2/8/2021

AF5102
Accounting Theory

Lecture 6
The Measurement Approach to Decision Usefulness
& Market Inefficiencies

Dr. Zhang Yong

Email: yong.zhang@polyu.edu.hk
Office: M1042

What Is the Measurement Approach?

• Greater use of current values in the financial

statements proper
• Recall two versions of current value
• Fair value: exit price
• Value-in-use: present value of future cash receipts or
payments
• Goal of measurement approach is to increase decision
usefulness by increasing financial statement relevance

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Why Are Accountants Moving Towards a

Measurement Approach?

• To the extent that average investors are not fully

rational and securities markets are not fully
efficient, a measurement perspective may improve
decision-making and market efficiency
• The greater relevance of current values may enable
ordinary investors to improve their decision making
• This assumes that the increased relevance is not
outweighed by lower reliability

Why Are Accountants Moving

Towards a Measurement Approach? (Continued)

Low R squared

 Empirical evidence that net income explains very

little share price variation (i.e., low “market
share”). Lev (1989), Section 6.9

 Better measurement may increase

accounting “market share” in explaining
share price changes

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A Logical Inconsistency in the Efficient

Market Hypothesis
• S. Grossman and J. Stiglitz. “On the impossibility of
informationally efficient markets”. American Economic Review
(1980)
• Prices cannot be always fully informative if arbitrage activities are
costly (e.g. information acquisition cost)

• How to compensate for costly arbitrage

• Liquidity trader
• Decision not based on information
• Irrational trader
• Use information inefficiently

Are Securities Markets Fully Efficient?

• Return Predictability
• The size effect
• Small firm high return
• The value effect
• Value firm (high B/M, E/P) high return
• The momentum effect
• Past winner high return, past loser low return
• The equity issuance effect
• IPO and SEO firms low return

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How Inefficiency Can Arise

• Investor psychology
• Errors do not cancel out in aggregation
• Overconfidence
• Prospect theory
• Disposition effect
• Limited attention
• Limit of arbitrage
• Mispricing can’t be wiped out by arbitrageurs
• Fundamental risk
• Noise trader risk
• Implementation cost

Prospect Theory

Kahneman and Tversky. “Prospect Theory: An Analysis of Decision under Risk”

Econometrica (1979)
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In addition to whatever you own, you have been given

1000. Now choose between
A = (1000, 0.5)
B = (500, 1)

In addition to whatever you own, you have been given

2000. Now choose between
C = (-1000, 0.5)
D = (-500, 1)

Now choose between

A = (US$50,000, 0.0001)
B = ($5, 1)

Now choose between

A = (US$-50,000, 0.0001)
B = ($-5, 1)

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Other common behavioral biases

• Disposition effect
• You bought a stock at $10, and today’s price is $12. Sell?
• You bought a stock at $10, and today’s price is $8. Sell?

• Limited attention
• What stocks do you purchase?
• Liu, Sherman and Zhang (2014, MS): a simple, objective measure of pre-IPO
media coverage is positively related to the stock’s liquidity, analyst coverage,
institutional investor ownership, and long-term valuation.
• Breaking news → pre-IPO media coverage → post-IPO long-run effects

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Evidence That Investors Misprice

Accounting Information

• Post earnings announcement drift (PEAD)

• Prices continue to drift upwards (downwards) after
announcement of good news (bad news)
• Naïve investors don’t understand earnings persistence
• Accrual Anomaly
• High accrual companies earn low return
• Naïve investors don’t understand the difference between accruals and
cash flows

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PEAD

Bernard and Thomas. “Post-

Earnings-Announcement Drift:
Delayed Price Response or Risk
Premium?” Journal of Accounting
Research (1989)

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PEAD: Further Evidence

Bernard and Thomas. “Evidence that stock prices do not fully reflect the implication of
current earnings for future earnings” Journal of Accounting and Economics (1990)

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The Accrual Anomaly

Accruals are less persistent than cash flows

Sloan. “Do stock prices fully reflect information in

accruals and cash flows about future earnings?” The
Accounting Review (1996) 15

The Accrual Anomaly: Do investors get it?

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The Measurement Approach

• Greater use of current values in the financial
statements to increase decision usefulness
• Market inefficiency
• Naïve investors needs protection
• Low value relevance of financial statement information
• Low R2 problem: R2 a measure of proportion of share return
explained by accounting information
• Low value relevance of earnings and other financial statement
information

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How Much New Information in Earnings?

Ball and Shivakumar. “How Much New Information Is There in Earnings” Journal of Accounting
Research (2008) 18

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Why Current Value Accounting Increases the Value

Relevance of Earnings

• Feltham Ohlson model (1995)

• PAt = BVt + Gt
• PA is market value
• BV is book value
• G is goodwill or present value of abnormal earnings
• Clean surplus accounting: all gains and losses flow through
the income statement
• The model relates firm value with accounting earnings and
net assets

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Historical Cost and Current Value

• Uncertainty Inc.
• Only one asset, no liabilities
• Discount rate is 10%
• Cash flow generated each year will depend on the state of
economy
• Good economy: $200
• Bad economy: $100
• During each year the two states of economy occur with same
probability (0.5)

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Balance Sheet As at End of Year 0

Capital Asset $260.33 Shareholders’ Equity $260.33

Income Statement for Year 1 (Bad Economy)

Accretion of discount (0.1 x $260.33) $26.03

Less: Abnormal earnings (due to bad economy) 50.00

Net Loss $23.97

Balance Sheet As at End of Year 1 (Bad Economy)

Cash $100.00 Shareholder’s Equity

Capital Asset 136.36

$236.36 $236.36

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Balance Sheet As at End of Year 0

Capital Asset $260.33 Shareholders’ Equity $260.33

Income Statement for Year 1

(Straight-line Depreciation)
Revenue $100
Expense (Depreciation) $260.33/2 = $130.17
Net Income $(30.17)

Balance Sheet As at End of Year 1 (Bad Economy)

Cash $100.00 Shareholder’s Equity

Capital Asset 130.16

$230.16 $230.16

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Historical Cost
• Equity = 260.33 at time 0.
• Straight-line depreciation of $130.16 in two periods
• Expected net income in period 2 given bad state in period 1
• (100*0.1)+0.5*(100-130.16) + 0.5*(200-130.16) = 29.84
• Expected normal earnings (Accretion of discount)
= 0.1*230.16 = 23.02
• Expected abnormal earnings = 29.84-23.02 = 6.82
• Goodwill = 6.82/1.1 = 6.20
• PA1 = BV1 + G1 = 230.16 + 6.2 = $236.36

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Significance of Feltham Ohlson

model (1995)
• An alternate approach to estimating firm value
• Theoretically sound
• Uses accounting variables
• May be easier to apply than discounted cash flow
• Increased emphasis on predicting net income
• Since needed for expected abnormal earnings calculation
• Supports measurement approach

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Conclusions on Measurement Approach

• Assuming reasonable reliability, current value
accounting can increase decision usefulness relative to
historical cost accounting
• There is a trend (in accounting standard setting etc.) for
increased use of current value accounting (including
impairment tests) in financial reporting
• Suggested reasons
• Markets not fully efficient
• Low explanatory power of net income for share returns
• Feltham Ohlson model (1995)
• Auditor liability

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