The Measurement Approach to Decision Usefulness

Report
The Measurement Approach to
Decision Usefulness
By Mark Allan, Christopher Keuleman, Stephanie
Howatt, Gregory Sheremeta, Christa Walsh and
Jennifer Watson
The Measurement Approach to
Decision Usefulness
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, providing that this can be done with
reasonable reliability, thereby recognizing an
increased obligation to assist investors to predict firm
performance and value
The Measurement Approach to
Decision Usefulness
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, providing that this can be done with
reasonable reliability, thereby recognizing an
increased obligation to assist investors to predict firm
performance and value
Intent is to enable better predictions of this performance by
means of a more informative system
The Measurement Approach to
Decision Usefulness
Two main questions to examine:
Are investors rational?
Are securities markets efficient?
Are Investors Rational?
Characteristics of the Average Investor:
 Limited Attention – lacking time, inclination or ability to
process all available information
 Conservative– people put more weight on prior beliefs
and revise their beliefs by less than Bayes’ theorem
 Overconfident – overestimate the precision of
information they collect themselves
Are Investors Rational?
Characteristics of the Average Investor:
 Limited Attention – lacking time, inclination or ability to
process all available information
 Conservative– people put more weight on prior beliefs
and revise their beliefs by less than Bayes’ theorem
 Overconfident – overestimate the precision of
information they collect themselves
Average investor behaviour may not correspond with the
rational decision theory and investment models
Are Investors Rational?
Psychological Theories to Explain Investor Behaviour:
 Representativeness- assigning too much weight to
evidence that is consistent with the individual’s
impression of the population from which the evidence is
drawn
 Self-attribution bias – assuming good outcome are due
to skill and bad outcomes are due to states of nature
Are Investors Rational?
Psychological Theories to Explain Investor Behaviour:
 Share price momentum – as share price rises people buy
more shares and price rises further
 Motivated reasoning – accepting information that is
consistent with preferences while attempting to discredit
information that is inconsistent with preferences
Are Investors Rational?
Prospect Theory
 An investor considering a risky investment will separately
evaluate prospective gains and losses
 Individuals dislike even small losses (loss aversion) rate of
utility loss is greater than the rate of utility gain
Are Investors Rational?
Prospect Theory
 An investor considering a risky investment will separately
evaluate prospective gains and losses
 Individuals dislike even small losses (loss aversion) rate of
utility loss is greater than the rate of utility gain
Are Investors Rational?
Prospect Theory
 An investor considering a risky investment will separately
evaluate prospective gains and losses
 Individuals dislike even small losses (loss aversion) rate of
utility loss is greater than the rate of utility gain
 Leads to “irrational” behaviours:
•
•
Staying out of the market because of a fear of losses
Holding on to losing securities to avoid realizing losses,
while selling winning securities (disposition effect)
Are Markets Efficient?
Excess Stock Market Volatility
Shiller finds that:
 Aggregate expected dividends determine the market
portfolio (all other things constant)
 Therefore, if market is efficient changes in portfolio should
not outpace aggregate dividends
However:
 Stock market index is more volatile than aggregate
dividends
 This represents inefficiencies
Problems with this Theory
Inefficiency occur:
 Behavioural factors
 Dividends are firm specific but variability can be diversified
to be insignificant
 Economy wide factors
A better determinate:
- Earnings variability (cannot be diversified away)
- Higher correlation between earnings and market index
Stock Market Bubbles
Share prices rise far above fundamental values
Influenced by:
 Positive feed back trading
 “herd” behaviour
 Optimistic projections from “experts”
Efficient Securities Market Anomalies
Post Announcement Drift:
 After earnings announcement it is expected
people adjust the price immediately
 Does not actually happen and prices drift
towards the expected over time
 Less likely when greater portions of firm is held by
intuitional investors
 More expertise
 Focused on arbitrage
Efficient Securities Market Anomalies
Market Response to Accruals
Net Income = Cash flow from Ops +/- Net Accruals
Net Accruals: Changes in items such as receivables,
allowances, and amortization.
Expected that larger emphasis be placed on cash flow
as accruals are estimates and less reliable
Efficient Securities Market Anomalies
Unfortunately, this is not the case:
 Investors do not seem to alter their response
based on cash flow and accruals
 Fail to see changes in future earnings/cash flows
 Less likely to effect institutional investors but still do
not fully take advantage
 Mostly because accrual anomaly is not yet fully
understood
Anomalies
Why do they not disappear over time?
 Complex situations should give way to arbitrage
Limits on arbitrage
 Uncertainty and risk adverseness
 Transaction costs
 Idiosyncratic risk
 Non-diversified
Reasons for Anomalies
Why do they exist?
 Investor behavior vs. rational behaviour theories
Rational Investor
 Estimation risk will exist due to inside info,
complexity of situation, etc.
 Thus, a rational investor will estimate the likely
hood of future performance
 Stock fluctuates, and continues to fluctuate with
new information
Reasons for Anomalies
Adaptive Market Hypothesis
 Humans adapt to change over time
 3 year time frame
Over vs. Under reaction
 Investors will over react to consistent growth
 Investors will under react to 1 time growth
Market Inefficiency
Supports measurement approach
Speed up investors’ response to information
 More informative MD&A
 Information surrounding the current state of the
company
Market Efficiency
Extent of efficiency is the key measure
Markets seem to be relatively efficient
Thus, theory can be relied on for accounting
and measurement accounting should be
used to provide better, more relevant
information
Additional Reasons
Value Relevance of F/S Information
Auditors’ Legal Liability
Asymmetry of Investor Losses
Value Relevance of F/S Info
Extent to which info allows users to predict
future firm value
Information release seems to have little
effect on total value, share price
 2-7% of total returns
Indicates that the information is not as
relevant as it could be
Auditors’ Legal Liability
Pressure from management to stretch the
rules of GAAP
For example the savings and loan
associations fail, convert more pressure to
switch to the measurement approach
Short-term interest rates became higher than
long-term rates, which caused
overstatements on net assets due to failure
to write down to current value
Auditors’ Legal Liability
Gains trading, also known as “cherry
picking”
Such pressures resulted in million dollar
lawsuits against audit firms
http://www.youtube.com/watch?v=TFVeN7
4FDW4
Auditors’ Legal Liability
How can auditor’s protect themselves?
Used ethical behavior and recognition of
change in current value of items such as
assets and liabilities.
Lower-of-cost-and-market extension to
support a stronger form of conservatism.
Ceiling Test
Auditors’ Legal Liability
 Basu (1997) measured conservatism by the
correlation between net income and share
returns.
 Firms performing well, WILL NOT included the
unrealized increases in assets. Where as,
earnings of firms that are performing poorly WILL
include decreases in the value of their assets
 Investor losses, auditor liability, and severe
penalties for managers who overstate earnings
reinforce conservative accounting
Asymmetry of investor Losses
Example: Joe is currently a student, he
invests in company Y. The market value of his
shares is $10,000. He plans to use this
investment to live over the next two years.
To make the most of his utility, Joe splits his
investment and sells $5,000 now, and holds
the other portions of his investment to sell at
the beginning of the second year.
Asymmetry of investor Losses
 At the beginning of the second year some of Y’s
assets have fallen in value. This loss is unrealized by
both management and the auditors. The loss is
realized during year 1, resulting in Joes remaining
shares to be valued at $3,000.
 EU (Overstatement) = √(5,000) + √(3,000 = 125.48
 EU* (Overstatement) = √(4,000) + √(4,000) =126.50
 Joe Loses utility of 126.50 – 125.48 = 1.02, as a result
of an opening $2,000 wealth overstatement
Asymmetry of investor Losses
 Alternative, Y’s assets have risen in value by
$2,000 during year 1, but again this gain in
unrealized. The gain eventually becomes
realizes during the year and Joe’s share value
raises to $7,000.
 EU(Understatement) = √(5,000)+ √(7,000)
= 154.38
 EU*(Understatement) = √(6,000) + √(6,000)
= 154.92
 Joe, again loses utility of 154.92 – 154.38 = 0.54
Anticipating the investor’s loss asymmetry,
the auditor acts to being conservative.
Accountants and auditors strengthen ethical
behavior, increase usefulness for investors,
and protect themselves against legal liability
is to expand conditional conservatism.
Conditional conservatism requires
measurement of current values, we can
regard it as an asymmetric version of the
measurement approach.
Conclusion on the Measurement
approach to Decision Usefulness
 Securities markets may not be as efficient
 Behavioral theory suggests that help may be
supplied by moving some information
 Market share of 2-7% for net income seems low
 Legal liability may forces accountants, auditors
and management to increase conservatism
 The measurement approach is reinforce by the
development of the Ohlson clean surplus theory
Measuring Wealth article
Charles M. C. Lee
Overview
This article introduces the EBO (Edwards-BellOhlson) model
The purpose of the model is to compute the
fundamental values of publicly traded stocks
Derived from the EVA (economic valueadded) model
EBO and EVA
Both are based on the concept of residual
income
 Earnings in excess of an expected performance
level
EVA is also a powerful tool to value a firm
over an extended period of time
 EBO expanded on this concept, using a dividend
valuation model
EBO and EVA Differences
EBO focuses on equity investors
EVA focuses on long-term investors and longterm debt holders
 Also used as a performance measure
EBO uses return on equity (ROE)
EVA uses return on assets (ROA)
EVA Equation
EVAt = earningst – r * capitalt l
capitalt l = asset base (net assets employed
at the beginning of period t)
r = cost of that capital
earningst = actual earnings on the capital
EBO Equation
Left side is price/book value
Right side represents future abnormal ROEs
and growth in book value
The author assumes certainty to keep the
notation simple
EBO
In a competitive equilibrium, a firm’s ROE
should be close to its cost of equity capital
(re)
The formula shows that firms should trade at
a P/B ratio close to 1
Firms that are expected to earn abovenormal ROEs should trade at higher P/B ratios
EBO equation components
We can estimate Pt* (firm’s intrinsic value), or
the present value of its future dividends, if we
have four inputs:
1.
2.
3.
4.
Current book value per share (Bt)
Cost of equity capital (re)
ROE forecasts for T future periods
Estimate of the dividend payout ratio (k)
Other Related Models
EBO components are also based off of DDM
(dividend discount model) and DCF
(discounted cash flow) model
However, DDM and DCF have limitations
that EBO solves, by not relying solely on
dividends or non-balance sheet information
DCF
Ascribes all the firm’s value to its future
earnings (cash flow) stream
Uses terminal value estimations
 Higher and more volatile than they need to be
 Due to a large portion of the projected CF
pertains to the current capital base
EBO reduces this problem by projecting only
the future residual income
Estimation Uncertainty
 ROE forecasts for T future periods
 Estimate of the dividend payout ratio (k)
ROE Forecasts
Experts use industry benchmarks as a basic
for forecasting future ROEs
Use firms with similar risk profiles and
accounting policies
Also base longer forecasts on cyclical trends
Dividend Payout Ratio
In theory, k should not affect a firm’s
valuation
In reality, if a firm increases k but wants to
maintain the same level of operations, they
must borrow more
 Increasing re
 Increasing ROE
Timberland Example
Students used the EBO equation to calculate
the intrinsic value of Timberland, based on:
 Book value – $9.55 per share at Jan. 1993
 Cost of equity, using CAPM
 Dividend payout ratio – Timberland has never
paid dividends (0)
 Forecasted future earnings – using a forecasting
firm’s estimations
Timberland example
The students calculated Timberland’s intrinsic
value at $22.70
At the time this information was collected,
Timberland’s shares were selling for $60
This makes it look like EBO is an invalid model
However, within two months the share price
was trading at about $20
Conclusion
In practice, the EBO model shows how
shareholders’ wealth is related to the
numbers on the income statement and
balance sheet
Using the DCF model after EBO allows for
adjustments in each cash flow item
Overall, EBO helps identify over- and
undervalued firms

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