[The traditional functional fixation view states that investors are always unsophisticated and, therefore, fail to unscramble the true cash flow implications of accounting data. At the other extreme, the efficient market hypothesis states that investors are always sophisticated and very accurately unscramble the true cash flow implications of accounting data. This article proposes and tests a middle ground between these opposite views. The extended functional fixation view proposes that when responding to accounting data, sometimes a firm's stock price is set by a sophisticated marginal investor, and sometimes it is set by an unsophisticated marginal investor. The likelihood that the stock price will be set by the latter type is conjectured to be measured by the relative proportion of a firm's stock held by unsophisticated investors as a whole. The extended functional fixation view is tested by examining the stock price reaction to quarterly earnings announcements of firms that undertook debt-equity swaps. Swaps produced an immediate accounting gain that amounted to about 20 percent of earnings for the quarter in which the swap was undertaken. Because sophisticated investors would have seen this gain at the initial swap announcement, the efficient market view predicts that there will be no stock price reaction to the re-announcement of the gain as part of the swap quarter's earnings. However, the extended functional fixation view predicts that there will be a reaction to the re-announcement of the gain because unsophisticated investors would not have known about the gain until the earnings announcement, at which time they would have misinterpreted it as a real gain, rather as just a realization of a previously unrealized capital gain. The larger the likelihood that a swapping firm's stock price was set by unsophisticated investors, the larger the stock price reaction. Overall, the empirical evidence presented appears inconsistent with the efficient market view, but consistent with the extended functional fixation view.]

[This study examines the testable implications of two hypotheses for why firms undertook debt-equity swaps over the period August 1981-June 1984. The first hypothesis is that firms used the accounting-based reported earnings gain from the swap to smooth an unexpected and transitory decrease in their earnings per share. The second hypothesis is that a swap enabled the firm to relax potentially binding sinking-fund constraints in the cheapest feasible manner. Empirically, this study concludes that firms undertook debt-equity swaps for both reasons, but that swapping to smooth earnings was a much stronger motivation than swapping to relax potentially binding sinking-fund constraints.]

In this paper I assess the degree of similarity in the cross-sectional pricing of Internet and non-Internet stocks during the tumultuous year of 2000. Despite large differences in their economic fundamentals, I find that the equity market values of Internet firms with immaterial web traffic, firms that are randomly selected, and firms that went public at the same time as Internet firms are similarly related to analysts' forecasts of earnings in 2001 and the long-term rate of growth in earnings. This is not the case for firms with intensive web traffic. I also find that at the peak of Internet prices in March 2000 the market rewarded losses of web-traffic-intensive firms but did not reward profits, while after the peak the market reversed its view, rewarding profits but not losses. Beyond earnings, web traffic is significantly positively priced both at and after the Internet peak. However, I find no evidence that two proxies for supply and demand forces – the degree of public float and short interest – are value-relevant for Internet firms. Overall, I argue that there are enough similarities in the cross-sectional pricing of Internet and non-Internet firms to make it unlikely that the pricing of Internet stocks during 2000 was entirely irrational. Moreover, any irrationality in the prices of Internet stocks cannot be linked to public float and short interest. JEL classifications: G12, G14, M41.

Investor sophistication, Analyst forecasts, Analyst forecast error, LIFO adoption

Inventory valuation, Accounting methods, LIFO adoption, Uncertainty

[This study uses experiments to examine whether individuals' earnings forecasts correctly reflect the time series properties of quarterly earnings, in particular, the positive autocorrelation in seasonal quarterly changes and the negative fourth-order moving average term documented by Brown and Rozeff (1979). We find that individuals' forecasts are sensitive to the magnitude of these time series components; however, individuals typically underweight the moving average term and under- (over-)weight the most recent seasonal quarterly change when it has a strong (weak) effect on future earnings. Individuals also place slightly more weight on quarterly changes when earnings are reported relative to those four quarters prior. These results suggest that the documented stock market under-reaction to quarterly earnings may not hold universally; rather, it may be composed of under-reactions to firms with strong autocorrelation in seasonal changes and over-reactions to firms with weak autocorrelation in seasonal changes.]

This study examines the value relevance of financial statement data and nonfinancial statement information within and across the pre-IPO venture capital and post-IPO public equity markets. For a sample of U.S. biotechnology firms, I find that financial statements are highly value-relevant in the venture capital market, and that the signs of the associations between equity values and financial statement data in that market are similar to those in the public equity market, despite significant structural differences between the two. I also find that the value relevance of financial statements generally increases as firms mature, consistent with financial statements capturing the increasing intensity of assets-in-place relative to future investment options. In contrast, the value relevance of nonfinancial statement information decreases as firms mature, indicating that, in a dynamic sense, financial statements and nonfinancial statement information of venture-backed pre-IPO biotech companies are information substitutes in valuation, not complements.

Abstract Presents a reply to Ray Ball and S.p. Kothari's critique of `A Test of the Extended Functional Fixation Hypothesis,' published in the 1990 issue of the `Accounting Review.' Focus on the firm-size effect on security returns; Critique on the result of the examination of the extended functional fixation hypothesis proposed by the author.

Proposes and tests a probabilistic extension of the efficient market hypothesis toward the functional fixation hypothesis (FFH). Calendar time positioning of the swap announcement and swap quarter's earnings; Debt-equity swaps as a test of extended FFH (EFFH); Empirical methods.