Chapter 6: The Measurement Perspective on Decision
Usefulness
Introduction
The focus of the chapter is to analyze if accounting information can be made more useful
in decision-making by taking a more measurement orientated approach in financial
reporting. The measurement perspective differs from the information perspective that has
been presented in previous chapters. The information perspective concentrates on
providing information that is useful in predicting future firm performance. In contrast, the
measurement perspective can be defined as follows:
The measurement perspective on financial reporting is an approach
under which accountants undertake a responsibility to incorporate fair
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 future firm performance.
Reasons for Attention to Measurement
Explanatory Power of Net Income
While it has been shown through studies like Ball and Brown (BB) that security returns
do respond to new releases regarding earnings, Lev (1998) has pointed out that the effect
can be as small as 2-5% of the abnormal variability of narrow window security returns
around the date of the new release. It should be noted that even though a result of a study
like BB demonstrates a strong reaction (i.e. a deviation from zero), in reality the effect
could be quite small. Therefore, the significance of data can be divided into 2 categories:
statistical significance and practical significance.
Statistical Significance- Occurs when data shows deviation from a baseline reading. For
example, security markets display a reaction to earnings information.
Practical Significance- Occurs when the data shows statistical significance but lacks any
strong implication for the marketplace.
A study done by Collins, Kothari, Shanken and Sloan (1994) has accumulated evidence
to show that it is this lack of timeliness and relevance of historical cost based earnings
that have led to the small market response to this information. It then follows that
earnings information could be improved by introducing a measurement perspective into
financial reporting. Furthermore, net income cannot explain all of the abnormal returns
(except under ideal conditions). The reason being that there are all sorts of other
information sources available. There are also noise and liquidity traders that add to the
abnormal variability.
Ohlson’s Clean Surplus Theory
The study done by Feltham and Ohlson (F&O) (1995) resulted in the clean surplus
theory. The theory illustrates a way of calculating the market value of a firm, and
ultimately the security returns, by means of balance sheet and income statement
components. The assumptions of the study are as follows:


Ideal Conditions
Dividend irrelevancy
The starting point of the theory is in understanding that the main predictor of a firm’s
value is its dividend stream. See example in Appendix A.
Earnings Persistence
OXta = wOXt-1 + et where w is the persistence parameter. The persistence parameter
has a value between 0 <= w < 1. The above example handled the case when w = 0. When
w < 1, the earnings persistence will die out over time. In Chapter 5 it was discussed that
the higher the ERC coefficient, the higher the persistence in earnings, similarly, the
higher the value of w, the greater the income statement impact. The example in Appendix
A handles the case when w >1.
Implications
1. Under ideal conditions, all action is no longer on the balance sheet. The income
statement is important because it reveals current year’s abnormal earnings.
2. The formulas imply that investors will want information to help them access
persistent earnings since they are important to the persistence of the firm.
This second implication is consistent with Chapter 5 ERC discussions: the greater the
persistence, the greater the investor response to current earnings. We can also use
F & O to estimate the value of a firm’s shares, which can then be compared to actual
market value to determine the possibility of mis-priced securities. See example in
Appendix A.
If a firm’s actual share value is comparable to the model value, you would be more likely
to invest in that firm rather than invest in a firm whose share value is not as “backed up”
by book value and expected abnormal earnings.
The clean surplus theory leads to the measurement perspective since the more fair values
that are incorporated into the book value, the less the need to predict abnormal earnings.
The clean surplus theory also emphasized the usefulness of current financial information
to predict future earnings as opposed to examining the relationship between current
financial information and share returns as is done with the information perspective.
Auditors Legal Liability
Additional support for the measurement perspective comes from a legal standpoint. The
failures of many large firms and financial institutions have led to increased pressure on
auditors to insure that the financial statements truly reflect the continuance of the firm as
a going concern. This pressure for legal responsibility can be partially alleviated by
introducing more fair values into the statements. By doing so the auditors can point out
that the financial statements predicted certain events like bankruptcy and environmental
liabilities. However, the perspective also increases the amount of estimation in the
financial statements. As long as the auditors and accountants are willing to adopt these
fair values estimates without substantial loss of reliability, the measurement perspective
offers added legal benefits.
Measurement Examples
Financial statements contain a certain amount of fair value estimates even when
they are conventionally referred to as being based on historical cost. Examples include
accounts receivable and accounts payable at net realizable value, fixed contract cash
flows, the lower of cost or market rule, ceiling test on capital assets, and push down
accounting for acquisitions.
More Recent Fair-Value-Oriented Standards
Pension and Other Post-Employment Benefits (OPEB)
Accounting on a present value basis is being extended to other post-employment benefits
in Canada. Currently, defined-benefit pension plans are accounted for this way. Instead of
accounting for things like health care and insurance (for retired employees) on a cash
basis, present value accounting will be the standard. This allows OPEBs to be consistent
with FASB.
These new changes will impact firms because of the large expense that has to be recorded
for accumulated OPEB obligations. Under FASB, the expense either can be recorded in
the year of adoption or be amortized. Our concern is the use of discounted PV in order to
calculate the above.
Impaired Loans
Under Section 3025, in loans that become impaired or restructured, the lender is to write
down the loan to its estimated realizable amount based on expected future cash flows.
Losses are included in the income statement and the carrying value of impaired loans has
to be adjusted. This is a departure from the lower-of-cost-or-market rule.
Financial Instruments
Introduction
A financial instrument, under Section 3860, is, “any contract that gives rise to both a
financial asset and a financial liability or equity instrument of another party.”
Primary instruments include A/R, A/P, N/R, N/P, and debt and equity securities. Section
3860 does not explain how to value financial instruments; rather, it gives an information
perspective of financial instruments.
Valuation of Debt and Equity Securities
There are 3 categories into which debt securities and equity securities are classified
according to SFAS 115 of the FASB:
1-Held-to-Maturity—valued at amortized cost.
2-Trading—valued at fair value; unrealized gains or losses included in income.
3-Available-for-Sale—valued at fair value; unrealized gains or losses included in other
comprehensive income.
There are 2 problems with the above; gains trading, in which firms sell securities that
have risen in order to realize the gain while holding on to securities that have fallen, and
the unpredictability of net income reported. Firms are protected somewhat from risk by
natural hedging.
Derivative Instruments
Derivative instruments are contracts such as options and interest rate caps and floors.
Their value depends on an underlying variable such as price, interest rate, exchange rate,
etc.
Derivatives are difficult to deal with as they are characterized by low initial investment.
Thus there is little or no cost to account for, meaning that all or part of the contract is offbalance sheet.
The requirements of fair value information, terms and conditions, as well as credit risk
information are therefore important. Accounting for derivatives is that of a measurement
perspective. For balance sheet purposes, all derivatives must be measured at fair value
with the changes in fair value reflected in net income.
The Black/Scholes (1973) pricing model for options, based on 5 variables, is commonly
used for non-traded derivatives.
Hedge Accounting
Hedging occurs when a firm that has a risky asset, acquires a hedging instrument (asset or
liability) in an effort to offset the hedged item’s gain or loss. The hedging instrument’s
value should move in the opposite direction of the hedged item, but it may not be entirely
effective, so the risk associated with this is called basis risk.
Matching is an important concern, as hedge accounting wants to have the gains and
losses in the same period. Changes have occurred, under SFAS 133, regarding hedge
accounting. Gains and losses on fair value hedges (hedges on existing assets and
liabilities) are included in current earnings. Gains and losses on cash flow hedges,
(hedges on projected transactions), are included in other comprehensive income.
Reporting on Risk
Beta Risk
Since beta and other accounting-based risk measures are correlated, financial-statementbased risk measures could reflect a change in beta, faster than the market model. Beaver,
Kettler and Scholes(BKS) tested this relationship and their findings support the above
claim. Others have tested this relationship and the conclusions reached by them seem to
corroborate with that of BKS.
Stock Market Reaction to Other Risks
Barth, Beaver and Landsman looked at the effects on banks of supplemental fair-value
disclosure on the market value of equity. The effect on savings and loan associations of
interest rate risk of derivatives-based hedging has also been examined by Schrand. The
results of both studies showed that the market is more sensitive to interest rate risk than to
beta. In addition, the size of the market response is affected by natural hedging and
derivatives hedging.
Wong looked at the foreign exchange risk of manufacturing firms, but was unable to
explain the size of the sensitivity.
A Measurement Perspective on Risk Reporting
The risk disclosure requirements established by the SEC include quantitative price risk
disclosures. The 3 forms of these disclosures are tabular presentation, sensitivity analysis
and value at risk. The last 2 forms are measurement oriented while the first is
information-perspective-oriented. The latter 2 have the greater decision usefulness
potential as firms prepare their quantitative risk assessments and they will have the most
accurate risk information for themselves.
Appendix A
EXAMPLE 1:
Assume a discount rate of 10%.
STATE
BAD
GOOD
INCOME
$100
$200
PROBABILITY
0.50
0.50
PA0= 0.5[100/1.10 + 200/1.10] + 0.5[100/1.102 + 200/1.102] = 260.33
Assume Bad year took place in year one.
PA1= 0.5[110/1.10 + 100/1.10] + 0.5[110/1.10 + 200/1.10] = 236.36
Assume Good year took place in year one.
PA1= 0.5[220/1.10 + 100/1.10] + 0.5[220/1.10 + 200/1.10] = 336.36
The Market Value of a firm can be calculated by:
PAt = bvt + gt
t = year
bvt= bv of firm’s asset at time t
gt= expected value of future abnormal earnings (goodwill)
Nb- For this formula to work properly, all gains and losses must be reported through the
income statement.
As from Chapter 5, abnormal returns are calculated by:
Abnormal Returns= Actual Earnings [OXt]- Expected Earnings [OXta]
Therefore, we arrive at the formula:
OXta= OXt - Rf bvt-1
Abnormal returns for the Bad year are:
PV1-PV0= 236.66-260.33= -23.97= OX1
OX1a= OX1 - Rf bv0= -23.97 - 0.10[260.33]= -50.00
Abnormal returns for the Good year are:
PV1-PV0= 336.66-260.33= 76.03= OX1
OX1a= OX1 - Rf bv0=76.03 - 0.10[260.33]= -50.00
Since the probabilities of the good and bad states are the same, goodwill is calculated as
follows:
g1= 0.5[50.00] + 0.5[-50.00]= 0
then by substitution, PA1= 236.66 + 0 =236.66. Thus, in this example there is no
persistence of abnormal earnings and good will. Zero goodwill is a special case of the
F & O study called unbiased accounting. When this occurs, all of the firm value will
appear on the balance sheet.
EXAMPLE 2:
Assume now a persistence coefficient of 0.40. We know from the previous example that
if the Bad states occurs OX1 = -50.00. With a persistence coefficient of 0.40, 40% of that
–50.00 will reduce next years’ earnings.
At Year 1, the PV of remaining future cash flows (assuming the bad state in year 1)
PA = 0.50 [100/1.10 + 200/1.10] = 136.36
Therefore, the amortization expense for year one is 123.97 [ 260.33-136.36]. Similarly
amortization expense for year two is zero.
Therefore, we can calculate PA1 as follows:
PA1= 0.5/1.10 [ 110 – 0.40(50.00) + 100] + 0.5/1.10 [ 110 – 0.40(-50.00) +200]= 218.18
Reduction of earning due to persistence.
Previous PA = 236.36
Current PA = 218.18
18.18 = PV of the 20.00 [ 40% of 50.00]
Thus, F & O show that a firms’ goodwill can be expressed in terms of current years
abnormal income.
PAt= bvt +
[ OXta ] where
is the Capitalization factor.
= w/[ 1+ Rf]
For t=1 ( assuming bad state)
Cash on hand $100
BV of Asset
136.36 [260.33-123.97]
bvt
236.36
Therefore we can now calculate Pa1 by
PA1 = 236.66 + 0.40/[1+.10][-50.00] = 218.18
EXAMPLE 3:
Assumptions (all numbers in millions):
Bombardier 1997 Net income:
$537.4
January 31, 1997 BV
2456.0
January 31, 1996 BV
1931.10
1997 ROE*
0.278 [ 537.4 / 1931.1]
* assume it will continue for the next seven years
1997 Preferred and Common Dividends
71.10
Dividend Payout Ratio*
0.132 [ 71.1 / 537.4]
* assume it will continue for the next seven years
CAPM equation: E[Rjt] = Rf [1- Bj] + Bj E[Rmt]
j= specific firm notation, Bombardier
t= 1997
Rf = 0.04
E[Rmt] = 0.11, Actual return on TSE for January 31, 1998
Bombardier Beta = 1.2
E[Rjt] = 0.04 [1-1.2] + 1.2[0.11] = 0.124
bvt+1= bvt + NIt+1 – dt=1
dt = k [NIt] , where d = dividends and k = dividend payout ratio. Therefore the above
formula can be substituted with the dt formula and arrive at:
bvt+1= bvt + (1-k) NIt+1
and substituting ROE
bv98 = 2456.0 + [ 1 + (1-.132)(.278)] = $3048.00
Similarly,
bv99= 3783.00
bv00= 4695.00
bv01= 5826.00
bv02= 7230.00
bv03= 8972.00
bvt+1= bvt +[1 + (1-k) ROE ]
Expected earnings = Cost of Capital * Opening BV
Actual earnings = ROE * Opening BV
Abnormal Earnings 98 = OX98a= [ROE – E[Rj] ] * bv97 = 0.278-.124= 378.2
Similarly.
OX99a= 469.4
OX00a= 582.6
OX01a= 723.0
OX02a= 897.2
OX03a= 1,113.4
OX04a= 1,381.7
Now we can calculate the PV of abnormal earnings,
g97= 378.2/1.124 + 469.4/1.1242 + … +1381.7/1.1247 = 3,233.4
Now we can calculate the PA97 = bvt + gt = 2,456.0 + 3,233.4 = 5,689.4
Chapter 6 Quiz
1. Define and contrast statistical and practical significance.
2. a) To what does Lev attribute low market share for net income?
b) What evidence, presented by Collings, Kothari, Shanken, and Sloan (1994)
supports Lev’s claim?
c) What implications did their findings have for the measurement perspective?
3. Explain the implications of persistence considerations on the Clean Surplus Theory
(F&O) and relate it to ERC. Include a definition of goodwill in terms of abnormal
earnings.
4. How can the measurement perspective help auditors deal with the pressure of legal
liability?
5. What could some of the disadvantages be of using the measurement
perspective?
6. Despite the historical-cost orientation of financial statements, many instances of the
use of fair value can still be found. Name and expand upon or give an example for 3
of these.
7. According to Section 3025, what accounting actions are necessary when a loan
becomes impaired or restructured?
8. a) What are the 3 categories that debt and equity securities are classified into (SFAS
115) and how is each one valued?
b) Name one of the problems associated with these classifications.
9. What were the results of the Barth, Beaver and Landsman and Schrand studies
regarding market reaction to other risks?
10. What are the 3 forms of SEC quantitative price risk disclosures, and what are the
orientations of each.
Chapter 6 Quiz Answers
1. Statistical Significance – occurs when data shows deviation from a baseline reading.
Practical Significance – occurs when the data shows statistical significance but lacks
any strong implication for the marketplace.
2. a) Lev attributes low “market share” to poor earnings quality
b) CKSS showed that this is due to a lack of timeliness of historical cost based
earnings
c) Their research illustrated that an improvement could be made in earnings quality
by introducing a measurement perspective to financial statements.
3. Once persistence is introduced, goodwill – the expected present value of future
abnormal earnings – is no longer 0. It is possible that the effects of state realization
will continue into future periods, at a portion of their current-year amount, and this
amount is captured by ‘w’. However, since ‘w’ is always between 0 and 1, any
specific abnormal earnings amount will dissipate over the long run. The addition of
persistence also means that the income statement now has information value, as it will
reveal abnormal earnings that will persist. It also suggests that this is important to
investors for assessment, as there is now a future firm performance implication. The
greater the abnormal earnings persistence is, i.e. The higher the value of ‘w’, the
higher earnings response coefficients (ERCs) are.
4. Due to the significant failures of some large firms, auditors are under increased
pressure to report more relevant information. This can be achieved by introducing
more fair value figures into financial statements, to provide better indicators of future
performance than may be had with historical cost statements. This could remove the
liability and accusations placed on auditors now when clean audit opinions, based on
historical figures, don’t predict a subsequent major disaster in the firm.
5. Using more fair value figures increases the amount of estimation necessary in
financial statements, and could cause decreased reliability.
6. An impaired or restructured loan has to be written down to its estimated realizable
amount based on expected future cash flows. The carrying value is adjusted and
losses are included in the income statement.
7.
The 3 classifications are:
1-Held-to-Maturity—valued at amortized cost.
2-Trading—valued at fair value.
3-Available-for-Sale—valued at fair value.
Problems: Either of: gains trading and the unpredictability of net income reported.
8. Both the Barth, Beaver and Landsman and Schrand studies showed that the market is
more sensitive to interest rate risk than to beta, and also that the size of the market
response is affected by the natural hedging and derivatives hedging.
9. The 3 forms of these disclosures are tabular presentation, sensitivity analysis and value
at risk. Tabular presentation is information perspective oriented; sensitivity analysis
and value at risk are measurement oriented.
10. Any 3 out of the 5:
Accounts Receivable and Payable – listed at net realizable value.
Cash Flows fixed by contract – eg. issuance of long term debt or lease agreements.
Lower-of-cost-or-market rule – when market values fall below book values, they are
required to be written down to market (Section 3010); they can’t be written up again.
Ceiling tests for Capital Assets – must be written down (Section 3060) when the net
recoverable amount is lower than the net carrying value.
Push Down Accounting – when all or virtually all of a firm is acquired at arms
length, the assets and liabilities of the acquired entity are revalued recorded on the
books of the acquired entity.