MEASUREMENT PERSPECTIVE ON DECISION USEFULNESS 1.

MEASUREMENT PERSPECTIVE ON DECISION USEFULNESS

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Class Announcements

Assignment #4 returned in class today Cost of Egg survey in-class Assignment #5 due February 10th

(today); available on-line Assignment #6 due February 20th;

available on-line Research Paper Part #2 due February 13th

Midterm is February 17th (in-class) – discussed at end of class

© 2012 Pearson Prentice Hall. All rights reserved.

Research Paper Part #2

Discussion of accounting treatment related to CICA 1000- e.g. criteria for asset/liability, user need, qualitative characteristic such as relevance, etc. – choose one aspect of CICA 1000.

Due: February 13th (in-class) Worth: 2.5% Length: Cover page, One page submission

(double spaced), Reference page, with Part#1 and Marking Key #1 attached to the back.

Class Objectives

1. Issues with the Information Perspective of Decision Usefulness

2. Securities Markets Inefficiency: Anomalies3. The Measurement Perspective recognizes

an increased obligation to assist investors to predict firm performance and value

Information Perspective

An approach to financial reporting: that recognizes individual responsibility

for predicting future firm performance that concentrates on providing useful

information for this purpose. that assumes securities market

efficiency (i.e. the market will react to useful information from any sources including the financial statements).

Information Perspective: Issues

“To the extent that markets are not efficient and investors are not rational, reliance on these theories to justify historical cast based financial statements enhanced by much supplementary disclosure with underlies the information approach to decision usefulness, is threatened”. (p. 185) .1Markets may not be as effective as once believed

Much empirical research on usefulness of financial statement information relies on efficient securities markets

2.Behavioral tendencies : limited attention, overconfidence , self-attribution biases Investors are not as adept at processing information

as rational decision theory assumes 3.Net income accounts for 2% to 7% of abnormal

return

Information Perspective: Issues “If these questions are valid the practice of

relying on supplementary information in notes and elsewhere to augment historical cost based financial statements proper may not be completely effective in conveying useful information to investors.” (p. 186) Supplementary info to augment historic cost

many not be effective “Furthermore if shares are mispriced improved

financial reported may be helpful in reducing inefficiencies thereby improving the working of the securities markets” (p. 186) Reporting on risk: β is no longer the only

relevant risk measure

Securities Markets Inefficiency: Anomalies

1) January Effect 2) Weekend Effect 3) Stock Split Effect 4) Short Skirt Theory 5) Super bowl Indicator

Securities Markets Inefficiency: Anomaly: January Effect

Amid the turn-of-the-year market optimism, there is one class of securities that consistently outperforms the rest. Small-company stocks outperform the market and other asset classes during the first two to three weeks of January. This phenomenon is referred to as the January effect.

Securities Markets Inefficiency: Anomaly: Weekend Effect

The weekend effect describes the tendency of stock prices to decrease on Mondays, meaning that closing prices on Monday are lower than closing prices on the previous Friday. For some unknown reason, returns on Mondays have been consistently lower than every other day of the week. In fact, Monday is the only weekday with a negative average rate of return.

Years Monday Tuesday Wednesday Thursday Friday

1950-2004

-0.072% 0.032% 0.089% 0.041% 0.080%

Source: Fundamentals of Investments, McGraw Hill, 2006

Securities Markets Inefficiency: Anomaly: Stock Split Effect

Stock splits increase the number of shares outstanding and decrease the value of each outstanding share, with a net effect of zero on the company's market capitalization. However, before and after a company announces a stock split, the stock price normally rises. The increase in price is known as the stock split effect.

Many companies issue stock splits when their stock has risen to a price that may be too expensive for the average investor. As such, stock splits are often viewed by investors as a signal that the company's stock will continue to rise. Empirical evidence suggests that the signal is correct.

Securities Markets Inefficiency: Anomaly: Skirt Length Theory

“The idea that skirt lengths are a predictor of the stock market direction.  According to the theory, if skirts are short, it means the markets are going up.  And if skirt are long, it means the markets are heading down.

The idea behind this theory is that shorter skirts tend to appear in times when general consumer confidence and excitement is high, meaning the markets are bullish.  In contrast, the theory says long skirts are worn more in times of fear and general gloom, indicating that things are bearish.

Although some investors may secretly believe in such a theory, serious analysts and investors - of examining skirt length to make investment decisions - insist on focusing on market fundamentals and data.” -Investopedia

Securities Markets Inefficiency: Anomaly: Superbowl Indicator

When a team from the old American Football League wins the game, the market will close lower for the year. When an old National Football League team wins, the market will end the year higher. Silly as it may seem, the SuperBowl indicator was correct more than 80% of the time over a 40-year period ending in 2008 . However, the indicator has one limitation: It contains no allowance for an expansion-team victory.

Seehttp://www.investopedia.com/articles/stocks/08/stock-market-indicators.asp

Securities Markets Inefficiency: Accounting Examples

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Evidence of market inefficiency that specifically involves accounting evidence suggests market may not respond to information exactly as market efficiency theory predicts. 1)Post-announcement drift

Following news price changes up (good news) or down (bad news) for 60 day period

Investors appear to underestimate the implications of current earnings

Securities Markets Inefficiency: Accounting Examples (cont’d)16

2)Financial statement ratios Market does not respond to some balance sheet information Strategy based on financial statement ratios results in

abnormal returns 3) Net income = OCF ± net accruals

Market should react more strongly to $1 of good news from cash than from accruals; accruals are more subject to errors of estimation and possible managers bias than cash flows

Cash flow is more persistent; operating cash flow results from continuing operations

Research suggests reaction is not fine tuned to account for accruals vs. cash flows

4) Stock Market Bubbles Wherein share prices rise far above fundamental value

(e.g., technology bubble) Attribute to combination of self attribution, momentum

buying, herd behaviour, etc.

Securities Markets Inefficiency: Behavioral

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Investors are not as adept at processing information as rational decision theory assumes

Behavioral characteristics can produce a wide variety of share price behaviors over time. Limited attention

+ - 7 pieces of information Prospect theory

Prospect theory is a behavioral based alternative to rational decision theory Framing analysis problems in an isolated manner Separate evaluation of gains and losses - Loss aversion

Overconfidence Overestimate the precision of information they collect themselves Rare events overweighed and probable events underweighted

Representativeness Assess to much weight to evidence consistent with the individual’s impressions

Self Attribution Bias Individuals feel that good outcomes are a result of their abilities (internal

factors) and bad outcome are a result of external factors.

Securities Markets Inefficiency: Beta

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CAPM implies beta is sole risk measure to explain share return Higher ß higher return, & vice versa

Research suggest beta had little ability to explain stock market returns Book to market and firm size had explanatory

power of stock market returns Beta may shift (i.e., not constant)

If beta is not only relevant risk measure, increase role of financial statements

Weak empirical results threaten CAPM and the efficient securities market theory on which it is based

Measurement Perspective: Definition

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“The measurement perspective to decision usefulness is an approach to financial reporting under which accountants undertake a responsibly to incorporate current values into the financial statements proper, providing that this can be with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm performance and value.” (p. 184)

Stand setters have been moving toward the greater use of the measurement approach for many years.

The Measurement Perspective: Implications

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The measurement perspective on decision usefulness: greater use of current values in the

financial statements – increased relevance increased relevance must outweigh any

reduction in reliability increased fair value disclosure = increased

usefulness implies a larger role in determining fair

value suggests a balance sheet approach

Conclusions21

1.Possible explanations for anomalies that are consistent with securities market efficiency Risk – unsophisticated investor Transactions costs

2.Efficiency a matter of degree efficiency is measured as price reflecting available

information not fundamental value overtime prices will move toward fundamental value conclude actual markets are “close enough” that

efficient securities market model still most useful to guide accountants about investor decision needs

3.Theory and evidence of behavioral finance has progressed to point where it supports a measurement perspective

Class Objectives - Revisited

1. Issues with the Information Perspective of Decision Usefulness

2. Securities Markets Inefficiency: Anomalies3. The Measurement Perspective recognizes

an increased obligation to assist investors to predict firm performance and value

Midterm

Worth – 25% When –Monday (17th) Coverage –

Conceptual Framework (CICA 1000); Accrual Accounting;

Efficient Markets (Chapter 4); Information Perspective (Chapter 5); Measurement Perspective (Chapter 6); Positive Accounting Theory (Chapter 8);

Format: short answer with multiple parts; choice of 3 out of 4; no quantitative problems

Midterm: Typical Question

In measuring the response of the market (i.e., change in market price), how do accounting researchers determine if the market is responding to financial accounting information? (5 marks)

Solution: Research can obtain past data on Rjt and RMt and use

regression analysis to estimate the coefficient of the model

Abnormal return is the rate of return on firm j’s share for day after removing the influence of market wide factors.

A positive abnormal share return constitute evident that investor are reacting favorably to unexpected good news in earning

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Midterm: Typical Question

How does the historical cost basis of reporting financial statement information affect the concept of net income? (5 marks)

Solution: Under historical cost accounting, the income statement is the primary

financial statement. Net income for a period represents the difference between revenue

recognized during the period and the historical costs of earning that revenue.

When revenue is received in advance, it is deferred to future periods when it will be matched with the costs of earning that revenue. Deferred revenue is not viewed as a liability, as it would be under a measurement perspective, but rather as revenue that is not yet earned.

Asset values on the balance sheet are not intended to represent their value, but rather the costs of those assets that have will be matched with revenues in future periods.

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Midterm: Typical Question What does a market response to financial accounting

information indicate? (5marks) Solution: A market response to financial accounting information

indicates that accounting information has information value; the accounting profession wants the market to react to accounting information

Accounting information is meant to have decision usefulness; that is the market uses that information to revise expectations and assumptions and corresponding adjusts expectations about share price.

Market participants have multiple and competing sources for information about share price

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Assignment #4

Average: 2.20/2.50 or 88% Hi: 2.50/2.50 (100%) Lo: 1.35/2.50 (54%) Comments:

Support conclusion about Canadian market form of market efficiency

Form of Market efficiency– info included in price – not a reflection of inefficiency (e.g., weak form)

Include assignment and course # Avoid casual or conversational language Do not end sentence or phrase in a preposition