Market Efficiency, Bounded Rationality, and Supplemental Business Reporting Disclosures

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.

Limited attention, information disclosure, and financial reporting

“…To explain the returns on these dates as large (in absolute value) daily risk premia would seem to require large (in absolute value) daily covariances with aggregate market factors. 6 Such effects have been found in the context of recognition versus disclosure of pension liabilities (Harper et al, 1987), classification of the same hybrid financial instrument as debt, equity or mezzanine financing in the balance sheet (Hopkins, 1996), the previewing of negative earnings news with an adverse qualitative preannouncement (Libby and Tan, 1999), and the use of the purchase method of accounting for business combinations with the premium ratably amortized versus the use of pooling-of-interest (Hopkins et al, 2000) and the inclusion of other comprehensive income items in the income statement rather than in the statement of changes in shareholders' equity (Hirst and Hopkins, 1998), as well as in market settings (Dietrich et al, 2001).…”

Feedback loops, fair value accounting and correlated investments

“…Prior psychology research provides evidence that the way in which information is presented can affect judgment and decision behavior (see, e.g., Johnson, Payne, & Bettman, 1988;Russo, 1977;Sanbonmatsu, Kardes, Posavac, & Houghton, 1997). Numerous studies in accounting have applied this perspective to research examining the effects of Dietrich, Kachelmeier, Kleinmuntz, and Linsmeier (2001) and Belkaoui (1984) underreact to information that is presented in only one source. Providing a redundant report strengthens participants' responses to the information, reducing the underreaction.…”

“…For recent examples, seeHopkins (1996) with respect to hybrid securities,Kennedy, Mitchell, & Sefcik (1998) with respect to contingent liabilities,Hirst and Hopkins (1998) andMaines and McDaniel (2000) with respect to comprehensive income,Hopkins, Houston, and Peters (2000) with respect to business combinations,Luft and Shields (2001) with respect to intangibles,Dietrich et al (2001) with respect to oil reserves, andHirst, Hopkins, and Whalen (2004) with respect to fair-value accounting.9 We do not vary the sign of a (i.e., whether the firm is taking a long or short position on its own stock) because the key implication of our model is that price volatility increases with | aeK |.…”

The Psychological Attraction Approach to Accounting and Disclosure Policy*

“…For example, the issue of whether to expense employee stock options versus report them in footnotes has generated vigorous debate and heavy political lobbying. In an experimental study, Dietrich et al (2001) find that disclosure of information that is redundant with information in financial statements can improve market efficiency.…”