Measurement Approach to Decision Usefulness - Coursework Example

Introduction The focus of this paper is to undertake a clear analysis on whether a measurement approach can be used to make accounting information more useful for purposes of decision making in organizations (Abarbanell and Bushee, 1997). The main assumption made in this paper is that the measurement approach in financial reporting differs greatly from the information approach that has been used widely in financial reporting (Johnson, 2003). The reason for this is that the information approach focuses on providing useful information that can be used to make future predictions of the performance of the firm. The measurement approach is defined as a financial reporting approach or perspective where organizations accountants take as their responsibility to entrench fair values during financial reporting into the financial statements in order to provide investors with the ability to make accurate predictions about the performance of the firm in the future (Feltham and Ohlson, 1996). The measurement approach obligates the accountants to move further from information approach as one way of empowering the investors (Patricia, 2001). Different reasons for including and giving fair values more attention in financial statements, including evidence and theory that market for securities are not always efficient are proposed in this paper. It is unlikely that the historical-cost method of accounting will be replaced by the measurement approach. However, it seems likely that the balance of fair value-based and cost-based information in the statements of accounts is moving towards the direction of the fair-value based method (Patricia, 2001). Given the numerous problems that have arisen due to the application of RRA accounting techniques, this may seem strange to a certain extent (Beaver, 1999). However, the change in emphasis where financial statements reporting are moving towards the direction of fair-value reporting can be explained through a number of reasons (Greene, 2000). Examples of measurement Derivatives instruments Even when they are based on historical cost, financial statements contain fair value estimates. Examples of fair value estimates contained in financial statements include accounts payable, accounts receivable, capital assets ceiling test, and the cash flows fixed contract (Patricia, 2001). The requirements of terms and conditions as well as fair value and credit risk information are important (Feltham and Ohlson, 1996). The measurement perspective is largely required in accounting for derivatives because for purposes of the balance sheet, the measurement of derivatives must be undertaken using the fair value approach with fair value changes shown in the net income (Beaver, 1999). Hedge Accounting Hedging occurs when a hedging instrument (liability or asset) is acquired by a firm with a risky asset in the effort to offset the loss or gain on the hedged item. The value of the hedging instrument and the hedged item should move in opposite direction. However, this is not always the case and the basis risk emerges (Patricia, 2001). Because hedging accounting may want to have losses and gains matching becomes an important concern. The SFAS 133 accounting requirements have occurred where fair value losses and gains on current earnings are included thus raising the need for the measurement approach (fair-value oriented) to be used in hedge accounting (Patricia, 2001). Beta risk From the accounting point of view, beta is not the only risk measure that can be deployed. However, beta can be used to increase financial statements role in reporting risk information that is useful, for example, the book-to-market ratio (Keiso and Weygandt, 2003). In this perspective, it is important to conclude that beta may change with time. There is evidence that shows that changes in beta with time causes anomalies in share prices behavior that makes it difficult for investors to rely entirely on better for future predictions (Dechow, Hutton and Sloan, 1999). Hence, the measurement approach comes in as an alternative approach for using fair values to predict future share earnings. Reasons for moving towards the measurement approach (fair-value based financial statements) Net income explanatory power Different studies have revealed that returns on security to any form of earning releases. However, other studies have indicated that the extent of response of security returns to earnings releases can be as minimum as 3% of the of the abnormal variability of narrow window security returns around the date of the new release (Keiso and Weygandt, 2003). The effect of this could be very small (Frankel and Lee, 2003). Hence, the importance of information can be grouped into two categories, which include practical and statistical significance (Callen and Morel, 2001). Practical importance emerges when there is no strong marketplace implication of statistical importance of data (Frankel and Lee, 2003). Statistical importance of data emerges when a significant deviation between baseline reading and data is noted, for example, earning information results into reaction of security markets (Keiso and Weygandt, 2003). Evidence from studies show that lack of historical cost based information and lack of timeliness resulted to a small response in the market to earnings information (Frankel and Lee, 2003). In this regard, it follows that improvement in earning information could be achieved by introducing the measurement approach into financial statements (Feltham and Ohlson, 1995). It also follows that abnormal returns cannot be explained by net income except under ideal conditions (Keiso and Weygandt, 2003). The reason for this is that other information sources could be still be used by accountants. Abnormal variability is also added by liquidity and noise traders. Legal liability of auditors The movement towards the measurement approach can be explained from a legal perspective. The collapse of financial institutions and large firms has raised the need to ensure that financial statements reflect the firm as a going concern (Begley and Feltham, 2002). This pressure that has mounted on firm auditors can be avoided through inclusion of fair values into the financial statements (Keiso and Weygandt, 2003). Auditors can therefore be able to determine whether financial statements prepared by accountants had indications of environmental liabilities and bankruptcy. This does not only increase the extent of estimation in the statements of accounts but it also offers legal benefits because by adopting the fair value based method accountants and auditors are saved from being held responsible for collapse of institutions (Begley and Feltham, 2002). Inefficiency of security markets Numerous questions have been raised in the recent years regarding the extent to which market for securities are efficient (Feltham and Ohlson, 1996). Such questions are indeed significant because their validity indicates that the previous accounting practice used by accountants to use supplementary information in financial statements to enhance the historical-cost based method may not yield the required objectives of providing investors with vital information (Keiso and Weygandt, 2003). Additionally, given that market for securities is not completely efficient, it means that to reduce inefficiency in the security markets, advanced or improved financial reporting must be applied to improve the operation of market for securities (Keiso and Weygandt, 2003). It means that investors can be empowered to estimate the firm’s fundamental value once better reporting practices are adopted by accountants. This can help investors to identify easily securities that have been mispriced. The basic premise for the question on whether security markets are efficient is based on the fact that the behavior of an average investor may not be in line with investment models and rational decision theories (Ahmed, Morton and Schaefer, 2000). This is because the reaction of the investors to information may be biased relative to the requirements by Baye’s theorem on how investors should react (Keiso and Weygandt, 2003). Overconfidence is one of the investors behavior suggested by psychological evidence, which means that investors tend to overestimate the clarity of collected information (Feltham and Ohlson, 1996). This behavior exhibited by investors’ shows that the price of shares are likely to overact following the investors overestimating behaviors. Prospective theory The prospective theory is an alternative to the rational decision theory. The prospective theory holds that an investor will always evaluate prospective losses and gains when considering risky ventures (Keiso and Weygandt, 2003). This differs from the decision theory where investors evaluate investment decisions in terms of the manner in which such decisions affect the total wealth of the investors. Evaluation of losses and gains separately can be regarded as a narrow framing psychological concept because problems are analyzed in isolated ways in order to economize on the investors’ mental effort. Too much information for decision making held by the investor paves way for the mental effort (Keiso and Weygandt, 2003). Sometimes the investor may feel as if he/she does not need further information to make investment decisions. This means that a small loss reported in the financial statements may result to a strong negative reaction on the part of the investor. Likewise, a small positive earnings reported in the financial statements may result to a strong positive reaction on the part of the investor (Fama and French, 1997). In order to avoid a negative reaction from the investors, firm managers manage earnings upwards in order to enjoy a positive reaction from the investors. Similarly, managers of firms that make huge losses undertake earnings management in order to avoid negative reactions from the investors (Keiso and Weygandt, 2003). The need for the measurement approach is to help investors make effective investment decisions based on measurable data through the fair value-based approach. Additionally, the measurement approach would help to avoid the vice of earning management advanced by firm managers to avoid negative reaction from the investors (Keiso and Weygandt, 2003). Volatility of the stock market Volatility of stock market at the market level is evidence that raises questions regarding efficiency of security market that makes financial reporting lean towards the measurement approach (Maheshwari, 2004). Holding the risk free interest and beta constant, expected return on market investment results to a change in the return of the shares of the firm. Excessive volatility of the stock market may be due to a number of reasons (Maheshwari, 2004). First, non-stationarity caused by overshooting of market prices and immediate fall back in share prices. Overshooting is caused by investors that rely on positive feedbacks that rush to buy shares when share price shows signs of rising upwards (Maheshwari, 2004). This behavior by investors results to excessive volatility of stock market as investors strive to take advantage of the rising share price. Hence, the need for the measurement approach is to neutralize the effects caused by excessive market volatility on the firm’s share price by reporting a fair-value market price of the firm’s shares in the financial statements by focusing on the current share return to predict future earnings (Maheshwari, 2004). Ohlson’s Clean Surplus Theory The clean surplus theory emerged from the study conducted by Feltham and Ohlson (1995). The theory demonstrates the way in which the firm’s market value can be calculated by means of the components of the income statement and balance sheet (Feltham and Ohlson, 1996). The study was conducted on the assumptions of dividend irrelevance and ideal conditions. The theory holds that the value of the firm can be predicted using the dividend stream (Maheshwari, 2004). The measurement approach or perspective is therefore depicted in the clean surplus theory because incorporating fair values into the book value lead to less prediction of abnormal earnings (Shukla and Grewal, 2002). The clean surplus theory emphasizes on current information usefulness to predict earnings in future (Liu and Ohlson, 2000). This is contrary to the examination of the relationship between share returns and current financial data which is done using the information approach (historical cost approach) (Shukla and Grewal, 2002). In conclusion, empirical research has shown that information on net income can be used to predict future activities of the market to a certain extent. Accounting information usefulness can therefore be evaluated using efficient market price criteria. However, information perspective raises a number of questions. First, market for securities is not always efficient. This shows that for investors to evaluate the implications of future returns they need a more effective approach of predicting future earnings on their investments and this can only be achieved using the measurement approach. Additionally, accountants may be forced to increase the use of the fair values in order to escape legal liability. The measurement approach to decision usefulness seems to reinforce the above questions particularly in the use of Ohlson clean surplus theory in determining the future value of the firm. References Abarbanell, J. and Bushee. J. (1997). ‘‘Fundamental Analysis, Future Earnings, and Stock Prices’’. Journal of Accounting Research 35, 1–24. Ahmed, A. Morton, M., and Schaefer, F. (2000). ‘‘Accounting Conservatism and the Valuation of Accounting Numbers: Evidence of the Feltham-Ohlson (1996) Model’’. Journal of Accounting, Auditing and Finance 15, 271–292. Beaver, W. 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