Accounting and Business Research

ISSN: 0001-4788 (Print) 2159-4260 (Online) Journal homepage: http://www.tandfonline.com/loi/rabr20

The Usefulness of Annual Reports: the Anomaly

between the Efficient Markets Hypothesis and
Shareholder Surveys

R. D. Hines

To cite this article: R. D. Hines (1982) The Usefulness of Annual Reports: the Anomaly between
the Efficient Markets Hypothesis and Shareholder Surveys, Accounting and Business Research,
12:48, 296-309, DOI: 10.1080/00014788.1982.9728822

To link to this article: http://dx.doi.org/10.1080/00014788.1982.9728822

Published online: 27 Feb 2012.

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 296
The Usefulness of Annual Reports:
the Anomaly between the
Efficient Markets Hypothesis and
Shareholder Surveys++
R. D. Hines
Introduction
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Recent literature has cast doubt on the usefulness
of annual reports to shareholders. Two areas of
research relate directly to the question of whether
shareholders use annual reports. Firstly, the Effi-
cient Markets Hypothesis (EMH) implies that
annual reports are issued too late to be of use to
shareholders. Secondly, investor surveys indicate
that shareholders do use annual reports. This
paper investigates the apparent conflict between
these two research areas in an effort to resolve the
anomaly.
EMH implications for annual report
usefulness
The semi-strong version of the Efficient Mar-
kets Hypothesis posits that all publicly available
information is impounded unbiasedly in share
prices, as soon as it becomes available. Notation-
ally this may be expressed as follows:’
fVt+1/40 = f m (PI+1/43
where
f(.)= the ‘true’ conditional probability
distribution of security prices in
period t + 1,
4t = the information set available at
period t,
fm(.) = the market-assessed conditional
probability distribution based on
4F, and
47 = the information set used by the
market at period t .
*The author acknowledges the very helpful comments of
Professor Carrick Martin.
‘Eugene F. Fama, Foundations of Finance (Basic Books:
New’ York, 1976).
A C C O U N T I N G A N D B U S I N E S S RES EA RCH
An implication of this equation is that, since all
publicly available information is used by the mar-
ket in assessing expected future returns and
prices. an investor cannot use publicly available
information as the basis of a trading system with
expected returns in excess of equilibrium expected
returns. Simply stated by Williams and Findlay:
‘By the time one reads some new information, it is
too late to profit from it’.2
Extensive testing of the Efficient Markets Hy-
pothesis in recent years has produced results
which are generally consistent with the hypoth-
e s k 3 The implication of this evidence is that
annual reports cannot be used by shareholders to
make abnormal profits-for two reasons. Firstly,
annual report content is publicly available infor-
mation, and as such it is impounded unbiasedly in
market prices immediately it becomes available,
thus eliminating the possibility of a purchase or
sale of shares based upon such information at a
price which would yield an abnormal return.
Secondly, even if this were not the case, their con-
tent has already been conveyed to the market by
the more timely preliminary final r e p ~ r t ,much
~
of the information even in this report having been
anticipated by the market (using other infor-
mation sources, such as leakages, statements by
corporate officials, releases issued by brokerage
firms, releases issued by market newsletter ser-
vices, etc.). To test whether an information source
possesses ‘informational value’, EMH research
*Edward E. Williams and M. Chapman Findlay 111, Inuest-
ment Analysis (Englewood Cliffs, New Jersey: Prentice-Hall,
Inc., 1974), p. 371.
%eorge Foster, Financial Statement Analysis (Englewood
Cliffs, New Jersey: Prentice-Hall, Inc., 1978) Chapter 11, for a
review of this research.
4Most stock exchanges, including those of Australia, USA
and UK, require an unaudited preliminary final profit report
to be released soon after balance date.
 A U T U M N 1982
measures share market reaction to the release of
the i n f ~ r m a t i o n . ~
Tests of stockmarket reaction to the release of
annual reports supports that: ‘By the time the
“glossy” annual report comes out, some time after
the preliminary, it is “old hat”. There is no impor-
tant news in it and there is no recognisable share
price reaction to it’.6
Although the market-reaction definition of
‘informational value’ has facilitated a great deal of
research in the area of finance, one aim of this
article is to show that for the purposes of
determining the usefulness of accounting reports,
specifically annual reports, such a definition is too
simple. Usage of annual reports by shareholders
may not produce an immediate market reaction,
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for a number of reasons.
Shareholder survey implications for
annual report usefulness
The major disadvantage of survey research is
that the results of an individual survey may be
biased; for example, sample selection bias may
occur, or response bias. Also, bias may be intro-
duced into the results by such factors as misun-
derstanding, a desire to ‘please’ the researcher, or
wishful thinking on the part of respondents.’
Since a number of shareholder surveys have
now been completed, however, it is possible to
examine their results in aggregate. The replication
of individual surveys, using different sample
populations, questionnaires and procedures, may,
it is hoped, act to offset survey biases within par-
ticular studies. The results of these surveys appear
in Table 1.
The results are remarkably consistent. The
Chairman’s Report appears to be the most popu-
lar section of the annual report. Over 50% of all
respondents to each of the surveys indicate that
they ‘thoroughly read’ the Chairman’s Report
section of the annual report (refer Column 4,
’William H. Beaver, ‘The Information Content of Annual
Earnings Announcements’, Empirical Research in Accounting :
Selected Studies, 968 (Chicago: Institute of Professional
Accounting, 1969), p. 69.
6Ray Ball, ‘Will Australian Investors Get Index Funds?’,
Journal of T h e Australian Society of Security Analysts, June
1977, p. 5.
’See A. N. Oppenheim, Questionnaire Design and Attitude
Measurement (London: Heinemann Educational Books Ltd.,
1966) for a review of the problems associated with survey
research.
297
Table 1). Anderson,8 Lee & Tweedie,’ and Wl-
ton & Tabb” also report that a further 35.6%,
44.1% and 35.1% respectively of their respondents
report ‘brief reading’ of the Chairman’s Report.
Thus nearly all respondents in each study indicate
Some reading of at least the Chairman’s Report
section of the annual report.
The Profit and Loss Statement appears to be
the most popularly used section of the annual
report for decision-making. Although only two
studies report the relevant percentages, over 50%
of the respondents to both studies (Lee & Twee-
die and Wilton & Tabb) indicate that the Profit
and Loss Statement is of great importance to
them for decision-making (Column 5, Table 1).
Most surveys also asked shareholders to rank
the importance for decision-making of annual
reports as against other sources of equity invest-
ment information. The results of this question,
which appear in Column 6 of Table 1, display
different formats due to differing questionnaire
designs and multiple response options. They
strongly suggest that annual reports are an im-
portant primary source of information to individ-
ual shareholders and some institutional investors.
Furthermore, they indicate that annual reports
are an important secondary or indirect source of
information-the studies indicate heavy share-
holder reliance on stockbrokers, and the Clift and
Mason surveys of stockbrokers indicate that
annual reports are a very important source of in-
formation to the latter group (‘critical’ to 60% of
Clift’s responding stockbrokers). Additionally,
newspapers and magazines rate highly and, to a
lesser but still considerable degree, advisory ser-
vices and statistical reports: all these information
sources draw on annual report information.
The Clift and Mason results, which indicate
that annual reports are used by institutional
investors and stockbrokers, also lend support to
the results of the individual investor surveys. Pre-
viously it was pointed out that biases may
influence survey results, due to respondents being
confused or ignorant, improperly aware or forget-
ful of their own behaviour, or misguided in their
‘R. H. Anderson, ‘The Usefulness of Annual Reports to
Australian Investors’, paper presented at the Accounting As-
sociation of Australia and New Zealand 1979 Conference,
University of Melbourne, Australia, Table 4.
’T. A. Lee and D. p. Tweedie, ‘Accounting Information: An
Investigation of Private Shareholder Usage’, Accounting and
Autumn 19753p. 281.
“Robert L. Wilton and J. Bruce Tabb, ‘An Investigation
into Private Shareholder Usage of Financial Statements in
New Zealand, Accounting Education, May 1978, p. 171.
 Downloaded by [New York University] at 02:05 17 November 2015

Table 1:
Shareholder Surveys

1 2 3 4 5 6

Strrnp/r
A rrtltor Popirltrtion

/t/l~r
s / t t ~ r l ~ / i ~ l Srrrre\.s
<I,
1/0

Anderson' I 2682 individual 966 I. Chairman's Rcport 52.8 1. Profit and Loss I. Stockbrokers 46.4
Australian share- 36.02",, 2. Profit and Loss 48.8 2. Balance Shcct 2. Annual Reports 38.6
holders selected 3. Directors' Report 40.1 3. Chairman's Report 3. Newspnpers/Magazines 38. I
from the share 4. Balance Sheet 36.0 4. Statistical Summary 4. Advisory Services 10.7
registers of 15 5. Statistical Summary 33.0 5. Directors' Report 5. Advice of Friends 6.9
public companies 6. Funds Statement 24.6 6. Funds Statement 6. Company Visits 6.9
7. Notes to Accounts 21.6 7. Notes to Accounts 7. Advice of Bank Manager 4.2
8. Auditor's Report 17.0 8. Auditor's Report 8. Government Publications 4.1
9. Statement of 9. Statement of Accounting 9. Tips and Rumours 2.5
Accounting Policies 14.5 Policies

Baker and 1623 individual 851 1. Stockbrokers 46.8

z
0
Haslem' common shareholders 52.4". 2. Advisory Services 15.6
in metropolitan 3. Newspapers/Magazines 14.8 >
Washington, DC, 4. Advice of Friends
z
0
selected randomly and/or Relatives 9.7
W
from the customer 5. Financial Statements 7.9 C
lists of five stock- 6. Other (e.g. Tips and rA
w
broking firms Rumours) 5.2 z
n
r
A
IOO.0 r
A
icr
m
rA
n
>
icr
n
z
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Chang and 1034 individual I82 N/A N/A I. Annual Reports 46.8
Most" common shareholders 17.6"/<,, 2. Newspapers/Magazines 38.0 -
W
in the Miami. 3. Stockbrokers 33.3 W
Florida area 4. Advisory Services 32.1 N

selected randomly 5. Proxy Statements 16.6

from the mailing 6. Advice of Friends 13.1
list of a large 7. Tips and Rumours 7.8
national stock-
broking firm

Chen hall 1025 shareholders 476 N;A N/A I. Financial Statements 30.0
and from two 'investor 46.4",, 2. Stockbrokers 27.5
Juchau14 interest' groups 3. Newspapers/Magazines 16.6
4. Other (e.g. Tips and
Rumours) 15.1
5. Advisory Services 7.6
6. Friends and/or
Relatives 3.2

100.0
-
~

Lee and All 1594 share- 374 1. Chairman's Report 51.6 I. Profit and Loss 52.8 N/A
Twccdic" holders of a 23.5",, 2. Profit and Loss 46.5 2. Chairman's Report 44.3
London-b;lsed 3. Directors' Report 35.0 3. Balance Sheet 42.0
engineering company 4. Balancc Sheet 34.0 4. Directors' Report*
remaining after 5. Notes to Accounts 29.4 5. Notes to Accounts*
exclusion of instit- 6. Statistical Data 26.5 6. Statistical Data*
utional shareholders. 7. Auditor's Report 17.4 7. Auditor's Report*
nominees, executors,
overseas shareholders *Not reported

Securities Unreported number 4.400 interviews: 91% of respondents N/A N/A

and Exchange of shareholders response rate reported reading Annual
Commission holding less than not reported Reports. 77",, of
Advisory 1.000 shares in respondents reported
Committee on about 15 public reading Annual Reports
Corporate US companies thoroughly.
Disclosure''

N
W
W
 Downloaded by [New York University] at 02:05 17 November 2015

W
0
Table I rout inired

Wilton and 300 individual 165 1. Chairman’s Report 51.0 I. Profit and Loss 58.8 N/A
Tabb” shareholders 55.0. 2. Profit and Loss 48.5 2. Balance Sheet 51.5
randomly selected 3. Balance Sheet 40.6 3. Chairman’s Report 40.0
from the registers 4. Directors’ Report 37.0 4. Directors’ Report 29.1
of two New Zealand 5. Statistical Data 29.7 5. Notes to Accounts 20.0
cconipanies (a 6. Notes to Accounts 22.4 6. Statistical Data 16.4
linancial institution 7. Auditor’s Report 11.5 7. Auditor’s Report 10.3
and ii construction;
manufacturing/
retail company)

Winfieldl8 850 individual 319 (Section of the Annual N/A (Source and Percentage of
shareholders in 38.0”,, Report which Respondents Respondents Using Each
II Western Australian found most Informative) Source of Information)
company. (Principal
linc of business not I . Chairm;in!Directors’ I. Annual Reports 70.5
stated.) Report 56.4 2. Financial Press 55.8
3. Profit and Loss & 3. Stockbrokers 34.8
Balance Shect 41.1 4. Discusssions with
3. Funds Statcment 28.5 Colleagucs 19.7
4. Financial High- 5. Other 19.1
lights 26.3
5. Historical Operating
S ti m mar y 18.9
6. No Preference 17.6

University 300 individual 85 N/A N/A 1. NewspapersiMagazines 57.0

0f New Zealand 28.3”,, 2. Stockbrokers 51.8
Canterbury, shareholders. 3. Annual Reports 39.5
New Zealand” randomly selected 4. Published Statements by
from the registers Company Directors 26.3
of a number of 5. Advisory Services 14.1
public companies 6. Advice of Friends 8.7
7. Tips and Rumours 3.7
 Downloaded by [New York University] at 02:05 17 November 2015

Table 1-continued

Stockbroker and Instirutional Shareholder Suruejs

CliftZo All I10 Victorian 51 interviews N/A N/A (Information Sources considered
stockbroking firms 46.4% Critical to Equity Decision-Making
and Percentage of Respondents
Naming Source as being Critical)
1. Annual Reports 60.8
2. Interim Reports 56.9
3. Chairman's Report 54.9
4. Company Vksits 23.5
5. Current Market Infor-
mation 21.5
6. Contacts 19.6
7. Stock Exchange Statistics 17.6
8. Share Price History 15.7
9. Financial Press 11.8
10. Management 9.8

Masonz1 Sample population (a) 24 U K investing NIA NIA 1. Stockbrokers 83.3

not reported institutions 2. Statistical Cards 33.3
3. Press 25.0
4. Personal Contacts 20.8
5. Company Reports 16.7
Sample population (b) 18 UK stock- I. Personal Contacts 61.1
not reported brokers 2. Company Reports 33.3
I 3. Press 16.7
4. Statistical Cards and
Other Services 11.1

"R. H. Anderson, 'The Usefulness of Annual Reports to
Australian Investors', paper presented at the Accounting As-
sociation of Australia and New Zealand 1979 Conference,
University of Melbourne, Australia.
"H. Kent Baker and John A. Haslem, 'Information Needs
of Individual Investors', Journd of Accountuncg. November
1973. pp. 64-69.
"Lucia S. Chang and K. S. Most, 'Investor Uses of Finan-
cial Statements: An Empirical Study', Sinyupore Accountant,
VOI. 12, 1977, pp. 83-91.
I4R. H. Chenhall and R. Juchau, 'Investor Information
Needs-An Australian Study', Accounting and Business
Reseurch, Spring 1977, pp. 111-1 19.
I5T. A. Lee and D. P. Tweedie, 'Accounting Information:
An Investigation of Private Shareholder Usage'. Accounring
urrd Business Reseurch, Autumn 1975, pp. 28C291.
"'SEC Survey Shows Investor Reliance on Annual
Reports', Journul of Accoutiruncj, October 1977, pp. 14-15.
"Robert L. Wilton and J. Bruce Tabb, 'An Investigation
into Private Shareholder Usage of Financial Statements in
New Zealand', Accouiitiiiy Educution, May 1978, pp. 93-101.
ISR. R. Winfield, 'Shareholder Opinion of Published Finan-
cial Statements', paper presented at the Accounting Associ-
ation of Australia and New Zealand 1978 Conference, Univer-
sity of Otago, New Zealand, pp. 1-12.
IgUniversity of Canterbury, New Zealand survey, cited by
Chang and Most, op. cit., pp. 83-91, details of publication not
specified.
'OR. C. Clift, 'An Investigation Into the Nature and Quality
of Information Utilized by Advisers in the Stockbroking
Industry in Victoria', unpublished Ph.D. dissertation, Univer-
sity of Melbourne, Australia. 1973.
"Sandra Mason, 'Information for Investment Decisions-
ir
How Efficiently Is I t Used?'. / ~ ~ r e . s t i i i c ~ i Aiitilysr. Scptember
1971, pp. 3-16.
 302 A C C O U N T I N G A N D B U S I N E S S RESEARCH

motivation. Professional investors such as stock-
brokers and institutions would probably be more
aware of their investment decision-making than
many individual investors, and hence the results
indicating their use of annual reports may be seen
as confirming the perhaps less self-aware individ-
ual investors’ responses. Anderson,” Lee and
T ~ e e d i e , ’and
~ Wilton and TabbZ4 analysed the
association between individual shareholders’
financial sophistication and their use of annual
reports. They found that individual shareholders
are more likely to use annual reports if they pos-
sess knowledge and job experience in accounting
and finance.
The results in Column 6, which indicate that
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even when not required for governments, argu-
ments and even law suits by comptrollers and
public accountants over changes in accounting
procedures, etc.’26 Yet, after reviewing the Effi-
cient Markets research, he concludes: ‘Thus, on
the whole, the evidence does not support the hy-
pothesis that published annual financial state-
ments are useful (net of investment costs) for
investment decisions, when published, or that
government required disclosure provides inves-
tors with useful inf~rmation’.~’
The EMH itself contains the anomaly. If share-
holders cannot hope to make an abnormal return
by the fundamental analysis of publicly available
information, why do they perform such an analy-

shareholders use a number of information sources sis, thereby keeping the market efficient? The
for their investment decision-making, are consist- anomaly relates not only to the fundamental
ent with the EMH, which implies that annual analysis of annual reports but to the fundamental
reports exist in an environment of competing in- analysis of all publicly available information.
formation. Overall, however, the results in Table This article is restricted to consideration of
1, which strongly suggest that annual reports are annual reports, since their usefulness, as already
useful to shareholders, are in conflict with the mentioned, is doubly condemned by the EMH-
EMH, which implies that annual reports are of no they are publicly available information and their
‘informational value’ to shareholders. content is pre-empted by the preliminary final
profit report. The annual report would therefore
seem to be the ideal information source from
The EMH-investor survey anomaly which to approach the anomaly.
Few writers seem to have recognised explicitly It is surprising that the paradox has not
the conflict between the results of these two areas received more attention, particularly considering
of research. The only investor survey researcher the recent recognition by writers such as Klei-
who mentions the EMH is Anderson, who states: don,28Sterling,29 and Wells3’ that anomalies are
‘Empirical studies using the efficient markets an important constituent in the progress of
framework have provided evidence that annual research. ‘Discovery commences with the aware-
reports possess only limited usefulness due to the ness of a n ~ m a l y ’ , ~according
’ to Kuhn, upon
availability to market participants of other more whom these writers have drawn. ‘When con-
timely sources of i n f ~ r m a t i o n ’ . ~However,
~ fronted by anomaly [researchers] will devise
Anderson makes no attempt to reconcile this ob- numerous articulations and ad hoc modifications
servation with his survey results, which indicate of their theory in order to eliminate any apparent
that annual reports are used by shareholders. conflict’.
Benston, one of the few researchers to draw Discussion of the EMH-shareholder survey
together evidence relating to both individual anomaly will initially be confined to considering
investor behaviour and the EMH states: ‘At the
outset one fact seems clear. Investors. . . are inter-
ested in financial reports. Casual supportive evi- 26G. J. Benston, Corporate Financial Disclosure in the U K
and rhe U S A (London: D. C. Heath Ltd., 1976), p. 128.
dence abounds, such a s . . . subscriptions to ser-
27Benston,op cit., p. 140
vices (such as Moody’s and Standard and Poor’s)
”A. W. Kleidon, ‘Accounting Theories and Practice: Arbi-
that report and compile financial data, prep- trary? Incorrigible? or Useful?, paper presented at the
aration and publication of financial statements Accounting Association of Australia and New Zealand 1976
Conference, Perth, Australia.
”Anderson, op. cit., p. 7. 29RobertR. Sterling, ‘On Theory Construction and Verifica-
23T. A. Lee and D. P. Tweedie, ‘The Private Shareholder: tion’, Accounting Review, July 1970, pp. 444-457.
His Source of Financial Information and His Understanding ’OM. C. Wells, ‘A Revolution in Accounting Thought?’,
of Reporting Practices’, Accounting and Business Research, Accounting Review, July 1976, pp. 471-482.
Autumn 1976, pp. 311-313. ”Thomas S . Kuhn, T h e Structure of Scientific Revolutions
24Wilton and Tabb, up. cit., p. 172. (Chicago: University of Chicago Press, 1970), p. 52.
25Anderson, op. cit., p. 4. 321bid,p. 78.
 A U T U M N 1982 303

why investors might perform fundamental analy- vey results previously summarised indicated that
sis of any publicly available information, if no a high proportion of sophisticated investors uses
rewards in terms of abnormal gains are possible annual reports-indeed that sophisticated share-
from this activity. Consideration of why investors holders use annual reports significantly more than
might use annual reports, when not only are they naive shareholders. Additionally, since share
publicly available information but they are also traders must keep account of their share invest-
pre-empted by earlier information sources, will be ments and earnings therefrom for taxation, and in
discussed subsequently. the case of public companies, for public disclo-
sure, they are presumably aware of the returns
which they make over time from their share trad-
Possible explanations for the ing. It is difficult in these circumstances to under-
anomaly stand why, in the absence of returns greater than
One explanation for the anomaly may be that the market rate commensurate with the level of
shareholders believe that publicly available infor- risk inherent in their holdings, they continue to
mation may be used to earn abnormal gains when perform fundamental analysis.
in fact it cannot. Sterling,33 for example, suggests A study by Mayer-Sommer found that, whilst
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that shareholders may have been conditioned to between 34% and 54% of US financial analysts
such thinking. Sterling, however, does not offer sampled understood the EMH and its impli-
any evidence in support of this suggestion, and cations, at least 86% rejected the implication that
indeed Foster34 presents strong contrary evi- abnormal returns cannot be made using funda-
dence. Foster compared the trading volume reac- mental analysis of publicly available infor-
tion of two groups of firms to the preliminary m a t i ~ n . ~It’ would seem that investors would not
earnings announcement. The first group of firms be likely to continue to believe in the possibility
announced an earnings per share estimate after of abnormal returns, in the presence of a theory
the end of the fiscal year but before the prelimi- which rejected such beliefs, unless their experience
nary profit report. The second group of firms was to the contrary.
made no such announcement prior to the prelimi- Another explanation for the anomaly might be
nary profit report. The mean absolute percentage that share markets are not perfectly efficient and
error of earnings per share estimates for the first that abnormal returns can in fact be earned by
group of firms was only 1.8%. If EPS were pre- some investors. Several studies performed early in
dicted to be the same as the previous year’s EPS, the 1970s display results which are incompatible
the average absolute error would have been with perfect market e f f i ~ i e n c y but , ~ ~ several meth-
26.7%. The first group displayed a 51% increase in odological weaknesses within the studies regard-
trading volume in the week in which the estimate ing data, rate of return measurement and risk
was made, relative to the 16 weeks surrounding adjustment make them less than conclusive.
the estimate; this same group displayed only a 1% Several later studies, however, which correct these
increase in volume in the week in which the pre- deficiencies, display results consistent with the
liminary profit report was released. The second existence of some market inefficiency. bas^,^'
group of firms, which did not have an EPS esti- using two different analytical procedures, found
mate announced prior to release of the prelimi- that for his sample of 753 firms on the New York
nary profit report, displayed, however, a 47% in-
crease in trading volume in the preliminary profit
35Alan P. Mayer-Sommer, ‘Understanding and Acceptance
report week relative to the 16 surrounding weeks. of the Efficient Markets Hypothesis and its Accounting Impli-
These results suggest that the market reacts to the cations’, Accounting Review, January 1979, p. 103.
information contained in reports rather than the 36C, P. Jones and R. H. Litzenberger, ‘Quarterly Earnings
reports per se. Reports and Intermediate Stock Price Trends’, journal if
Finance, March 1970, pp. 143-148; H. A. Latank, 0. M. Joy
Many investors, particularly and C, p, Jones, ‘Quarterly Data, Sort-Rank Routines, and
who ‘make’ the market, are highly sophisticated, Security Evaluation’, Journal of Business, October 1970, pp.
and there appears to be no a priori reason to 427438 and R. H. Litzenberger, 0. M. Joy and C. P. Jones,
justify sterlings suggestion. The shareholder sur- ‘Ordinal Predictions and the Selection of Common Stocks’,
Journal of Financial and Quantitative Analysis, September
1971, pp. 1059-1068.
37S. Basu, ‘The Information Content of Price-Earnings
33Sterling, op. cit., p. 453. Ratios’, Financial Management, Summer 1975, pp. 53-63 and
34George Foster, ‘Stock Market Reactions to Estimates of ‘Investment Performance of Common Stocks in Relation to
Earnings per Share by Company Officials’, Journal of Account- Their Price-Earnings Ratios: A Test of the Efficient Market
ing Research, Spring 1973, pp. 25-37. Hypothesis’, Journal of Finance, June 1977, pp. 663481.
 304 ACCOUNTING A N D BUSINESS RESEARCH

Stock Exchange over the fourteen year period Another study which is inconsistent with per-
1956 to 1969, portfolios composed of low price- fect market efficiency is Black’s analysis of the
earnings ratio stocks earned 2 to 44% more than Value Line Investment Survey.42 Analysing the
implied by their level of systematic risk, while performance of the Value Line Investment system
high price-earnings portfolios earned 23 to 3% per over the 1965 to 1970 period, Black found that
annum less than implied by their level of risk. stocks selected as the best (worst) potential price
Joy, Litzenberger and McEnally3’ examined performers did earn an abnormal, risk-adjusted
market reaction to the interim earnings an- return of 10% ( - 10%) per year, which was signifi-
nouncement of 96 New York Stock Exchange cant at the 0.0001 level.
firms over the 1963 to 1968 period. They found Nevertheless, these studies are few in compari-
that, for a group of firms with large positive unex- son to the wealth of studies which support market
pected earnings changes, post announcement efficiency. It is possible, however, that although
abnormal return for a 26 week period was over capital markets are generally efficient, there may
4.0%; the comparable figure for large negative exist opportunities for some investors to make
earnings changes was -2.6%. These results held abnormal profits. The nature of these opportuni-
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for several alternative estimates of systematic risk ties will now be investigated. Subsequent to this
and residual rates of return. discussion, it will be considered whether annual
Brown39 studied 158 companies on the New reports might be useful to an investor in taking
York and American Stock Exchanges over the advantage of these opportunities.
period 1968 to 1971 and concluded that there
were significant price trends of approximately forty-
five days created by large quarterly and annual Possibility of earning abnormal
earnings announcements. Similarly, Latane and returns in an efficient market:
Jones, in two separate studies,40 found that unex- the interpretation of information
pectedly high (low) earnings were significantly as- Evidence suggests that shareholders are hetero-
sociated with high (low) holding period returns geneous with respect to their investment objec-
over the three month period following the earn- tives, expectations, abilities, evaluative methods
ings announcement. and horizons. The shareholder surveys summar-
Further evidence indicating less than complete ised previously clearly indicate that shareholders
and instantaneous impounding of information differ in their accounting and financial education
into security prices is provided by Jaffe.41 US cor- and experience, and hence presumably in their
porate officials who qualify as ‘insiders’ are abilities. The diversity of shareholder opinion
required to file details of their trading in securities revealed by the surveys concerning the impor-
with the Securities and Exchange Commission. tance of various sources and items of information,
The SEC publishes this information in the Official is also consistent with the assumption that share-
Summary of Insider Trading. Jaffe reported that, holders are not a homogeneous group. Ander-
for his various samples, a policy of investing in questioned shareholders regarding their
stocks in which evidence of intensive insider trad- investment objectives and horizons and found
ing was publicly available would have yielded an diversity amongst shareholders regarding both
eight-month cumulative abnormal return of these attributes. Bing44 surveyed the financial
4.93%. Such an abnormal return was significant at analysts of 34 US institutional investors and
least at the 0.001 significance level. found substantial diversity of evalu’ation tech-
nique.
If shareholders are heterogeneous, then infor-
M. Joy, R. H. Litzenberger and R. W. McEnally, ‘The
Adjustment of Stock Prices to Announcements of Unantici- mation is not absolute, and its perceived impli-
pated Changes in Quarterly Earnings’, Journal of Accounting cations will not be the same for all shareholders.
Reseurch, Autumn, 1977,pp. 207-225.
”S. L. Brown, ‘Earnings Changes, Stock Prices and Market
Efficiency’, Journul of Finance, March 1978,pp. 17-28.
4 2 F. Black, ‘Yes Virginia, There is Hope: Test of the Value
40H. A. Latane and C. P. Jones, ‘Measuring and Using Stan-
dardised Unexpected Earnings’, paper presented at the Line Ranking System’, Finnncial Analysts Journal, September-
American Finance Association Meeting, New York, 1977 and October 1973,pp. l(t14. cited by Foster, Financial Statement
‘Standardized Unexpected Earnings-A Progress Report’, Analysis, pp. 307-31 1.
Journal of Finance, December 1977,pp. 1457-1465. 43Anderson, op. cit., Tables 2 and 3.
41J. F. JaRe, ‘Special Information and Insider Trading’, 44 Ralph A. Bing, ‘Survey of Practitioners’ Stock Evaluation
Journal of Business, July 1974, pp. 41(t428, cited by Foster, Methods’, Financial Analysts Journal, May-June 1971, pp.
Financial Statement Analysis, pp. 392-393. 55-60.
 A U T U M N 1982
Even if we allow that the equilibrium price struc-
ture in the market reflects all publicly available
information, the effect of heterogeneous share-
holder decision models would be such as to pro-
duce a dispersion of individual expectations
around the market’s average response. Some of
these individual expectations could be superior,
due perhaps to superior predictive or interpreta-
tive ability, thus allowing abnormal returns to be
made by some shareholders.
Ball, Brown and Finn recognise the distinction
between information and its interpretation, and
the consequent implication that investors with
superior interpretative or predictive ability may
be able to earn abnormal returns:
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A very common misconception is that advo-
cates of market efficiency claim new infor-
mation is always ‘correctly’ reflected in price or
that current market price represents ‘true
intrinsic value’ of a security. Rather, market
efficiency advocates claim that new infor-
mation is reflected in price in an ‘unbiased’
manner. Security prices are based on expecta-
tions of future returns, and since the future is
not perfectly predictable, expectations only
rarely turn out to be perfect descriptions of
actual events.45
They conclude:
. . . Our results do not imply that investment
analysis is useless. . . . The analyst who can
make superior forecasts of fundamental factors,
such as changes in earnings and dividends, will
be in a position to earn abnormal returns.46
Sharpe also recognises that ‘unbiased’
impounding of information does not necessarily
imply ‘correct’ impounding:
I still believe the market is highly efficient, but
I can no longer adhere to a hard-line view that
the market is hyperefficient and never pro-
cesses its information
45Ray Ball, Philip Brown and Frank J. Finn, ‘Published
Investment Recommendations and Share Market Efficiency’,
unpublished paper, Australian Graduate School of Manage-
ment, University of New South Wales, Australia, November
1977, p. 2.
461bid, p. 12.
47‘A Difference of Opinion: Second Thoughts About the
“Efficient Market”, Interview of William F. Sharpe and J.
Michael Murphy by A. F. Ehrbar, Fortune, February 26, 1979.
p. 105.
A.B.R. 12/48-E
305
Unfortunately, with the exception of mutual
fund testing, there have been few studies of
whether investors do actually earn abnormal
returns. The only study of individual investor per-
formance so far apparent in the literature is that
of Lewellen, Lease and S ~ h l a r b a u m The
. ~ ~ results
of their study support the suggestion that inves-
tors exist who, through superior skills, are able to
earn abnormal returns:
The combined body of evidence cited suggests
strongly that there were, during the years in
question, quite distinct internally-homoge-
neous investment performance sub-groups
within the individual investor sample studied.
Certain of those sub-groups did extremely
well-and others remarkably poorly-in their
respective common stock trading activities. As
importantly, both sorts of groups did so very
consistently, transaction after transaction
departing from benchmark equivalent-risk
market return opportunities by substantial
margins throughout. Although the point is
debatable, we interpret that finding as reflective
not merely of the normal vagaries of fortune
but, because of the internal consistency dis-
played, as indicative in fact of underlying dif-
ferences in investment acumen as
A recent study by Groth” reports evidence
which indicates that the degree of perfection, and
hence efficiency, of the information market varies
across securities and, with respect to particular
securities, across time. Groth’s results suggest that
available information for some securities does not
have an impact (or not a sufficient impact) on the
pricing mechanism and that analysts exist who
can identify such securities and hence make
abnormal returns.
There are strong reasons why the research indi-
cating that mutual funds do not earn abnormal
returns,51 should not be taken as conclusive evi-
dence that investors cannot earn abnormal
4 8 W i l b ~ rG. Lewellen, Ronald C. Lease and Gary G.
Schlarbaum, ‘Investment Performance and Investor Behavior’,
Journal of Finmicia/ and Qirantitatiue Analysis, March 1979,
pp. 29-57.
491hid, p. 56.
50John C. Groth, ‘Security-Relative Information Market
Efficiency: Some Empirical Evidence’, Journal of Financial and
Quaniitatice Analysis, September 1919, pp. 573-594.
”See Thomas R. Dyckman, David H. Downes and Robert
P. Magee. Eficient Capital Markets and Accoirriting : A Criti-
cal Analysis (Englewood Cliffs, New Jersey: Prentice-Hall,
Inc., 1975), pp. 31-32 for a review of these studies.
 306
returns. There are a number of reasons why insti-
tutional investors, such as mutual funds, would
not be expected to earn abnormal returns. Firstly,
large funds may not be able to acquire substantial
amounts of a promising issue without influewing
the market price, unless their holding is accumu-
lated over time.52 Secondly, even if large funds
could find inadequately investigated and hence
possibly mispriced companies, the shares of these
firms would represent only a small percentage of
a large fund’s assets. Thirdly, legal requirements
constrain the investment policies of many types of
institutional investors, and fourthly, the compen-
sation schemes employed by most funds encour-
age sub-optimal b e h a ~ i o u rIndeed,
. ~ ~ a number of
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authoritative authors, relying on research evi-
dence, have conceded that mutual funds do not
perform optimally.54
G r ~ b e l suggests
~~ that when a portfolio
manager has investment success with a particular
portfolio, it often presents him with opportunities
to manage different and larger portfolios and that
as long as his success continues he will continue
to move from one portfolio to another larger
portfolio. The test of abnormal performance
therefore, according to Grubel, requires analysis
of the performance history of the manager. rather
than the performance history of the portfolio.
The most that can be said, at this stage, is that
the evidence from the Efficient Market research is
not inconsistent with the proposition that abnor-
mal returns can be made by some investors.
Indeed the possibility of abnormal returns
appears to be explicitly supported by Ball, Brown
and Finn:
The first and most obvious conclusion is that
there are gains that can possibly be made from
52Some research results indicate that securities are perfectly
substitutable and hence that block transactions do not
influence market prices. See Ray Ball and Frank J. Finn, ‘The
Effect of Large Transactions on Share Prices: Experimental
Issues and Australian Evidence’, paper presented at the
Accounting Association of Australia and New Zealand 1980
Conference, James Cook University, Australia. However, even
if this should be the case, block transactions may have infor-
mation content which affects share prices.
53Refer Williams and Findlay, op. cit., pp. 372-373 for more
detailed discussion of these factors.
54See, for example, Ray Ball, ‘Will Australian Investors Get
Index Funds?’, op. cit., p. 7 and ‘A Difference of Opinion:
Second Thoughts About the “Efficient Market’”, Interview of
William F. Sharpe and J. Michael Murphy by A. F. Ehrbar,
op. cit., p. 106.
55Herbert G. Grubel, ‘The Peter Principle and the Efficient
Market Hypothesis’, Financial Analysts Journal, November-
Dec’ember 1979, pp. 72-75.
ACCOUNTING A N D BUSINESS RESEARCH
security analysis. . . . We finish by stating how
these results fit into the much maligned ‘effi-
cient markets’ viewpoint. This hypothesis sug-
gests the following: 1. In a well-functioning,
competitive marketplace, returns should be
consistent with efforts (there should be no free
lunches)56
Allowance of the possibility of abnormal ’
returns does not detract from general market effi-
ciency-few hypotheses hold perfectly in reality-
and at the same time, it resolves the confounding
anomaly of the EMH regarding why sophisticated
investors should bother to analyse publicly avail-
able information, thus keeping the market effi-
cient, if there exists absolutely no possibility of
earning abnormal returns.
Such a conclusion also resolves the subsidiary
question of why investors would bother to
analyse the annual report, which is not only pub-
licly available information, but is pre-empted by
other more timely sources. Once it is appreciated
that information is subject to interpretation, the
timeliness of information loses much of its impor-
tance. An investor with superior interpretative
abilities would not be prohibited from using the
annual report (probably together with other infor-
mation), to earn an abnormal return simply
because most annual report information is con-
veyed to the market by, inter alia, the preliminary
profit report.
Explanation of market non-reaction
to annual reports
The above reasoning assists in explaining why,
even though shareholders apparently use annual
reports, the stock market does not react to their
release.
Usage of annual reports by shareholders may
not produce an immediate market response for a
number of reasons. Firstly, studies of short-term
market reaction overlook longer term price reac-
tions. Shareholders may analyse the annual
reports of companies some time after they are
received. Even though much of the information in
annual reports is conveyed to the market via
more prompt sources, it would seem that the
earning of abnormal returns by the superior inter-
pretation of essentially old annual report infor-
56Ray Ball, Philip Brown and Frank J. Finn, ‘Published
Investment Recommendations and Share Prices: Are There
Free Lunches in Security Analysis?’, Journal of Australian
Society of Security Analysts, June 1978, p. 9.
 A U T U M N 1982
mation would not necessarily depend upon the
promptness with which an investor analysed and
acted upon such information. In fact, there would
not appear to be any a priori reason for investors
to react promptly to annual reports thus causing
a short-term market response. (It should be clari-
fied at this point, that the above reasoning does
not suggest that all investors who attempt to
make abnormal returns using the annual report
will do so. Many investors may only think, or
hope, that they have superior interpretative abili-
ties.)
A second reason why shareholder usage of
annual reports would not necessarily produce a
short-term market response, is that transactions
costs and capital gains taxation deter share-
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holders from frequent trading, as various studies
Since the most important information
concerning a company is usually released to the
market via more prompt sources, it is likely that
annual reports generally do not contain new in-
formation which is of a sufficiently critical nature
to cause immediate substantial trading. This how-
ever does not negate their possible usefulness as
one of the information inputs to shareholders’
decision-making.
A third reason why market non-reaction is not
inconsistent with shareholder usage of annual
reports, is that the annual report, which contains
the auditor’s report, usually confirms the prelimi-
nary final profit report. Since investors react to
the preliminary final profit report, it is unlikely
that they would alter previous decisions in re-
sponse to confirmatory information. However,
this does not imply that such confirmatory infor-
mation is useless to shareholders. This confirma-
tory, or validatory, role will be discussed further
in the following section.
The above discussion illustrates that the EMH
definition of ‘informational value’ is not an ad-
equate one for the purposes of determining the
information content, or usefulness, of accounting
reports.58 The EMH research which indicates
”Refer Anderson, op. cit., Table 1; ‘What John Discovered
from Poll of Shareholders’, Australian Financial Review, 17
December, 1975, p. 33, and R. J. Briston, ‘The Fison’s Stock-
holder Survey: An Experiment in Company Shareholder Re-
lations’, Journal of Business Policy, Autumn 1970, pp. 3 8 4 6 .
5sA number of other authors have advanced this point of
view, relying upon different reasoning. See particularly R. J.
Chambers, ‘Stock Market Prices and Accounting Research:,
Abacus, June 1974, pp. 39-54 and M. Chapman Findlay 111,
‘On Market Efficiency and Financial Accounting’, Abacus,
December 1977, pp. 106-122.
307
that the stock market does not react to the release
of annual reports is seen, therefore, not to contra-
dict the shareholder survey results which indicate
that shareholders use annual reports. The follow-
ing section suggests specific uses which the annual
report may serve for shareholders.
Possible functions of annual reports
for shareholders
In the previous section it was suggested that the
annual report may serve to confirm or deny pre-
viously released information which investors have
used in their decision-making. Generally, the only
information source to be independently verified,
or audited, is the annual report, hence it contains
‘new’ information relating to the validity of pre-
viously released information.
Recent findings of Firth59 are consistent with
the validator role. Firth found large negative price
responses to audit reports which contained a qua-
lification relating to the general truth and fairness
of the financial statements contained in his
sample of annual reports. These qualifications
related principally to the validity of the assump-
tion that a firm was a going concern or to the
valuation of assets. He concluded that: ‘. . . inves-
tors are reacting to an earnings announcement
and then revising this when they learn, some
weeks later, that this figure has been “qualified” in
some sense by the firm’s auditors’.60
An Australian study by Ball, Walker and
Whittred61 found a price response to some types
of audit qualifications, leading them to conclude
that certain types of audit qualifications are as-
sociated with changes in shareholders’ assess-
ments of the value of securities.
A further use of the annual report may be to
provide a summary of operations, results and
financial position enabling risk assessment. Inves-
tors require risk information to enable them to
purchase shares which meet their desired combi-
nation of risk and return and to combine shares
in portfolios that reduce aggregate risk.
59Michael Firth, ‘Qualified Audit Reports: Their Impact on
Investment Decisions’, Accounting Review, July 1978, pp.
642-650.
601bid, p. 649.
61Ray Ball, R. G. Walker and G. P. Whittred, ‘Audit Quali-
fications and Share Prices’, Abacus, June 1979, pp. 23-34.
 308
The Capital Asset Pricing Model developed by
Sharpe,62L i n t n e ~ and
- ~ ~M0ssi1-1,~~ maintains that
the only variable which determines the difference
in the expected returns of different shares is the
risk coefficient ‘beta’, called ‘systematic’ or ‘non-
diversifiable’ risk. Systematic risk is that risk
which cannot be eliminated by diversification,
that is, in statistical terms, the covariance of
returns between a particular security and the mar-
ket as a whole. For example, the variance of a
security’s returns may be high, indicating that the
stock has a high total risk, but if the security’s
returns have a low covariance with the market
portfolio, it will be viewed as a low risk stock
because some of its total risk can be eliminated by
combination with other stocks through diversifi-
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cation (unless, of course, all securities in the mar-
ket are perfectly positively ~ o r r e l a t e d ) . ~ ~
Conventionally, systematic risk has been esti-
mated by reference to historical share prices. The
association between these market estimates of risk
and accounting variables has been extensively
examined, but most studies of the association
between security market estimates of beta and
accounting variables have lacked an explicit
theoretical foundation, that is, the choice of vari-
ables has not been guided by a theoretical model
linking the firm’s financing, investment and pro-
duction decisions with the beta of its securities.
Consequently, generalisations based on this em-
pirical research are difficult, and in fact there are
apparent inconsistencies in the variables reported
as significant in different studies. Although
various studies have found a strong correlation
between security market estimates of beta and
various accounting variables,66 researchers have
62W. F. Sharpe, ‘Capital Asset Prices: A Theory of Market
Equilibrium Under Conditions of Risk’, Journal of Finance,
September 1964, pp. 425-442.
63J. Lintner, ‘The Valuation of Risky Assets and the Selec-
tion of Risky Investments in Stock Portfolios and Capital
Budgets’, Review of Economics and Statistics, February 1965,
pp. 13-37.
64J. Mossin, ‘Equilibrium in a Capital Asset Market’, Econo-
metrica, October 1966, pp. 768-783.
Foster, Financial Statement Analysis, pp. 236261 for a
more detailed explanation of systematic risk.
66See W. H. Beaver, P. Kettler and M. Scholes, ‘The Associ-
ation Between Market-Determined and Accounting-
Determined Risk Measures’, Accounting Review, October 1970,
pp. 654682; W. H. Beaver and J. Manegold, ‘The Association
Between Market-Determined and Accounting-Determined
Measures of Systematic Risk: Some Further Evidence’, Jour-
nal of Financial and Quantitative Analysis, June 1975, pp.
231-284; and D. J. Thompson, ‘Sources of Systematic Risk in
Compon Stocks’, Journal of Business, April 1976, pp. 173-188,
all cited by Foster, Financial Statement Analysis, pp. 272-275.
ACCOUNTING A N D BUSINESS RESEARCH
not been successful in defining a model which is
capable of explaining beta in terms of accounting
variables-due, probably, to the abovementioned
lack of a theoretical model of risk, which would
guide the choice of accounting variables and their
form. One of the most successful studies so far, for
example, by Bilder~ee,~’defines a model using
six accounting variables, which is able to explain
only 23.9% of the variation in the betas of firms.
In order for an investor to choose a portfolio
with a specified level of risk for a particular
period however, an ex ante measure of beta is
required-beta must be predicted, rather than
merely explained. The few exploratory studies of
beta prediction indicate that beta is best predicted
using a combination of both accounting and non-
accounting variables. Rosenberg and Marathe6*
measured beta forecasting ability as the percent-
age of the future security returns that could be
explained by various beta forecasting models.
Using a total of 80 variables, they found that a
combination of market-based variability descrip-
tors, such as security return estimated betas and
share turnover, together with accounting-based
descriptors, such as operating profit margins and
quick ratios, explained 18% more of the variance
in future security returns than only market-based
descriptors, and 28% more than only accounting-
based descriptors.
Eskew has also produced evidence indicating
that the addition of accounting data improves
conventional (i.e. historic share price) forecasts of
systematic risk.69
Just how investors assess risk is not known
(although, as suggested earlier, it appears that dif-
ferent investors have different methods of estimat-
ing risk and return). However, the evidence indi-
cating that risk assessment is improved by the use
of accounting variables which are extracted from
financial statements suggests that annual reports
may be useful for risk assessment and prediction.
Annual reports would presumably be even
more important to inadequately diversified inves-
67J. S. Bildersee, ‘Market-Determined and Alternative
Measures of Risk‘, Accounting Review, January 1975, pp.
81-98.
68B. Rosenberg and V. Marathe, ‘The Prediction of Invest-
ment Risk: Systematic and Residual Risk‘, Proceedings of the
Seminar on the Analysis of Security Prices, Center for
Research in Security Prices, Graduate School of Business,
University of Chicago, November 1975, pp. 85-159, cited by
Foster, Financial Statement Analysis, pp. 279-28 1.
69Robert K. Eskew, ‘The Forecasting Ability of Accounting
Risk Measures: Some Additional Evidence‘, Accounting
Review, January 1979, pp. 107-1 18.
 A U T U M N 1982
tors for assessing non-systematic risk as well as
systematic risk. Although there have not been
many studies dealing with the extent to which
investors diversify, it would seem likely that some
individual investors do not adequately diversify.
For instance, 18.2% of the respondents to Ander-
son's survey held shares in five or fewer com-
panies at the time of the which is below
the level of six to ten securities at which most
diversification benefits are a ~ a i l a b l e . ~
Conclusion
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This article has explored the apparent conflict
between investor survey research and the EMH.
Investor surveys indicate that shareholders per-
form fundamental analysis of annual reports. The
EMH implies, however, that annual reports are
issued too late to be of use to shareholders, and
the lack of short-term market reaction to their
release has been interpreted as indicative of
annual reports possessing no 'informational
value'.
The conflict is important, and not merely to the
question of whether shareholders use annual
reports. Perhaps more importantly, resolution of
the conflict is necessary for logical coherence of
the EMH itself: why should investors perform
fundamental analysis of any publicly available in-
formation, including annual reports, thereby
keeping the stock market efficient, if it is imposs-
"Anderson, op. cit., Table 1.
'l Foster, Financial Statement Analysis, p. 243
309
ible to reap rewards, in terms of above-average
risk-adjusted returns for such effort?
It was suggested that above-average risk-
adjusted returns may be available to some inves-
tors who have superior interpretative or predic-
tive abilities. This is not inconsistent with the
EMH evidence suggesting that stockmarkets,
generally, are information-efficient. Indeed it
appears that it is the existence of the possibility of
abnormal returns which provides the motivation
for investors to perform fundamental analysis and
so keep the market information-efficient.
Apart from mutual funds, which, as explained,
would not be expected a priori to earn abnormal
returns, there has been little testing of actual indi-
vidual investor performance. Research to date on
this question indicates that such returns may be
available to some investors. This would seem a
very fruitful area for future research, and, since
investors are required by taxation law to keep
records of their share dealings, data availability
should not be a serious obstacle to such research.
It appears, then, that annual reports are of use
to shareholders, notwithstanding the absence of
short-term stock market reaction to their release.
It seems that annual reports may be an important
input to investors' long-term investment decision-
making, specifically, inter a h , as a confirmer or
disconfirmer of information which investors have
previously received, and as a convenient summary
of operations, results and financial position assist-
ing investors in their assessment of risk.
An important implication for accounting of this
conclusion is that short-term stock market reac-
tion is not an adequate indication of the useful-
ness of accounting information to investors.