Valuation Approach Flashcards
Decision usefulness
Disclosures are emphasized. Assumes securities market efficiency
Issues with the value relevance approach
1) Markets may not be as effective as once believed
2) behavioural tendencies: limited attention, overconfidence, self-attribution biases. (investors are not as adept at processing information as rational decision theory assumes
3) Net income accounts for 2% to 7% of abnormal return
Securities markets inefficiency anomalies (5)
1) January effect
2) Weekend effect
3) Stock split effect
4) Short skirt theory
5) Superbowl indicator
January Effect
Small company stocks outperform the market and other asset classes during the first 2-3 weeks of January
Weekend Effect
Tendency of stock prices to decrease on Mondays, meaning that closing prices on Monday are lower than closing prices on the previous Friday. Returns on Mondays have been consistently lower than every other day of the week
Stock Split Effect
stock splits increase the number of shares outstanding and decrease the value of each outstanding share, with a net effect of 0 on the company’s market capitalization. Before and after a company announces a stock split, the stock price normally rises. This is because investors view stock splits as a signal that the company’s stock will continue to rise.
Skirt length theory
shorter skirts tend to appear in times when general consumer confidence and excitement is high, meaning that the markets are bullish. Long skirts are worn more in times of fear and general gloom, indicating that things are bearish.
Superbowl indicator
When a team from the Old American Football League wins the game, the market will close lower for the year. When a team from the Old National football league wins, the market will end higher.
Accounting examples of securities markets inefficiencies (4)
1) Post-announcement drift
2) Financial statement ratios
3) Net income = OCF plus/minus net accruals
4) Stock market bubbles & excess volatility
Post announcement drift (inefficiency)
Following news price changes up (good news) or down (bad news) for 60 day period
Investors appear to underestimate the implications of current earnings
Financial statement ratios (inefficiency)
Market does not respond to some balance sheet information
Strategy based on financial statement ratios results in abnormal returns
Net income = OCF +/- net accruals (inefficiency)
- Market should react more strongly to $1 of good news from cash than from accruals; accruals are more subject to errors of estimation and possible managers bias than cash flows.
- Cash flow is more persistent; operating cash flow results from continuing operations.
- Research suggests reaction is not fine tuned to account for accruals vs. cash flows
Stock Market Bubbles & Excess volatility (inefficiency)
- share prices rise far above fundamental value (e.g., technology bubble)
- Attribute to combination of self attribution, momentum buying, herd behaviour, etc.
Behavioural characteristics can produce a wide variety of share price behaviors over time due to:
- Limited attention
- Prospect theory
- Overconfidence
- Representativeness
- Self attribution bias
- motivated reasoning
Finish the sentence: “To the extent that investors are not ___ and the market is not ___, reliance on value relevance approach to guide accounting disclosure is threatened
Rational, efficient.
Valuation approach definition
The Valuation Approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements proper, providing that this can be with reasonable reliability, thereby recognizing an increased obligation to provide investors with up to date information
True or False: Stand setters have been moving towards the greater use of the Valuation approach for many years
TRUE
Implications of valuation approach
- greater use of current values in the financial statements
– increased relevance
increased relevance must outweigh any reduction in reliability (increased fair value disclosure = increased usefulness) - implies a larger role in determining fair value
- suggests a balance sheet approach
- use of current value method of measurement (IFRS)
- intent is to able better predictions of future performance
- does not invalidate investor responsibility to make own predictions
Differences between Value relevance approach and valuation approach
Value Relevance:
- Markets are efficient
- Greater use of disclosures in notes to financial statements
- Focus on Income Statement
- Investor responsible to make own predictions
Valuation:
- Markets are not completely efficient
- Greater use of recognition (current value)
- Focus on Balance Sheet
- Investor responsible to make own predictions
What model is the most useful guide for accountants about investor decision needs
efficient securities market model
Possible explanations for anomalies
- risk (unsophisticated investor)
- Transactions costs
True or False: Theory and evidence of behavioral finance has progressed to point where it supports a Valuation Approach
TRUE
