LECTURE 1: IDEAL CONDITIONS: It is an application of the PV accounting when ideal conditions do not exist. It is movements.
PV accounting when ideal conditions do not exist. It is movements. In this case, the firm-specific release changes investors’ expectation of
What are the ideal conditions? Ideal condition means perfect and complete markets
where there is no information asymmetry and accounting reports in this setting are
both, relevant and reliable. Perfect markets - every party has the same level of
information o r can obtain information without costs. Complete Market- anything
that anyone cares about can be sold. Accountant’s role in this setting is very lil as inv
have the same info as managers.
Relax ideal conditions  information asymmetry problem: information relevant to
evaluate the firm is no longer costlessly available. Causes 2 issues:
1) Adverse selection problem: One or more parties have the info advantage over the
other parties in a (potential) business transaction (i.e inside info). Other parties do not
have the info to separate a good firm from a bad one.
2) Moral Hazard Problem: One or more parties can observe their actions but other
parties cannot. (eg. Unobservability of manager effort). But here the question is how
to reduce this? By providing incentive-based compensation.
ADVERSE SELECTION PROBLEM:
Definition: Given Above.
Implication: Since investors cannot distinguish between good and bad firms, they
either walk away from the investment or apply heavier price discounts.
Mitigation Way in capital markets from the accounting perspective: i) Understand
how investors use info in making decisions ii) Firms voluntarily disclose more and
high-quality accounting information iii) The decision usefulness (i.e. Information) role
of the accounting information.
Intuition behind this problem: Assume one has no way of distinguishing between
choice A which is of 10 bucks and choice B which is of 20 bucks. What is likely to
happen in an online auction is that I will not be willing to pay more than 15 bucks for
it. Only sellers of choice A will list their products since the choice B sellers will incur a
loss. What can be a solution for this?  voluntarily provide more info (eg. Pics,
ratings, descriptions, guarantees, etc).
MORAL HAZARD PROBLEM:
Definition: Given Above.
Implication: Inv would want managers to behave in their best interest BUT they
cannot observe managers’ efforts. Managers may not work hard or might end up
taking excessive risks.
Mitigation Way in capital markets from the accounting perspective: i) Tie accounting
information to managers’ compensation contracts and incentivize managers to work
hard (e.g., net income as benchmark for CEO bonus) ii) The stewardship/governance
role of accounting information (i.e., align the interests between investors and
managers).
Intuition behind this problem: Insurance companies cannot observe insurees’ effort
in taking care of their own health. Insurees overspend on medical bills.
CURRENT VALUE BASED ACCOUNTING (CVBA):
Types of current values: Value in use- discounted CF. Think of it as PV of the firm. OR
Fair Value: exit value or opportunity cost (i.e. the amt the firm receives if the asset is
disposed off. Think of FV as the mkt price of firm.
How is it a solution to adverse selection?  it favors CVBA: timely and mkt based
info.
How is it a solution to moral hazard?  CVBA can improve the governance role as
well since ultimately managers are responsible for everything including current value
gains and losses. However, the solution may not favor CVBA since mkt conditions are
beyond the managers’ control.
Therefore, the more reliable numbers might be the best for evaluating managers but
they don’t provide relevant info needed to address adverse selec.
INFORMATION VS GOVT ROLE OF ACC INFORMATION:
- While standard setters emphasize the information role of accounting information,
they also start to pay attention to the governance role of accounting information. -
Corporate governance and accounting regulations in response to market failures:
Dotcom bubbles and accounting scandals in late 1990s and early 2000s and 2008
Financial crisis. - ESG disclosure (International Sustainability Standards Board)
CONCEPTS OF IDEAL CONDITIONS: WITH CERTAINTY
i) Future CFs are known ii) Discount rates are known.
How to prepare Financial Statements? i) Assets/Liabs is the PV of CFs ii) Realized NI =
Expected NI. Expected NI= Opening shareholder * Interest Rate. It reflects the change
in shareholder’s equity. Expected NI is also called accretion of discount, which reflects
the accrual of value as the timing of the payoff of cash flow is closer.
CONCEPTS OF IDEAL CONDITIONS: WITH UNCERTAINTY
i) Possible states of nature are publicly known ii) Probabilities of states are objective
and publicly known iii) Ex-post realization of the state is publicly observable iv) Disc
rates are known (i.e. fixed interest rates) v) cash flows are known conditional on the
states of nature in the scenario of “with uncertainty”, and there is still no information
asymmetry.
How to calculate? i) Assets/Liabilities: PV of future CFs ii) Realized NI= E(NI) +
Abnormal Earning iii) Expected income= Opening balance of SE * Interest rate iv)
Abnormal Earnings= Actual realized CFs – E(CFs) v) Expected CFs is the avg CFs across
different states of nature
CHARECTERISTICS OF FINANCIAL STATEMENTS UNDER IDEAL CONDITIONS
i) FS are relevant and reliable: Acc info reflects the firm’s future performance &
nobody can lie about it as they have the same info. ii) NI has no info content beyond
B/S: Everyone can calc it based on SE & Int rate. iii) PV (VIU) = MV (FV): everyone gets
the same number.
1) Lack of ideal conditions leads to incomplete markets. Reason for incompleteness:
i)Thin Markets ii) Info asymmetry. Significance of incomplete markets: i) Cannot
always use MV as a proxy of PV ii) If there is no MV, est PV. Conclusion: If everyone
has to estimate PV, everyone’s PV of asset & NI is diff.
2) Lack of ideal conditions means that estimates are needed to apply PV Acc: Future
state realizations may not be currently known leading to need for estimates of
quantities/of future sales and purchases and timing of future transactions. You
would also need to estimate probabilities of future state realizations and estimates
are subject to bias and error.
RESERVE RECOGNITION ACCOUNTING:
VALUATION APPROCH TO DECISION USEFULNESS: Normally, the decision usefulness
applies to proved reserves only. The CFs have to be discounted at 10%. Revenues are
recognized as reserves are proved. This method uses past year’s oil and gas prices.
Critiques of Reserve Recognition Accounting: i) Past year prices may not be good
proxies for expected prices ii) Estimates are needed to apply RRA iii) The
consideration of proved reserves is itself subjective because it means there’s
reasonable certainty of recovery under current economic, regulatory, and operating
conditions. Iv) Estimates are subject to bias and errors.
RELEVANCE VS RELIABILITY:
Relevant Info: Informative of future performance. Reliable Info: Representationally
faithful and free from bias. Greater relevance requires more estimates but more
estimates decrease reliability.
Historical costs favors reliability while FV favors relevance.
So which val model is used?  Mixed model where assets are at historical cost but
subject to impairment.
TAKEAWAYS FROM THiS LECTURE: True economic income, which is defined as an
objective income that everyone agrees on, does not exist if no ideal setting.
LECTURE 2: DECISION USEFULNESS APPROACH TO FINANCIAL REPORTING:
Concept of decision usefulness: If we cannot prepare theoretically correct financial
statement, we can at least make it useful. Non-ideal conditions provide a role for
financial statements to be useful. The role of accounting depends on how users make
decisions and how users use info (eg. Accounting reports). Therefore, to understand
how accounting can be useful for decision making, we must first understand how
individuals use information and how they make decisions!
Decision usefulness is the ability of financial accounting info to help investors make
good decisions. It was incorporated in the Conceptual Framework of IASB. The
objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders
and other creditors in making decisions relating to providing resources to the entity.
Key elements of the single person decision theory: i) Non Ideal conditions ii)
Investment decision iii) rational decision-maker (implied that an individual will always
make a decision that maximizes his utility. The utility function relates payoff amounts
to the decision-maker’s utility for those amounts.
Role of risk aversion: Risk aversion is basically how a rational investor reacts to
uncertainty. It is the hesitation of the individual to agree to a situation with an
unknown payoff rather than another situation with a more certain payoff but
possibly lower expected payoffs.
A utility function of a risk averse investor is the square root of payoff amounts.
Prior probabilities: Prob (High)= 30% & Prob (Low)= 70%. Therefore expected utilities
from buying shares: 0.3*√1600 + 0.7*0= 12. Buying bonds: 1*√225= 15. Therefore,
they would buy the bond.
Now suppose Gill makes a decision based on FS and it is good new? How will they
update the probabilities then?
40 is √1600
Concept of information system: Conditional probabilities- Diagonal elements are the
key. The higher they are relative to the off-diagonal elements, the more informative
the info. Accounting info needs to be high quality. Information helps investors to
assess the probabilities of several outcomes.
Links to conceptual framework: Provide theoretical foundation for conceptual
framework- To provide info that is useful of assessing the amounts, timing & certainty
of CFs. Justify imp characteristics of conceptual framework- Relevance- Makes impact
on decision-making and faithful rep- must faithfully represents the phenomena that it
purports to represent.
LECTURE 3: IDEAL CONDITIONS:
Semi-strong form: Incorporates all publicly available information. An efficient
securities market is one where the prices of securities traded at all times fully reflect
all information that is publicly known about those securities.
Strong form: All info, incl inside info are priced in.
Concepts of market efficiency: i) Markets are quick and efficient processors of info. ii)
It can be visualized as individuals continuously revising their probabilities as new
information comes in from any source. iii) Individual errors cancel out provided that
there is no systematic bias.
RISK:
Types: Idiosyncratic, diversifiable risk- firm specific or industry specific factors OR
Systematic, non diversifiable risk- market-wide factors (eg. Macro).
EXPECTED RETURN = CAPM DERIVED
E(Rjt) = (E(Pjt + Djt) / Pjt-1) – 1. In an efficient market where prices reflect all the
publicly available info, he E(R) under CAPM equals the equation before. There is no
arb opportunity. Investors at max earn the expected return.
EXAMPLE: Suppose CAPM Return is 5.4% and the stock price is $10. Now suppose a
firm specific news leads to investors expecting the share price to become $11. The
expected return would still be 5.4%. WHY? Cus CAPM would not change with firm
specific news. The new stock price would be (11-x)/x=0.054 . We have now established
a link between information (through its impact on expectations) and price
the future price. Since the expected return of the firm does not change, the current
price changes. Thus, the release affects the current price through its impact on
expectation of the future price.
IF ONE FINDS A 10 $ BILL FALLEN:
Crude version would argue that if it was really a 10$ bill, it would have been taken by
now and that it is impossible.
Mild version is that he says it must be their lucky day and that they should pick it up
quick because the mkt is so efficient that it wobe there for long. Finding it is so rare
that finding a 10$ note would be a waste of time and foolish.
DEMAND FOR ACCOUNTING INFO IN EFFICIENT MARKETS:
Efficiency is defined relative to the publicly available info. If the info that is available is
of poor quality, if there is not “enough” of it, or If it is simply wrong, then prices will
reflect this. Poor quality accounting information increases the information
asymmetry between a firm and its investors. In the presence of information
asymmetry (in particular adverse selection), investors discount the information
provided by the firm and consider the firm riskier (i.e., higher estimation risk). Thus
accounting info has some role to play in order to make inside info to publicly available
info.
SOCIAL SIGNIFICANCE OF MARKET THAT WORKS WELL:
In a capital economy, allocation of scarce capital is accomplished by mkt prices.
Higher share prices attract more capital. Capital allocation is most efficient if share
prices reflect fundamental value. Higher share prices reflect higher fundamental
value.
Therefore, Social Significance of financial reporting: Maximise amount of publicly
available info. THIS IS SUBJECT TO A COST-BENEFIT CONSTRAINT: Litigation risk,
Proprietary cost, Direct cost, etc.
IMPLICATION OF FINANCIAL REPORTING:
i) Full-disclosure- including accounting policies: The more information is disclosed, the
narrower is the gap between efficient prices and fundamental value ii) Accounting
policies do not matter (unless with cash flow effects): As long as accounting policies
are disclosed and have no cash flow effects, investors will see through the “cosmetical
changes”. iii) “Naïve” Investors are price protected: Efficient price can be relied by
uninformed investors to make good investment decisions. iv) Accountants are in
competition with other information providers: Any value relevant information can
affect stock prices.
EXAMPLES OF FINANCIAL REPORTING IN EFFICIENT MARKETS: MD&A- i)
Supplements the financial statements ; ii) Provide a forward-looking orientation iii)
Includes discussion of risks facing the firm. OR Footnote Disclosure.
What roles do these play? Convert inside info to public info.
Voluntary/mandatory? MD&A is mandatory in US but providing a forecast is optional
around the world.
TAKEAWAYS: i) Efficient securities market is a relative concept, which allows for
informative financial reporting to play a role in improving the accuracy, timing, and
amount of a company’s stock. ii) Full disclosure allows investors to make better
decisions and improves the ability of securities markets to allocate resources more
efficiently. iii) Firms’ accounting policy choices should not affect their cash flows or
their stock prices, provided they are applying the full disclosure principle.
LECTURE 4: VALUE RELEVANCE AND EMPERICAL ANALYSIS:
Definition of value relevance: Acc info has value relevance if mkt price responds to the
release of accounting info. Usefulness of the accounting info is defined by the
magnitude of price change.
The fundamental question: Do investors use accountants’ products? The challenges in
answering this “simple question”: i) when do we look? Short/Long window ii) what acc
measures to be established? iii) How do we control for other events that affect the
stock prices?
Ball & Brown Study:
First study to document the share price movement to Net income announcement.
Basic Methodology: Step 1: Issuance of good or bad news? 
To assess whether the released is a good/bad news, they looked at the expected NI.
Only the unexpected component would cause a reaction. They took the last year’s
earnings as the expected earning. Nowadays people use analyst forecast to estimate
earnings. Step 2: What is the reaction of firm specific news?  need to separate mkt-
wide movement. Therefore use a narrower return. Abnormal return= Actual –
Expected return. Expected return is CAPM return = (1- beta) Rf + beta * Rm. first part
(in bold) is the slope. Basically, Use narrower window and delete firms that had other
major announcement during that time.
Causation vs Association: Short window study gives evidence on whether or not FS
statement causes stock price changes. It is more consistent with the decision
usefulness info. Long window studies gives evidence that FS statement is associated
with stock price changes.
EARNING RESPONSE COEFFICIENT:
It is the magnitude of change in stock price for each unit of unexpected eanings. It
measure how strong investors respond to earnings announcement. ERC= (Change in
stock price / Change in unexpected earnings).
How does ERC differ wrt firms’ fundamental charecteristics? – High Beta, Low ERC as
high risk firms increase the risk of investment portfolio. High Leverage Ratio, Low ERC
as high leverage increases default risk. High g, High ERC as higher g means future
earning capacity is high.
How does ERC differ wrt firms’ earning quality? –Higher the earning persistence,
Higher the ERC because high earnings today are going to stay. Higher the accrual
quality, higher the ERC as more info transparency. Example: If earning goes up by 1$
and and is expected to go up by 1$ each year with 10% interest, then the share price
goes up by 1+1/0.1= 11$ and the ERC is 11. This is if accounting rules only allow
recognition of 1$ today.
How does ERC differ wrt investors’ heterogeneity?- Higher the inv heterogeneity,
lower the ERC as different investor’s reaction cancel out and avg reaction is muted.
IMPLICATIONS OF VALUE RELEVANCE RESEARCH: i) Need to separate the one off
items in the FS from the continuing items. It might be that a lot of these are included
in the income from continuing operations. Ex: Restruc, GW impair. ii) Need to disclose
more info about the g opportunities in MD&A section.
(i.e. the information role of FS) does not have to be directly about value. It just
provides information that assists in predicting value. However, the valuation
approach to it means undertake a responsibility to incorporate current values into the
financial statements proper, providing that this can be done with reasonable
reliability, thereby recognizing an increased obligation to provide investors with up-to-
date information. Two types: 1) Exit price (fair value): Fair value is the price that
would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. 2) Value-in-use:
Discounted present value of cash expected to be received or paid with respect to the
use of the asset or liability.
Why is it imp? I) Securities markets may not be as efficient as previously believed. If
markets are not fully efficient, decision usefulness is not sufficient and the valuation
approach is needed. II) Ohlson’s clean surplus model: This is a theoretical framework
supportive of the valuation approach. III) Low share of earnings information in
explaining share price changes relative to other information sources. More current-
value accounting may increase accounting’s “market share” in explaining share price
changes. IV) Reduce auditor liability.
DECISION USEFULNESS & EFFICIENT MKT HYPO:
Decision usefulness is based on the efficient mkt hypothesis which is not true in
reality. Proved by I) Bernard & Thomas- Post Earning Announcement Drift: Abnormal
share returns drift upwards or downwards for several months following GN or BN in
quarterly earnings. Efficient securities market theory predicts immediate response to
GN or BN in reported earnings. II) Sloan- Accruals: Cash flows are more persistent
than accruals but the market treat them as they are equal.
BERNARD & THOMAS: POST EARNING ANNOUNCEMENT DRIFT:
They stated that seasonal earnings changes are positively correlated for up to 3
subsequent quarters. Investors take a lot of time to figure out or they underestimate
the magnitude. Buying Gn shares and selling Bn shares on the day of announcement
led to an avg return of 18% over the mkt.
SLOAN: CFS MORE PERSISTENT THAN ACCRUALS
Sloan (1996) argues that the cash flow component of earnings is more persistent than
the accrual component. If investors understand this, they should respond more
strongly to the GN or BN news in earnings the greater is the cash flow component
relative to the accrual component. By buying shares of low-accrual firms and short
selling shares of high-accrual firms, and holding for one year, one can earnings 10.4%
return above mkt return.
Why are securities mkt not fully efficient? I) Behavioral Finance: A) limited attention
leads to investors not using all the info. As a result, investors continue to ignore full
info content of FS. B) Overconfi: We tend to overestimate the precision of self-
collected data. C) Representativeness: We give more weightage to some kind of
evidence. D) Self-Attribution bias: Ascribe success to ownability. II) Transaction costs
are too high: It may not be worth exploiting anomalies if costs are too high (e.g., the
cost of shorting stocks).
Implication of inefficiency in markets: Rational decision theory model of investment
is still the most useful model to guide accountants about investor decision needs.
Securities markets are not fully efficient, but close enough so that accountants can be
guided by its reporting implications. Implications on the valuation approach: To the
extent that markets not fully efficient, the role of financial reporting increases.
Current value accounting helps to fulfil the increased role.
OHLESON’S CLEAN SURPLUS MODEL: Firm Value= Book Value + Premium. Premium is
the abnormal earnings. Abnormal earnings= Actual Earnings – Expected earnings.
The expected earning is the cost of capital * net capital investment. Therefore, Firm
Value= BV + PV of expected abnormal earnings.
Ex: In the good state, cash flows are $200, and in the bad state, cash flows are $100.
Assume the probability of each state is 50%. Present value of firm at t=0 is $260.33, at
t=1 is $236.4. Assume t=2 is a bad year then, Net Income = 23.64 + 100 – 150 = $-
26.36. Assume t=2 is a good year then Net Income = 23.64 + 200 – 150 = $73.64. E(Net
Income) = 0.5 X (-26.36+ 73.64) = $23.64. E(abnormal earnings)=E(net income)-
expected earnings =23.64-236.4*10%=0
Zero abnormal earnings represents a special case of ohleson which is called unbiased
accounting. Under this, All Assets/Liabs are valued at current value, abnormal earning
do not persist, all firm value appears on BS, Income statement has no info content.
Significance of Ohleson’s Clean surplus: It provides a framework consistent with the
valuation approach, by showing how the market value of the firm can be expressed
in terms of fundamental BS and income statement components. In practice, firms do
not record all the assets/liabs at current value. Since Bv is biased downwards relative
to MV and the expected abnormal income may not equal 0, this is called biased
accounting.
APPLICATION OF VALUATION APPROACH: I) Accounting for intangibles: A) Purchased
Intangible: GW arising from acquisition is accounted for at cost with no amortization
but subject to impairment. B) Self-Developed Intangible: GW arising from R&D is hard
to determine FV and cost are written off as incurred. This creates a recognition lag as
value shows up overtime on P&L. FV accounting of financial instruments: A) Exit Price:
Ideally MV but the mkt incompleteness complicates the measurement. It measures
the opportunity cost of retaining assets/liabs. B) FV Hierarchy: Level 1- Reasonable
well mkt value exists ; Level 2) Price can be inferred from MV of similar items ; Level 3:
Managers use their judgement on how a mkt participant would value these. As we go
down on levels, reliability goes down.
LECTURE 5