Transcript 4510_02
ADMS 4510 - ACCOUNTING THEORY SESSION 2 OVERVIEW INVESTOR’S PERSPECTIVE Decision usefulness objective Present value vs. historic cost • relevance and reliability • accounting-based valuation Market efficiency • demand for information, full disclosure Acknowledgement: Some of these slides are based on a presentation originally created by Paul Dunn, PhD. ADMS 4510 - ACCOUNTING THEORY What you are responsible for All assigned readings in Scott text All lecture notes and discussions ( lectures will cover some topics from the text that are not required reading, i.e. ‘excluding…’ or ‘skim…’ ] Also very desirable: Trying to apply the course material to current issues you read in financial news Framework of accounting theory - Figure 1-1 Investor’s perspective Inside information Investment decision Full disclosure Regulation - Accounting standard setting Value-based accounting (Ideal) Manager’s perspective Unobservable manager effort Contracts -compensation -debt covenants ‘Hard’ Net Income OBJECTIVES OF FINANCIAL REPORTING ( Conceptual Framework ) Objectives stem primarily from needs of external users [ investors/creditors ] Focus is on general-purpose, external financial reporting Objectives are broad-based, not narrow Relate to financial reporting, not just f/s OBJECTIVES OF FINANCIAL REPORTING ( Conceptual Framework ) DECISION USEFULNESS Investors make investment decisions • how much, when to invest, how long Investors need information to: • estimate probable future returns • choose among alternative investments Financial information helps investors to assess likelihood of: • future profits, cash flows, dividends INVESTORS What are they like? Rational => want a reasonable return Risk averse => want to diversify portfolio • portfolio risk versus systematic risk Financial information should help reduce portfolio risk by estimating probabilities of future returns FINANCIAL REPORTING LIMITATIONS This is but one source of information about the firm. Information pertains to firms, rather than to industries or economy as a whole. Measures are often approximate, not exact. Information largely reflects events of the past The information is provided & used at a cost. MAIN OBJECTIVE OF FINANCIAL REPORTING Provide useful information to present & potential investors & creditors in making rational investment & credit decisions Assumes a reasonably intelligent & thoughtful reader of the financial information “Decision-usefulness” approach What financial information do investors want ?? SPECIFIC OBJECTIVES Assess the amounts, timing & uncertainty of prospective cash receipts Economic resources, obligations, equity & their changes Financial performance & earnings Cash flows, liquidity & solvency Management's stewardship & performance THE CASE FOR DECISION USEFULNESS Approach is justified on basis that investors & creditors are the most prominent users This does not narrow the scope of financial reporting since this approach would be useful to other user groups The other users include almost everyone DECISION-USEFULNESS CHALLENGES Often there's too much information Investor needs to assess quality • financial statements, MD&A, press releases, analysts' briefings, investor presentations, web site Information should be presented clearly DECISION-USEFULNESS CHALLENGES [ cont. ] Information should be relevant & reliable • for comparability & consistency Reliable • precise & free from bias Relevant • useful for predicting future cash-flow • for predicting if good news or bad news will PERSIST into future periods INVESTOR'S PERSPECTIVE ‘IDEAL CONDITIONS’ INVESTORS & CASH FLOWS Value of firm is PRESENT VALUE of future dividends • function of firm's cash flows & interest rate Ideal conditions • Know both cash flows & interest rate with certainty • Dividend policy is irrelevant as value of firm is known with certainty IDEAL CONDITIONS PRESENT VALUE ACCOUNTING Present value financial statements would be both reliable and relevant, but, Real world conditions are not ‘ideal’, the future is uncertain Accounting information must find a reasonable balance relevance and reliability ==> ‘ DECISION USEFULNESS ’ IS HISTORIC COST USEFUL? Historic cost is reliable • assets & liabilities measured at cost . . . . but it may not be relevant • as market changes, cost may not equal PV Accountants often trade relevance for reliability, e.g. • amortization • lower of cost & market INVESTORS & UNCERTAINTY Decisions under conditions of uncertainty Investor is risk averse => diversifies portfolio • market-wide risk • firm-specific risk F/S => assess probability of future states • predict future investment returns • predict whether good/bad news will persist • predict future cash-flows ACCOUNTING-BASED VALUATION RESEARCH – Lee 1999 article Prediction of future payoffs to shareholders is the key to valuation models Accounting information is not directly informative about value, but is useful in prediction / forecasting models -> • net income is a reasonable performance measure • ex post settling up [actuals vs. forecasts] ACCOUNTING-BASED VALUATION RESEARCH – Lee 1999 article ‘Residual Income Model’: Firm Value = Book value (capital invested) + + PV of future abnormal earnings + + Other information not in f/s Accounting research can improve key forecasting estimates, e.g. long-term earnings, cost of capital, book-value growth Reference: Lee, C.M.C. ‘Accounting-based Valuation: Impact on Business Practices and Research.’ Accounting Horizons 13 (4), Dec. 1999, pp. 413-425. EFFICIENT MARKETS Efficient market hypothesis [ EMH ] Prices fully reflect all publicly available information (semi-strong form) Prices need not reflect underlying value - poor quality info, not enough, misinterpreted Decision makers constantly revise their predictions as new information is received Financial reporting improves quantity & quality of public information MARKET INEFFICIENCIES Why don't markets always behave efficiently ? Prospect theory • low (high) probabilities are over (under) weighted Post-announcement drift • investors don't fully digest good/bad news Earnings fixation • investors focus on EPS & ignore its components EMH INCONSISTENCY EMH holds that prices reflect all publicly available information, but . . . • information acquisition is costly, and • if prices reflect all information, no motivation to collect new info ! • prices then stop reflecting available info Result => share prices should self-destruct ( no equilibrium price exists) CONTINUOUS DEMAND FOR INFORMATION Because there are random elements (noise) in all markets, not all trades are based on rational evaluation of information Over time, on average, prices are efficient But at any point, prices can be over/under valued Result => continuous search for private info Note: no clear line between public/private information INVESTOR’S PERSPECTIVE ADVERSE SELECTION Insiders can take advantage of the market using their private information Problem reduced: • penalties, fines for insider trading • full disclosure (sometimes voluntary), but reporting is costly DECISION USEFULNESS - RECAP Provide information useful in making investing & credit decisions Reflect expectations about the future – often based on evaluation of the past Financial reporting: – focuses on earnings & its components – does not directly measure value – provides information to estimate value DECISION USEFULNESS, EMH IMPLICATIONS Accounting policies don't matter, unless they have direct effect on cash-flows • accounting policies in Note 1 to F/S Don't worry about naive investors Market is interested in all relevant information, not just accounting information Disclose as much as is feasible • see new CICA MD&A Guidelines