Part 1: Adverse selection

Transcription

1 Part 1: Adverse selection Context Utimate goal --- to make financial statements as useful as possible... 2 Ultimate trade off --- the relevance and reliability trade off... 2 Historic cost accounting... 3 General... 3 Relevance and reliability... 3 Revenue recognition... 3 Recognition lags... 3 Matching... 3 Fair value accounting... 4 General... 4 Revenue recognition principle... 4 Recognition lag... 4 Matching... 4 Trade-off... 4 General... 4 Chapter Assumption... 5 RRA... 5 No need for income statement in ideal condition... 5 Non-existence of true income... 5 Week Week General... 7 Implication to financial reports... 7 Learning objective... 7 M D&A... 7 Key term... 7 Market model... 7 Abnormal returns... 7 Unexpected earnings... 7 Event study (associated difficulties)... 8 Earnings response coefficients... 8 Persistent/transitory earnings...ошибка! Закладка не определена. Week Inefficient market Not-rational investors... 10

2 Limited arbitrage Evidence...Ошибка! Закладка не определена. Week Behavior biases Over-confidence Self-attribution biases Limited attention Law of small numbers Evidence of market inefficient Dead beta Excess stock market volatility Rationale Fact Suggested reasons People can earns abnormal return Beta not the sole explanatory factors Efficient Market anomalies Post announcement drift Accruals Conclusion of market efficiencyin the short run, market is efficient (i.e. when there is earnings announcement, price reacts instantaneously) ---FAMA s findings Implications Utimate goal to make financial statements as useful as possible Definition of decision usefulness: 1. Decision useful means informativeness. Information is useful if that information causes revision of priors about future outcome. (i.e. share price reaction) Ultimate trade off the relevance and reliability trade off If the market is efficient, as long as full disclosure, the information will be relevant. So we want to increase the reliability of the information to increase the usefulness. So accountants will just supply information to investors to let them to estimate, avoiding estimation by ourselves to increase the reliability of information. (information perspective) If the market is not efficient (one reason to shift to measurement perspective), simply supply information, is not relevant, because investors are not able to use all that information to make them relevant for their decision making. So accountants better play a role in estimating the underlying performance of the firm because management has a comparative advantage over investors in determining the value of the firm.

3 Historic cost accounting General 1. (Ch 2.5.1) Belief: past performance is the best predictor of future performance. The firm s past and current earnings performance represents the foundation upon which projections of future earnings can be based. Thus, under historic cost accounting, income statement is the primary statement, balance sheet is largely interpreted as reporting asset costs waiting to be matched against unrealized future revenues and the capital incurred to acquire these assets. Matching principle is the key. Relevance and reliability 1. Reliable a) Verifiable numbers. 2. Less relevant a) Market value at the acquisition date cannot explain the firm s prospect well. b) Recognition lag c) Market value change over time. Revenue recognition 1. Revenue is recognized when transactions with external party occur. Recognition lags 1. Definition: the extent to which the timing of revenue recognition lags behind the changes in real economic value. 2. Large recognition lag. Matching 1. Primary, since net income under historic cost accounting is a result of the matching of realized revenues with the costs of earning them. 2. Done through accruals. 3. Matching is not completely (perfect) reliable. (e.g. depreciation expense, estimate about the useful life and the salvage value need to be estimated. )

4 Fair value accounting Why?: The earnings is more volatile than historic cost. General 1. This measures the current values of asset and liabilities. Balance sheet is the primary statement, since its assets and liabilities have value that represents firm s future prospects. Income statement oriented to an explanation of the changes in assets and liabilities during the period. Matching principle is not that important. Revenue recognition principle 1. Revenue is recognized when change in current value occurs (i.e. economic event occurs) 2. Earlier recognition than historic cost. Recognition lag 1. Definition: the extent to which the timing of revenue recognition lags behind the changes in realeconomic value. 2. Little recognition lag. Why? Timing of the recognition is earlier. Matching 1. Not primary, since income is the change in current value of assets at two point in time. Trade- off between HC and FV 1. Look at the 2.17.c a) When switching to fair value accounting from historic cost accounting, if market price are available, the reliability may not decrease much. Because market may not be efficient, that market share price may not be reliable. Without market price, present value, estimates are unreliable. General 1. The information that does not affect the cash flows will not result in market reaction. Cash flows here means directly. 2. Steadily rising (for GN firms) and steadily falling (for BN firms) pattern of cumulative share returns shown in Figure Successful development of R&D will result in ERC>1 only under the condition of historic cost accounting. Under Fair value accounting, ERC = 1.

5 Week 2 Accounting under Ideal Condition Assumption Investors are risk neutral (P 40) n Then the market value will be the present value of future value not less. n The market value of the firm will be less to the extent that the investors are collectively risk- averse n and they will value the risky firm at less than its present value. Abnormal earnings in each period does not persist. Thus income statement has no information. When state probabilities are subjective, the income statement can provide information about what these probabilities are. Thus income statement has information. RRA RRA is a supplemental disclosure of financial statement in which its value is PV discounted at standardized measure. Provide investors about future CF than that contained in conventional historical cost based financial statements. RRA is more relevant than historic cost accounting but is not completely relevant, because it is not in the ideal world and market price is not available. The specification of interest rate and regulation reduces relevance, since the extent of the PV to predict future cash flows and risk is reduced. Improve accounting practices of oil and gas companies of natural resource reserves. No need for income statement in ideal condition As long as value of the net asset and the interest rate. True net income can be calculate. Ideal conditions certainity future cash flow of the firm and the interest rate in the economy are known. Non- existence of true income True income = change in the value of the net assets during a period, after adjustment of dividends. Can neither get income directly nor indirectly. Indirectly, get from change in market price. However, market is not complete, assets and liabilities do not have market price. Directly, get from present value, estimation of the present value need to be made. However, estimation is subject to errors and possible biases. Because the world is not ideal, the true income does not exist.

6 Income has different meanings under historic cost accounting and fair value accounting.