Efficient Market Hypothesis And The Cost Of Capital

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The quote shows a strong relation to the efficient market hypothesis (EMH), as it implies that the costs of capital are dependent from the amount of information given by the company. According to my opinion, agency theory is a good explanation for costs of capital. Agency theory defines contracts as under which one party called principal engages another party called the agent to perform service on the principal s behalf. Concluding, the principal delegates decision-making authority to the agent. Both sides of the contract are utility maximisers and the agent will not necessarily act in the principal s best interests. This leads to the rise of agency costs. Agency costs are the welfare reduction by the principal due to the divergence of the interest. There are three agency costs (1) monitoring costs, (2) bonding costs, and (3) residual loss. (1) Monitoring costs are the costs of monitoring agent s behaviour. They are expenses of the principal to measure, observe, and control the agent s behaviour. Good examples for monitoring costs are auditing costs. To protect themselves of huge monitoring costs principals are bearing the costs to agents. An example can be given in lending: A high-risk company has high monitoring costs, which leads to a high interest rate. Another example would be the reputation of the manager: Has he got a bad reputation, than his salary would be lower than usual. Agents try to reduce monitoring costs by installing mechanisms to guarantee that they will behave in the interest of the principal or by proposing to compensate principals for their losses. (2) The mechanisms mentioned above are bonding costs, because they are the costs of bonding the agent s interest to the principal s. Quarterly financial reports are bonding costs, namely the time and effort invested to generate the financial report. Agents will normally weigh bonding costs with monitoring costs and chose the cheaper alternative. (3) Despite bonding and monitoring costs, it is still likely that agents interests will not correspond exactly with the principals . If the manager is not motivated and does not invest his whole efforts, than his actual work output is lower than it would be, if his interests were exactly the same as principals interests. EMH-theory solves who bears the agency costs to which amount. In strong efficient markets the agent will bear the cost fully: The costs of capital are higher, his reputation will decrease, and his career opportunities will also slacken. In semi-strong and weak efficient markets exists the incentive for agents to act opportunistic, since they do not fully bear the costs of their behaviour. If the users just get the information the agents allows them to receive, than the information are likely to be filtered in the agents interest. As I have explained the fundamental prerequisite for understanding and evaluating the quote now, it is necessary to mention that it is not possible to measure the true financial performance of a company. Accounting is a social science and cannot be objective: Accounting as a social science is bidirectional and does not have an objective and separate existence from accountants (Godfrey-Jayne et al; 1997, p. 395). Accounting deals with measurements and should as good as possible enable users to determine the fair value: The amount for which an asset could be exchanged between a knowledgable, willing buyer and a knowledgable, willing seller in an arm s length transaction (AASB 1013). This leads to the principle of presenting a true and fair view of the company. If this aim could be achieved, than investors should gain full confidence in the integrity of markets, reducing their monitoring and bonding costs, which should result into a reduction of the cost of capital. But the production of accurate information is tricky, because accuracy is defined as relevant and reliable, but both criteria are based on each other. Their reasoning is circular. Then, comparability of information needs an explanation. This leads into either one standard for accounting procedures or different standards with firms obliged to mention which standard they have chosen. In the past, business fought constantly against the uniformation of standards and the problem of the latter suggestion is that it needs skilled users to evaluate the impact of the different standards on the financial statement. As only a limited group will be able to do this, the number of possible financers is reduced. Capital could become more expensive since in free market systems a broader supply of capital should result into lower prices for capital and the reverse effect is true. Further, accounting has difficulties to clearly measure performance and the value of assets. Therefore, many different methods exist as historical cost, present value, current replacement costs, net realisable value, and deprival value accounting and all are reasonable in their approaches. Trust of the public means more trust in managements behaviour. This is reflected in less monitoring and reduced bonding costs. The former reduction is obvious and with good experience in more trustworthy relationships the monitoring mechanisms should decrease. As these costs decrease, so should the costs of capital decrease caused by a decrease of interest expense or dividend payout. A capital market s development is dependent from investors trust into the information given by the investments . Capital markets can only develop if investors are willing to take risks and accept new financial instruments. To raise the trust of investors they must receive comparable information. Users have to be enabled to disarm and evaluate similarities and differences between the nature and effects of transactions and events, at one time over another time. For new financial instruments this is not possible, but a solid and regularly stated accounting policy should nurture enough confidence. Therefore, the regular disclosure of accounting policies is very important. Investors have to believe that they are not cheated, have good past experience and receive an interesting return to be willing to invest into risky/new ideas. The high expected return is due to the higher than normal uncertainty of new instruments, raising the capital cost but ultimately being the only way to introduce new financial instruments and develop the capital market. Another factor is government s trust in the self-regulation of the market. Unless this is achieved, governments will hinder the free development of capital markets. Then, the innovators of new financial instruments, which develop the capital market, have to know that there is a reward for their efforts. Unless the market honours their creativeness with extraordinary revenues, they won t be as innovative as they could be. Since the benefits of developing financial instruments won t equal the costs. The conceptual framework defines concepts as costs, liabilities, and revenues. This definition decreases the further need for standards and leads to fewer standards. The conceptual framework is a frame of reference for all users of accounting in their decision-making. It is used to solve current issues in accounting: There are thus two principal objectives of the SACs [conceptual framework]. First, they are designed to be used by standard setters as the foundation for the development of standards. Second, they should be used by accountants as a frame or reference when there is no relevant accounting standard to resolve an issue. (Lambert et al; 1996; p.6) A current, positive tendency is the outlawing of abuse of flexible accounting. Creative accounting and weak accounting standard setting led to bad experience in the mid-80 s. Both conspired to erode significantly the integrity of financial reports. This demonstrates how insufficient standards lower the trust in accounting and its integrity. Further, creative accounting raises monitoring costs. Debtholder could require more often certain accounting methods (ex ante approach) and regular reports (ex post). This is the reason, why even not ethically orientated managers should be interested in integer standards. Users are able to discover certain accounting alternatives. Eg they discover differences due to the depreciation method but cannot recognise small-scale alternatives. This takes them too much time, costs exceed benefits; instead, They expect accountants to provide comparable standards . (Anthony; 1983; p. 14) Even financial analysts (Trevor, 1972) state, it is difficult to compare net income across companies because of the variety of methods and creative accounting. If even the experts cannot gain enough useful information from financial statements, the market instead has to demand more monitoring mechanisms to determine the methods used by a firm. This increases costs of capital further. Lack of confidence in the pricing efficiency of the market tends to focus the attention of both investors and raisers of capital on potentially wasteful techniques of exploiting perceived inefficiencies, and away from a more positive recognition of the messages contained in the market price . (Kean; 1983; p.3) As I agree with the statement that accounting only exists because users need useful information, who needs an accounting system that does not produce the information users need? According to EMH more information leads to fairer prices and better decisions. The economic forecasts will be closer to reality, raise trust, making the future more calculable and ultimately reducing capital cost. Better information allow a better resource allocation. Satisfied customers are more probable to re-invest or start investing in new financial instruments. But since we do not have a strongly efficient market only a small group of users will benefit from the better information. The given more useful information do not reach all users. A lot of the mentioned arguments work in theory but not in practice. Not all users are skilled in accounting and do not know how to relativise information. More information raises production expenses but derives no equal benefits. Further, we can already speak of an information overload. A potential investor cannot analyse the financial statements of all companies that are listed on the domestic stock exchange, not to speak of international companies or derivates like currency swaps. Furthermore, studies have shown that shareholders prefer steady growth, instead of abrupt changes in income even if the sum of income is equal. Regarding to this, companies need creative accounting. Then, future opportunities and expectations normally influence the share prices not historical results presented in financial statements. Also, capital costs are determined by a variety of factors:  Risk of industry  Risk of company  Purpose of borrowing  Lengths of repayment period  Inflation  Past performance  Future expectation Better information would only have a small impact on the reduction of capital cost. Lastly, the costs of capital will only decrease if capital is too expensive at the moment. The current issues in accounting are joint ventures, foreign currency translation, intangibles, and leasing. A joint venture is a contractual association between two or more parties to undertake a certain project. In Australia exist the line-by-line and the one-line approaches to account for joint ventures. The former is a proportionate consolidation method and records the undivided share in each of the individual assets and liabilities. The latter is a one-line description of each interest in the venture. Other countries have different approaches and the IAS regards joint control as essential. Joint ventures cause a problem for the SAC asset & liability definition: One venturer has not fully control over the whole physical asset, the control is divided. Further, SAC does not define what control exactly is. To account for foreign currency translation the current method and the temporal method exist. In 1994 74% of the Australian companies used the current method but did not state why they did it [Source: J. Williams in Ryan and Heazlewood (1995), p.110]. Further, new financial instruments (derivate) cause a lot of accounting problems. Eg they have to be recorded different if they are used for different purpose as trading, hedging or speculation. Still, intangibles are a problem in accounting. Currently, there is no standard (ED49 was withdrawn in 1992) and no consensus concerning the nature, the recognition, and the measurement of intangibles. There is no accepted definition in accounting; a common one is found in the Corporations Law, which requires disclosure of intangibles in the two subheadings goodwill, and patents, trademarks and licenses. Leases are the next issue. They allow one party to obtain the use of property from the owner of the property, in return for a series of payments. Before the issue of ASB 1008 in 1986 leasing was an off-balance-sheet method of financing. But still it is possible to make arrangements that financial leases appear as operating leases in the balance sheet of the leaser. If these issues could be solved, accounting would have made a great step towards more accurate financial reports and performance evaluations, and would receive more trust by the public Theoretically I do agree with the quote but for an overall evaluation the following issues must be solved in favour of the quote. Firstly, the benefits of the newly introduced accounting standards must at least equal the costs. Secondly, the consensus process must not be time consuming because of the fast-changing environment, which continuously produces new issues. Lastly, the influence of historical (accounting) information on share prices and interest rates must be determined, how strongly it influences the cost of capital. Therefore, the quote has to prove its benefits first before further research in that subject should be done. At the end of my essay I want to mention that it is essential to have or form an attractive domestic capital market, because companies raise their capital everywhere nowadays. This is due to the tendency of global business and global sourcing. Before a country s standard-setters board invests a lot of money, effort and time to improve its domestic accounting standards it should look abroad first and seek compliance with international standards. REFERENCES Anthony, R. V. (1983), Tell it like is was: A conceptual framework for financial accounting, Richard D. Irwin Inc., Homewood, Illinois. Australian Accounting Research Foundation, (1994), Proposed Program for the Development of Concepts on Measurements of the Elements of Financial Statements, cited Financial Accounting III (Second Semester 1998), Ed. Phil Hancock, pp. 229-246, Murdoch Un

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