Accounting Theory

Chapter VIII Usefulness of Accounting Information to Investors and Creditors

Political economy of accounts tends to discuss many users of statements, however FASB basically as focused on two primary user groups -- investors and creditors.

Accounting data and the models of firm valuation. Gordon and Beaver Gordon Model = Estimated dividends/ ( k - g). Signaling nature of dividends Current accounting data is useful in predicting future dividends . predictive value of accounting information Problem with negative returns Miller and Modigliani Dividends policy is irrelevant ( in a perfect world of no taxes and transaction cost ). firm value is based on present value of cash-flows. FASB adopted cash-flow approach

An accrual accounting generally provides a better indication of an enterprise's present and continuing ability to generate favorable cash flows than information limited to the financial effects of receipts and payments.

The value of accounting information for investors Efficient Market Hypothesis (EMH) the market fully available information and market prices react instantaneously to new information This item is said to have information content..

Weak Form -- says securities prices reflect the information contained in public past historical documents -- annual reports -- Fundamental analysis is king Semi-Strong Form -- says securities prices reflect the information contained in public past historical documents and current information reports -- Fundamental analysis is iffy Strong Form -- says securities prices reflect all information (both private and public -- Fundamental analysis is useless Portfolio Theory -- rational investments choice and utility maximization risk can be reduced by holding a portfolio of securities Risk is the variability of expected returns (standard deviation) -- the more risk you are willing to take the more return you demand Unsystematic Risk-- diversifiable risk eliminated through diversification Systematic Risk -- non-diversifiable or market risk Capital Market Line -- alternative portfolios for (risk averse) investors to rationally choose a risk vs return relationship. Investors will not pick a lower return at a given risk level on the line. Capital Asset Pricing Model -- Rs = Rf + B(Rm - Rf)

Rm = Return on Security Rf = Risk Free Rate -- T-Bills

B = Beta Coefficient Beta = 1 the security moves with the market Beta > 1 the security moves faster than the market (aggressive) Beta < 1 the security moves slower than the market (defensive) Rm = Expected Return of the portfolio Abnormal vs Normal Returns greater than returns from CAPM

Information Content Research -- Sort of confirms the semi-strong theory Page 225 Third Paragraph -- price movements anticipated earnings results. naive-investor hypothesis ( accounting changes affect them because they do not understand them) -- Securities prices respond to accounting income numbers, alternative accounting policies can affect net income Page 226 lat paragraph -- line 8 market is not fooled by arbitrary and alterative accounting treatments. page 227 paragraph 3 LIFO vs FIFO LIFO produced a more positive cash flow for valuation purposes.

Fundamental analysis has its place in getting superior returns.

Summary of Capital Market Research Accounting earnings appear to have information content and to affect securities prices

1.

2. Alternative accounting policies with no apparent direct or indirect cash flow consequences to the firm do not seem to affect securities prices, though this issue is not entirely settled

Alternative accounting policies that have a direct or indirect cash flow consequence to the firm or owners do affect securities prices There are incentives to choose certain accounting polices, where choice exists, owing to indirect cash consequence. Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment.

The market will often incorporate accounting items that the FSB will not Pension Costs R & D Costs

Auditors Agency theory Signaling affect of an audit respect page 235 last paragraph

Accounting Data and Creditors

Default Risk -- premium in excess of the risk-free rate Usefulness of accounting data in predicting corporate bankruptcy -- Altman Z-Scores Association of accounting data with Bond ratings ( a proxy for default risk) Association of accounting data with interest rate premiums of debt. experimental studies of the role of accounting data in loan decision.

Accounting Allocations Allocations are incorrigible thus there is not correct or superior way to allocate accounting data between years. Allocations are always indefensible. Both ideas go against the core of historical accrual accounting Investors are not naive and are capable of adjusting accounting numbers.

Summary of Capital Market Research

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Accounting earnings appear to have information content and to affect securities prices

2. Alternative accounting policies with no apparent direct or indirect cash flow consequences to the firm do not seem to affect securities prices, though this issue is not entirely settled

Alternative accounting policies that have a direct or indirect cash flow consequence to the firm or owners do affect securities prices There are incentives to choose certain accounting polices, where choice exists, owing to indirect cash consequence. Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment. The market will often incorporate accounting items that the FSB will not such as Pension Costs & R & D Costs

Accounting Data and Creditors

Default Risk -- premium in excess of the risk-free rate

Usefulness of accounting data in predicting corporate bankruptcy -- Altman Z-Scores Association of accounting data with Bond ratings (a proxy for default risk) -- and: Association of accounting data with interest rate premiums of debt -- CAPM theory and the risk/return associations . Experimental studies of the role of accounting data in loan decision. -- Collateral Accounting Allocations

Recognitions of Cost over multiple periods

Allocations are incorrigible thus there is not correct or superior way to allocate accounting data between years. -thus Allocations are always indefensible. Both ideas go against the core of historical accrual accounting. Investors are not naive and are capable of adjusting accounting numbers.

Capital Market Theory

Theory or Person Formula Explanation

Gordon & Stock price = Beaver Estimated dividends/ ( k - g) k = Required rate of return g = Estimated Growth rate of Dividends Modigliani Cashflow/(1-k) and Miller

Problems with negative returns. Ease of estimating future dividends.

FASB adopted cash-flow approach: An accrual accounting

generally provides a better indication of an enterprise's present and continuing ability to generate favorable cash flows than information limited to the financial effects of receipts and payments

Efficient (EMH) the market fully Market available information Hypothesis and market prices react instantaneously to new information This item is said to have information content..

Weak Form -- says securities prices reflect the information contained in public past historical documents -- annual reports -- Fundamental analysis is king Semi-Strong Form -says securities prices reflect the information contained in public past historical documents and current information reports -- Fundamental analysis is iffy

Strong Form -- says securities prices reflect all information (both private and public -Fundamental analysis is useless Portfolio Risk is the variability of Investors are rational Theory -- expected returns and Risk Averse -(standard deviation) -- rational investors choice the more risk you are of utility where the willing to take the more maximum risk can be return you demand reduced by holding a portfolio of securities Unsystematic Risk--

diversifiable risk eliminated through diversification

Capital Asset Pricing Model

Capital Market Line -alternative portfolios for (risk averse) investors to rationally choose a risk vs Systematic Risk -- non- return relationship. diversifiable or market Investors will not pick a risk lower return at a given risk level on the line. Rs = Rf + B(Rm - Rf) Beta is the relationship of the securities returns Rs = Return on Security movement to the Markets Rm = Return on Security Return Movement. Rf = Risk Free Rate -- T- Beta = 1 the security moves with the market Bills B = Beta Coefficient Rm = Expected Return of the portfolio Beta > 1 the security moves faster than the market (aggressive) Beta < 1 the security moves slower than the market (defensive) Abnormal vs Normal Returns greater than returns from CAPM

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