Lecture 06

ACCT 332 – Accounting Thought and Practice

The Measurement Perspective and Applications

- Chapters 6 & 7

- Concepts No. 7 Using Cash Flow Information and Present Value

The Measurement Perspective

• Information Perspective:

- Financial Reporting is useful

• Does not have to be directly about value -- provides information (with full disclosure) that assists in predicting value.

• Research Evidence supports its usefulness (Chapter 5)

• Measurement Perspective- What is the Measurement Perspective to Decision Usefulness?

- Why is Financial Reporting Moving Towards a Measurement Perspective?

- Measurement Oriented Standards

• e.g., FV for security investments and goodwill

I. What is the Measurement Approach (Perspective)?

• Greater Use of Current Values in the Financial Statements

- Recognize an obligation to assist investors to assess firm value and to predict firm performance

- Measurement approach is to increase the decision usefulness over that of information approach

• Two versions of current value

- Exit price (fair value)

- Value-in-use: present value of future cash receipts / payments

II. Attraction of the Measurement Approach

• Securities markets may not be as efficient as previously believed- If markets are not fully efficient, information perspective is not

sufficient and the measurement perspective is needed

• Low R2

- Better measurement may increase accounting !market share" in explaining share price changes

• Ohlson’s clean surplus theory

- A theoretical framework supportive of the measurement approach

• Auditor Liability

- Better measurement may reduce auditor liability

- More fundamental issue: potentially misleading historical cost-based numbers (on B/S)

Lev and Zarowin (1999)

II-A. Accounting / Market Anomalies

• The information approach is based on the Efficient Market Hypothesis

• However, the market is not perfectly efficient:

- Post Earnings Announcement Drift -- Bernard & Thomas (1989)

• EMH says market should respond immediately to news but we observe a drift

- Accruals – Sloan (1996)

• Cash flows are more persistent than accruals but the market treat them as they are equal

- Other (not in Chapter 6):

• Non-earnings information

Bernard and Thomas (1989)

Sloan (1996)

II-A. Why Are Securities Markets Not Fully Efficient?

• Behavioural finance

- Behavioural characteristics that question market efficiency

• Limited attention: not using all new information

• http://www.youtube.com/watch?v=IGQmdoK_ZfY

• Overconfidence: overestimate the precision of self-collected data

• Representativeness: give more weight to some kinds of evidence

• Self-attribution bias: ascribe successes to own ability

• Transaction costs too high

II-A. Implications on Investor Rationality and Market Efficiency

• Rational decision theory model of investment is still the most useful model to guide accountants about investor decision needs- Securities markets are not fully efficient, but close

enough so that accountants can be guided by its reporting implications

• Implications of potential market inefficiency on measurement perspective- To the extent that markets not fully efficient, the role of

financial reporting increases- Current value accounting helps to fulfil this increased role

II-B. The Clean Surplus Model

• The measurement approach can be justified by Ohlson!s Clean Surplus Model

• Discussed in detail in other courses

- Corporate Reporting and Analysis

- Ohlson!s Clean Surplus Model has many applications

II-B. Ohlson!s Clean Surplus model

• Firm value = Book value + Premium- Start with the value that is in the balance sheet and then add the value

that is not recognized

• Premium is based on abnormal earnings: - Abnormal earnings = Actual earnings – required return

• the earnings that exceed the required return

- The required return will be cost of capital x net capital investment (!accretion of discount" covered in Chapter 2)

• Firm value = Book value + Present value of expected abnormal earnings- The basic idea: firms create extra !value" when they generate a return

on assets that is greater than their cost of capital (i.e. have positive abnormal earnings)

III. Application of the Measurement Approach

• Two primary examples

- Accounting for intangibles

- Fair value accounting for financial instruments

III-A Current Value Accounting

• Value-in-Use

- The present value of future receipts or future payments wrt the use of the asset

- Relevance: high

- Reliability:

• Error and possible bias in estimating inputs

• Management may change the intended use of the assets

- Concept of Business Model in IFRS 9

• May value certain financial assets at value-in-use if firm’s business model is to hold the assets to generate future cash flows from interest and principal

• Controls: management ability to change intended use

III-A Accounting for Intangibles

• Purchased intangibles

- Goodwill arising from an acquisition

• Accounted for at cost

• No amortization

• Subject to the impairment test

• Can lead to major writedowns

• Self-developed intangibles

- Self-developed goodwill, e.g., from R&D

• Hard to reliably determine fair value

• Costs written off as incurred

• Recognition lag: the value shows up over time on income statement

III-B Current Value Accounting

• Fair Value

- Exit price: Ideally, market value, but market incompleteness complicates the measurement

• It measures the opportunity cost of retaining asset/liability in firm

- Fair value hierarchy

• Level 1

• Level 2

• Level 3

- Effect on reliability as we move from level 1 to levels 2 and 3?

III-B Financial Instruments

• Definition

- A contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm

• Why use fair value for financial instruments?

- To increase the decision usefulness

• Relevant

• Many financial instruments traded on well-working markets → reasonable reliability

III-B Financial Instruments

• Applies to debt and equity securities

! Financial asset categories

• Trading

- Fair valued, gains/losses in net income

• Available-for-sale

- Fair valued, gains/losses in OCI

• Held-to-maturity, Loans & receivables

- Valued at cost, subject to impairment test

- May be written up again if fair value rises

! Two financial liabilities categories

• Trading, valued at fair value

• Other, valued at cost or amortized cost

- E.g., bonds outstanding, demand deposits

Summary

• Assuming reasonable reliability, current value accounting can increase the decision usefulness relative to information perspective

• Reasons for the increased use of current value accounting in financial reporting

- Markets not fully efficient

- Low explanatory power of net income for share returns

- Ohlson clean surplus theory

- Auditor liability

• Standard setters continue to favour current value measurements in financial statements

• Accountants recognize an increased obligation to measure and report on firm value and risk

Group Questions

• 40 minutes to complete group questions

• Assignment of discussion-leading groups