Module 5: Measurement Approach to Decision Usefulness
Measurement Approach
Measurement Approach: incorporates current value based information (based on
fair values) into the F/S proper. Note: on occasion, includes unrealized changes in
current values in income.
Impact: more emphasis on NI and Book Value as indicators of firm value
Note that the Information Approach relies on efficient security market theory
(investors will properly evaluate information from any source, including F/S notes
and supplemental information) but research seems to indicate that securities
markets may not be as efficient as originally believed – if investors are not as adept
at processing info as efficiency theory assumes then usefulness could be enhanced
by greater use of fair values in the F/S proper and will reduce the possibility that
investors are misled when fair values are buried in extensive notes. Also, legal
liability for firm failures may have provided motivation (auditors/accountants) to
trade off some reliability in favour of greater relevance.
Concern: need to incorporate more relevant values into the F/S without
sacrificing reliability.
IAS 39 defines fair value as: “the amount for which an asset could be exchanged, or
a liability settled, between knowledgeable, willing parties in an arm’s length
transaction” and states that “the best evidence of fair value is quoted prices in an
active market”.
“Current value” is used when referring generally to asset and liability valuations
that depart from historical cost. (Generally fair value but on occasion would be
value-in-use)
“Fair value” is used to refer specifically to measurements based on market value
(listed market value*, estimated based on recent market transactions for similar
assets/liabilities; use of models to estimate values for items such as non-traded
stock options and other illiquid securities)
“Value-in-use” refers to valuations based on discounted present value (if no
estimate can be made based on market values)
* Best evidence of fair value is market price
Reasons for increased attention to measurement
ARE SECURITIES MARKETS EFFICIENT?
Average investor behavior may not correspond with the rational decision theory and
investment models previously discussed. Investors may be biased in their reaction to
info.
For example, individuals tend to overestimate the precision of info they collect
themselves (overconfidence). If individual collects GN info, s/he will revise
subjective probability of high future earnings more than it should be according to
Bayes Theorem– to extent investors behave this way then share price will overreact.
Self Attribution bias – individuals feel that good decision outcomes are due to their
abilities but bad outcomes are due to unfortunate realizations of states of nature.
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Share price momentum – reinforced confidence following a rise in share price
leads to the purchase of more shares, and share price rises further. Confidence is
reinforced and process gains momentum.
Daniel, Hirshleifer and Subrahmanyam (1998) developed a model where momentum
develops when investors are overconfident and self attribution biased. Daniel &
Titman (1999) found that a strategy of buying portfolios of higher momentum shares
and short-selling low momentum ones earned high and persistent abnormal returns,
consistent with overconfidence and momentum arguments.
PROSPECT THEORY Kahneman and Tversky (1979)
(1) An investor considering a risky investment (a “prospect”) will separately evaluate
prospective gains and losses. (investor exhibits “risk taking” behavior with
respect to losses)



Narrow framing – separate evaluation of gains & losses is an implication of
narrow framing wherein individuals analyze problems in too isolated a
manner, as a way of economizing on the mental effort of decision-making.
(Results from info overload and/or feeling that it is not worth acquiring more
info.)
Loss aversion – a behavioral concept where individuals are averse to even
small losses.
Disposition effect – investors hold onto losers and sell winners.
Shefrin & Statman (1985) – identified a sample of investors whose rational decision
was to sell loser securities before the end of the tax year – however found that
investors tended to avoid selling, consistent with the disposition effect.
(2) Investors “weight” their payoff probabilities when calculating the expected value
of a prospect.
- low payoff probability overweighted
- high payoff probability underweighted
(1) and (2) can lead to a wide variety of “irrational” behaviors:
 Fear of losses may cause investors to stay out of the market, even if
prospects have positive expected value.
 Investors may underreact to bad news by holding onto losers in order to
avoid realizing a loss.
Per prospect theory -> Investor behavior depends on:
 levels of payoff probabilities
 risk aversion with respect to gains
 risk taking with respect to losses
(i.e. could result in anomalous behavior)
IS BETA ‘DEAD’?
Fama & French (1992) study found beta had little ability to explain stock returns.
Instead, found significant explanatory power for market acting as if firm risk:
 increases with book-to-market ratio increase
 decreases with firm size increase
Kothari, Shanken & Sloan (1995) found that over a longer period of time beta was a
significant predictor of returns.
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1) Beta is not stationary. To “rescue” beta, need to recognize that it may change
over time. Events such as interest rate changes, development of global markets,
etc, could affect the relationship between the return on individual firm shares and
the market wide return.
2) Market includes a class of investors that are subject to behavioural biases
(overconfidence). Beta continues to be an important risk measure for rational
investors but an accounting-based risk measure (the debt-to-equity ratio) is also
important, implying that the F/S have a role to play in reporting on risk as well as
helping investors to assess expected return.
Conclusion: CAPM remains the model that many analysts use in estimating firms’
costs of capital. Beta may change over time and may have to share its riskmeasuring role with accounting-based variables.
STOCK MARKET VOLATILITY
Shiller (1981) found that the variability of the stock market index was several times
greater than the variability of aggregate dividend. Interpreted this result as
evidence of market inefficiency.
Daniel, Hershleifer & Subrahmanyam momentum model implies excess market
volatility as share prices overshoot and fall back; DeLong, Shleifer, Summers &
Waldman (1990) assumes a market with both rational and positive feedback
investors. Positive feedback investors buy when share prices begin to rise (& vice
versa), then rational investors jump in the bandwagon -> as a result there is excess
market volatility.
Even if excess volatility exists, possibly can be explained by models based on nonstationarity. Or may be driven by behavioral factors, inconsistent with market
efficiency. Question of excess market volatility is still unresolved.
STOCK MARKET BUBBLES
Stock market bubbles occur when share prices rise far above rational values.
Represent an extreme case of market volatility. Bubbles are derived from a
combination of self-attribution and resulting momentum, positive feedback trading
and herd behavior reinforced by optimistic media predictions. Can continue for some
time but will burst with growing beliefs of impending recession or increasing inflation.
EFFICIENT SECURITIES MARKET ANOMALIES
Efficient Security Market theory predicts that security prices react quickly to new
info. If prices take some time to react to info or abnormal security returns persist for
some time, then these would be considered efficient security market anomalies.
POST ANNOUNCEMENT DRIFT
Appears that investors need more help in understanding the implications of F/S for
future returns.
 Expect that: once current earnings known, the info content should be quickly
incorporated into the share price
 Research shows: For GN firms, abnormal returns drift upwards for about 60
days after the earnings announcement (and vice versa) see Ball & Brown
graph in chapter 5.3
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Concern: presents a serious challenge to security market efficiency (would expect
that investors would realize this and buy shares of GN firms on day of earnings
announcement; sell 60 days later in order to earn a return in excess of the marketwide return)
Bernard & Thomas (1989) large sample of US firms from 1974-1986 documented
further proof of the post announcement drift.
Possible reasons for post announcement drift:
 firm’s risk level (beta) changes as earnings are announced (B&T presented
research that challenged this)
 transactions costs (B&T present some evidence that transaction costs limit the
amount of post announcement drift)
 investors tend to underestimate the implications of current earnings for future
earnings (B&T’s evidence suggested that post announcement drift results from
the market taking considerable time to go from current F/S info to probabilities of
future profit & return.)
First 2 reasons consistent with E.M. theory; 3rd reason not (serial correlation)
MARKET EFFICIENCY with respect to FINANCIAL RATIOS
NI is not the only source of info in the F/S -> expected that the market would
respond to B/S and supplementary info.
Difficult to prove hypothesis since market does not appear to fully respond to
Balance Sheet info.
 market may not fully use the non-earnings info (i.e. may not recognize
connection b/w WC $, low debt to equity, etc and future earnings
 may wait until the info shows up in future earnings before reacting
Concern: presents a serious challenge to security market efficiency (would expect
that investors would realize this and devise an investment strategy to “beat the
market”).
Ou & Penman - large sample of US firms; derived a list of 68 financial ratios and
calculated each ratio for each year; then investigated how well the ratio predicted
whether NI would rise or fall the next year. Several ratios predicted better than
others (ex return on total assets). Using a model Ou & Penman would buy shares for
firms (with predicted GN) 3 months after company’s year end, sell short that firm’s
shares (with predicted BN) 3 months after company’s year end. This strategy
earned a return of 14.53% over 2 years in excess of market wide return (before
transactions cost).
Findings: Unlikely that this is explained entirely by transaction costs (too high); or by
risk differences (O&P concluded that risk did not drive their results).
MARKET RESPONSE TO ACCRUALS
Sloan (1996) - separated reported NI into operating cash flows and accrual
components.
Cash flow is more “persistent”. Operating cash flows have higher persistence than
accruals.
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Therefore, we would expect that the efficient market should react more strongly to a
dollar of GN/BN in NI if that $ comes from operating cash flow rather than from
accruals.
Findings: Sloan found that this was not the case. Market does respond to GN/BN
but does not seem to “fine tune” its response (i.e. did not differentiate between cash
flow and accruals within the composition of the earnings.).
Overall Conclusion: Anomalies seem to be supported by research therefore
appears that security market efficiency is a matter of degree. Unless these anomalies
result from risk based or transactions cost based explanations, then rational
investors should exploit them and “bid” them away.
IMPLICATIONS OF SECURITIES MARKET INEFFICIENCIES FOR FINANCIAL
REPORTING
To the extent that securities markets are not fully efficient, this can only increase the
importance of financial reporting. Now can increase definition of noise traders to
include investors subject to behavioral biases. Would expect over time, rational
investors can discover the mispricing arising from activities of noise traders and will
take advantage of it, bringing prices back to a level more representative of firm
value. Improved financial reporting will give investors more info to enable them to
better predict firm’s fundamental value. Reduce costs of investor analysis -> may
reduce extent of investors’ behavioral biases.
Although inefficiencies exist, for a number of reasons, it is still concluded that
markets are close enough to full efficiency that the implications of efficiency for
financial reporting as laid out by Beaver are still valid.
OTHER REASONS SUPPORTING A MEASUREMENT PERSPECTIVE
Efficient market not as efficient as previously believed:
 Investors may need more help in assessing probabilities of future earnings
and cash flows than they obtain from historical F/S.
 Reported NI only explains a small part of variation of security prices on date
of announcement of earnings
Hence raising questions about relevance of historical-cost accounting.
Fair value information in the F/S proper should improve decision making:
 For behaviourally biased investors -> fair value accounting in the financial
statements proper improves decision making by reducing the need to dig
through masses of supplementary information.
 For rational investors -> since market values are the best predictors of future
values, fair value accounting reduces the need to evaluate financial statement
information by waiting for subsequent events.
VALUE RELEVANCE OF FINANCIAL STATEMENT INFO
Lev’s 1989 study indicates that the explanatory power of NI is low -> market’s
response to GN/BN in earnings is small; accounting for only approx. 2-6% of the
abnormal variability of security returns around date of release of earnings info.
Per Lev this is potentially due to poor earnings quality * (ability of NI to be a good
indicator of future performance of firm).
 High earnings quality -> high main diagonals
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ex. a firm which expenses (instead of capitalizing R&D) would have higher earnings
quality
Note that there could be other sources of information dissemination which are more
timely than earnings. (ex. company announcements, quarterly reports)
*earnings quality could be improved by introducing a measurement perspective into
the F/S.
AUDITOR’S LEGAL LIABILITY
Concerns:
 likely to have increased legal liability pressures
 firms are facing increasing pressures to behave in socially responsible &
environmentally responsible ways
 there are ethical issues as to whether the accountants or auditor have behaved
reasonably & responsibly
Solution: introduce more fair values into the F/S.
Thus, declines in fair values, which typically precede business failure, would be
contained in the F/S proper – > would reduce auditor exposure to lawsuits since the
auditor could claim that that info predicting a business failure was explicitly
disclosed.
Using clean surplus theory for firm valuation
Ohlson’s Clean Surplus Theory provides a framework consistent with the
measurement perspective. MV of firm (hence security returns) can be expressed in
terms of B/S and I/S components. Theory assumes ideal conditions.
Note: “clean surplus” accounting is based on all gains and losses flowing through the
income statement.
Market value of firm = NBV of firm’s net assets + expected PV of future abnormal
earnings (goodwill)
.’. can read firm value directly from B/S.
Unbiased accounting – when accounting is unbiased and abnormal earnings do not
persist, all of firm value appears on BS.
Once persistence is factored in, all the action is no longer in the B/S (even with ideal
conditions).
USES for Clean Surplus Theory:
 Clean surplus model provides an alternative to CAPM for cost of capital estimation
(eliminates the need to estimate beta and expected return on the market
portfolio)
 FO model can be used to estimate the value of a firm’s shares
 Frankel and Lee (1998) found that the ratio of estimated market value to
actual market value was a good predictor of share returns for 2 to 3 years
into the future
Clean Surplus Theory supports measurement approach:
 links financial statement variables and market value
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
the more fair value on the B/S, the less abnormal earnings need to be
predicted since there is a lower proportion of firm value included in unrecorded
goodwill(-> with more accurate predictions the F/S will be more useful)
MEASUREMENT ORIENTED STANDARDS IN GAAP
There are several major examples of Market Value and Present Value based
valuation within GAAP. Many of the longstanding measurement examples involve
only partial application of the measurement perspective. Still decision-useful to the
extent they reveal a material change in firm’s financial future.
LOWER OF COST OR MARKET RULE
Represents a partial application of valuation approach because
 asset values are written down when the market value is below cost
 but asset values are not written up subsequently when market value
increases
Writedown applies as follows:
Temporary investments -> when market value has declined below book value
Long Term Investments -> when there has been a loss in value other than a
temporary decline
CEILING TESTS FOR PROPERTY, PLANT & EQUIPMENT
Writedown required when the net carrying amount of the capital asset exceeds the
net recoverable amount.
Two-step ceiling test under U.S. standards to determine if assets are impaired.
1. Does the book value of the asset exceed the sum of its undiscounted
expected direct cash flow? If yes then:
2. Does the book value exceed the fair value? (Use quoted market prices – if
not available then use the discounted expected present value of the
asset’s direct future cash flows.
This represents a partial application of measurement perspective (i.e. one-sided)
because
 asset values are written down when the net recoverable value is below net
carrying amount
 but asset values are not written up subsequently if fair value is greater than
book value. Furthermore, a subsequent write-up of impaired assets is not allowed
if fair value rises.
IAS 36 requires a write-down for property, plant, and equipment (and various other
long-lived assets, including intangibles when the recoverable amount (fair value less
costs to sell or value-in-use, whichever is greater) is less than book value. Note that
write-downs can be reversed (but not to above book value) if recoverable value
subsequently increases.
IAS 2 allows subsequent write-up of previously written down inventory, but not to
above original cost.
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IAS 36, note the difference between fair value less costs to sell as opposed to value
in use
 Fair value is the price of the asset in a binding sale agreement in an arm’s
length transaction adjusted for incremental costs relating to the sale. Costs to
sell reflect such costs as legal costs, stamp duties, removal costs, etc.
 Value in use involves estimating future cash inflows and outflows from
continuing use of the asset and applying an appropriate discount rate to future
cash flows. Future cash flows estimates could be based on reasonable
assumptions or the most recent financial budgets/forecasts.
IFRS 6 (Exploration and Evaluation of Mineral Resources), the impairment test also
applies to the costs of oil and gas exploration when the carrying amount of an E&E
asset is greater than its recoverable amount. IFRS 6 allows firms the choice of
expensing or capitalizing E&E expenditures provided it is applied consistently.
Recent standards extend the measurement perspective -> to periodically
measure both value increases and decreases.
PENSION OBLIGATIONS & OTHER POST EMPLOYMENT BENEFITS (OPEB)
(major example of the measurement perspective.)
OPEB Liability is based on the expected present value of benefits to be paid on behalf
of current & future employees.
Projected benefit obligation (PBO) - discounted expected value of future
expected pension payments, including for expected compensation increases (i.e.,
value-in-use). SFAS 158 requires this liability to be shown on the balance sheet.
International standards allow pension gains and losses such as actuarial adjustments
due to changing lifespans, changes in interest rates, and changes in plan benefits, to
be off-balance sheet
The accounting for OPEBs does not go as far in a measurement direction as pensions
since it is the accumulated benefit obligation that is reported on the balance
sheet. This is similar to the projected benefit obligation except that expected future
benefit increases are not included. The reason is that OPEBs can be withdrawn by the
employer more easily than pension benefits. Thus, whether expected future
increases are really a liability can be questioned.
IAS 19 is similar to SFAS 87. Pension gains and losses can be deferred off-balance
sheet and amortized into net income. However, IAS 19 allows firms to adopt
alternative accounting for these gains and losses.
 One alternative is to recognize them in current net income, including the
offsetting debit or credit in the PBO on the balance sheet.
 The other is similar to SFAS 158, namely include them in other comprehensive
income, with the offsetting debit or credit in the PBO. If the latter alternative is
chosen, IAS 19 differs from SFAS 158 in that these gains or losses remain in
other comprehensive income, rather than being amortized into net income.
Both Defined Benefit plans and OPEB both use discounted PV to calculate expenses
and accumulated liabilities.
Financial Instruments
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IAS 39 categories of non-derivative financial assets and two of financial liabilities:
1. Important categories of financial instruments are fair valued, including
available-for-sale financial assets and held-for trading financial assets and
liabilities.
2. Unrealized gains and losses on available-for-sale financial assets are included
in other comprehensive income. Unrealized gains and losses on financial
assets and liabilities held for trading are included in net income.
3. Some financial instruments are valued at amortized cost, including loans and
accounts receivable, held-to-maturity financial assets and other financial
liabilities. IFRS 39 requires that a financial asset can be accounted for at
amortized cost only if (1) the entity has the positive intention and ability to
hold to maturity, and (2) the financial assets give rise to cash flows as
payments of principal and interest on specific dates.
4. Financial assets valued on this basis are subject to an impairment test.
Written-down financial instruments can be written back up again under IAS
39 if fair value subsequently improves.
Note that a write-down is not required if market value (that is, fair value) falls below
book value. Valuing the asset at its value-in-use suggests that temporary declines in
market value can be ignored providing the future receipts from the asset do not fall
significantly.
All financial assets and liabilities are not fair valued due to reliability and earnings
volatility concerns.
 Difficult to value reliably – examples include some equity financial
instruments, such as shares that are not traded and demand deposits
received by a financial institution, core deposit intangibles. (note 1)
 Fair valuing financial assets and liabilities generates unrealized gains
and losses – volatile since market values change constantly, often
significantly. Since all financial assets and liabilities are not fair valued,
it can happen that certain financial assets are fair valued while certain
financial liabilities are retained at cost (or vice versa).
Note 1: IAS 39 allows equity financial assets to be valued at cost if fair value is not
available, and prohibits fair valuing of deposit liabilities.
Excess net income volatility - unrealized gains and losses on available-for-sale
financial assets go into other comprehensive income, thus, net income gains and
losses do not offset. This creates volatility greater than the real volatility of the firm.
Mismatch occurs when one asset is fair valued but a matching liability is valued at
cost -> the volatility of reported net income exceeds the real volatility of the firm’s
operations.
Volatility of reported NI resulting from recognizing unrealized gains and losses from
only financial assets can be greater than that from natural hedging. However, a
generally-accepted method of fair-valuing demand deposit liability does not exist
(note that financial institutions are a major industry affected by SFAS115 – demand
deposits are their major financial liability).
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RELATED US STANDARDS
SFAS115 uses 3 categories:
* Held to maturity – debt securities with intent to hold to maturity
* Trading securities - hold for short time, intent to sell
* Available for sale – all other securities to which SFAS 115 applies
First category is recorded at amortized cost; other 2 are fair value.
Trading securities – unrealized gains & losses go to net income; Available for sale
unrealized gains & losses go to other comprehensive income. (Latter requirement
avoids some of the NI volatility.)
SFAS 157 creates a 3 level fair value hierarchy, consisting of three levels:
1) Assets and liabilities for which a reasonably well-working market price exists (for
the concept of a market that works well)
2) Assets and liabilities for which a market price can be inferred from the market
prices of similar items.
3) Assets and liabilities for which a market value cannot be observed or inferred.
Then, the firm shall use its own assumptions about how a prospective purchaser of
the asset or liability would value the item.
International standards dealing with fair value are consistent with the above
hierarchy.
Other comprehensive income (SFAS130) – separate category on I/S, reported
after net income. Once the gains/losses are realized they move into net income.
Gains Trading: ”sell winners, hold losers”:
 sell securities that have increased in value and record gain
 hold securities which have declined in value and argue that decline is only
temporary, in order to avoid writedown
Note: if Assets & Liabilities are recorded at fair value with the unrealized gains/losses
recorded in income, this would eliminate the concerns related to gains trading.
DERIVATIVE INSTRUMENTS
Derivative instruments are contracts whose value depends on some underlying price,
interest rate, FX exchange rate or other variable. Will convey a benefit to the holder
if there is a favorable movement in the underlying instruments. Since there is little
or no cost to account for, all or part of the contract is off-balance sheet. Hence, need
to have supplementary disclosure.
Note: If derivatives are used to speculate on the underlying price rather than to
manage risk, the amount that can be lost, for a low initial investment, can be very
large.
SFAS 107 – fair value info to be disclosed for financial instrument A&L, both
recognized and unrecognized, and details of terms & conditions. Also info about
credit risk is required (risk that the other party will not fulfill its obligations.)
SFAS133 (substantial move towards measurement perspective) – requires all
derivatives to be measured at fair value for B/S purposes. If traded, then use market
value; if not traded, use models of derivative value.
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HEDGE ACCOUNTING
Hedging is a method used by firms:

to manage price risk (interest rates, foreign exchange rates, commodity prices, etc)
and/or credit risk

to reduce cost of debt (new borrowing plus hedging could be less than initial
interest costs on hedged item)
Note: companies may co-ordinate the duration and other characteristics of their
financial assets and liabilities to create a natural hedge.
Fair value hedges. These are hedges of some asset owned by the firm. If the hedge is
outstanding at yearend, it is valued at fair value. To reduce excess net income volatility, the
hedged item is also fair valued.
Cash flow hedges. These are hedges of price risk of the firm’s products. Their purpose is to
lock in a price for product not yet produced. Cash flow hedges are valued at fair value at periodend. To reduce excess net income volatility, unrealized gains and losses on fair value hedges are
included in other comprehensive income. Next period, as the hedged product is produced and
sold, the unrealized hedging gains or losses are transferred from other comprehensive income to
net income, where they offset decreases or increases in product selling prices.
SFAS80: Change in MV of a futures contract will be recognized as a gain or loss in
the period the change takes place, unless it is a hedge of an exposure to price or
interest risk.
To be a hedge:
1. the item to be hedged must expose the enterprise to price or interest rate risk
2. hedging item must reduce exposure by being highly negatively correlated with
the hedge
Note: if set of states are incomplete a perfect hedge may not be possible. The risk from a lack
of perfect correlation is called basis risk.
If the item is hedged then the gains & losses are deferred until the hedged item has
matured. Note that if there is a net loss which is expected to continue to maturity
this loss is to be recognized currently.
Hedges can be of;
 existing assets/liabilities -> change in MV of the hedging instrument is
deferred by adjusting the carrying value of the hedged item
 anticipated transactions -> any change in MV of the hedging instrument is
deferred and included as an adj. of the revenue from/cost of the transaction
when it occurs
To be a hedge of an anticipated transactions there are 2 further criteria that must be
met:
1. the significant characteristics and unexpected terms of the anticipated
transaction are identified
2. it is probable that the anticipated transaction will occur
Consistent with matching principle – ensures that gains and losses from hedged
items and from their related hedging items are recognized during the same
accounting period.
Differences between SFAS 133 and IAS 39
Two differences of IAS 39 from SFAS 133 are worthy of note.
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
IAS 39, hedging instruments (also called hedging items) may include non-derivative
financial assets and liabilities when designated as a hedge of a foreign currency risk
exposure.

SFAS 133, only derivatives can be designated as hedges. If derivative markets are less
liquid than those in the United States, it could be quite costly for firms to hedge such risks
using derivatives. To the extent that higher hedging costs reduce the extent of hedging,
reported net income without this provision would be more volatile for Canadian and
foreign firms than for similar U.S. firms.
Both standards require that to be eligible for hedge accounting, hedges must be "highly
effective."
 SFAS 133 does not lay down rules to determine effectiveness.
 IAS 39 specifically mentions that effectiveness can be demonstrated.
Supplemental disclosures of financial instruments
Accounting standards (including IAS 39 and related FASB standards) require
extensive supplementary disclosure about financial instruments, including
derivatives, to assist investors to evaluate the terms and risks of firms’ financial
instruments.
Gigler, Kanodia, and Venegopulan (2007) model demonstrates conditions under
which historical cost accounting can be superior to fair value in alerting investors that
the firm has used derivatives to speculate rather than to control risk. The message is
not necessarily to abandon fair value accounting for derivatives, but to give sufficient
disclosure to enable investors to determine if the firm has suffered speculation
losses.
IFRS 7 promotes better understanding of the significance of financial instruments to
the firm’s financial position and performance. Includes requirements for disclosure of
gains and losses (including impairment losses) and fair values for IAS39 financial
instruments. Must disclose if fair values are based on price quotations from an active
market, unless there is no active market for the item (then would disclose the
valuation technique used to calculate fair values)
Accounting for Intangibles
Fair values for intangibles are difficult to establish with a reasonable degree of
reliability, especially if they are self-developed. (Note: goodwill is either purchased or
self-developed).
Costs of intangibles may be spread out over several years and it may take time to
determine if any future benefits will be produced. (Concerns: what is fair value; will
costs be recovered?)
Goodwill is defined as the present value of future abnormal earnings. A firm has
goodwill if its intangible assets generate abnormal earnings (Note: needs to earn
abnormal earnings above the expected rate of return/cost of capital.)
Reporting fair value of goodwill can increase decision usefulness since this may
reveal mgmt inside info about future expected earning power. But reporting fair
value of goodwill creates serious reliability problems.
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ACCOUNTING FOR PURCHASED GOODWILL
Purchase method requires that tangible and identifiable intangible assets and
liabilities of the acquired co. be valued at their values. Excess of purchase price and
net fair value is goodwill.
Goodwill is retained on consol. B/S at initial amount unless there is evidence of
impairment then ceiling test is applied to determine write-down amount. (Note: no
more pooling-of interests for acquisition, no more amortization of this goodwill ->
thus closer to measurement perspective.)
When goodwill amortization still applied, mgmt would circumvent this by
emphasizing cash income (NI before goodwill amortization & any related
restructuring charges) instead of NI, indicating that “goodwill amortiz. doesn’t
matter”. To extent they are successful in this, mgmt may be more likely to overpay
when acquiring other companies.
SELF DEVELOPED GOODWILL
No readily identifiable transactions exist to determine cost of self-developed goodwill.
Costs that may create goodwill, such as R&D, are usually written off as incurred –
revenues generated, if any, show up in future F/S.
Lev & Zarowin (1999) argue that the falling market share is due primarily to a failure
to account properly for self-developed intangibles. Current R&D accounting results in
a mismatch of costs of intangibles with the revenues they generate – thus
contributing to low/declining R2’s & ERCs. Took a sample of firms with increasing
R&D cost growth (on basis that R&D is a major contributor to self-developed
goodwill) – found lower association b/w share returns and reported earnings for
these firms than for firms with low R&D intensity.
Suggestions to improve this relationship: 1. capitalize R&D if it passes a
“reasonability test” (provides a reasonable trade-off b/w relevance & reliability;
reveals inside info about success of R&D) 2. restate current and previous F/S to
eliminate timing difference b/w initial expenditure and subsequent revenues
(improve matching; help the market to interpret the intangible asset.)
CLEAN SURPLUS MODEL REVISITED
Clean surplus model can be used to estimate fair value of goodwill since the present
value of expected future abnormal earnings provides an estimate of goodwill.
Reporting on Risk
From management’s perspective, perhaps the most important reason is to ensure
that sufficient cash is on hand to meet planned expenditures. It could be quite costly
to the firm if some unfortunate state realization (such as a sudden decline in the
price of the firm’s products) required capital projects to be delayed, or led to a need
to raise expensive outside capital.
From an investor perspective, even diversified investors are interested in reducing
estimation risk by reporting on risk management strategies, and enabling the
detection of speculation. Investors can be diversified ex ante, but could still lose ex
post if a particular firm suffers financial distress.
BETA RISK
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Module 5: Measurement Approach to Decision Usefulness
SFAC1 recognizes that investors need info on risk. Stock beta is sole firm specific
risk measure for a rational investor’s diversified portfolio.
Beta:
 Investor utility is dependent upon expected return of portfolio & portfolio risk
 Portfolio risk (for reasonably diversified investors) depends mainly on the betas
of the portfolio's securities -> F/S info must be useful in estimating beta
 Beta is also used by researchers to separate market wide & firm specific
security returns
How to estimate:
- obtain past data on the relationship b/w security's return & return on market
portfolio
- estimate market model with regression analysis
Re-estimate beta if there is knowledge of financial statement risk based measures
(ex firm enters new line of business; sells a division; takes on new financing)
Relationship b/w beta and certain accounting risk measures is high as per:
Beaver, Kettler & Scholes (1970) 307 NYSE firms for period 1 (1947 -56); period 2
(1957 - 65)
- used regression analysis to estimate beta of each stock
- calculated F/S risk measures (dividend payout, leverage, variability of earnings,
accounting beta)
Conclusion - high dividend payout = lower risk (high correlation); 3rd & 4th risk
measures also had relatively high correlation)
>> results support the argument that F/S based risk measures are useful in
estimating beta
Hamada (1972) showed that under ideal conditions there is a direct relationship
between debt-to-equity and beta.
Lev (1974) showed that under ideal conditions there is a direct relationship between
operating leverage and beta
BKS results suggest that these relationships carry over at least in part to non-ideal
conditions
Implications: off-balance-sheet liabilities should be brought onto the B/S at fair value
to maximize correlation of debt-to-equity with beta; firms should separate fixed and
variable operating costs (i.e. components of operating leverage) if investors are to
infer beta from the F/S.
STOCK MARKET REACTION TO OTHER RISKS
Over the past few years, std setters have been requiring increased risk-related info
in annual reports (MD&A discussion of risks and uncertainties; risk related
disclosures req’d by SFAS 107 and 133)
Info about firm risk is valued by the market, particularly for financial institutions
(financial A & L comprise most of their book value; many of the risk related
standards apply to financial A & L.)
Barth, Beaver and Landsman (1996) looked at effects of SFAS 107 supplemental
disclosure on market value of equity. Found a market response to FV of banks’ loan
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Module 5: Measurement Approach to Decision Usefulness
portfolios -> suggests that the relevance of FV reporting outweighs the reliability
difficulties in measuring loan value.
Shrand (1997) studied effect of interest rate risk of derivatives-based hedging
activities (measured interest sensitivity by “maturity gap” -> amount of interestsensitive assets maturing in a year less the amount of interest-sensitive liabilities
maturing in a year).
Other ways to report on risk include sensitivity analysis and value at risk.
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