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Does Accounting Measurement Impact Market Efficiency?

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Market Bubbles:

In his book Irrational Exuberance, Robert Shiller notes the word bubble creates a mental picture of an expanding soap bubble, destined to pop suddenly and irrevocably. An asset bubble is similar to a soap bubble and exists when the market price of an asset deviates from its fundamental value. They are often hard to detect until they occur because of disagreement over the asset's fundamental value.

Tulipmania:

Tulipmania is the earliest speculative market bubble in recorded history. It took place during the Dutch Golden Age (1581-1672), a period when the Netherlands was the wealthiest country in Europe. As a result, people's willingness to exchange money for tulips increased. Tulips are challenging to breed. June to September is a dormant phase where bulbs could be moved around. For the rest of the year, individuals bought future contracts promising to purchase the bulbs at the end of the season.

More people bought tulip futures because they speculated on the future price of tulips as being higher than the amount paid, rather than having a desire to own the tulip for its intrinsic value. The price of tulip bulbs increased twenty-fold from November 1636 to February 1637, followed by a precipitous decline of 99% by May 1637. 

Dot Com Bubble:

A more recent market bubble occurred in the late ’90s when Internet companies began to get popular among investors. With the introduction of the Internet as a profitable technology, everyone wanted to invest in the next success story. Investors were investing in such early-stage businesses that they could not use traditional cash flow valuation methods to properly value companies, which contributed to significant overvaluations for many.

For example, eToys.com, an online toy retailer, was projected to be a huge success in the online shopping industry. The company’s stock went from $20 to $76 on its first trading day in 1999, a 280% increase. However, in February 2001 the company would file for bankruptcy because of a mounting $247MM in debt and a lack of profitability. This was not uncommon for companies during this time, as many as 5,000 were shut down or acquired during the fallout of the bubble.

What led to the ultimate crash in 2001 was the quick realization that many of these companies who were being valued on the basis of the size of the network and other non-financial based metrics proved to be very unprofitable and in terrible financial condition, leading to the share price to plummet. It was known that most start-ups would fail, but it was the influence of the crowd to ignore common sense in pursuit of finding the one company that would pay for the rest of the losses.

Laboratory Asset Markets:

In real-world markets, variables such as the fundamental value of a financial asset, the information conditions, and the asset life period are difficult to account for. Laboratory environments enable researchers to control and observe the key parameters of the market, and to measure the individual judgments and decisions that underlie market phenomena. These features allow researchers to test the causes and properties of bubbles in financial markets.

What the study accomplished: 

The purpose of this study is to measure the effect historical cost (HC) and mark-to-market (MTM) accounting play in the perception and asset mispricing of traders. Historically, it has been argued that MTM increases market volatility or that it acts as a bystander in times of crisis. The laboratory tests markets in this study serve to provide more information and insight towards this ongoing debate. 

In the study, researchers manipulated the accounting measurement regime to which each market is initialized. Accounting regimes differ in the method of assigning carrying values to asset holdings based either on a proportion of their original price (HC) or based on recent prices (MTM), with carrying values being recognized in accounting income.  

Results: 

Traders in the study appear to understand market economics differently depending on the accounting regime employed. Traders systematically assigned lower weights to asset fundamentals, and greater weights to market price changes under MTM, resulting ultimately in greater market-level mispricing under MTM. Overall, the study demonstrated that accounting measurement regimes could influence market-level mispricing, separate from underlying market factors.

Data:

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