50 YEARS OF EFFICIENT MARKET HYPOTHESIS (EMH): BENEFITS AND

CHALLENGES TO ACCOUNTING RESEARCH AND PRACTICE

By

Adzor Ibiamke
nickibiamke@yahoo.com

Department of Accounting, Kwararafa University Wukari

Abstract

The purpose of this paper is to unravel the benefits and challenges that EMH has to accounting
research and practice in the past fifty (50) years of its existence and its probable future influence. The
paper is basically a review of literature pertaining to the implications of EMH basically to accounting
profession. The review have identified areas benefited by accounting profession with the emergence of
EMH to include the standard setting arena, clients advising, capital market research in accounting,
level of disclosure in financial reports and for legal evidence to establish claims for damages. On
the other hand the review found that the emergence of EMH has change the accounting orientation to
forward looking information which is less reliable and fraud tempting.

Keywords: Efficient Market Hypothesis, Accounting, Research, practice

Introduction
An integral part of today’s real world of accounting is the efficient market hypothesis (EMH), a
theory published by Eugene Fama in 1965. Since the work of Fama (1965) accounting literature
contains a plethora of articles whose aim is either to counter, support or test certain assertions using
the theory. The bountifulness of accounting research alongside the evidence of the use of this
borrowed theory in accounting practice has motivated an appraisal of its implications on accounting
particularly now as the theory celebrates its jubilee anniversary.

The purpose of this paper is to unravel the benefits and challenges that EMH has to accounting
research and practice in the past fifty (50) years of its existence and in its probable future influence.
The rest of the paper is divided into four sections: Section II deals with the meaning and forms of
market efficiency. Section III contains the benefits and challenges of EMH to accounting. Finally,
section IV is the summary and conclusion of the paper.

Meaning and Forms of Market Efficiency

There is a great deal of confusion in public discussions on EMH (Brown, 2011; Deitrick & Walter,
2001). An efficient market is a market in which resources are allocated to the most efficient entities.
That is, “allocational efficiency”. To others, efficient markets are markets whose cost and number of
time taken to execute a deal is minimal, “operational efficiency”. However, in the context used by
Eugene Fama it is “a market in which prices provides accurate signals for resources allocation”
(Fama, 1991:1). An efficient market in our discussion and as used by Fama connotes a market in
which security prices always “fully reflect” available information (i.e., informational efficiency). It is
on the basis of efficient markets that Fama developed a theory entitled “efficient market hypothesis”.

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EMH postulates that the market is efficient under free market conditions and absorbs all the available
information through the forces of demand and supply. Put differently, EMH is a proposition that
current stock prices fully reflect all available information about the value of the firm, and there is no
way to earn abnormal profit using this information. According to Eugene Fama and his subsequent
followers, the EMH depicts that, at all times prices of securities in an efficient market reflects all
known available information (public or privately held). As such there is no room for anyone for
fooling investor(s) since all investments in the market are fairly priced.

Basically, there are three forms or versions of market efficiency which include the following:

 The “weak form” of market efficiency: This form of market efficiency asserts that current
security prices incorporate all information contained in past price history only. This form of
market efficiency implies that nobody can “beat” the market or generate profit by analysing
past data such as past price series and trading volume data.
 The “semi-strong form” efficiency: This form of efficiency depicts that current security prices
fully incorporate all publicly available information (past and current). Just as the above
version, this form of market efficiency implies that one should not be able or expect to profit
from information that is known by “every other person” (i.e. both past and current publicly
known information).
 The “strong form” efficiency: This states that current security prices fully incorporate all
existing information both public and private (i.e. insider information). This suggests that not
even the insider (e.g. manager) can be able to earn profit by trading on the basis of
information not yet released to the public. This form of efficiency also asserts that stock
prices as quick as possible incorporate information known even only by the insiders.

Evidence is compelling that stock markets are efficient in a weak form (Deitick & Walter, 2001).
Much evidence also supports the semi-strong form efficiency although with anomalies. The strong
form may not be realistic since managers and securities exchange specialists appear to earn excess
returns. The semi-strong form has a strongest implication on accounting profession because
accountants produce financial statement information that is disclosed publicly.

The Benefits and Challenges of EMH to Accounting profession

EMH has several applications in accounting research and practice. Two aspects of EMH are of
particular interest to accounting. The first according to Katz and Wyatt (1983) is that, security prices
adjust rapidly to new information. Secondly, security prices adjust to new information in an unbiased
manner. The idea behind these statements is that security prices will react to accounting information
very quickly and accurately irrespective of where and how they are disclosed (i.e., whether in
financial statements, notes or Management Discussion and Analysis [MD&A]).

Why then should EMH interest accountants? Beaver (1973) provides a partial answer to this question
in his paper titled “what should be the FASB objectives?” Beaver’s response to this question was
directed to standard setters. He stated that in the standard-setting arena, it is common for the standard
setters (i.e., Financial Accounting Standards Board [FASB], International Accounting Standards
Board [IASB]) to commission capital market research projects. In addition to standard setters,
practitioners like the American Institute of Certified Public Accountants also studied the stock price
effects of the subject-to opinion during its deliberations to abolish or retain the type of opinion.
Although this paper cannot determine the exact weight given EMH findings in the actual standard-

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setting process, it is obvious that EMH is not being ignored.

What is the implication of this fact for accounting practice? It is the EMH influencing today's
accounting and auditing standards. Beaver’s critique to FASB action relate to the five implications of
EMH for standard setting. In brief, they were:
i. Standard setters should realize that financial report is not the only supplier of information
to investors. Accountants must therefore, stop acting as if they are the only suppliers of
information about the company.
ii. A role of accounting data is to prevent superior returns accruing from inside information.
To achieve this he suggested that there should be full disclosure.
iii. Standard setters should sponsor a full-scale research program in most trivial areas found
in accounting today, so that it may have some evidence of the consequences of their
choices among different sets of financial accounting standards.
iv. Financial statements should not be reduced to the level of understanding of the naive
investor who can get hurt by presuming that they can trade on published data and earn
abnormal profit.
v. Many reporting issues are capable of a simple disclosure solution and do not warrant an
expenditure of FASB time and resources in attempting to resolve them
Beaver's conclusion was "I give the FASB full credit for the first four implications and half-credit for
the fifth. That is a score of 90% to which I would give a grade of ‘A’....” Therefore, it would seem that
accountants would want to keep abreast of the factors that are shaping the direction of accounting
standards.

Apart from Beaver’s contention EMH has other important benefits to accounting research and
practice. Some of the areas of application of EMH to accounting include:

 Advising clients: EMH is used as a basis for advising clients by the accounting
practitioner. Often times accountants advice clients that changing an accounting policy to
manipulate reported income for the purpose of supporting stock price cannot fool the
market since the market is sophisticated to see through such attempts to increase earnings
artificially or to conceal an underlying negative shift in a company. In the nutshell, using
EMH assertions, clients can be advised that the stock market reacts to underlying
economic phenomena (e.g., cash flows) rather than to cosmetic accounting appearances.
Finally, by being well informed about EMH, accountants can assist clients in anticipating the
reaction of the stock market to various types of financial disclosures.

 EMH and the capital market research in accounting. Another very important area
in accounting where EMH has had a very important implication is the accounting
research. More specifically the EMH has given rise to a line of research in accounting
called capital market research or paradigm. The commonest of these studies is the
value relevance studies. Most of these studies were market reaction to accounting
releases of good and / or bad news (e.g., Ball 1966).

 Disclosure. In a semi-strong efficient market, publicly available information is impounded

into stock prices, regardless of where it is reported. Thus, empirical research demonstrates

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 that the substance of an accounting disclosure is more important than its form or location in
the financial report. This means that the resolution of controversial issues such as the
capitalization or expensing of a particular cost (e.g., research and development), the question
of balance sheet presentation or note disclosure or the choice of disclosure in a primary
financial statement or in a supplementary report is not expected to affect security prices
unless material economic consequences are based on reported financial statement amounts.

 EMH as legal evidence to establish claims for damages. It is common for legal
proceedings involving lawsuits to examine claims for damages resulting from market
transactions in a widely traded security. Often EMH provide the framework and the
quantitative methodology for estimating such damages. Not only is EMH evidence admissible
in court but it also can play a key role in damage settlements.

EMH have positive effects to accounting practice as stated above on one hand. It has
negative influence to the accounting profession on other hand. Notable of these is the
changing focus of accounting from historical to forward look information. The consequence,
of this is an increased in the likelihood of corporate executive fraud. This is discussed in a
more details below:

 EMH, accounting orientation and corporate executive fraud. EMH has a powerful
(negative) effect on modern accounting (Cunningham, 2005). Under EMH, all historical
information, including accounting data, is rapidly impounded into stock price. Moreover,
under this hypothesis, all publicly available information is accurately interpreted no matter
how or where it is presented. The implication of this is that any effort to improve accounting
theory or practice is meaningless (Cunningham, 2005; Gilson & Kraakman, 1984). Three
specific reasons are adduced for this statement: (i) the form of presenting accounting
information does not matter implying that promoting accounting quality is wasteful effort
(Downes & Dyckman, 1973); (ii) Accounting’s allocation of economic events to discrete
time periods become moot, and; (iii) As market price responds to cash flow effects of
managerial decisions and policy, and not on reported earnings per share, companies should
never seek to manage earnings because investors see through it. If so, accounting need not
develop tools to discover or detect earnings management. In a nutshell there is no justification
for an elaborate system of internal control over financial reporting. EMH’s contribution to
accounting is thus its retardation (Lowenstein, 1994).

EMH invokes presentiation. In an efficient market all numerical history is absorbed into
current stock price and becomes instantly irrelevant; all that matters is the future which is
even “discounted” into current price. The implication of discounting the future into the
present is that financial reporting orientation has been shifted from historical to a forward
looking which is less reliable and fraud tempting. This is evidence in the recent years shift in
accounting to favour relevance over reliability. The “fair value” accounting and “cash flow
statements” are two leading examples of EMH forces driving accounting development
(Swanson, 2004; FASB, 2000). Specifying the target creates pressures to meet them and when
fundamental business strategies cannot do so, accounting massage becomes more tempting
(Langevoort, 1997). In the extreme, therefore, finance destroys accounting (Cunningham,
2005) and creates a pressure for financial statement fraud.

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Summary and conclusions

EMH have been a part of the accounting environment since the 1960s. It is a theory describing the
relationship between security prices and information. Empirical evidence shows that stock prices are
more influenced by the disclosure of real economic events than by cosmetic accounting effects. This
implies that the market is not fooled by differences in accounting techniques that are not accompanied
by economic differences. Capital market research is built on the EMH foundation to examine the
effects of actual accounting disclosures on stock prices. The issues discussed in this article
demonstrate that EMH is an integral part of accounting today. If Wyatt is correct that few practicing
accountants are aware of EMH and even fewer understand it, there is reason for concern. This lack of
awareness and understanding can bias perspectives and impair service to clients and to the public. In
this vein, Wyatt asks, "What can be done to better educate managers and accountants about the
ramifications of the hypothesis? This article is a step toward addressing that question.

References

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Brown, S.J. (2011).The efficient markets hypothesis: The demise of the demon of chance? Accounting
and Finance, 51, 79–95.

Deitrick, D. & Walter, T. H. (2001). EMH, CMR and the accounting profession. Journal of
Accountancy, February, 82-94.

Fama, E. F. (1965). The behavior of stock market prices. Journal of Business, January, 34-105.

Fama, E. F. (1970) Efficient capital markets: A review of theory and empirical work The Journal of
Finance, 25(2): 383-417. Retrieved from http://www.jstor.org/stable/2325486

Fama, E. F. (1991). Efficient capital markets II. Journal of Finance, 46, 1575–1617.

Katz, J. E. & Wyatt (1983). The FASB in a world with partially efficient markets. Journal of
Accounting, Auditing & Finance, May, 29-43.

Cunningham L. A. (2005). Finance theory and accounting fraud: Fantastic futures versus conservative
histories. Buffalo Law Review, 53: 789-814.

Gilson R.J. & Kraakman, R.H. (1984). The mechanisms of market efficiency. Virginia Law Review,
70(4): 549-644.

Downes T.A. & Dyckman, T.R. (1973). A critical look at the efficient market empirical research
literature as it relates to accounting information. Accounting Review, 48(2): 300-317.

Lowenstein, L. (1994). Efficient market theory: Let the punishment fit the crime, Washington and Lee
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Swanson, G. A. (April 6, 2004). Accountability and the Drift towards ‘Fair Value Measurement’,
American Accounting Association Regional Meeting Paper, SSRN ID= 487043.

Financial Accounting Standards Board, (2000). Statement of Financial Accounting Concepts No. 7,
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