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The Measurement Approach. Group C Approach to Decision Usefulness. provides elements of a forecasting model that gives price as a function of earnings, expected returns, and change in book value. Definition.
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TheMeasurement Approach Group C Approach to Decision Usefulness provides elements of a forecasting model that gives price as a function of earnings, expected returns, and change in book value
Definition • The measurement approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements proper, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm performance and value.
ARE SECURITIES MARKETS FULLY EFFICIENT? Reasons an investor may not correspond with the rational decision theory and investment models previously outlined are below: • limited attention • Individuals can be conservative • be overconfident • representativeness • self-attribution bias • Motivated reasoning
Prospect Theory • What is prospect theory?
Utility Function and the Implications • Burgstahlerand Dichev • Loss aversion • Disposition effect
Is Beta Dead? • Fama and French • Book-to-market ratio • Firm size • Daniel, Hirshleifer, and Subrahmanyam • A moving beta
Efficient Securities Market Anomalies • Cases that appear inconsistent with securities market efficiency • There are 2 specific anomalies: • Post-Announcement Drift (PAD) • Market Response to Accruals
Post-Announcement Drift • Following the month of release share returns tend to shift for some time following. • Bernard and Thomas completed a study which suggest that investors underestimate the implications of current earnings for future earnings • PAD is less if an institution holds a greater proportion of a firm’s shares.
Market Response to Accruals • Sloan examined the reported net income based on cash flow and accrual portions and noted: • The market responds more strongly to news based on higher cash flow components • The market does not fine-tune the response but over time share returns of high accrual firms will shift downward over time.
Limits to Arbitrage Why not Arbitrage on the anomalies? • Complex environment • Economy parameters are constantly changing • High transaction costs • Less diversification which means?
Market Efficiency vs. Behavioural Finance • There is not a unified theory to describe over and under reaction to information (Fama) • Behavioural does not look at the big picture • Barberis, Shleifer, and Vishny argue that under reaction occurs if new evidence occurs on a one time basis.
A Defence of Average Investor Rationality • The adaptive market hypothesisdrops the rational expectations assumption the underlies the market efficiency theory • It views investors as boundedly rational • Which theory do you think is operative? The Market Efficiency Theory, Behavioural Finance Theory, or the Adaptive Market hypothesis?
Answer It is very difficult to distinguish which theory is the operative theory since they predict the same share behaviour over time.
Conclusions About Securities Market Efficiency • Securities markets are considered semi-strong efficient even though prices can depart from value. Thus accountants can still be guided by the theory. • Supplementary information can continue to be used but more information should be included in the financial statements proper.
Clean Surplus Theory • Also called the “Residual Income” Model • Assumes ideal conditions in capital markets, including dividend irrelevancy • Has had success in explaining and predicting actual firm value • Demonstrated that firm value can be expressed equally well in terms of financial accounting as in terms of dividends and cash flows.
Overview of theory • Expresses market value of a firm in terms of fundamental BS and IS components • Calculated by not including transactions with shareholders (dividends, offerings etc) when calculating the return of an organization Change in BV = (Earnings – Dividends.) “capital contributions”
PAt= bvt+ gt • PAt - Market value of firm • bvt - NBV of firm’s net assets • gt - Expected PV of future abnormal earnings (goodwill) It is necessary that ALL items of gain or loss pass through the income statement. This is “clean surplus” since it impacts earnings.
“Abnormal Earnings” • Difference between actual and expected earnings • Under ideal conditions there is unbiased accounting’ with zero goodwill. No information content on IS, all value found on BS. • Does management’s decisions cause the company to perform better or worse than expected? • The model says that investors should pay more than book value if earnings are higher than expected and vice versa.
Support of Measurement Approach • Decision usefulness increases as firm value is more easily read on BS. • Current value accounting moves more of firm value onto BS reducing unrecorded goodwill that needs to be estimated. • Reduces extent of biased accounting
RESULTS • Ability to generate same firm value regardless of accounting policy used. PRO – investor need not be concerned with policy in decision making CON – provides no guidance as to what the policy should be. • Research (Frankel & Lee 1998) shows that the ratio compared to actual market value was good predictor of share returns for up to 3 years into the future.
“Earnings Persistence” Earnings persistence Implications • All action is no longer on balance sheet. • Implies that investors will want information to help assess persistent earnings. (Need for appropriate classification of items with low persistence)
Apply to investor decisions Two companies are trading at $75 with the following estimated share values: Firm A - $40 Firm B - $46 Which firm would you sooner invest in?
Other Reasons to Support Measurement Approach • Securities markets not as efficient as believed • Investors need more help in determining future firm performance • Evidence suggests that net income explains a small part of variation in security price around earnings announcements • Clean surplus theory is consistent with measurement approach
Value Relevance of Financial Statement Information • Value Relevance-uses changes in share price surrounding earnings releases to measure the extent to which financial statement information assists investors to predict future firm value • Measured by R2 and Earnings Response Coefficient (ERC)
VALUE RELEVENCE • Increasing tendency for firms to report additional accounting information • Value relevance is falling • Response to earnings announcements taken as a whole is increasing • Suggests there is plenty of room for accountants to improve usefulness of financial statement information
Measuring Wealth • EVA and EBO are useful tools to measure wealth with balance sheet and income statement numbers • EBO relies on balance sheet and income statement numbers
AUDITORS’ LEGAL LIABILITY http://www.torontosun.com/2012/01/18/accused-nortel-execs-behind-false-records-crown
How can auditors protect themselves against pressures and potential liabilities? • Ethical Behaviour
Conservative Accounting • Inventories • The lower-of-cost-and-market rule • Capital Assets and long-terms debt • Historical Cost Accounting • Ceiling Test • Capital Assets and Goodwill
Example 1 • Bill Cautious, a rational investor, has an investment in the shares of X Ltd., with current market value of $10,000. He plans to use this amount to live the next two years. After that time, he will graduated and will have a high-paying job. Consequently, he is not concerned right now about planning beyond 2 years, His goal is to maximize his total utility over this year, For simplicity, we assume that X Ltd, pays no dividends over these two years, Bill is risk-averse, with utility in each equal to square root of the amount he spends in that year.
The Loss is unrealized, auditor fails to recognize it… Calculate Bill’s utility for the two years, evaluated as at the end of year 1: EUª (Overstatement) = √5000+ √3000 = 70.71 +54.51 = 125.48 Where EUª denotes Bills actual utility, being the utility of the $5000 he spends in the 1year + the utility to come in year 2 from the sale of his shares for $3000
If he knew at the beginning of 1ST year that wealth was $8000: • He would plan to spend $4000 each year • His expected utility would have been EU (Overstatement) = √4000 + √4000 = 63.25 +63.25 =126.50 • Where EU denotes Bill’s utility if he knew the ultimate value of his shares. Thus Bill lose utility of 126.5-125.48 = 1.02 as a result of an opening $2000 wealth overstatement.
The unrealized gain is not recognized by the auditor • The gain becomes realized during the year, and Bill’s share rise in value to $7000 at year-end, • His actual utility over the two year is: EUª (Understatement) = √5000+√7000 =70.71 + 83.67 = 154.38
CONT’D • Whereas, if Bill had known his wealth was $12.000, EUª (Understatement) = √6000+√6000 = 77.46 +77.46 = 154.92 • Thus, Bill lose utility of 154.92 –154.38 =0.54 as a result of an opening wealth understatement.
Auditor is more likely to be sued for overstatement errors • The main point of the example is that while the amount of the misstatement is the same, Bill’s loss of utility for an overstatement is almost twice the loss for an understatement of the same amount. • The example illustrates conditional conservatism. The economic loss in value has already occurred, although it has not been realized at the beginning of year1,since write-downs are conditional on a loss in value actually taking place.
One-sided Asymmetry • In sum, one way that accountants and auditors can bolster ethical behaviour, increase usefulness for investors, and protect themselves against legal liability is to expand conditional conservatism, since conditional conservatism requires measurement of current values, we can regard it as an asymmetric (one-sided) version of the measurement approach.
Unconditional conservatism • Historical cost accounting also introduces conservatism into the information system, For example, profitable capital investments are recorded at historical cost rather that current value, and inventories are carried at cost until objective evidence of realization is achieved.
Unconditional conservatism • This recognition lag for good news in the financial statement lowers the probability of GN/high state. We call this type of conservatism unconditional conservatism, since assets are valued at less than current value even though a loss in value has not taken place.
Conclusions on the Measurement Approach to Decision Usefulness • The information approach to financial reporting is content to accept the historical cost basis of accounting and rely on full disclosure to enhance earning quality and usefulness to investors. • The measurement approach is reinforced by the development of the Ohlson clean surplus theory, which emphasizes the fundamental role of financial accounting information in determining firm value.
