ADMS 4510 - ACCOUNTING THEORY
SESSION 2 OVERVIEW
INVESTOR’S PERSPECTIVE
 Decision usefulness objective
 Present value vs. historic cost
• relevance and reliability
• accounting-based valuation
 Market efficiency
• demand for information, full disclosure
Acknowledgement: Some of these slides are based on a presentation
originally created by Paul Dunn, PhD.
ADMS 4510 - ACCOUNTING THEORY
What you are responsible for
 All assigned readings in Scott text
 All lecture notes and discussions
( lectures will cover some topics from
the text that are not required reading,
i.e. ‘excluding…’ or ‘skim…’ ]
 Also very desirable:
Trying to apply
the course material to current
issues you read in financial news
Framework of accounting theory - Figure 1-1
Investor’s perspective
Inside
information
Investment
decision
Full
disclosure
Regulation
- Accounting
standard
setting
Value-based
accounting
(Ideal)
Manager’s perspective
Unobservable
manager
effort
Contracts
-compensation
-debt covenants
‘Hard’
Net Income
OBJECTIVES OF FINANCIAL REPORTING
( Conceptual Framework )
 Objectives stem primarily from needs of
external users [ investors/creditors ]
 Focus is on general-purpose, external
financial reporting
 Objectives are broad-based, not narrow
 Relate to financial reporting, not just f/s
OBJECTIVES OF FINANCIAL REPORTING
( Conceptual Framework )
DECISION USEFULNESS
 Investors make investment decisions
• how much, when to invest, how long
 Investors need information to:
• estimate probable future returns
• choose among alternative investments
 Financial information helps investors to
assess likelihood of:
• future profits, cash flows, dividends
INVESTORS
What are they like?
 Rational => want a reasonable return
 Risk averse => want to diversify portfolio
• portfolio risk versus systematic risk
Financial information should help reduce
portfolio risk by estimating probabilities of
future returns
FINANCIAL REPORTING
LIMITATIONS
 This is but one source of information about
the firm.
 Information pertains to firms, rather than to
industries or economy as a whole.
 Measures are often approximate, not exact.
 Information largely reflects events of the past
 The information is provided & used at a cost.
MAIN OBJECTIVE
OF FINANCIAL REPORTING
Provide useful information to present &
potential investors & creditors in making
rational investment & credit decisions

Assumes a reasonably intelligent & thoughtful
reader of the financial information

“Decision-usefulness” approach
What financial information do investors want ??
SPECIFIC OBJECTIVES
 Assess the amounts, timing & uncertainty
of prospective cash receipts
 Economic resources, obligations, equity &
their changes
 Financial performance & earnings
 Cash flows, liquidity & solvency
 Management's stewardship & performance
THE CASE FOR DECISION
USEFULNESS
 Approach is justified on basis that
investors & creditors are the most
prominent users
 This does not narrow the scope of financial
reporting since this approach would be
useful to other user groups
 The other users include almost everyone
DECISION-USEFULNESS
CHALLENGES
 Often there's too much information
 Investor needs to assess quality
• financial statements, MD&A, press releases,
analysts' briefings, investor presentations,
web site
 Information should be presented clearly
DECISION-USEFULNESS
CHALLENGES [ cont. ]
Information should be relevant & reliable
• for comparability & consistency
 Reliable
• precise & free from bias
 Relevant
• useful for predicting future cash-flow
• for predicting if good news or bad news will
PERSIST into future periods
INVESTOR'S PERSPECTIVE ‘IDEAL CONDITIONS’
INVESTORS & CASH FLOWS
 Value of firm is PRESENT VALUE of future
dividends
• function of firm's cash flows & interest rate
 Ideal conditions
• Know both cash flows & interest rate with
certainty
• Dividend policy is irrelevant as value of firm is
known with certainty
IDEAL CONDITIONS PRESENT VALUE ACCOUNTING
Present value financial statements would be
both reliable and relevant, but,
 Real world conditions are not ‘ideal’, the
future is uncertain
 Accounting information must find a
reasonable balance relevance and
reliability
==> ‘ DECISION USEFULNESS ’
IS HISTORIC COST USEFUL?
Historic cost is reliable
• assets & liabilities measured at cost
. . . . but it may not be relevant
• as market changes, cost may not equal PV
 Accountants often trade relevance for
reliability, e.g.
• amortization
• lower of cost & market
INVESTORS & UNCERTAINTY

Decisions under conditions of uncertainty

Investor is risk averse => diversifies portfolio
• market-wide risk
• firm-specific risk

F/S => assess probability of future states
• predict future investment returns
• predict whether good/bad news will persist
• predict future cash-flows
ACCOUNTING-BASED VALUATION
RESEARCH – Lee 1999 article
 Prediction of future payoffs to shareholders
is the key to valuation models
 Accounting information is not directly
informative about value, but is useful in
prediction / forecasting models ->
• net income is a reasonable performance
measure
• ex post settling up [actuals vs. forecasts]
ACCOUNTING-BASED VALUATION
RESEARCH – Lee 1999 article
‘Residual Income Model’:
Firm Value = Book value (capital invested) +
+ PV of future abnormal earnings +
+ Other information not in f/s
 Accounting research can improve key
forecasting estimates, e.g. long-term
earnings, cost of capital, book-value growth
Reference: Lee, C.M.C. ‘Accounting-based Valuation: Impact on Business Practices and Research.’
Accounting Horizons 13 (4), Dec. 1999, pp. 413-425.
EFFICIENT MARKETS
Efficient market hypothesis [ EMH ]
 Prices fully reflect all publicly available
information (semi-strong form)
 Prices need not reflect underlying value
- poor quality info, not enough, misinterpreted
 Decision makers constantly revise their
predictions as new information is received
 Financial reporting improves quantity &
quality of public information
MARKET INEFFICIENCIES
Why don't markets always behave efficiently ?

Prospect theory
• low (high) probabilities are over (under) weighted

Post-announcement drift
• investors don't fully digest good/bad news

Earnings fixation
• investors focus on EPS & ignore its components
EMH INCONSISTENCY
EMH holds that prices reflect all publicly
available information, but . . .
• information acquisition is costly, and
• if prices reflect all information, no motivation
to collect new info !
• prices then stop reflecting available info
Result => share prices should self-destruct
( no equilibrium price exists)
CONTINUOUS DEMAND FOR
INFORMATION
Because there are random elements (noise) in
all markets, not all trades are based on
rational evaluation of information
Over time, on average, prices are efficient
But at any point, prices can be over/under valued
Result => continuous search for private info
Note: no clear line between public/private
information
INVESTOR’S PERSPECTIVE
ADVERSE SELECTION
 Insiders can take advantage of the market
using their private information
 Problem reduced:
• penalties, fines for insider trading
• full disclosure (sometimes voluntary), but
reporting is costly
DECISION USEFULNESS - RECAP
 Provide information useful in making
investing & credit decisions
 Reflect expectations about the future
– often based on evaluation of the past
 Financial reporting:
– focuses on earnings & its components
– does not directly measure value
– provides information to estimate value
DECISION USEFULNESS, EMH
IMPLICATIONS
 Accounting policies don't matter, unless
they have direct effect on cash-flows
• accounting policies in Note 1 to F/S
 Don't worry about naive investors
 Market is interested in all relevant
information, not just accounting
information
 Disclose as much as is feasible
• see new CICA MD&A Guidelines