The Measurement Approach to Decision Usefulness

1. The Measurement Approach to Decision Usefulness By Mark Allan, Christopher Keuleman, Stephanie Howatt, Gregory Sheremeta, Christa Walsh and Jennifer Watson

2. The Measurement Approach to Decision Usefulness The measurement approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm performance and value

3. The Measurement Approach to Decision Usefulness The measurement approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm performance and value Intent is to enable better predictions of this performance by means of a more informative system

4. The Measurement Approach to Decision Usefulness Two main questions to examine: • Are investors rational? • Are securities markets efficient?

5. Are Investors Rational? Characteristics of the Average Investor: • Limited Attention – lacking time, inclination or ability to process all available information • Conservative– people put more weight on prior beliefs and revise their beliefs by less than Bayes’ theorem • Overconfident – overestimate the precision of information they collect themselves

6. Are Investors Rational? Characteristics of the Average Investor: • Limited Attention – lacking time, inclination or ability to process all available information • Conservative– people put more weight on prior beliefs and revise their beliefs by less than Bayes’ theorem • Overconfident – overestimate the precision of information they collect themselves Average investor behaviour may not correspond with the rational decision theory and investment models

7. Are Investors Rational? Psychological Theories to Explain Investor Behaviour: • Representativeness- assigning too much weight to evidence that is consistent with the individual’s impression of the population from which the evidence is drawn • Self-attribution bias – assuming good outcome are due to skill and bad outcomes are due to states of nature

8. Are Investors Rational? Psychological Theories to Explain Investor Behaviour: • Share price momentum – as share price rises people buy more shares and price rises further • Motivated reasoning – accepting information that is consistent with preferences while attempting to discredit information that is inconsistent with preferences

9. Are Investors Rational? Prospect Theory • An investor considering a risky investment will separately evaluate prospective gains and losses • Individuals dislike even small losses (loss aversion) rate of utility loss is greater than the rate of utility gain

10. Are Investors Rational? Prospect Theory • An investor considering a risky investment will separately evaluate prospective gains and losses • Individuals dislike even small losses (loss aversion) rate of utility loss is greater than the rate of utility gain

11. Are Investors Rational? Prospect Theory • An investor considering a risky investment will separately evaluate prospective gains and losses • Individuals dislike even small losses (loss aversion) rate of utility loss is greater than the rate of utility gain • Leads to “irrational” behaviours: • Staying out of the market because of a fear of losses • Holding on to losing securities to avoid realizing losses, while selling winning securities (disposition effect)

12. Are Markets Efficient? Excess Stock Market Volatility Shiller finds that: • Aggregate expected dividends determine the market portfolio (all other things constant) • Therefore, if market is efficient changes in portfolio should not outpace aggregate dividends However: • Stock market index is more volatile than aggregate dividends • This represents inefficiencies

13. Problems with this Theory Inefficiency occur: • Behavioural factors • Dividends are firm specific but variability can be diversified to be insignificant • Economy wide factors A better determinate: • Earnings variability (cannot be diversified away) • Higher correlation between earnings and market index

14. Stock Market Bubbles Share prices rise far above fundamental values Influenced by: • Positive feed back trading • “herd” behaviour • Optimistic projections from “experts”

15. Efficient Securities Market Anomalies Post Announcement Drift: • After earnings announcement it is expected people adjust the price immediately • Does not actually happen and prices drift towards the expected over time • Less likely when greater portions of firm is held by intuitional investors • More expertise • Focused on arbitrage

16. Efficient Securities Market Anomalies Market Response to Accruals Net Income = Cash flow from Ops +/- Net Accruals Net Accruals: Changes in items such as receivables, allowances, and amortization. Expected that larger emphasis be placed on cash flow as accruals are estimates and less reliable

17. Efficient Securities Market Anomalies Unfortunately, this is not the case: • Investors do not seem to alter their response based on cash flow and accruals • Fail to see changes in future earnings/cash flows • Less likely to effect institutional investors but still do not fully take advantage • Mostly because accrual anomaly is not yet fully understood

18. Anomalies Why do they not disappear over time? • Complex situations should give way to arbitrage Limits on arbitrage • Uncertainty and risk adverseness • Transaction costs • Idiosyncratic risk • Non-diversified

19. Reasons for Anomalies • Why do they exist? • Investor behavior vs. rational behaviour theories • Rational Investor • Estimation risk will exist due to inside info, complexity of situation, etc. • Thus, a rational investor will estimate the likely hood of future performance • Stock fluctuates, and continues to fluctuate with new information

20. Reasons for Anomalies • Adaptive Market Hypothesis • Humans adapt to change over time • 3 year time frame • Over vs. Under reaction • Investors will over react to consistent growth • Investors will under react to 1 time growth

21. Market Inefficiency Supports measurement approach Speed up investors’ response to information • More informative MD&A • Information surrounding the current state of the company

22. Market Efficiency • Extent of efficiency is the key measure • Markets seem to be relatively efficient • Thus, theory can be relied on for accounting and measurement accounting should be used to provide better, more relevant information

23. Additional Reasons • Value Relevance of F/S Information • Auditors’ Legal Liability • Asymmetry of Investor Losses

24. Value Relevance of F/S Info • Extent to which info allows users to predict future firm value • Information release seems to have little effect on total value, share price • 2-7% of total returns • Indicates that the information is not as relevant as it could be

25. Auditors’ Legal Liability • Pressure from management to stretch the rules of GAAP • For example the savings and loan associations fail, convert more pressure to switch to the measurement approach • Short-term interest rates became higher than long-term rates, which caused overstatements on net assets due to failure to write down to current value

26. Auditors’ Legal Liability • Gains trading, also known as “cherry picking” • Such pressures resulted in million dollar lawsuits against audit firms • http://www.youtube.com/watch?v=TFVeN74FDW4

27. Auditors’ Legal Liability • How can auditor’s protect themselves? • Used ethical behavior and recognition of change in current value of items such as assets and liabilities. • Lower-of-cost-and-market extension to support a stronger form of conservatism. • Ceiling Test

28. Auditors’ Legal Liability • Basu (1997) measured conservatism by the correlation between net income and share returns. • Firms performing well, WILL NOT included the unrealized increases in assets. Where as, earnings of firms that are performing poorly WILL include decreases in the value of their assets • Investor losses, auditor liability, and severe penalties for managers who overstate earnings reinforce conservative accounting

29. Asymmetry of investor Losses • Example: Joe is currently a student, he invests in company Y. The market value of his shares is $10,000. He plans to use this investment to live over the next two years. • To make the most of his utility, Joe splits his investment and sells $5,000 now, and holds the other portions of his investment to sell at the beginning of the second year.

30. Asymmetry of investor Losses • At the beginning of the second year some of Y’s assets have fallen in value. This loss is unrealized by both management and the auditors. The loss is realized during year 1, resulting in Joes remaining shares to be valued at $3,000. • EU (Overstatement) = √(5,000) + √(3,000 = 125.48 • EU* (Overstatement) = √(4,000) + √(4,000) =126.50 • Joe Loses utility of 126.50 – 125.48 = 1.02, as a result of an opening $2,000 wealth overstatement

31. Asymmetry of investor Losses • Alternative, Y’s assets have risen in value by $2,000 during year 1, but again this gain in unrealized. The gain eventually becomes realizes during the year and Joe’s share value raises to $7,000. • EU(Understatement) = √(5,000)+ √(7,000) = 154.38 • EU*(Understatement) = √(6,000) + √(6,000) = 154.92 • Joe, again loses utility of 154.92 – 154.38 = 0.54

32. Anticipating the investor’s loss asymmetry, the auditor acts to being conservative. • Accountants and auditors strengthen ethical behavior, increase usefulness for investors, and protect themselves against legal liability is to expand conditional conservatism. • Conditional conservatism requires measurement of current values, we can regard it as an asymmetric version of the measurement approach.

33. Conclusion on the Measurement approach to Decision Usefulness • Securities markets may not be as efficient • Behavioral theory suggests that help may be supplied by moving some information • Market share of 2-7% for net income seems low • Legal liability may forces accountants, auditors and management to increase conservatism • The measurement approach is reinforce by the development of the Ohlson clean surplus theory

34. Measuring Wealth article Charles M. C. Lee

35. Overview • This article introduces the EBO (Edwards-Bell-Ohlson) model • The purpose of the model is to compute the fundamental values of publicly traded stocks • Derived from the EVA (economic value-added) model

36. EBO and EVA • Both are based on the concept of residual income • Earnings in excess of an expected performance level • EVA is also a powerful tool to value a firm over an extended period of time • EBO expanded on this concept, using a dividend valuation model

37. EBO and EVA Differences • EBO focuses on equity investors • EVA focuses on long-term investors and long-term debt holders • Also used as a performance measure • EBO uses return on equity (ROE) • EVA uses return on assets (ROA)

38. EVA Equation EVAt = earningst – r * capitalt l • capitalt l= asset base (net assets employed at the beginning of period t) • r = cost of that capital • earningst = actual earnings on the capital

39. EBO Equation • Left side is price/book value • Right side represents future abnormal ROEs and growth in book value • The author assumes certainty to keep the notation simple

40. EBO • In a competitive equilibrium, a firm’s ROE should be close to its cost of equity capital (re) • The formula shows that firms should trade at a P/B ratio close to 1 • Firms that are expected to earn above-normal ROEs should trade at higher P/B ratios

41. EBO equation components • We can estimate Pt* (firm’s intrinsic value), or the present value of its future dividends, if we have four inputs: • Current book value per share (Bt) • Cost of equity capital (re) • ROE forecasts for T future periods • Estimate of the dividend payout ratio (k)

42. Other Related Models • EBO components are also based off of DDM (dividend discount model) and DCF (discounted cash flow) model • However, DDM and DCF have limitations that EBO solves, by not relying solely on dividends or non-balance sheet information

43. DCF • Ascribes all the firm’s value to its future earnings (cash flow) stream • Uses terminal value estimations • Higher and more volatile than they need to be • Due to a large portion of the projected CF pertains to the current capital base • EBO reduces this problem by projecting only the future residual income

44. Estimation Uncertainty • ROE forecasts for T future periods • Estimate of the dividend payout ratio (k)

45. ROE Forecasts • Experts use industry benchmarks as a basic for forecasting future ROEs • Use firms with similar risk profiles and accounting policies • Also base longer forecasts on cyclical trends

46. Dividend Payout Ratio • In theory, k should not affect a firm’s valuation • In reality, if a firm increases k but wants to maintain the same level of operations, they must borrow more • Increasing re • Increasing ROE

47. Timberland Example • Students used the EBO equation to calculate the intrinsic value of Timberland, based on: • Book value – $9.55 per share at Jan. 1993 • Cost of equity, using CAPM • Dividend payout ratio – Timberland has never paid dividends (0) • Forecasted future earnings – using a forecasting firm’s estimations

48. Timberland example • The students calculated Timberland’s intrinsic value at $22.70 • At the time this information was collected, Timberland’s shares were selling for $60 • This makes it look like EBO is an invalid model • However, within two months the share price was trading at about $20

49. Conclusion • In practice, the EBO model shows how shareholders’ wealth is related to the numbers on the income statement and balance sheet • Using the DCF model after EBO allows for adjustments in each cash flow item • Overall, EBO helps identify over- and undervalued firms