Chapter 6: measurement approach

Question 1

what is the measurement approach?

Answer 1

approach under which accountants undertake a responsibility ot incorporate current values into the FS proper, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict firm perf/value.

Question 2

What are the 2 versions of current value accounting

Answer 2

Fair value (exit price) and value in use (PV of future cash receipts or payments)

Question 3

Why are accountants moving towards measurement approach?

Answer 3

1) Securities markets may not be fully efficient
2) to extent that investor not fully rational and markets not fully efficient, a measurement perspective may improve deicison making and market efficiency.
3) low R2 ***

Question 4

Ohlson’s clean surplus theory

Answer 4

• low proportion of share price variability explained by net income.
• theoretical framework supportive of a measurement approach.

Question 5

Behavioural finance.

Answer 5

characteristics that question investor rationality and market efficiency:

1) limited attention: no time, inclination, ability to process all info
2) conservative: excess weight in prior beliefs
3) overconfidence: overestimate precision of self collected info
4) representativeness: too much weight to evidence consistent with impressions drawn.
5) self-attribution bias: good outcome = ability, bad outcome = unfortunate realization of nature.
6) motivated reasoning: skeptical of info inconsistent with preferences.

–> do security prices reflect all publicly avail. info?

Question 6

Prospect theory

Answer 6

1) Separate evaluation of gains and losses (narrow framing: isolate problems in too isolated a manner)
2) weighting of probabilities: overconfidence (event probabilities under-weighted) , representativeness (event prob overweighted)
3) Disposition effect: Hold on to losers and sell winners
4) Earnings management to avoid small losses (small gap just before 0)

Question 7

Does CAPM have ability to explain stock returns

Answer 7

little ability to explain stock returns. (higher beta should be higher return but empirical results are weak)

Question 8

What variabls other than beta better explain stock returns

Answer 8

book to market ratio and firm size.

Question 9

what are positive feedback investors? What effect do they have on the markets

Answer 9

positive feedback investors buy when stock price begins to rise. LEads to excessive market volatility

Question 10

Bubble

Answer 10

share prices rise far above fundamental values (extreme case of market volatility)

Question 11

Why do bubbles form?

Answer 11

biased self-attribution and momentum. positive feedback trading and herd behaviour reinforced by optimistic media prediction of market experts

Question 12

Was 2008 a bubble?

Answer 12

Maybe not. The risky investment strategies of financial institutions caused the bubble. This may not have been public information.

Question 13

Anomalies

Answer 13

market inefficiency. share prices may not fully react to F/S right away or may not extract all info content from F/s

Question 14

Post announcement drift

Answer 14

GN leads to abnormal return drift upward for some time. investors underestimate the implications of current earnings on future earnings.

Question 15

Post announcement drift arbitrage

Answer 15

buy GN shares and short other companies shares whose returns were perfectly correlated with efficient market price changes of the GN shares. PAD is less if there is higher institutional ownership b/c they are better able to capitalize on the arbitrage opportunity.

Question 16

implications of anomalies

Answer 16

to extent investors not fully rational and securities market not fully efficient, role of financial reporting increases. speed up share price response to full info content of F/S.

Question 17

accruals

Answer 17

-lower persistence than cash flows. more errors of estimation and mgmt bias.

Question 18

Criticism of behavioural finance

Answer 18

its meerely a collection of models and evidence rather than a coherent alternative theory to market efficiency.

Question 19

behavioral finance

Answer 19

• share price undereacts to 1 time significant event (conservatism)
• shareprice overeacts to longer-term series of events (representativeness)
• shareprice underreacts to info in F/S notes but not when same info incorporated in financial statements proper.

Question 20

WHY do anomalies continue to exist in markets?

Answer 20

1) behavioural biases

2) rational investors subject to trans cost and idiosyncratic risk (depart from diversified strategy)

Question 21

Does market take into account accrual vs OCF component of earnings?

Answer 21

Yes but not right away. share returns of high accrual firms drifted downwards over time instead of falling right away

Question 22

Why do high growth firms tend to generate low stock return in future years?

Answer 22

Representativeness under which investors overestimate the continuing performance of the growth firm. (accruals also grow)

Question 23

how is share price behaviour of rational investors similar to that predicted by behavioural finance?

Answer 23

Following a substantial increase in earnings, investors does not know if this increase in persistent because this is inside info (estimation risk). Investors place some probability on each and gradually change these probability weights as more information becomes available.

Question 24

R squared problem

Answer 24

r-squared is a measure of proportion of share return explained by accounting information. Empirical evidence shows that it is quite low (2-5%) and getting lower.

Question 25

Ohlson’s clean surplus theory

Answer 25

Also residual income model. provides framework consistent with measurement approach by showing how the MV of the firm can be expressed in terms of B/Sand I/S components.

Question 26

Ohlson’s clean surplus theory (formula)

Answer 26

PAt = BVt + gt
PAt=value of firm
BVt = net book value of assets
Gt = goodwill (expected pb of future abnormal earnings)

Question 27

Residual income model applied to real life

Answer 27

under historical cost, conservative accounting, bv is biased down relative to its value. The rest appears in unrecorded goodwill. Measurement approach moves more value on to balance sheet and reduces goodwill

Question 28

abnormal earnings persistence formula

Answer 28

ox(t) = wox(t-1) + v(t-1) + E
W = persistence parameter (0<1)
v(t-1) = effects of other info. is 0 when accounting is unbiased.

Question 29

Why does FO (clean surplus) model underestimate value?

Answer 29

forecast horizon and terminal value.
-> conservative accounting biases down book value + earnings. Not all of this bias is counteracted b/c forecast horizon is shorter than real life of the company.

Question 30

will measurement approach reduce auditor liability?

Answer 30

perhaps but current values may be subject to manager bias if no market value available. hard to resist manager bias.

Question 31

conditional conservatism

Answer 31

change of asset value has already occurred and investor is risk averse. Opportunity loss of expected utility if decline in asset value not recorded is higher than if an increase in asset value not recorded. more likely to sue auditor. Responds by ceiling tests to reduce likelihood a decline in asset value not recorded/

Question 32

reasons for increased use of current value accounting

Answer 32

1) markets not fulling efficient
2) low explanatory power of net income for share returns (historical costing)
3) ohlson clean surplus theory
4) auditor liability (ceiling test)