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

An approach by which accountants undertake the

responsibility to incorporate current values (whether it is (1)
value-in-use, or (2) fair value) into the financial statements
proper, provided this can be done with reasonable
reliability.

What is the Measurement Perspective to Decision Usefulness?

Measurement Oriented Standards

Why is Financial Reporting Moving Towards a Measurement

Perspective?
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)

Price that would be received to sell an asset or paid to

transfer a liability in an orderly (arms-length) transaction
between market participants at the measurement date

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

payments
Discounted present value of cash expected to be received or paid with respect to
the use of the asset or liability.

Disadv of fair value: Markets may be incomplete or illiquid

Disadv of Value-in-use: Possible unreliability of projections of CFs, and the intent of management regarding the
use of the asset

II. Attraction of the Measurement Approach

Securities markets may not be as efficient as previously

believed

Low R2

Based on R-square

Better measurement may increase accounting !market share" in

explaining share price changes

Ohlsons clean surplus theory

If markets are not fully efficient, information perspective is not

sufficient and the measurement perspective is needed

A theoretical framework supportive of the measurement approach

Auditor Liability

Measurement approach places more responsibility on auditors in valuation.

This then reduces their liability when companies do poorly, because they will
have already done what they can with the available market information.

Better measurement may reduce auditor liability

More fundamental issue: potentially misleading historical costbased numbers (on B/S)

Under info perspective, all we need to do is provide the information. Full disclosure is key, and it
doesnt matter how we report it so long as the information is provided.

Constant sample should be healthier firms, as they are firms which have survived from 1978 to 1996.

Lev and Zarowin (1999)

a2

Over time, R-square

has decreased,
indicating that earnings
and s in earnings are
increasingly less able
to predict stock
returns. The decision
usefulness of the
information provided is
thus lower.

The fall in ERC also

indicates that earnings
s have an increasingly
lower . Earnings
persistence and
earnings quality are
thus lower

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

Shows potential to earn abnormal returns after earnings announcements, reflecting market inefficiency

Bernard and Thomas (1989)

Should long firms with

the best GN, and short
firms with the worst
GN

Persistence for cash flows is higher than that of accruals.

Sloan (1996)

Shows potential to earn abnormal returns after

earnings announcements, reflecting market
inefficiency

E.g. Company A
has Cash Sales of
100, COGS 50
Cash +100, Sales
Revenue +100,
COGS +50,
Inventory -50
Net Income 50 =
Accruals of -50 +
Cash Flows of 100

E.g. Company B has

Sales on Account
100, COGS 50
Cash 0, AR +100,
Sales Revenue -100,
COGS +50,
Inventory -50

Sloan created a
trading strategy
where he, for the
same amount of
overall net income,
bought firms with
the most CF, and
shorted firms with
the most accruals,
and found that he
could obtain
abnormal earnings.

Net Income 50 =
Accruals of 50 +
Cash Flows of 0

Even though net income is the same for the two examples, because cash flows are more persistent, the rational choice
should be to invest in the firm in B. However, Sloan found that investors did not differentiate between them.

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 selfcollected data
Representativeness: give more weight to some kinds
of evidence Streak of results are weighted more heavily, recency effects, etc.
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

A.k.a Residual Income Model

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)

In the past, when book value was largely based on historical cost and therefore lower, there were higher abnormal earnings
Now, as book values are largely based on current values and therefore higher, there are lower 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
firms 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

No market value for Goodwill or

R&D

Costs written off as incurred

Recognition lag: the value shows up over time on
component of R&D expensed, but there are future
income statement Research
inflows of benefits from R&D that will eventually show up on the
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? Down

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

Increase relevance and reliability

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 Not exceeding carrying if unimpaired.

! 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
Midterm on Saturday
Time: 1300 - 1515
Location: Ngee Ann Kongsi Auditorium
Material: Chapters 1~5
Practice midterm on elearn
Calculators required