The Measurement Approach to Decision Usefulness

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 VolatilityShiller 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 BubblesShare 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 AccrualsNet Income = Cash flow from Ops +/- Net AccrualsNet 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

AnomaliesWhy 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 InefficiencySupports 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=TFVeN74FDW4

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 articleCharles M. C. Lee

Overview This article introduces the EBO (Edwards-

Bell-Ohlson) model The purpose of the model is to compute

the fundamental values of publicly traded stocks

Derived from the EVA (economic value-added) 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

long-term debt holders Also used as a performance measure

EBO uses return on equity (ROE) EVA uses return on assets (ROA)

EVA EquationEVAt = 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 above-normal 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. Current book value per share (Bt)2. Cost of equity capital (re)3. ROE forecasts for T future periods4. 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