Financial Accounting Theory: Decision Usefulness and Measurement Approach - Example

Running Head: Accounting Name: University: Course: Tutor: Date of Submission: Introduction Investors have a right to know the performance of the organization to enable them make a better decision. The investors are mainly classified as owners and creditors. Owners are concerned about the level of the returns accruing to them while creditors are keen to gauge the safety of their lending (Deegan, 2009). Thus, the financial records have to serve this purpose owing to the fact that the stakeholders as well as investors are the providers of the finances invested. Owing to this fact financial statements are required to clearly indicate the performance a firm’s securities for proper decision making by the investors (Schroeder, 2009). Without the accurateness of the financial statements information, the financial records may not serve the required functions as well as they can be deemed insufficient for use by investors. As a result of these facts today the trend has changed with many accountants moving towards Measurement Approach in financial reporting. Measurement approach to decision usefulness entails proper usage of current values in the financial statements. Current values is a term which can be defined from two perspectives thus fair value referring to an exit price and value-in-use defining present value of future cash receipts or payments. Primarily, the goal of measurement approach is to increase decision usefulness over that of information approach (Scott, 2012). This implies a larger role for the financial statements proper in assisting investors to predict firm’s fundamental value, thus the exact value of the firm’s share if all the relevant information has been communicated to the investors. Discussion Reasons as to why financial reporting is moving towards a Measurement Approach Problems associated with Historical costs Historical cost based accounting over the years is associated with low ability to explain abnormal securities returns hence in accounting these costs are of low value relevance. Moreover, with increasing investor pressure many firms’ want accurate and best asset evaluation and liabilities(Schroeder, 2009). With this, in mind many questions have been raised about including relevant information in the financial statements without really sacrificing its reliability. As a result of this many accountants have been forced to adopt a measurement approach to decision usefulness as a way of increasing information reliability. Explanatory Power of Net Income Previous research studies done by Ball and Brown (BB), indicates that security returns of a specific firm respond quickly to new information releases on earnings. In conclusion BB research studies indicates that there is a strong reaction thus deviation from zero around this period (Schroeder, 2009). On other hand a study by Lev (1998), reveals that this effect can be as small as 2-5% of the abnormal variability of narrow window security returns around the date of the new release. Analyzing the two studies by Ball and Brown (BB) and Lev (1998), it is quiet evident that the effect on security returns around the date of new earnings release is very small as proved by Lev (1998) . From “Low R2” argument, greater use of fair values in financial reporting as well as measurement of net income is important in reversing the unexpected earnings caused by apparent declines as well as inappropriate information on abnormal share price variability. Incorporating Low R2 is important because it will results to better measurement which in turn may increase accounting “market share” in explaining share price changes(Scott, 2012 ). In another evidence research on this effect by Collins et al (1994), it was concluded that small market response to the earnings information was due to lack of timeliness as well as relevance of historical cost based earnings. This actually implies that the earnings information can only be improved through the introduction of a measurement approach into the financial reporting hence the need for measurement approach in financial reporting. Additionally, the net income cannot be used to explain all the abnormal returns unless under ideal conditions. This is due to the existing numerous sources of information as well as noise and liquidity traders who on daily basis add to the abnormal variability. To control this problem and ensure normal variability there is need for accountants to move towards measurement approach to decision usefulness. Securities markets may not be fully efficient In the recent years, theory and evidence indicates that securities markets are not fully efficient as the information perspective assumes which suggests major implications for accounting. This has led to increasing questions about the extent of securities market efficiency. The first questions raised by behavioral finance theory about market efficiency are related to the behavioral characteristics of a rational investor (Scott, 2012).The other question is related to the Prospect Theory. Prospect theory outlined by Kahneman and Tversky (1979), tend to provide behavioral- based alternatives to rational decision theory. According to the theory, if an investor is considering making a risky investment, then he or she should a separate evaluation of losses and losses (Schroeder, 2009). This is contrary to the decision theory, which requires investors to evaluate investment decisions basing on effects of these decisions on their total wealth. Prospect theory, makes this assumption basing loss aversion behavioral concept in which individuals are assumed to be averse to even very small losses leading to the disposition effect. Disposition effect is a situation whereby investors tend to hold onto their losers as well as sell winners. In a research conducted by Shefrin and Statman (1985) on this effect it was concluded that, investors avoid selling consistent with the disposition effect (Deegan &Unerman, 2006). Additionally, prospect theory assumes overconfidence weighting ramification when calculating the expected value of an investment, resulting to a low state of individual’s posterior probabilities on those states which are likely to happen as well as a high individual’s posterior probabilities on those states which are unlikely to happen. All of these posterior probabilities are assumed to be less than one (Jones & Riahi-Belkoui, 2010). Evaluation of separate gains and losses in combination with the two weighting probabilities widely used in this theory can lead to a wide range of irrational behaviors in financial reporting. For instance, fear of losses may make some investors to stay out of the market for sometime, even if their investments are expected to give a positive value according to a decision theory calculation. Additionally, basing on wrong market information investors may react to the bad news through holding onto losers primarily as away of avoiding losses or alternatively they may make a bad decision of buying more of a loser stock hence taking one more added risk. In another research conducted by Burgstahler and Dichev (1997) on large firm’s in the united states, it was evident that only a few firms tends to report small loses under this theory, rather most firms prefer reporting small positive earnings. Many firms manipulated cash flows as well as accruals primarily as away of managing their reported earnings upwards as well as reporting positive earnings. These activities show adequately the existing inefficiencies in the market securities (Scott, 2012). In finance beta is considered as the only relevant risk measure as well as sole firm determinant of expected return on stock as outlined by CAPM. This implies that in efficient markets, CAPM should first and foremost capture accurately and effectively behaviors of rational investors. Secondly, a firm’s share returns should show a positive increment towards j (Scott, 2012). Additionally, these values should be unaffected by a particular firm’s specific risk measures in various diversified ways. Research on larger firms trading on the US stock exchange over the period of 1964-1996 by Fama and French (1992), indicated that the ability of beta to explain stock returns at a larger extend was limited (Jones & Riahi-Belkoui,2010). Their study found a significant power for the book to market ratio in predicting a firm’s performance compared to Beta. The results from the research indicated that, instead of beta acting as a risk measure, it makes the market to act as if the firm’s risk is increasing with book –to- market hence it decreases with the firm size(Jones & Riahi-Belkoui,2010). The results from the study led to some researchers suggesting that beta is “dead.” On other hand research results reported by Kothari, Shanken, and Sloan (1995), indicates a different view about the performance of beta. From their research evidence, beta was a significant predictor of return while the Book-to- market was a relative weak predictor in particular during the longer period time of (1942–1992). Though, this is the case the status of CAPM is still unknown hence the need to rescue it by accountants recognizing that beta performance in value prediction as well as risk measurement may change over time with accounting-based variables (Scott, 2012). Further questions are related to excess stock price volatility within the markets. Evidently, if a market is efficient then changes in E(RMt) is supposed not to exceed the relevant changes in aggregate expected dividends(Scott, ). Research by Shiller (1981), indicates that the variability of the stock market index in the market securities has been severally greater than the expected aggregate variability in the firm’s dividends. According to Shiller, these results imply securities market inefficiencies (Scott, 2012) Ohlson clean surplus theory The third reason is associated with Ohlson clean surplus theory which actually provides support for increased effective measurement in the financial reporting. This theory attests to effective and efficiency in financial reporting measurement from the legal accounting liability aspect which indicates that accountants are exposed when firms they work with become financially distressed (Scott, 2012). Additionally, the theory supports efficiency of measurement, because theoretically the value of a firm can be derived from the information presented in its financial statements as well as information from the dividends or cash flows. Since this derivation starts with the net profit recorded on the balance sheet, and then adding on it discounted expected future abnormal earnings, basing the balance sheet on the current values is important in reducing abnormal future earnings prediction. Current values by definition, incorporates expected future values which can either be market future values or value-in-use which implies that, incorporating current vales in the balance sheet means better predictions of firm’s expected future performance value (Henderson, 2004). Moreover, using dividend, cash flow and financial statement-based approaches to firm valuation automatically puts a firm’s value earnings prediction on theoretical basis, leading naturally to a measurement perspective. Auditor’s legal liability Auditors legal liability is the last reason as to many accountants are moving towards measurement approach. . In the recent years there has been increased pressure on the side of auditors to ensure efficiency in financial statements measurement proper. This pressure was as a result of increasing failures of various financial institutions in the United States during the 1980s. To avoid these failures SEC one of the accounting bodies has over the years pushed for current value accounting (Deegan 2009). Moreover, greater use of current values in the accounts is expected to change market financial distress anticipation hence reducing the number of auditor lawsuits. Link between Decision Usefulness and Measurement Approach Decision usefulness theory is one of the accounting theories which in-depth explain the relationship between useful accounting decisions, principles and concepts. Decision usefulness therefore can be perceived as an accounting theory which in detail explains how usefulness decisions are made using proper judgment. On other hand measurement approach entails proper use of current values to enhance proper decision making. Decision usefulness as well as measurement approach therefore can be seen as important aspects in financial reporting which play a significant role in assisting investors to make wise decisions regarding international investments in particular when investing in companies whose financial statements are prepared using either IASB or FASB. Decision usefulness and measurement approach incorporates the use of fair values in making informed financial investor decision. Alternative to Measurement approach Information approach which entails the use of historical costs rather than fair values is an alternative to measurement approach. The information usefulness concentrates on providing useful information for predicting future firm performance to the investors’. The two differ greatly, because measurement approach recognizes an increased obligation towards useful decision making beyond that of the information approach in assisting investors to predict future firm performance Conclusions In summary, since evidence indicates that securities markets are not fully efficient as they are thought to be, over reliance on supplementary information in notes as well as elsewhere by accountants to supplement the historical cost based financial statements may not accurately convey important decision making information to the investors which threatens the effectiveness of measurement approach to decision making. Enhancing efficiency and usefulness therefore entails greater use of fair values in the financial statements proper. Incorporating current values into the financial statements proper is anticipated to increase market future firm prediction through better financial reporting (Scott, 2012). Better financial reporting of a firm’s value is significant because it will enable investors to accurately and effectively estimate fundamental values as well as easily identify mispriced securities. This is because current values are assumed to be relevant more than historical costs basing on the definition relevance is the ability to predict future economic performance (Scott, 2012). Since market securities are not fully efficient, improving financial reporting could be helpful in reducing these inefficiencies. Reducing the existing market efficiencies will in turn result to improved securities market operations References Deegan, C. 2009. Financial Accounting Theory, 3rd Edition. Sydney Australia: McGraw-Hill, Deegan, C, & Unerman, J. 2006. Financial Accounting Theory. Sydney, NSW: McGraw-Hill, Godfrey, J. et al, .2010. Accounting Theory, 7th Edition. Australia: John Wiley & Sons Henderson, S et al, .2004.Financial Accounting Theory. Frenchs Forest, NSW: Prentice Hall,. Jones, S & Riahi-Belkoui, A.2010. Financial Accounting Theory, 3rd edition. Australia: Cengage Learning Schroeder, RG. 2009. Financial accounting theory and analysis: text readings and cases, 9th edition. New York: Wiley & Hoboken, Scott, W., R. 2012. Financial Accounting Theory, 6th ed. Canada: Prentice-Hall, 2012 Read More