Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
194
CHAPTER 6
THE MEASUREMENT APPROACH TO DECISION USEFULNESS
6.1 Overview
6.2 Are Securities Markets Fully Efficient?
6.2.1 Introduction
6.2.2 Prospect Theory
6.2.3 Is Beta Dead?
6.2.4 Excess Stock Market Volatility
6.2.5 Stock Market Bubbles
6.2.6 Discussion of Market Efficiency versus Behavioural Finance
6.3 Efficient Securities Market Anomalies
6.4 Limits to Arbitrage*
6.5 A Defence of Average Investor Rationality*
6.5.1 Dropping Rational Expectations
6.5.2 Dropping Common Knowledge
6.6 Summary re Securities market Inefficiencies
6.7 Conclusions About Securities Market Efficiency and Investor Rationality
6.8 Other Reasons Supporting a Measurement Approach
6.9 The Value Relevance of Financial Statement Information
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
195
6.10 Ohlson’s Clean Surplus Theory
6.10.1 Three Formulae for Firm Value
6.10.2 Earnings Persistence
6.10.3 Estimating Firm Value
6.10.4 Empirical Studies of the Clean Surplus Model
6.10.5 Summary
6.11 Auditors’ Legal Liability
6.12 Asymmetry of Investor Losses*
6.13 Conclusions on the Measurement Approach to Decision Usefulness
LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. To Understand the Measurement Approach to Financial Reporting
I begin coverage of this chapter with a discussion of what the measurement approach
means. In essence, it means the introduction of more forward–looking information into
the financial statements proper. Points that I bring out are as follows:
(i) Review the implications of securities market efficiency for financial
reporting, under which it is assumed that the market can quickly digest all
available information. The value relevance literature discussed in Chapter 5, by
and large, studied the information content of historical cost–based financial
statements. The conclusion was that such statements were found to be decision
useful since share prices responded in predictable ways to reported net income.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
196
The question then is, if historical cost-based financial statements are value
relevant, why are standard setters moving towards introducing more
measurement into accounting standards?
(ii) Review the concept of current value, introduce in Section 1.2, since
current values are more forward-looking than historical costs. As pointed out in
that section, with further discussion in Section 7.2, there are two approaches to
current value—value–in–use and fair value.
(iii) Tie both current value approaches to the concept of decision usefulness.
That is, given the ample evidence that historical-cost-based net income has
information content for investors, why try to “fix” historical cost accounting if it
“ain’t broken”? An answer is that perhaps decision usefulness can be further
increased by building more current values into the financial statements proper,
hence into the measurement of earnings. The focus of this chapter is to explore
why standard setters have moved towards a measurement approach.
(iv) Don’t forget about reliability. If the measurement approach is to enhance
decision usefulness, there must not be a significant reduction in reliability. While
RRA is supplementary information, not information in the financial statements
proper, it illustrates how forward–looking information can suffer from reliability
issues. Also, many cases of premature revenue recognition referred to in
Chapter 2 (Problems 12, 14, 25, and 26 of Chapter 2 relate to revenue
recognition) resulted from low reliability. I sometimes tie this argument back to
the information system (Table 3.2). That is, the ability of accounting information
to predict future firm performance will only be enhanced if increased relevance
under the measurement approach is not cancelled by reduced reliability, relative
to historical-cost-based information. It is the net effect on the main diagonal
probabilities of the information system that will govern whether or not fair value
accounting increases decision usefulness.
2. To Appreciate Reasons Why Financial Reporting is Moving in a
Measurement Direction
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
197
The text suggests four reasons why financial reporting is moving in a measurement
direction. These are:
(i) Theory and evidence that securities markets may not be as fully efficient
as the value relevance studies reviewed in Chapter 5 assumes. Then, building
more current values into the financial statements proper may enable the market
to better predict future firm performance. This, of course, is because current
values, being primarily future–oriented, are more relevant than historical costs,
and, by definition, relevance is the ability to predict future economic
performance.
(ii) Low value relevance of financial statement information. This is Lev’s
(1989) “low R2” argument. Perhaps the apparent decline in the proportion of
abnormal share price variability explained by unexpected earnings can be
reversed by introducing more current values into the measurement of income.
(iii) Ohlson’s clean surplus theory. This theory demonstrates that,
theoretically, firm value can be derived from financial statement information just
as well as from dividends or cash flows. The derivation starts with balance sheet
net worth and adds discounted expected future abnormal earnings. To the extent
that the balance sheet is based on current values, there are less future abnormal
earnings to predict, since, by definition, current value incorporates expected
future value, either by fair value or value–in-use. Thus, other things equal, the
better the balance sheet incorporates current values, the better the predictions of
firm value. More fundamentally, the demonstration of the equivalence of
dividend, cash flow and financial statement–based approaches to firm valuation
puts earnings prediction on a firm theoretical basis, leading naturally to a
measurement approach.
(iv) Auditor liability. My own view is that much of the pressure for more
measurement in the financial statements proper arises from auditor liability,
particularly with respect to the failures of savings and loans financial institutions
in the United States during the 1980s and early 1990s. Perhaps greater use of
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
198
current values in the accounts will better enable the market to anticipate financial
distress, thereby reducing the number of auditor lawsuits.
I have gone out on a bit of a limb in suggesting these reasons for increased attention by
standard setters to measurement issues, since they are speculative on my part.
Instructors are urged to challenge them if they do not agree. Certainly, as will be
documented in Chapter 7, accounting practice has moved in a measurement direction,
although events during the 2007–2008 market meltdowns have resulted in some
movement by the IASB from fair value to value–in–use (i.e., amortized cost accounting)
accounting for financial instruments—see Chapter 7, Section 7.5.2. The FASB seems
somewhat more committed to fair values than the IASB. For example, it is not clear that
the FASB will accept the business model concept that the IASB uses to justify
amortized cost accounting. Also, the FASB allows more general use of the fair value
option than the IASB (Section 7.5.3). However, both bodies are working on a new
standard to recognize loan losses sooner than at present. When completed, the new
standard will represent a major step in the measurement direction (Section 7.5.4).
3. To Review Theory and Evidence that Securities Markets May Not be Fully
Efficient.
The 2007–2008 market meltdowns have raised serious questions about the efficient
market hypothesis. Instructors should discuss at least some, and possibly more, of the
behavioural finance theories and evidence underlying these criticisms outlined in
Section 6.2.
The post–announcement drift and accruals anomalies are some of the strongest
evidence questioning investor rationality and market efficiency. My reading of the
research on these anomalies is that while we still do not fully understand them, they are
slowly yielding to cost– and risk–based explanations (see discussion of limits to arbitrage
in Section 6.4 (optional section)). Note that while these anomalies suggest that markets
are not fully efficient, they do not necessarily conflict with average investor rationality.
4. To Defend Market Efficiency Theory and Average Investor Rationality
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
199
In this edition, I admit that securities markets are not fully efficient. One reason follows
from the accruals and post–announcement drift anomalies, which supply convincing
evidence that prices do not always fully and immediately react to new information
(although this may be due as much to limits to arbitrage as to behavioural biases). A
second reason is that the theory can break down at times, such as during the bubble
behaviour of security prices during the 2007–2008 market meltdowns. The meltdowns,
in particular, have generated considerable criticism of market efficiency theory and
investor rationality. I do maintain, however, that except during bubble periods, security
prices are sufficiently close to full efficiency that the theory of market efficiency is still
the best available theory for accountants to understand the role of information in
investment decisions and the economy.
Some instructors may wish to discuss these criticisms, particularly since they underlie
many of the new standards that are described in Chapter 7. Consequently, Sections 6.5
(optional section), 6.6, and 6.7 contain my argument in favour of the theories.
My argument basically is that while securities markets may not be fully efficient, the
theory of rational investor behaviour can still be saved. That is, average investor
rationality is at least as consistent with observed security price behaviour as are the
behavioural theories of investor behaviour. To pursue the argument, if one drops the
assumptions of rational expectations and common knowledge that underlie many
economic models, such as the CAPM, security price behaviour, such as post–
announcement drift, can be explained by models of rational investment. To illustrate, I
outline the models of Brav and Heaton (2002) and Allen, Morris, and Shin (2006), and
supporting empirical studies, in optional Section 6.5. Interested instructors may also
wish to review the discussion of rational expectations and common knowledge
assumptions in Section 4.5.2.
4. To Introduce Ohlson’s Clean Surplus Theory
I usually confine my presentation to illustrating how the theory can be used to estimate
firm value, following the development in Section 6.10.3 for Canadian Tire Corp., or
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
200
some other well–known firm. On the way through my illustration, however, I bring out
relevant aspects of the theory. The following are the major points I bring out.
(i) I treat this theory as providing a demonstration of how firm value can be
expressed in terms of financial statement variables, consistent with the
measurement approach. The theory is based on dividends as the fundamental
determinant of firm value. Given arbitrage, dividend irrelevance, and risk neutral
firm valuation, firm value is also determined by the value of the firm’s net balance
sheet assets plus the expected present value of its future abnormal earnings
(i.e., its goodwill). This is because the value of the firm’s net balance sheet
assets captures the present value of its future “normal” earnings, and sooner or
later all earnings – normal plus abnormal – will be paid out as dividends.
(ii) A fundamental significance of the clean surplus theory is that it roots
financial accounting theory solidly in the theory of value. Instead of having to
borrow theories from economics and finance, financial accounting itself contains
a theoretically sound valuation benchmark. In this sense, the theory plays a role
analogous to the Modigliani–Miller theory in finance.
(iii) Under the simplest version of clean surplus theory (unbiased accounting
and no earnings persistence) the expected present value of future abnormal
earnings is zero and, with no persistence of abnormal earnings, the value of the
firm is read directly from the balance sheet, as in Example 2.2.
(iv) How do earnings enter into the theory? Given the wealth of evidence in
Chapter 5 that the securities market responds to earnings, the theory seems
incomplete if earnings play no valuation role. When accounting is unbiased, they
do not play a role, since all value appears on the balance sheet (i.e., unrecorded
goodwill is zero) However, when earnings lag real economic performance
(biased accounting), expected abnormal earnings are the basis for estimating
unrecorded goodwill. This is illustrated in the latter part of Section 6.10.1 by
assuming the firm uses straight line, rather than economic, amortization. In the
example, straight line lags economic depreciation.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
When the use of the clean surplus model to estimate firm value is applied to Canadian
Tire in 2012, the firm’s actual share price is considerably less than the clean surplus
estimate. The text goes into considerable soul–searching at this point. One point to
bring out is the assumption in Section 6.10.3 that Canadian Tire’s abnormal earnings
will continue at their present rate for seven years and then fall to zero. Obviously, a
variety of other assumptions can be made, as discussed in the text. The important
point, however, is that prediction of future earnings is the most critical aspect of the
application of the theory to valuation. The length of time during which abnormal
earnings will persist depends on how successful the firm is in staving off the competition
that is inevitably attracted to the presence of abnormal earnings. The answer ultimately
depends on the firm’s business strategy, a topic beyond the scope of this text. After this
soul searching, the text concludes that the main reason for the discrepancy is that
analyst forecasts are for a decline in future profitability of Canadian Tire, due to
increasing competition, a conclusion that is consistent with reasonable market
efficiency.
For instructors who wish to pursue clean surplus theory in greater depth, Section 6.10.2
gives a simplified version of the Feltham and Ohlson earnings dynamic. The
persistence parameter ω of the earnings dynamic specifies a linkage between current
and future abnormal earnings. Thus, according to the theory, the market looks to the
income statement for the current realization of abnormal earnings, consistent with the
empirical evidence of the impact of earnings on share price given in Chapter 5.
If the accounting is biased, as under the historical–cost basis, the income statement
assumes still greater relevance since it then also indicates how much of the bias of bvt
is realized in the current period. The parameter νt-1 captures the impact on future
earnings of events in year t–1 that are not recognized in net income of year t–1. Other
examples of how additional information can be used to refine estimates of future
earnings are discussed in Section 6.10.4. See Abarbanell and Bushee (1997) re
“fundamental signals” from the balance sheet, and Begley and Feltham (2001) re
capital expenditures.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
202
Note that earnings can be predicted using analysts’ forecasts, instead of by means of
the earnings dynamic. This is discussed in Sections 6.10.3 and 6.10.4. For instructors
who wish to dig more deeply into the use of the earnings dynamic versus analysts’
forecasts in predicting earnings, see the paper of Courteau, Kao and Richardson (2001)
referenced in Section 6.10.4.
Most students find an assignment requiring them to use the clean surplus model to
estimate firm value and compare with actual share price to be quite interesting. The
Canadian Tire example in Section 6.10.3 provides a template. See also C.M.C. Lee,
“Measuring Wealth,” in CA Magazine (April, 1996), pp. 32–37. The Canadian Tire
example in the text is based on the procedure outlined in Lee.
When working on this assignments, students often use the previous year’s return on the
market as an estimate of the expected return on the market needed to apply the CAPM.
However, this approach is problematic, especially if the previous year’s market return is
negative. The concept of market risk premium, that is, the extra return over the risk free
rate demanded by the market to invest in risky equities, provides another way to
estimate the expected return on the market. See Note 39 of chapter 6 re the market risk
premium. For a brief outline of how to apply the market risk premium in a CAPM context
see Bernard, Healy and Palepu, Business Analysis and Valuation, second edition
(Cincinnati, Ohio: South–Western College Publishing, 2000), pp. 12–14 to 12–16.
5. To Appreciate how Auditor Legal Liability leads to Conservative
Accounting
Section 6.11 outlines the famous, or infamous, Savings and Loan debacle of the 1980s
and 1990s, which led to large auditor liabilities. This incident demonstrated a “fatal flaw”
in historical cost accounting that enabled financial institutions to conceal approaching
financial distress, and was instrumental in leading to the development of impairment
tests for most assets. The section also includes an introduction to the concepts of
conditional and unconditional conservatism, including the well–known Basu (1997)
paper that developed a market–based measure of conditional conservatism. Recall that
this text views conservatism as a partial application of the measurement approach.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
203
For instructors who may wish to dig somewhat deeper into conservatism as a reaction
to auditor liability, Section 6.12 (optional section) develops a legal liability motivation for
conservatism due to the asymmetry of utility loss suffered by a risk averse investor.
That is, such an investor loses more utility from a wealth overstatement than an
understatement of the same amount. If so, a downwardly biased (i.e., conservative)
valuation of net assets leads to greater investor expected utility than an unbiased (i.e.,
current value) valuation. Downwardly–biased valuations thus contribute to reducing
auditor liability because downward biasing reduces the likelihood that there will be an
overstatement error, and it is overstatement errors, rather than understatements that
usually lead to lawsuits against auditors.
This argument is demonstrated using an elaboration of the single–person decision
theory illustrated in Section 3.3. In the process, the distinction between conditional and
unconditional conservatism is brought out.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
204
SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. The following reasons for a measurement approach are suggested:
• It appears that historical cost–based net income explains only about 2–7%
of the variability of share prices around the time of earnings
announcement. This is Lev‘s (1989) “low R2” argument. Introducing more
value–relevant information into the financial statements proper may
2. Adoption of a measurement approach will increase the relevance of financial
statement information. Relevant information is information that enables users to
evaluate the firm’s future performance. The measurement approach implies the
use of current values of assets and liabilities, such as fair value (if markets work
205
3. a. Reasons why prospect theory predicts that security prices will differ from
their prices under efficient securities market theory:
• Disposition effect. This arises from the Prospect Theory assumption
of loss aversion, under which investors dislike even a small loss
more that they like a small gain of equivalent magnitude. As a
earnings, security prices take time to fully respond to this
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
information. That is, they drift up and down following good and bad
news in the earnings announcement. This is an anomaly because
than cash flows. Since errors and bias tend to reverse quickly, they
further reduce persistence. The accrual anomaly is that while
security prices respond to net income, they do not seem to respond
to the proportion of accruals to operating cash flows in that net
income. This is an anomaly because under securities market
reaction under market efficiency.
• Limited attention. Investors subject to limited attention do not bother
to process all the information available to them. In an accounting
context, they may ignore supplemental information such as RRA,
notes disclosures, and MD&A. As a result, share prices under–react
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
207
d. To the contrary. To the extent that investors are behaviourally biased, the
importance of high quality reporting increases, since better reporting can
help to reduce the share mispricing that such biases produce. Reporting
improvements that can help reduce biases include moving information
4. Post-announcement drift is the tendency for the share prices of firms that report
GN or BN in quarterly earnings to drift upwards and downwards, respectively, for
a lengthy period of time following the release of the earnings report.
It is known that quarterly seasonal earnings changes are positively correlated.
The reporting of, say, GN this quarter (compared with the same quarter last year)
5. The efficient market will respond more strongly to the GN or BN in earnings (i.e.,
a higher ERC) the greater is the persistence of the GN or BN. Cash flows are
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
6. a. According to rational single–person decision theory, the investor will likely
prefer the first fund, since it has both a higher expected return and a lower
standard deviation of return.
Note: In assessing risk, the investor may be attracted to the second fund
because of its guarantee of no negative return. This guarantee becomes more
209
7. a. Earnings quality, also called informativeness of the information system, is
the ability of current earnings to enable investors to predict future firm
performance. It can be conceptualized by the main diagonal probabilities of the
information system (Table 3-2). The higher the main diagonal probabilities
relative to the off–main diagonal, the greater the quality.
bias), the ability of net income to predict future firm performance is
reduced.
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 6
• Poor disclosure. Poor disclosure may prevent investors from fully
evaluating earnings persistence, thereby reducing the ability of net
of investments and capital assets, changes in the present value of long–term
debt, successful research, etc. Reliability will not decrease providing fair values
are based on well–working market prices. However, to the extent such market
values are not available, greater use of measurement requires estimation, which
will decrease reliability due to the possibility of error and manager bias. If the
8. From a single person decision theory perspective, reported earnings are value
relevant if they lead to buy/sell decisions, as investors revise their beliefs about
future firm performance during a narrow window surrounding the date of release
of the earnings information. These buy/sell decisions in turn lead to rapid
changes in share prices and returns.
