Market Efficiency, Bounded Rationality, and Supplemental Business Reporting Disclosures

Market Efficiency, Bounded Rationality, and Supplemental Business Reporting Disclosures The AICPA Special Committee on Financial Reporting has urged disclosure of relevant forward‐looking information on risks and opportunities to supplement conventional financial statements. We conduct a laboratory market experiment to assess the effects of such disclosures on capital allocation decisions. We develop two sets of competing hypotheses regarding how capital markets react to supplemental disclosures. One set is based on the assumption of semi‐strong market efficiency, while the other posits that the bounded rationality of individual traders leads to inefficient market prices. We find that explicit disclosure of management’s best estimate of an uncertain quantity improves market efficiency, even though this disclosure is redundant with information in financial statements. Second, we find disclosure of an upper bound of management’s estimate has the potential to bias security prices upward, while informationally equivalent disclosure of both upper and lower bounds removes this bias. These results suggest that experimental market reactions to these supplemental disclosures are inconsistent with market efficiency. Supplemental analyses of individuals’ price predictions and trading behavior support our conclusion that inefficiencies are at least partially attributable to individual information processing biases. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Accounting Research Wiley

Market Efficiency, Bounded Rationality, and Supplemental Business Reporting Disclosures

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Publisher
Wiley
Copyright
University of Chicago on behalf of the Institute of Professional Accounting, 2001
ISSN
0021-8456
eISSN
1475-679X
D.O.I.
10.1111/1475-679X.00011
Publisher site
See Article on Publisher Site

Abstract

The AICPA Special Committee on Financial Reporting has urged disclosure of relevant forward‐looking information on risks and opportunities to supplement conventional financial statements. We conduct a laboratory market experiment to assess the effects of such disclosures on capital allocation decisions. We develop two sets of competing hypotheses regarding how capital markets react to supplemental disclosures. One set is based on the assumption of semi‐strong market efficiency, while the other posits that the bounded rationality of individual traders leads to inefficient market prices. We find that explicit disclosure of management’s best estimate of an uncertain quantity improves market efficiency, even though this disclosure is redundant with information in financial statements. Second, we find disclosure of an upper bound of management’s estimate has the potential to bias security prices upward, while informationally equivalent disclosure of both upper and lower bounds removes this bias. These results suggest that experimental market reactions to these supplemental disclosures are inconsistent with market efficiency. Supplemental analyses of individuals’ price predictions and trading behavior support our conclusion that inefficiencies are at least partially attributable to individual information processing biases.

Journal

Journal of Accounting ResearchWiley

Published: Sep 1, 2001

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