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