Chapter 6: The Measurement Perspective on Decision

Usefulness

Introduction

The focus of the chapter is to analyze if accounting information can be made more useful

in decision-making by taking a more measurement orientated approach in financial

reporting. The measurement perspective differs from the information perspective that has

been presented in previous chapters. The information perspective concentrates on

providing information that is useful in predicting future firm performance. In contrast, the

measurement perspective can be defined as follows:

The measurement perspective on financial reporting is an approach

under which accountants undertake a responsibility to incorporate fair

values into the financial statements proper, providing that this can be done

with reasonable reliability, thereby recognizing an increased obligation to

assist investors to predict future firm performance.

Reasons for Attention to Measurement

Explanatory Power of Net Income

While it has been shown through studies like Ball and Brown (BB) that security returns

do respond to new releases regarding earnings, Lev (1998) has pointed out that the effect

can be as small as 2-5% of the abnormal variability of narrow window security returns

around the date of the new release. It should be noted that even though a result of a study

like BB demonstrates a strong reaction (i.e. a deviation from zero), in reality the effect
could be quite small. Therefore, the significance of data can be divided into 2 categories:

statistical significance and practical significance.

Statistical Significance- Occurs when data shows deviation from a baseline reading. For

example, security markets display a reaction to earnings information.

Practical Significance- Occurs when the data shows statistical significance but lacks any

strong implication for the marketplace.

A study done by Collins, Kothari, Shanken and Sloan (1994) has accumulated evidence

to show that it is this lack of timeliness and relevance of historical cost based earnings

that have led to the small market response to this information. It then follows that

earnings information could be improved by introducing a measurement perspective into

financial reporting. Furthermore, net income cannot explain all of the abnormal returns

(except under ideal conditions). The reason being that there are all sorts of other

information sources available. There are also noise and liquidity traders that add to the

abnormal variability.

Ohlson’s Clean Surplus Theory

The study done by Feltham and Ohlson (F&O) (1995) resulted in the clean surplus

theory. The theory illustrates a way of calculating the market value of a firm, and

ultimately the security returns, by means of balance sheet and income statement

components. The assumptions of the study are as follows:

 Ideal Conditions
 Dividend irrelevancy

The starting point of the theory is in understanding that the main predictor of a firm’s

value is its dividend stream. See example in Appendix A.

Earnings Persistence

OXta = wOXt-1 + et where w is the persistence parameter. The persistence parameter

has a value between 0 <= w < 1. The above example handled the case when w = 0. When

w < 1, the earnings persistence will die out over time. In Chapter 5 it was discussed that

the higher the ERC coefficient, the higher the persistence in earnings, similarly, the

higher the value of w, the greater the income statement impact. The example in Appendix

A handles the case when w >1.

Implications

1. Under ideal conditions, all action is no longer on the balance sheet. The income

statement is important because it reveals current year’s abnormal earnings.

2. The formulas imply that investors will want information to help them access

persistent earnings since they are important to the persistence of the firm.

This second implication is consistent with Chapter 5 ERC discussions: the greater the

persistence, the greater the investor response to current earnings. We can also use

F & O to estimate the value of a firm’s shares, which can then be compared to actual

market value to determine the possibility of mis-priced securities. See example in

Appendix A.

If a firm’s actual share value is comparable to the model value, you would be more likely

to invest in that firm rather than invest in a firm whose share value is not as “backed up”

by book value and expected abnormal earnings.

The clean surplus theory leads to the measurement perspective since the more fair values

that are incorporated into the book value, the less the need to predict abnormal earnings.
The clean surplus theory also emphasized the usefulness of current financial information

to predict future earnings as opposed to examining the relationship between current

financial information and share returns as is done with the information perspective.

Auditors Legal Liability

Additional support for the measurement perspective comes from a legal standpoint. The

failures of many large firms and financial institutions have led to increased pressure on

auditors to insure that the financial statements truly reflect the continuance of the firm as

a going concern. This pressure for legal responsibility can be partially alleviated by

introducing more fair values into the statements. By doing so the auditors can point out

that the financial statements predicted certain events like bankruptcy and environmental

liabilities. However, the perspective also increases the amount of estimation in the

financial statements. As long as the auditors and accountants are willing to adopt these

fair values estimates without substantial loss of reliability, the measurement perspective

offers added legal benefits.

Measurement Examples

Financial statements contain a certain amount of fair value estimates even when

they are conventionally referred to as being based on historical cost. Examples include

accounts receivable and accounts payable at net realizable value, fixed contract cash

flows, the lower of cost or market rule, ceiling test on capital assets, and push down

accounting for acquisitions.

More Recent Fair-Value-Oriented Standards

Pension and Other Post-Employment Benefits (OPEB)

Accounting on a present value basis is being extended to other post-employment benefits

in Canada. Currently, defined-benefit pension plans are accounted for this way. Instead of

accounting for things like health care and insurance (for retired employees) on a cash

basis, present value accounting will be the standard. This allows OPEBs to be consistent

with FASB.

These new changes will impact firms because of the large expense that has to be recorded

for accumulated OPEB obligations. Under FASB, the expense either can be recorded in

the year of adoption or be amortized. Our concern is the use of discounted PV in order to

calculate the above.

Impaired Loans

Under Section 3025, in loans that become impaired or restructured, the lender is to write

down the loan to its estimated realizable amount based on expected future cash flows.

Losses are included in the income statement and the carrying value of impaired loans has

to be adjusted. This is a departure from the lower-of-cost-or-market rule.

Financial Instruments

Introduction

A financial instrument, under Section 3860, is, “any contract that gives rise to both a

financial asset and a financial liability or equity instrument of another party.”

Primary instruments include A/R, A/P, N/R, N/P, and debt and equity securities. Section

3860 does not explain how to value financial instruments; rather, it gives an information

perspective of financial instruments.

Valuation of Debt and Equity Securities

There are 3 categories into which debt securities and equity securities are classified

according to SFAS 115 of the FASB:

1-Held-to-Maturity—valued at amortized cost.

2-Trading—valued at fair value; unrealized gains or losses included in income.

3-Available-for-Sale—valued at fair value; unrealized gains or losses included in other

comprehensive income.

There are 2 problems with the above; gains trading, in which firms sell securities that

have risen in order to realize the gain while holding on to securities that have fallen, and

the unpredictability of net income reported. Firms are protected somewhat from risk by

natural hedging.

Derivative Instruments

Derivative instruments are contracts such as options and interest rate caps and floors.

Their value depends on an underlying variable such as price, interest rate, exchange rate,

etc.

Derivatives are difficult to deal with as they are characterized by low initial investment.

Thus there is little or no cost to account for, meaning that all or part of the contract is off-

balance sheet.
The requirements of fair value information, terms and conditions, as well as credit risk

information are therefore important. Accounting for derivatives is that of a measurement

perspective. For balance sheet purposes, all derivatives must be measured at fair value

with the changes in fair value reflected in net income.

The Black/Scholes (1973) pricing model for options, based on 5 variables, is commonly

used for non-traded derivatives.

Hedge Accounting

Hedging occurs when a firm that has a risky asset, acquires a hedging instrument (asset or

liability) in an effort to offset the hedged item’s gain or loss. The hedging instrument’s

value should move in the opposite direction of the hedged item, but it may not be entirely

effective, so the risk associated with this is called basis risk.

Matching is an important concern, as hedge accounting wants to have the gains and

losses in the same period. Changes have occurred, under SFAS 133, regarding hedge

accounting. Gains and losses on fair value hedges (hedges on existing assets and

liabilities) are included in current earnings. Gains and losses on cash flow hedges,

(hedges on projected transactions), are included in other comprehensive income.

Reporting on Risk

Beta Risk

Since beta and other accounting-based risk measures are correlated, financial-statement-

based risk measures could reflect a change in beta, faster than the market model. Beaver,

Kettler and Scholes(BKS) tested this relationship and their findings support the above
claim. Others have tested this relationship and the conclusions reached by them seem to

corroborate with that of BKS.

Stock Market Reaction to Other Risks

Barth, Beaver and Landsman looked at the effects on banks of supplemental fair-value

disclosure on the market value of equity. The effect on savings and loan associations of

interest rate risk of derivatives-based hedging has also been examined by Schrand. The

results of both studies showed that the market is more sensitive to interest rate risk than to

beta. In addition, the size of the market response is affected by natural hedging and

derivatives hedging.

Wong looked at the foreign exchange risk of manufacturing firms, but was unable to

explain the size of the sensitivity.

A Measurement Perspective on Risk Reporting

The risk disclosure requirements established by the SEC include quantitative price risk

disclosures. The 3 forms of these disclosures are tabular presentation, sensitivity analysis

and value at risk. The last 2 forms are measurement oriented while the first is

information-perspective-oriented. The latter 2 have the greater decision usefulness

potential as firms prepare their quantitative risk assessments and they will have the most

accurate risk information for themselves.

 Appendix A

EXAMPLE 1:

Assume a discount rate of 10%.

STATE INCOME PROBABILITY

BAD $100 0.50
GOOD $200 0.50

PA0= 0.5[100/1.10 + 200/1.10] + 0.5[100/1.102 + 200/1.102] = 260.33

Assume Bad year took place in year one.

PA1= 0.5[110/1.10 + 100/1.10] + 0.5[110/1.10 + 200/1.10] = 236.36

Assume Good year took place in year one.

PA1= 0.5[220/1.10 + 100/1.10] + 0.5[220/1.10 + 200/1.10] = 336.36

The Market Value of a firm can be calculated by:

PAt = bvt + gt t = year

bvt= bv of firm’s asset at time t
gt= expected value of future abnormal earnings (goodwill)

Nb- For this formula to work properly, all gains and losses must be reported through the
income statement.

As from Chapter 5, abnormal returns are calculated by:

Abnormal Returns= Actual Earnings [OXt]- Expected Earnings [OXta]

Therefore, we arrive at the formula:

OXta= OXt - Rf bvt-1

Abnormal returns for the Bad year are:

PV1-PV0= 236.66-260.33= -23.97= OX1
OX1a= OX1 - Rf bv0= -23.97 - 0.10[260.33]= -50.00

Abnormal returns for the Good year are:

PV1-PV0= 336.66-260.33= 76.03= OX1
OX1a= OX1 - Rf bv0=76.03 - 0.10[260.33]= -50.00
Since the probabilities of the good and bad states are the same, goodwill is calculated as
follows:
g1= 0.5[50.00] + 0.5[-50.00]= 0

then by substitution, PA1= 236.66 + 0 =236.66. Thus, in this example there is no

persistence of abnormal earnings and good will. Zero goodwill is a special case of the
F & O study called unbiased accounting. When this occurs, all of the firm value will
appear on the balance sheet.

EXAMPLE 2:

Assume now a persistence coefficient of 0.40. We know from the previous example that
if the Bad states occurs OX1 = -50.00. With a persistence coefficient of 0.40, 40% of that
–50.00 will reduce next years’ earnings.

At Year 1, the PV of remaining future cash flows (assuming the bad state in year 1)

PA = 0.50 [100/1.10 + 200/1.10] = 136.36

Therefore, the amortization expense for year one is 123.97 [ 260.33-136.36]. Similarly
amortization expense for year two is zero.

Therefore, we can calculate PA1 as follows:

PA1= 0.5/1.10 [ 110 – 0.40(50.00) + 100] + 0.5/1.10 [ 110 – 0.40(-50.00) +200]= 218.18

Reduction of earning due to persistence.

Previous PA = 236.36
Current PA = 218.18
18.18 = PV of the 20.00 [ 40% of 50.00]

Thus, F & O show that a firms’ goodwill can be expressed in terms of current years
abnormal income.

PAt= bvt + [ OXta ] where is the Capitalization factor.

= w/[ 1+ Rf]

For t=1 ( assuming bad state)

Cash on hand $100
BV of Asset 136.36 [260.33-123.97]
bvt 236.36
Therefore we can now calculate Pa1 by

PA1 = 236.66 + 0.40/[1+.10][-50.00] = 218.18

EXAMPLE 3:

Assumptions (all numbers in millions):

Bombardier 1997 Net income: $537.4
January 31, 1997 BV 2456.0
January 31, 1996 BV 1931.10
1997 ROE* 0.278 [ 537.4 / 1931.1]
* assume it will continue for the next seven years
1997 Preferred and Common Dividends 71.10
Dividend Payout Ratio* 0.132 [ 71.1 / 537.4]
* assume it will continue for the next seven years

CAPM equation: E[Rjt] = Rf [1- Bj] + Bj E[Rmt]

j= specific firm notation, Bombardier

t= 1997
Rf = 0.04
E[Rmt] = 0.11, Actual return on TSE for January 31, 1998
Bombardier Beta = 1.2

E[Rjt] = 0.04 [1-1.2] + 1.2[0.11] = 0.124

bvt+1= bvt + NIt+1 – dt=1

dt = k [NIt] , where d = dividends and k = dividend payout ratio. Therefore the above
formula can be substituted with the dt formula and arrive at:

bvt+1= bvt + (1-k) NIt+1 and substituting ROE bvt+1= bvt +[1 + (1-k) ROE ]

bv98 = 2456.0 + [ 1 + (1-.132)(.278)] = $3048.00

Similarly,
bv99= 3783.00
bv00= 4695.00
bv01= 5826.00
bv02= 7230.00
bv03= 8972.00

Expected earnings = Cost of Capital * Opening BV

Actual earnings = ROE * Opening BV

Abnormal Earnings 98 = OX98a= [ROE – E[Rj] ] * bv97 = 0.278-.124= 378.2

Similarly.
OX99a= 469.4
OX00a= 582.6
OX01a= 723.0
OX02a= 897.2
OX03a= 1,113.4
OX04a= 1,381.7

Now we can calculate the PV of abnormal earnings,

g97= 378.2/1.124 + 469.4/1.1242 + … +1381.7/1.1247 = 3,233.4

Now we can calculate the PA97 = bvt + gt = 2,456.0 + 3,233.4 = 5,689.4

 Chapter 6 Quiz

1. Define and contrast statistical and practical significance.

2. a) To what does Lev attribute low market share for net income?

b) What evidence, presented by Collings, Kothari, Shanken, and Sloan (1994)

supports Lev’s claim?
c) What implications did their findings have for the measurement perspective?

3. Explain the implications of persistence considerations on the Clean Surplus Theory

(F&O) and relate it to ERC. Include a definition of goodwill in terms of abnormal
earnings.

4. How can the measurement perspective help auditors deal with the pressure of legal
liability?

5. What could some of the disadvantages be of using the measurement

perspective?

6. Despite the historical-cost orientation of financial statements, many instances of the

use of fair value can still be found. Name and expand upon or give an example for 3
of these.

7. According to Section 3025, what accounting actions are necessary when a loan
becomes impaired or restructured?

8. a) What are the 3 categories that debt and equity securities are classified into (SFAS
115) and how is each one valued?

b) Name one of the problems associated with these classifications.

9. What were the results of the Barth, Beaver and Landsman and Schrand studies
regarding market reaction to other risks?

10. What are the 3 forms of SEC quantitative price risk disclosures, and what are the
orientations of each.
 Chapter 6 Quiz Answers

1. Statistical Significance – occurs when data shows deviation from a baseline reading.
Practical Significance – occurs when the data shows statistical significance but lacks
any strong implication for the marketplace.

2. a) Lev attributes low “market share” to poor earnings quality

b) CKSS showed that this is due to a lack of timeliness of historical cost based
earnings
c) Their research illustrated that an improvement could be made in earnings quality
by introducing a measurement perspective to financial statements.

3. Once persistence is introduced, goodwill – the expected present value of future

abnormal earnings – is no longer 0. It is possible that the effects of state realization
will continue into future periods, at a portion of their current-year amount, and this
amount is captured by ‘w’. However, since ‘w’ is always between 0 and 1, any
specific abnormal earnings amount will dissipate over the long run. The addition of
persistence also means that the income statement now has information value, as it will
reveal abnormal earnings that will persist. It also suggests that this is important to
investors for assessment, as there is now a future firm performance implication. The
greater the abnormal earnings persistence is, i.e. The higher the value of ‘w’, the
higher earnings response coefficients (ERCs) are.

4. Due to the significant failures of some large firms, auditors are under increased
pressure to report more relevant information. This can be achieved by introducing
more fair value figures into financial statements, to provide better indicators of future
performance than may be had with historical cost statements. This could remove the
liability and accusations placed on auditors now when clean audit opinions, based on
historical figures, don’t predict a subsequent major disaster in the firm.

5. Using more fair value figures increases the amount of estimation necessary in
financial statements, and could cause decreased reliability.

6. An impaired or restructured loan has to be written down to its estimated realizable

amount based on expected future cash flows. The carrying value is adjusted and
losses are included in the income statement.

7. The 3 classifications are:

1-Held-to-Maturity—valued at amortized cost.

2-Trading—valued at fair value.
3-Available-for-Sale—valued at fair value.
Problems: Either of: gains trading and the unpredictability of net income reported.
8. Both the Barth, Beaver and Landsman and Schrand studies showed that the market is
more sensitive to interest rate risk than to beta, and also that the size of the market
response is affected by the natural hedging and derivatives hedging.

9. The 3 forms of these disclosures are tabular presentation, sensitivity analysis and value
at risk. Tabular presentation is information perspective oriented; sensitivity analysis
and value at risk are measurement oriented.

10. Any 3 out of the 5:

Accounts Receivable and Payable – listed at net realizable value.
Cash Flows fixed by contract – eg. issuance of long term debt or lease agreements.
Lower-of-cost-or-market rule – when market values fall below book values, they are
required to be written down to market (Section 3010); they can’t be written up again.
Ceiling tests for Capital Assets – must be written down (Section 3060) when the net
recoverable amount is lower than the net carrying value.
Push Down Accounting – when all or virtually all of a firm is acquired at arms
length, the assets and liabilities of the acquired entity are revalued recorded on the
books of the acquired entity.