonlyDiscountedatmandatedrateof10%RevenuerecognizedasreservesareprovedUsesaverageoil&gaspricesfortheperiodNotwhenexpectedtobesold

>>Continued2-32ReserveRecognitionAccounting(continued)RRArelevanceversusreliabilityRelevantinformationInformationaboutfuturefirmperformanceHowrelevantisRRAinformation,comparedtohistoricalcostsale-basedaccounting?ReliableinformationComplete(i.e.,nothingleftout)FreefrommaterialerrorFreefrombiasHowreliableisRRAinformationcomparedtohistoricalcostsale-basedinformation?

>>Continued2-33ReserveRecognitionAccounting

(continued)CanadianReserveRecognitionAccountingText,Chapter2,Problem28,NI51-101RelevancecomparedtoSFAS69?ReliabilitycomparedtoSFAS69?WhydomanylargeCanadianfirmsoptoutinfavourofSFAS69?

>>Continued2-34ReserveRecognitionAccounting

(continued)CritiqueofRRAEstimatesneededtoapplyRRAEstimatesofquantitiesEstimatesoftimingofextractionEstimatesofpricesStateprobabilitiesnotobjectiveEstimatesaresubjecttoerrorandbiasMajoradjustmentstopreviousestimatesusuallyneeded

>>Continued2-35ReserveRecognitionAccounting

(continued)CritiqueofRRA(continued)Management’sReactiontoRRAConcernaboutrelevanceandreliabilityConcernaboutlegalliabilityWhyisRRAreportedassupplementaryinformation?2-36Conclusionsre.LackofIdealConditionsGreaterrelevancerequiresmoreestimatesBut,moreestimatesdecreasereliabilityRelevanceandreliabilitymustbetradedoffSeenextslide2-37Relevancev.ReliabilityTradeoff2-382.5HistoricalCostv.CurrentValueAccountingDifferenttradeoffsbetweenRelevanceandreliabilityTimingofrevenuerecognitionRecognitionlagMatchingofcostsandrevenues

>>Continued2-39HistoricalCostv.CurrentValueAccounting(continued)ThemixedmeasurementmodelCurrentvalueaccountingforAccountsreceivableFinancialinstrumentsAccountspayablePost-retirementbenefitsHistoricalcostaccountingforInventoryProperty,plant&equipment(usually)Purchasedgoodwill- Whydifferentbasesofaccountingfordifferentfinancialstatementitems?2-40

2.6TheNon-ExistenceofTrueNetIncome

Why?IncompletemarketsReasonsforincompletenessthinmarketsAsforoilandgasreservesinformationasymmetryToomuchasymmetry,nomarketdevelopsIfnomarketvalue,cannotusemarketvalueasproxyforpresentvalueIfhavetoestimatepresentvalue,truenetincomedoesnotexist

>>Continued2-41

TheNon-ExistenceofTrueNetIncome(continued)

ImplicationsforaccountantsAccountantsnotneedediftruenetincomedidexistJudgementrequiredtoestimatenetincomeJudgementisessenceofaprofession2-423-43Copyright?2015PearsonCanadaInc.3-44Chapter3

TheDecisionUsefulnessApproachtoFinancialReporting3-453.2TheDecisionUsefulnessApproachInvestorsareanimportantconstituencyofaccountingItistheinvestor’sresponsibilitytomakeowninvestmentdecisionsThetheoryofrationaldecisionmakinghelpstheaccountanttoknowinvestors’decisionneedsKnowinginvestors’decisionneedsenablestheaccountanttoprepareusefulfinancialstatements3-463.3TheRationalDecisionTheoryModelInvestorsmakedecisionsinavarietyofwaysTheirbuyandselldecisionsinteracttoformthemarketpriceofasecurityTherationaldecisiontheorymodeldoesnotclaimtocapturethedecisionprocessofanindividualinvestorItclaimstocapturethedecisionprocessoftheaverageinvestorThatis,itclaimsthatinvestordecisionsare,onaverage,rationalArationalinvestormakesdecisionstomaximizehis/herexpectedutilityContinued3-47TheRationalDecisionTheoryModel(continued)RoleoftherationaldecisiontheorymodelinfinancialreportingHelpsusunderstandhowfinancialstatementinformationhelpstheaverageinvestortomakeinvestmentdecisionsTherebyhelpstheaccountanttoprovideusefulinformationforinvestmentdecisions3-48Bayes’TheoremAdevicetorevisestateprobabilitiesuponreceiptofnewevidenceΘisstateofnaturemismessagereceivedP(θ)ispriorprobabilityofθ(subjective)Formula3-49Bayes’TheoremAppliedtoAccountingInformationθisstateoffirmθ1=H=highfuturefirmperformanceθ2=L=lowfuturefirmperformancemisevidencereceivedfromthefinancialstatementsm1=GN=financialstatementsshowgoodnewsm2=BN=financialstatementsshowbadnewsSupposeGNisreceived:3-503.3.2TheInformationSystem

ShowsEvidenceProbabilities,ConditionalonEachState,forInputintoBayes’TheoremCurrentFinancialStatementEvidencemGNBNTotalHStateofNatureθL

P(GH/H)

P(BN/H)1P(GN/L)P(BN/L)13-51TheInformationSystem(continued)Thehigherthemaindiagonalprobabilities,thebettertheinvestorcanpredictthestateofnature(i.e.,futurefirmperformance)ThemaindiagonalprobabilitiescapturefinancialstatementinformativenessHighlyinformativefinancialstatementsalsocalled:TransparentPreciseHighquality

>>Continued3-52TheInformationSystem(continued)PriorprobabilitiesaresubjectiveInvestorassessesthembasedonallinformationavailablepriortotheinvestmentdecisionInformationsystemprobabilitiesareobjectiveReflectqualityofGAAPHowknownbyinvestor?Thetheoryassumesrationalexpectations,thatis,theinvestorquicklyfiguresouttheprobabilities

>>Continued3-53TheInformationSystem(continued)PriorprobabilitiesandinformationsystemprobabilitiesinputintoBayes’theoremtogiveposteriorprobabilitiesIfpriorprobabilitiesaresubjective,soareposteriorprobabilitiesHowever,iffinancialstatementinformationisinformative,posteriorprobabilitiesarebetterpredictorsoffuturefirmperformancethanpriorprobabilities

3-543.3.3DefinitionofInformationInformationisevidencethathasthepotentialtoaffectanindividual’sdecision3.4TheRational,Risk-AverseInvestorAmodeloftheaverage

investorDoesnotclaimthatallinvestorsarerationalInvestorisusuallyassumedrisk-averseConcaveutilityfunctionforwealthRisk-averseinvestortradesoffriskandreturnIfriskincreases,demandshigherreturn,andviceversa3-553-563.5ThePrincipleofPortfolioDiversificationDividealleventsaffectingthereturnsonfirms’sharesintotwotypes(factors)Market-widefactorsE.g.,centralbankchangestheinterestrateFirm-specificfactorsE.g.,GNorBNinafirm’sfinancialstatementsIfinvestorbuysaportfolioofsecurities,firm-specificfactorstendtocanceloutAfullydiversifiedportfolioisonewherefirm-specificfactorscompletelycancelout,leavingonlyundiversifiablemarket-widefactorstoaffectreturns,calledholdingthemarketportfolio3.6.2,3 ManagementDiscussionandAnalysisManagement’soutlineandexplanationofthefirm’soperationsTosupplementthefinancialstatementsForward-lookingorientationIncludesdiscussionofrisksfacingthefirmConsistentwithrationaldecisionmakingForwardorientationandriskinformationmayincreasemaindiagonalprobabilitiesofinformationsystemMorerelevantthanthefinancialstatementsLessreliable?3-573.6.4 IsMD&ADecisionUseful?Li(2010)studiedtheabilityofMD&Atopredictfuturefirmperformance(earnings)AnapplicationofdecisiontheorySelect30,000forward-lookingsentencesfromalargesampleofMD&AsManuallyclassifyeachsentenceintoits“tone”.Results:Positivetone,20%ofsentencesNegativetone,40%ofsentencesNeutraltone,40%ofsentencesThesegivepriorprobabilitiesofstatesofnature(i.e.,ofthetoneofaforward-lookingMD&Asentence)3-58IsMD&ADecisionUseful?(continued)TheinformationsystemForthe6,000positivetonesentences,countnumberoftimestheword“will”appearsIfitappears,say,300times,theprobabilitythat“will”appearsinaforward-lookingsentenceconditionalonthatsentencebeingofpositivetoneis300/6000=0.05Repeatforallotherwordsinthe6,000sentencesRepeatsameprocedureforthenegativeandneutraltonesentencesTheresultisa(large)informationsystem,givingforeachstateofnature(tone)theprobabilityofeachwordappearing,conditionalonthetoneofthesentenceinwhichthatwordappears.>>Continued3-59IsMD&ADecisionUseful?(continued)

Extract13millionforward-lookingsentencesfromallU.S.MD&As,1994-2007ForeachMD&A,classifyeachofitsforward-lookingsentencesintoitstoneTodoso,usethepriortoneprobabilities,and,fromtheinformationsystem,theconditionalprobabilitiesofeachwordofthatsentence,inBayes’theoremtoassesstheposteriorprobabilitythatthesentenceisofpositivetoneRepeattoassesstheposteriorprobabilitythatsentenceisofnegativetoneandofneutraltone.ThetoneofthesentenceistakenasthattonewiththehighestposteriorprobabilityThetoneoftheMD&Aistakenastheaveragetoneoftheforward-lookingsentencesitcontains>>Continued3-60IsMD&ADecisionUseful?(continued)Theresultwas145,479MD&AsclassifiedintotheirtonesDoesthetoneofanMD&Apredictearningsoverthefollowing4quarters?Answerwasyes,consistentwithMD&AbeingdecisionusefulThisstudyshowsthepotentialofcomputeranalysisoflargeverbaldatabasestoincreaseourunderstandingofaccountinginformation3-613-623.7TheIASB/FASBConceptualFramework

Orientedtoinvestors’investmentdecisions(primaryusers)Financialstatementsprovideinformationthatisusefultoinvestorsabouttheamount,timing,anduncertainty

offuturecashflows(i.e.,offuturefirmperformance)DecisionusefulnessisimpliedInvestorriskaversionisimpliedInformationsystemisimplied,sinceinformationsystemlinkscurrentandfutureperformance“Past(includingcurrent)”firmperformanceis“usuallyhelpfulinpredicting”futureperformanceSuggeststhatinvestorsusecurrentperformancetoupdatetheirprobabilitiesoffuturefirmperformanceOverall,reasonablyconsistentwithdecisiontheoryContinued3-63TheIASB/FASBConceptualFramework(continued)RoleofaccrualsintheFrameworkTopredictfuturecashflowsConsistentwithbalancesheetprimaryfinancialstatement(i.e.,accrualsroleisnottomatchcostsandrevenues)DesirablecharacteristicsofaccountinginformationRelevanceInformationaboutfutureeconomicprospectsReliabilityCalled“faithfulrepresentation”intheframeworkComplete,freefrommaterialerror,andunbiased3-64ConclusionsRationaldecisiontheoryprovidesatheoreticalunderpinningforstudyofinformationneedsofinvestorsHelpsaccountantstoprovideinformationthatisusefulTheConceptualFrameworkseemsconsistentwiththerationaldecisiontheorymodel4-65Copyright?2015PearsonCanadaInc.4-66Chapter4

EfficientSecuritiesMarkets4-674.2EfficientSecuritiesMarketsDefinition(Semi-strongform)Atalltimes,marketpriceofasecurityfullyreflectsallpubliclyavailableinformationaboutthatsecurityCharacteristicsofmarketefficiencySecuritypricesdonotreflectinsideinformationEfficiencyisarelativeconcept,definedrelativetoastockofpubliclyavailableinformationInvestingisafairgame—nobargainsSecuritypricesfluctuaterandomlyovertimeEfficiencyisatheoreticalidealThequestionofhowcloseactualsecuritymarketsaretothisidealisdiscussedinChapter64-684.3AccountingImplicationsofSecuritiesMarketEfficiencyW.Beaver,“WhatShouldBetheFASB’sObjectives,”JournalofAccountancy(1973)Fulldisclosure,incl.acc.policiesAccountingpoliciesdonotmatter(unlesscashfloweffects)“Na?ve”investorsprice-protectedAccountantsincompetitionwithotherinformationproviders4-694.4TheInformativenessofPriceIfmarketisfullyefficient,sharepricesfullyreflectallpubliclyavailableinformation.Thatis,pricesarefullyinformativeaboutvalueIfsharepricesarefullyinformative,noonewouldbothertogatherinformation,sincecan’tbeatthemarket(fairgame)Ifnoonegathersinformation,sharepriceswillnotreflectallpubliclyavailableinformationIfsharepricesdonotreflectallpubliclyavailableinformation,investorswillgatherinformation.SharepricewillquicklybecomefullyinformativeThen,noonewouldbothertogatherinformation,etc.,etc.Hencealogicalinconsistency

>>Continued4-70TheInformativenessofPrice(continued)AwayoutofthelogicalinconsistencyNoisetradingExpectedvalueofnoise=0Sharepricesstillefficient,butinanexpectedvaluesenseSharepricesarepartiallyinformativeinpresenceofnoisetradingSharepricemaydeviatefromitsefficientvalueduetonoisetradingRestoresincentiveofinvestorstogatherinformation

>>Continued4-714.5ACapitalAssetPricingModelCAPME(Rjt)=Rf(1-βj)+βjE(RMt)MarketsetssharepricesothatexpectedreturnE(Rjt)(i.e.,firm’scostofcapital)isgivenbyrightsideofequationNotethatonlyfirm-specificcomponentis?jHowisexpectedreturndefined?SeeEquation(4.2)intext:

>>ContinuedConceptofaSecurity’sBeta

Betameasuresthecovarianceofsecurity’sreturnjwithmarketportfolioreturnM

βj=Cov(j,M)/Var(M)MeasuresriskcontributedbyasecuritytoafullydiversifiedportfolioVar(M)isthevarianceofthemarketportfolio

(Astandardizationdevicesothatbetasfromsecuritiestradedondifferentmarketscanbecompared)4-724-73ACapitalAssetPricingModel(continued)Howdoesaccountinginformationaffectshareprice?InEquation(4.2),accountinginformationaffects

thenumeratorE(Pjt+Djt)E(Rjt)doesnotchange,sinceonlyfirmspecificcomponentinCAPMisbetaThusPj,t-1(i.e.,currentshareprice)mustchangeinthedenominatorofEquation4.2

tokeep

(Ejt)unchanged>>Continued

ACapitalAssetPricingModel(continued)Section4.5.2(optionalsection)CritiqueoftheCAPMCAPMassumesrationalexpectationsInvestorsassumedtoknowbetaInpractice,investorsdonotknowbeta,somustestimateit,creatingestimationriskCAPMassumescommonknowledgeEveryoneknowsthateveryoneknowsbeta,etc.Thisrulesoutsophisticatedinvestors’abilitytotakeadvantageofordinaryinvestorswhohaveinferiorknowledgeofbetaCAPMassumesnotransactionscostsandliquidmarketsCAPMassumesrationalinvestorsDespitetheselimitations,CAPMisagoodplacetostarttoappreciatetheroleofinformationincapitalmarkets4-744-754.6InformationAsymmetryThefundamentalvalueofashareThevalueofafirm’sshareonanefficientmarketifallinformationaboutthefirmispubliclyavailable(i.e.,noinsideinformation)InsideinformationInformationaboutthefirmthatisnotpubliclyavailableContinued4-76InformationAsymmetry(continued)InvestorreactiontoinsideinformationInsideinformationanothersourceofinvestorestimationriskThelemonsproblem(Akerlof(1970))Wouldyoubuyausedcarfromsomeoneyoudonotknow?Ifso,howmuchwouldyoupay?Wouldyoubuyashareinthepresenceofinsideinformation?No,withdrawfrommarket,marketcollapses(e.g.,post-Enron,post2007-08marketmeltdowns),orYes,butpayless,toprotectagainstestimationriskContinued4-77InformationAsymmetry(continued)EffectofestimationriskonsharepricesEfficientmarketpriceincludesa“discount”forexpectedestimationrisk(i.e.,forexpectedlossesatthehandsofinsidertrading)Ineffect,investorsdemandahigherreturnThen,CAPMmayunderstatecostofcapital,sinceignoresestimationriskTosomeextent,estimationriskmaybediversifiedaway,but,sinceoutsideinvestorsmorelikelytolosethangainfrominsidertrading,somediscountwillremainContinued4-78InformationAsymmetry(continued)ControllingestimationriskInsidertradinglawsFinancialreportingRoleoffinancialreportingistoconvertinsideinformationintooutside,therebyreducingestimationriskCannoteliminateallinsideinformation.Why?Definitionofmarketsthat“workwell”Lowestimationrisk,sharepricesasclosetofundamentalvalueasiscosteffective4-79AGraphicalIllustrationofEstimationRisk4-804.7SocialSignificanceofMarketsthatWorkWellInacapitalisteconomy,allocationofscarcecapitaltocompetingdemandsisaccomplishedbymarketpricesFirmswithproductivecapitalprojectsshouldberewardedwithhighshareprices(lowcostofcapital)andviceversaCapitalallocationismostefficientifsharepricesreflectfundamentalvalueSocietyisbetteroffthecloseraresharepricestofundamentalvalu