Question

Discuss the significance of the efficient markets hypothesis to your understanding of financial reporting. Discuss the role of financial reporting in an efficient market.

Answer 1

Discuss the significance of the efficient markets hypothesis to your understanding of financial reporting.

Information can be classified as two types depending upon availability:

• Private: known to select few
• Public: Known to all

Information can be of two types:

• Historical: relates to past
• Futuristic: related to future expected performance of forecast

Market efficiency refers to the extent all the information available (public as well as private) on the security is factored in its price. Efficient markets are the markets wherein all the stock related information is factored in the stock prices. The efficient market hypothesis (EMH) classifies markets in three forms

1.   Strong Form: the security price reflects all the public and private information relevant to the security. Since, the current price reflects all information, public as well as private, hence no investors will be able to consistently find undervalued stocks. This means even an insider will not be able to generate abnormal returns.
2.   Semi-strong Form: All the publicly available information (and not the private information) is incorporated in security prices. Since the current price reflects the information contained not only in past prices but all public information (including financial statements and news reports), an insider (with private information) can continuously find undervalued stocks and generate abnormal returns.
3.   Weak Form: The security price reflects only recent price movements. The current price reflects the information contained in all past prices, suggesting that charts and technical analyses that use past prices alone would not be useful in finding undervalued stocks.

Discuss the role of financial reporting in an efficient market.

Financial reporting is the way companies show their performance to outside world. The objective behind financial statement analysis is to use the company’s financial statements & other relevant information to make economic decisions. Such an analysis is used to evaluate a company’s past performance & current financial position and project company’s ability to earn profits and future cash flows so that economic decisions like whether to invest in the company's securities or whether to extend bank credit to the company can be taken.

There are two types of users of these financial statements: internal (working inside the company) and external (outside of company). Please refer to the table below:

Sl. No.	Stakeholder	Objectives / Needs
A.	INTERNAL USERS
1.	Management	Financial Performance assessment Preparation of budgets, forecasts etc. Take Business Decisions
2.	Employees	Financial performance assessment to evaluate the impact on wages/salaries (variable compensation) Negotiate for wages and salaries
B.	EXTERNAL USERS
1.	Shareholders / Prospective Investors	Investment Decisions – ROI Risk vs Return
2.	Financial Institutions / Lenders	Credit worthiness
3.	Suppliers	Liquidity Position - Credit Terms
4.	Customers	Sustainability of operations
5.	Capital markets / Regulators	Corporate Governance Check conformance to regulations
6.	Competitors	Cross Sectional Analysis Strategies to improve competitiveness
7.	Government	Correctness of tax declaration Economic development Employment generation
8.	General Public	Impact on economy, environment & local community, Employment generation
9.	Financial advisors and analysts	To analyse and assist investors with recommendations