CHAPTER 6
The Measurement
Approach to
Decision Usefulness
Nicole Fitzmaurice,
Eric Poolman, Lisa Landon,
Pang Koh & Ping Zhou
"is an approach to
financial reporting
under which
accountants undertake
responsibility to
incorporate current
values into the financial
statements proper,
providing that this can
be done with
reasonable reliability,
thereby recognizing an
increased obligation to
assist investors to
predict firm
performance & value."
The
Measurement
Approach
to decision
usefulness
MARKET EFFICIENCY/INEFFICIENCY
 Security
market is not as efficient as originally
believed
 Does the theory of rational decision-making
underlie an average investor’s behavior?
 Do securities reflect publicly available
information?
 The Measurement Approach can reduce extend
of inefficiency and non-rational investor
behaviour.
BEHAVIOURAL FINANCE
 Limited

Attention
Do not have time or ability to process all available
information
 Overconfidence

Overestimate precision of information that was selfcollected
 Representativeness

Assigns too much weight to evidence consistent with
individual’s impression of the population from which
the evidence is drawn
BEHAVIOURAL FINANCE CONT’D
 Self-attribution

Feels that good decision outcomes are due to their
ability and bad outcomes are not their fault
 Motivated

bias
Reasoning
Accept at face value information that is consistent
with their preferences and beliefs (GN).
All these behaviours are inconsistent with securities
market efficiency and rational decision theory
 States:
“an
investor
considering a
risky investment
(a ‘prospect’) will
separately
evaluate
prospective
gains and losses”
 Results in narrow
framing
 Utility defined
over deviation
from zero
The Prospect
Theory
DISPOSITION EFFECT
Risk-taking
Risk-averse
IS BETA DEAD?
 Under
CAPM, stock’s beta is the sole
firm-specific determinant of expected
returns on that stock
 Fama and French study
 Beta
had little ability to explain stock returns
 B/M (book-to-market value) more
explanatory
IS BETA DEAD?
Other studies conclude
 Kohari, Shaken and Sloan


B/M relatively weak in predicting returns
Beta significant over longer periods
 Behavioural

Finance
Beta and B/M positively related to future
share return
Note: Beta changes over time; is not static
EXCESS STOCK MARKET VOLATILITY
 Concerns
about securities market efficiency
come from evidence of excess stock prove
volatility at market level
 Shiller (1981) argued that the higher aggregate
expected dividends are, the more investors will
invest in the market
 Found variability of market index was greater
than aggregate dividends
 Thus, market inefficient
EXCESS STOCK MARKET VOLATILITY
 DeLong,
 They
Sheifer, Summer &Waldmann
assume capital market with both
rational and positive feedback investors
 Believe rational investors anticipate action of
less experienced investors and “jump on
band wagon”
 Thus, excess volatility
STOCK MARKET BUBBLES
 What
is a stock bubble?
 Represents
an extreme case of market volatility
 Where share prices rise far above
fundamental values
 Shiller
(2000) investigated how they are
derived
 Will eventually burst
 Causing
serious challenges to the market
efficiency theory
6.2.6 EFFICIENT SECURITIES
MARKET ANOMALIES
 Market
does not respond to
accounting information exactly as
the efficiency theory predicts
 These inconsistencies are called
efficient securities market anomalies
 Post-Announcement Drift
 Market Response to Accruals
6.2.7 IMPLICATIONS OF SECURITIES MARKET
INEFFICIENCY FOR FINANCIAL REPORTING
 Improved
financial reporting will speed up
share price response to the full
information content of financial
statements
 Examples of improved reporting include:
 Full disclosure of low persistence
components of earnings
 High quality MD&A
 Moving current value information into
the financial statements proper
6.2.8 DISCUSSION OF MARKET EFFICIENCY
VERSUS BEHAVIORAL FINANCE
 Variety
of investor activities prevent
a totally efficient market
 New information results in under and
overreaction in share price
 Despite being fully rational, some
investors don't consider information
due to the manner and place that it
is disclosed in the financial
statements
6.2.9 LIMITS TO ARBITRAGE
 Efficient
market anomalies don't die out
over time
 Transaction costs
 Bid-ask spreads
 Large amount of time and effort
required to monitor and analyze all of
the information required to exploit the
mispricing
 Idiosyncratic risk
6.2.10 A DEFENSE OF AVERAGE
INVESTOR RATIONALITY
Inability
to interpret the significance
of market activity
Estimation risk related to making
decisions results in conservative
decisions
Investors are viewed as boundedly
rational
6.2.11 CONCLUSIONS ABOUT
SECURITIES MARKET EFFICIENCY
 Securities
markets are not fully efficient
 Markets are generally close to full
efficiency
 Accountants can continue to rely on
supplementary disclosures on financial
statement notes and MD&A as an
important way to inform the market
6.3 OTHER REASONS SUPPORTING A
MEASUREMENT PERSPECTIVE
 Securities
markets not that efficient
 Investors need more help in
assessing the future performances
 Clean Surplus Theory (Ohlson) shows
that the market value of the firm
can expressed using the income
statement or the balance sheet.
6.4 THE VALUE RELEVANCE OF
FINANCIAL STATEMENT INFORMATION
 Significance
of statistics to measure value
relevance, like Earnings Ratio Coefficient
 Does this mean that the relevance of ERC
is deteriorating?
 Market Model, Landsman and Maydew
(2002)
 How is it possible for the ERC to fall but the
abnormal return increase?
6.5 OHLSON’S CLEAN SURPLUS THEORY
 Expresses
firm value in terms of accounting
variables
 Balance sheet components (net book value)
 Income statement components (goodwill)
 Firm value = net book value ± present value of
future abnormal earnings (goodwill)
 2 Assumptions
 Ideal conditions, including dividend
irrelevancy
 All gains and losses go through net income
(thus the term “clean surplus”)
6.5.1 THREE FORMULAS FOR FIRM VALUE
1. Firm value = PV of expected future dividends
 The fundamental determinant of firm value
2. Firm value = PV of expected future cash flows
3. Firm value = net book value ± PV of expected
future abnormal earnings (goodwill)
 The clean surplus theory model
 ALL THREE formulas will give the SAME firm
value in principle.
UNBIASED VS BIASED ACCOUNTING
 Unbiased
accounting
 All assets and liabilities are valued at current
value
 Unrecorded goodwill = zero ; NBV = firm value
 Biased accounting
 Assets and liabilities are not valued at current
value
 E.g., historical cost accounting, conservative
accounting
 Unrecorded goodwill ≠ zero ; NBV ≠ firm value
BIASED ACCOUNTING
(STRAIGHT-LINE AMORTIZATION)







PA0 (firm value) = $260.33 (amortized across 2 years)
Straight-line amortization in year 2 = $130.16
NBV1 = 100 + 130.16 = $230.16
E{NI2} = (100 x 0.10) + 0.5 (100 – 130.16) + 0.5 (200 –
130.16) = $29.84
E{ox2a} = 29.84 – (0.10 x 230.16) = $6.82
NI on book Accretion of discount
g1 = 6.82/1.10 = $6.20
PA1 = 230.16 + 6.20 = $236.36 (would be the same
under formula 1 and 2 as in pg210 of the textbook)
RELATION TO MEASUREMENT
APPROACH
Ohlson’s
clean surplus theory
supports measurement approach
 Increased use of current value
accounting moves more of firm
value on balance sheet.
 Thus, less need to estimate
unrecorded goodwill
6.5.2 EARNINGS PERSISTENCE
 FO
introduced earnings dynamic formula to
calculate earnings persistence
 0≤ω≤1
is the persistence parameter
 vt-1 represents effect of other information
becoming known in year t-1;
 vt-1=0 when accounting is unbiased

are the effects of state realization in period
t on abnormal earnings
FIRM VALUE UNDER PERSISTENCE
 PA1
= bvt + (α x oxta) ;
= $236.36 + (0.4/1.1 x -$50)
= $236.36 - $18.18
= $218.18
 Implication of FO model with persistence:
 Even under ideal conditions, income
statement is relevant
 Investors will want information to help assess
persistent earnings, and accountants can
help
6.5.3 ESTIMATING FIRM VALUE
(USING FINANCIAL STATEMENTS)
 Estimated
firm value = net book value as at date
of valuation ± expected PV of abnormal earnings
 To estimate the above components, first need to
calculate:
1. Beta


Estimate using
Also available on financial sites like Google finance
2. Cost of Capital using CAPM
ESTIMATING FIRM VALUE (CONT’D)
 Calculating
NBV:
bvend = bvbeg + NI – d
= bvbeg + (1-k)NI ; k= dividend payout ratio
= bvbeg(1 + (1-k)ROE) ; ROE= NI/NBV
 Calculating
abnormal earnings
oxa = [ROE – E(R)]bvbeg
oxa2007 = (0.14 – 0.09) x 2,785.2
= $139 [Example 6.2]
ESTIMATING FIRM VALUE (CONT’D)
 If
we assume that abnormal earnings persist, we
would have to calculate all the abnormal
earnings.




oxa2007 = $139
oxa2008 = $156
oxa2009 = $175
oxa2010 = $196
 PA2006
oxa2011 = $219
oxa2012 = $245
oxa2013 = $275
= 2,785.2 (NBV) + 972
= $3,757.2
SIGNIFICANCE OF CLEAN SURPLUS
THEORY TO ACCOUNTANTS
 An



alternate approach to estimating firm value
Theoretically sound and perhaps better than the
others
Uses accounting variables, there is less to predict
May be easier to apply than discounted cash flow
 Increased

Since needed in calculating unrecorded goodwill
 Supports

emphasis on predicting net income
measurement approach
More current values, smaller proportion of
unrecorded goodwill, less potential mistake in
estimating
AUDITORS’ LEGAL LIABILITY
● The
management or politicians often
create substantial pressure on
auditors to stretch GAAP to meet their
performance targets.
● Savings and loan associations
● As a result, a stronger form of
conservatism was implemented by
standard setters.
AUDITORS’ LEGAL LIABILITY
● How
do auditors protect themselves
from legal liability?
 For
capital assets or goodwill, there is a
standard called ceiling test.
 Book Value > Undiscounted Future Cash
Flows
 The asset is written down to its current
value.
 2 Implications
AUDITORS’ LEGAL LIABILITY
●
As a result, the earnings of firms that are
performing well will not include the unrealized
increases in assets. On the other hand, the
earnings of firms that are performing poorly will
include decreases in assets.
Good performance
Poor performance
AUDITOR’S LEGAL LIABILITY AND
CONSERVATIVE ACCOUNTING
● Auditor
is sued for failing to report a
potential loss
● Auditors’ reaction: conservative
accounting to reduce likelihood of
lawsuit
 This
is known as unconditional
conservatism
6.7 ASYMMETRY OF INVESTOR
LOSSES
 Risk-averse
investor Bill has shares of X Ltd.,
with current value of $10,000.
 Bill’s utility in each year equal to the square
root of the amount he spends in that year.
 Bill’s utility evaluated as at the end of year
one.
EUª (Overstatement) =
= 70.71 +54.51
= 125.48
6.7 ASYMMETRY OF INVESTOR
LOSSES
 If
he knew at the beginning of year one that
wealth was $5,000+$3,000=$8,000
 He would plan to spend $4000 each year
 His expected utility would have been
EU (Overstatement) =
= 63.25 +63.25
= 126.50
 Bill
lose utility of 126.5-125.48 = 1.02 as a
result of an opening $2000 wealth
overstatement.
6.7 ASYMMETRY OF INVESTOR
LOSSES

Assume X Ltd. assets have risen in value by $2,000 at the
beginning of year one.
 The
gain becomes realized during the year, and
Bill’s share rise in value to $7000 at year-end,
 His
actual utility over the two year is:
EUª (Understatement) =
= 70.71 + 83.67
= 154.38
6.7 ASYMMETRY OF INVESTOR
LOSSES
 If
Bill had known his wealth was $12.000,
EUª (Understatement) =
= 77.46 +77.46
= 154.92
 Thus, Bill lose utility of 154.92 –154.38 =0.54
as a result of an opening wealth
understatement.
6.7 ASYMMETRY OF INVESTOR
LOSSES
 Same
amount of misstatement $2,000
 1.02 (understatement)>>0.54 (overstatement)
 Auditors are more likely to be sued for
overstatement errors
 This is an example of conditional conservatism.
 Conditional conservatism requires measurement of
current values, we can regard it as an asymmetric
(one-sided) version of the measurement approach
6.7 ASYMMETRY OF INVESTOR
LOSSES

How should auditor value asset at statement date?
If asset valued at $10,000 (current value), investor
expected utility = 39.93
 If asset valued at $9,400 (conservative valuation), investor
expected utility = 40.00
This example illustrates unconditional conservatism since
assets are valued at less than current value even though a
loss in value has not taken place.
It suggests an investor demand for conservatism.



CONCLUSION
 Current
financial statement information
should be used to improve predictions
 Better predictions of firm value will lead to
better investment decisions
 The measurement approach is useful
when information is provided to financial
statement users since it takes into
account current values needed to
provide more accurate and relevant
information
CONCLUSION (CONT’D)
●
●
●
Information approach to financial accounting
relies on historical cost
Vs.
Measurement approach to financial accounting
relies on current value
 Markets not fully efficient
 Low explanatory power of net income for share
returns
 Ohlsön clean surplus theory
 Legal liability forces accountants, auditors and
managers to increase conservatism
As a result, decision usefulness for investors may
be further increased by conservative accounting
“MEASURING WEALTH” BY CHARLES
M.C. LEE
 Parallels
the valuation model by Edward
Bells Ohlson (EBO) and the economic
value added (EVA) model by Bennett
Stewart
EVA = earnings – r*capital
Capital = asset base
r = cost of capital
ECONOMIC VALUE ADDED
A company can improve EVA in 3 ways:
 By increasing earnings while using the
same amount of capital
 By reducing the amount of capital
employed while generating the same
earnings
 By decreasing the cost of capital
ECONOMIC VALUE ADDED,
EQUATION 2
EVA = (ROA – WACC)*TA
ROA = return on assets
WACC = weighted average cost of capital
TA = total assets
EBO
Under the EBO, the equation changes to be:
EVA = (ROE – r)*B
ROE = return on equity
r = cost of equity capital
B = book value
PRICE TO BOOK RATIO

DIVIDEND PAYOUT RATIO

QUESTIONS?