THEORIES) ) )
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THEORIES) # Sets#of#ideas#used#to#explain#and#understand#real#world#observations# • Easier#forecasting#thus#planning#if#circumstances#change# • Better#understand#and#predict#outcomes#under#certain#scenarios/conditions# • Understand#how#groups#will#react#if#regulations#change/introduced# # TIMELINE) # # 1800)$)1955:)General)Scien8fic)Period# 1956)$)1970:)Norma8ve)Theory# Pre$Theory)Period) Separate#ownership#&#control,#theory# Driven#by#infla*on;#develped#best# # Ad#hoc#accoun*ng# developed#through#observing#prac*ces# prac*ce#with#focus#on#beAer# prac*ces,#double# ) but#no#explana*on#as#to#why#prac*ces# valua*on#measures#and#'true# enrty#book6keeping# were#chosen# income'# ) ) TODAY:)Renewed#focus#on#valuation#and#‘fair#value’# ) Positive)vs.)Normative) Normative#theories#prescribe# • Bayes’#Theorem:#rational#decision#makers#should#use## # Positive#theories#explain#or#predict# • Empirical#and#based#on#real6world#observations#
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1970)$)Present:) Posi8ve)Accoun8ng) Theory# Reliance#on#emprical# appraoch#
INFORMATION)ASYMMETRY) # Where#one#party#to#a#transaction#has#an#information#advantage#over#another# • FAT#explains#how,#when,#and#why#IA#is#minimised# o Financial#accounting#is#a#device#to#reduce#IA# o Should#capture#substance#of#transactions# # Extreme#IA#leads#to#collapse#of#financial#markets# • Risk#too#high#for#investors# • Firms#find#it#harder#to#raise#capital# • Inefficient#allocation#of#resources:#increased#cost#of#capital#is#not#socially#optimal# # Adverse)Selection) Where#one#party#to#a#transaction#has#an#information#advantage#over#another#before#the#transaction# is#entered#into# • Example:#Hiring#new#employees# o Mitigate#through#application#process:#finding#more#information# # For#financial#markets# • Efficient#markets:#no#adverse#selection#between#investors,#but#there#is#insider#information# • No#ideal#conditions#of#accounting,#so#financial#statements#do#not#show#true#income# • Need#additional,#decision6useful#information#to#assist#rational#investors# • Investors#are#Bayesian#and#use#information#to#update#prior,#subjective#probabilities# o Decision6useful#information#will#be#informative#and#increase#main#diagonals# • Information#should#be#relevant#and#reliable# o Information#Perspective:#Historical#Accounting# ! Assumes#efficient#market# ! Issues# • Behavioural#biases# • Market#anomalies# o Measurement#Perspective:#Fair#value#Accounting# ! Market#is#inefficient# ! Issues# • Volatility#in#earnings#and#information#is#not#reliable# # Moral)Hazard) Where#one#or#more#parties#to#a#transaction#can#observe#their#actions#in#fulfilment#of#the#contract# following#the#transaction,#but#others#cannot# • Occurs#because#of#separation#of#ownership#and#control# • Shareholders/creditors#cannot#directly#observe#management#effort# • Example:#Employee#shirks#after#signing#employment#contract# o Mitigate#through#probationary#periods,#KPIs#inserted#into#contract# • Where#agency#relationships#exist,#agent#has#private#incentives#not#to#work#in#best#interests# of#principal# o Management#and#debtholders#and#shareholders# o Management#remuneration#can#be#tied#to#reported#net#income#to#motivate# managers#to#work#hard# o Management#has#interest#in#measurement#of#reported#net#income#as#this#affects# their#remuneration# o Incentives#to#manage#earnings#
IDEAL)CONDITIONS) ) Theoretically)Ideal) • Future#economic#prospects#fully#disclosed:#RELEVANT# • Information#is#precise#and#free#from#bias:#RELIABLE# o In#real#life,#there#are#random#and#systematic#measurement#errors# ) Certainty) • Assumptions:# o Future#firm#cash#flows#known#by#everyone:#expected#profit#is#realised#profit# o Single#cost#of#capital#across#economy#known#to#everyone# o True#income#observable# • No#information#asymmetry#about#current#or#future#prospects# o Fair#value#will#be#market#value#as#market#is#fully#efficient# # Accounting#Under#Ideal#Conditions#of#Certainty# • Only#balance#sheet#required,#as#this#is#show#the#PV#of#total#assets#of#the#firms# o Income#statement#provides#no#additional#information,#as#accretion#of#discount#(the# only#and#true#income#of#the#firm)#can#be#calculated#using#the#balance#sheet#alone# • PV#is#value6in6use#=#discounted#future#net#cash#inflows# • Fair#value#will#be#present#value#in#this#case# o As#FV#is#MV,#the#value6in6use#(PV)#will#be#the#same#as#MV:#no#information# asymmetry#so#arbitrage#would#always#push#prices#to#efficient#level# o FV#also#known#as#exit#price#or#opportunity#cost# • Expected#net#income#is#realised#net#income# # Uncertainty) • Assumptions# o States#of#nature#complete#and#publicly#known# o State#probabilities#known/objective# o State#realisation#observable# # Accounting#Under#Ideal#Conditions#of#Uncertainty# • Expected#income#not#equal#to#realised#net#income# o But#as#realised#states#are#observable,#true#income#is#observable## • Net#income#is#predictable#conditional#on#the#state#of#nature,#so#income#statement#has#no# additional#content#to#the#balance#sheet# # Results) • ‘Perfectly’#reliable#&#relevant#FS#that#completely#eliminate#IA# • Dividend#irrelevancy#as#only#a#single#rate#of#return,#investors#and#firms#generate#same#return# • Impossible#but#provides#framework#for#theoretical#discussion#and#assessing#current#practices# • Present#value#basis#for#accounting# o Income#recognition#occurs#as#changes#in#present#value#occur# # Lack)of)Ideal)Conditions) In#the#real#world:# • State#probabilities#are#subjective:#investors#know#their#predictions#are#subject#to#error,#and# will#thus#be#alert#to#information#sources#that#enable#them#to#revise#probabilities# o Income#statement#is#one#source,#so#it#has#a#use#in#the#real#world# o True#income#cannot#be#observed#
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Markets#are#incomplete,#so#measurement#perspective#cannot#be#implemented#completely# and#the#balance#sheet#does#not#reveal#everything# o Market#value#may#not#exist## o Thin#or#inefficient#markets# Need#for#estimates#of#states#of#nature,#and#state#probabilities# Incomplete#set#of#states# Market#value#will#not#be#equal#to#present#value# Relevance#and#reliability#face#a#trade6off,#as#both#cannot#exist#fully#at#once#
# Reserve#Recognition#Accounting# • Application#of#present#value#accounting#when#ideal#conditions#do#not#exist# • Applies#to#oil#and#gas#industry# • Mixture#of#historical#cost#and#fair#value#accounting# ) As#ideal#conditions#do#not#exist,#we#need#to#consider#how#users#make#financial#decisions#and#what# will#be#useful#to#them## )
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DECISION)USEFULNESS:)MITIGATING)ADVERSE)SELECTION)RISK) # The#user#perspective#or#valuation#objective:#want#information#in#order#to#value#a#firm’s#stock# # How)are)investment)decisions)made?) • Specify#states# • Specify#probability#of#states# • Specify#payoff#conditional#on#the#states# • Specify#risk# • Gather#information?#Update#your#priors?# • Make#a#decision## # Decision)Usefulness)Approach) • Since#we#can’t#prepare#theoretically#correct#financial#statements,#at#least#the#role#of# financial#reporting#is#to#supply#information#that#is#useful#for#this#purpose.## • To#prepare#useful#information,#accountant#must#know#investor’s#decision#needs# • Understand#how#investors#make#decisions#will#help#with#the#point#above# • Deducing#information#needs#of#users#by#studying#their#decision#problems# #
Rational)Decision)Theory)Model)
# Role#of#rational#decision#theory#model#in#financial#reporting:# • Understand#how#FS#assist#with#investment#decisions# • Captures#average#investor#behaviour# # Single)Person)Decision)Theory) Formal#model#of#rational#decision#making# • Acknowledges#that#people#make#decisions#under#uncertainty# • Recognises#that#state#probabilities#are#not#objective# • Information#is#evidence#that#has#the#potential#to#affect#an#individual#decision# • Models#how#investors#update#their#subjective#beliefs#of#future#firm#payoff# • Consider#the#investor’s#utility#function:#rational#investors#will#choose#the#alternative#with#the# highest#expected#utility# o Investors#are#assumed#to#be#risk6averse:#declining#marginal#utility#of#wealth,#concave# utility#function# o Utility#is#a#function#of#risk#and#return,#so#investors#will#want#information#about#both# # Bayes’)Theorem) Formal#model#used#to#revise#probabilities#on#the#receipt#of#new#information# • Understanding#how#new#evidence#affects#the#probability#that#a#theory#is#true# # The#below#equation#gives#posterior#probabilities#of#θ# # P θ P(m|θ) P θ|m = # P m|θ P θ # θ = state!of!nature, m = new!evidence, P θ = prior!subjective!probability!of!θ# # #
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The#higher#the#main#diagonal#probabilities,#the#better#the#investor#can#predict#the#state#of# nature#(i.e.#future#firm#performance#–#this#relates#to#earnings#quality)# o Main#diagonal#probabilities#capture#financial#statement#informativeness# o Under#ideal#conditions,#main#diagonal#probabilities#=#1,#since#the#information#in#FS# tells#investors#what#the#value#of#the#firm#is#and#what#the#future#payoffs#of#the#firm# are#going#to#be,#there#is#no#noise# o Highly#informative#financial#statements:#transparent,#precise,#high#quality# Information#system#probabilities#are#objective#(the#table#with#4#different#probabilities#=# giving,#conditional#on#each#state#of#nature,#the#objective#probability#of#each#possible# financial#statement#evidence#item),#reflect#quality#of#standard#setters# Prior#probabilities#are#subjective# o Thus#posterior#probabilities#are#also#subjective,#but#if#information#is#informative,# posterior#probabilities#will#be#better#predictors#of#future#firm#performance# Off6diagonal#probabilities:#the#greater#they#are,#the#higher#the#noise,#lower#the#earnings# quality# o Noise:#information#system#doesn’t#have#much#explanatory#force# o Weak#relationship#between#new#information#and#future#firm#performance# FS#are#an#input#for#predicting#investment#returns,#hence#influences#investment#decisions# o Current#period#earnings#provides#information#to#predict#future#periods’#earnings,# which# o Provide#information#to#develop#expectations#about#dividends#in#future#periods,# which# o Provide#information#to#determine#share#value#–#PV#(expected#future#D)#
# (A#way#to#improve#relevance#without#sacrificing#reliability#would#be#through#supplementary)current) value)information#e.g.#RRA)# # If#we#use#conservatism#in#our#accounting,#then#BN|L#is#higher#than#GN|H#(since#losses#need#lower# standard#of#verification#than#gains)# # Note:#how#to#determine#the#information#system#probabilities:# • Use#research#e.g.#gather#past#data# • See#analyst#revision#(revision#coefficient)#of#their#forecast#after#earnings#announcement# o The#revision#coefficient#is#a#proxy#for#the#average#earnings#quality#of#their#sample# firms# o Reflects#the#magnitude#of#the#information#system#probabilities# o This#is#also#a#way#to#evaluate#information#system#informativeness## # Professional)Accounting)Bodies)and)the)Rational)Decision)Theory)(draft)IASB)Conceptual) Framework)) • Oriented#to#investors’#decisions#(primary#user#group)# • Framework#adopts#entity#view#=#financial#reports#reflect#the#perspective#of#the#entity#rather# than#the#perspective#of#entity’s#shareholders# • Accepts#that#investors#are#risk#averse,#BS#is#paramount#(current#value#accounting)# • FS#provide#information#to#help#investors#assess#(posterior#probabilities#of)#amount,#timing,# and#uncertainty#of#investment#proceeds,#which#implies#Bayes’#Theorem# o Expected#future#payoffs#important#–#accounting#information#need#to#provide#linkage# between#current/past#performance#and#future#prospects#(linked#through#the# information#system#probabilities)# • Role#of#accruals#in#the#Framework#is#to#help#predict#future#CF# • Accounting#information#should#be#relevant#and#reliable#(faithfully#represented)#
THEORIES) # Sets#of#ideas#used#to#explain#and#understand#real#world#observations# • Easier#forecasting#thus#planning#if#circumstances#change# • Better#understand#and#predict#outcomes#under#certain#scenarios/conditions# • Understand#how#groups#will#react#if#regulations#change/introduced# # TIMELINE) # # 1800)$)1955:)General)Scien8fic)Period# 1956)$)1970:)Norma8ve)Theory# Pre$Theory)Period) Separate#ownership#&#control,#theory# Driven#by#infla*on;#develped#best# # Ad#hoc#accoun*ng# developed#through#observing#prac*ces# prac*ce#with#focus#on#beAer# prac*ces,#double# ) but#no#explana*on#as#to#why#prac*ces# valua*on#measures#and#'true# enrty#book6keeping# were#chosen# income'# ) ) TODAY:)Renewed#focus#on#valuation#and#‘fair#value’# ) Positive)vs.)Normative) Normative#theories#prescribe# • Bayes’#Theorem:#rational#decision#makers#should#use## # Positive#theories#explain#or#predict# • Empirical#and#based#on#real6world#observations#
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1970)$)Present:) Posi8ve)Accoun8ng) Theory# Reliance#on#emprical# appraoch#
INFORMATION)ASYMMETRY) # Where#one#party#to#a#transaction#has#an#information#advantage#over#another# • FAT#explains#how,#when,#and#why#IA#is#minimised# o Financial#accounting#is#a#device#to#reduce#IA# o Should#capture#substance#of#transactions# # Extreme#IA#leads#to#collapse#of#financial#markets# • Risk#too#high#for#investors# • Firms#find#it#harder#to#raise#capital# • Inefficient#allocation#of#resources:#increased#cost#of#capital#is#not#socially#optimal# # Adverse)Selection) Where#one#party#to#a#transaction#has#an#information#advantage#over#another#before#the#transaction# is#entered#into# • Example:#Hiring#new#employees# o Mitigate#through#application#process:#finding#more#information# # For#financial#markets# • Efficient#markets:#no#adverse#selection#between#investors,#but#there#is#insider#information# • No#ideal#conditions#of#accounting,#so#financial#statements#do#not#show#true#income# • Need#additional,#decision6useful#information#to#assist#rational#investors# • Investors#are#Bayesian#and#use#information#to#update#prior,#subjective#probabilities# o Decision6useful#information#will#be#informative#and#increase#main#diagonals# • Information#should#be#relevant#and#reliable# o Information#Perspective:#Historical#Accounting# ! Assumes#efficient#market# ! Issues# • Behavioural#biases# • Market#anomalies# o Measurement#Perspective:#Fair#value#Accounting# ! Market#is#inefficient# ! Issues# • Volatility#in#earnings#and#information#is#not#reliable# # Moral)Hazard) Where#one#or#more#parties#to#a#transaction#can#observe#their#actions#in#fulfilment#of#the#contract# following#the#transaction,#but#others#cannot# • Occurs#because#of#separation#of#ownership#and#control# • Shareholders/creditors#cannot#directly#observe#management#effort# • Example:#Employee#shirks#after#signing#employment#contract# o Mitigate#through#probationary#periods,#KPIs#inserted#into#contract# • Where#agency#relationships#exist,#agent#has#private#incentives#not#to#work#in#best#interests# of#principal# o Management#and#debtholders#and#shareholders# o Management#remuneration#can#be#tied#to#reported#net#income#to#motivate# managers#to#work#hard# o Management#has#interest#in#measurement#of#reported#net#income#as#this#affects# their#remuneration# o Incentives#to#manage#earnings#
IDEAL)CONDITIONS) ) Theoretically)Ideal) • Future#economic#prospects#fully#disclosed:#RELEVANT# • Information#is#precise#and#free#from#bias:#RELIABLE# o In#real#life,#there#are#random#and#systematic#measurement#errors# ) Certainty) • Assumptions:# o Future#firm#cash#flows#known#by#everyone:#expected#profit#is#realised#profit# o Single#cost#of#capital#across#economy#known#to#everyone# o True#income#observable# • No#information#asymmetry#about#current#or#future#prospects# o Fair#value#will#be#market#value#as#market#is#fully#efficient# # Accounting#Under#Ideal#Conditions#of#Certainty# • Only#balance#sheet#required,#as#this#is#show#the#PV#of#total#assets#of#the#firms# o Income#statement#provides#no#additional#information,#as#accretion#of#discount#(the# only#and#true#income#of#the#firm)#can#be#calculated#using#the#balance#sheet#alone# • PV#is#value6in6use#=#discounted#future#net#cash#inflows# • Fair#value#will#be#present#value#in#this#case# o As#FV#is#MV,#the#value6in6use#(PV)#will#be#the#same#as#MV:#no#information# asymmetry#so#arbitrage#would#always#push#prices#to#efficient#level# o FV#also#known#as#exit#price#or#opportunity#cost# • Expected#net#income#is#realised#net#income# # Uncertainty) • Assumptions# o States#of#nature#complete#and#publicly#known# o State#probabilities#known/objective# o State#realisation#observable# # Accounting#Under#Ideal#Conditions#of#Uncertainty# • Expected#income#not#equal#to#realised#net#income# o But#as#realised#states#are#observable,#true#income#is#observable## • Net#income#is#predictable#conditional#on#the#state#of#nature,#so#income#statement#has#no# additional#content#to#the#balance#sheet# # Results) • ‘Perfectly’#reliable#&#relevant#FS#that#completely#eliminate#IA# • Dividend#irrelevancy#as#only#a#single#rate#of#return,#investors#and#firms#generate#same#return# • Impossible#but#provides#framework#for#theoretical#discussion#and#assessing#current#practices# • Present#value#basis#for#accounting# o Income#recognition#occurs#as#changes#in#present#value#occur# # Lack)of)Ideal)Conditions) In#the#real#world:# • State#probabilities#are#subjective:#investors#know#their#predictions#are#subject#to#error,#and# will#thus#be#alert#to#information#sources#that#enable#them#to#revise#probabilities# o Income#statement#is#one#source,#so#it#has#a#use#in#the#real#world# o True#income#cannot#be#observed#
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Markets#are#incomplete,#so#measurement#perspective#cannot#be#implemented#completely# and#the#balance#sheet#does#not#reveal#everything# o Market#value#may#not#exist## o Thin#or#inefficient#markets# Need#for#estimates#of#states#of#nature,#and#state#probabilities# Incomplete#set#of#states# Market#value#will#not#be#equal#to#present#value# Relevance#and#reliability#face#a#trade6off,#as#both#cannot#exist#fully#at#once#
# Reserve#Recognition#Accounting# • Application#of#present#value#accounting#when#ideal#conditions#do#not#exist# • Applies#to#oil#and#gas#industry# • Mixture#of#historical#cost#and#fair#value#accounting# ) As#ideal#conditions#do#not#exist,#we#need#to#consider#how#users#make#financial#decisions#and#what# will#be#useful#to#them## )
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DECISION)USEFULNESS:)MITIGATING)ADVERSE)SELECTION)RISK) # The#user#perspective#or#valuation#objective:#want#information#in#order#to#value#a#firm’s#stock# # How)are)investment)decisions)made?) • Specify#states# • Specify#probability#of#states# • Specify#payoff#conditional#on#the#states# • Specify#risk# • Gather#information?#Update#your#priors?# • Make#a#decision## # Decision)Usefulness)Approach) • Since#we#can’t#prepare#theoretically#correct#financial#statements,#at#least#the#role#of# financial#reporting#is#to#supply#information#that#is#useful#for#this#purpose.## • To#prepare#useful#information,#accountant#must#know#investor’s#decision#needs# • Understand#how#investors#make#decisions#will#help#with#the#point#above# • Deducing#information#needs#of#users#by#studying#their#decision#problems# #
Rational)Decision)Theory)Model)
# Role#of#rational#decision#theory#model#in#financial#reporting:# • Understand#how#FS#assist#with#investment#decisions# • Captures#average#investor#behaviour# # Single)Person)Decision)Theory) Formal#model#of#rational#decision#making# • Acknowledges#that#people#make#decisions#under#uncertainty# • Recognises#that#state#probabilities#are#not#objective# • Information#is#evidence#that#has#the#potential#to#affect#an#individual#decision# • Models#how#investors#update#their#subjective#beliefs#of#future#firm#payoff# • Consider#the#investor’s#utility#function:#rational#investors#will#choose#the#alternative#with#the# highest#expected#utility# o Investors#are#assumed#to#be#risk6averse:#declining#marginal#utility#of#wealth,#concave# utility#function# o Utility#is#a#function#of#risk#and#return,#so#investors#will#want#information#about#both# # Bayes’)Theorem) Formal#model#used#to#revise#probabilities#on#the#receipt#of#new#information# • Understanding#how#new#evidence#affects#the#probability#that#a#theory#is#true# # The#below#equation#gives#posterior#probabilities#of#θ# # P θ P(m|θ) P θ|m = # P m|θ P θ # θ = state!of!nature, m = new!evidence, P θ = prior!subjective!probability!of!θ# # #
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The#higher#the#main#diagonal#probabilities,#the#better#the#investor#can#predict#the#state#of# nature#(i.e.#future#firm#performance#–#this#relates#to#earnings#quality)# o Main#diagonal#probabilities#capture#financial#statement#informativeness# o Under#ideal#conditions,#main#diagonal#probabilities#=#1,#since#the#information#in#FS# tells#investors#what#the#value#of#the#firm#is#and#what#the#future#payoffs#of#the#firm# are#going#to#be,#there#is#no#noise# o Highly#informative#financial#statements:#transparent,#precise,#high#quality# Information#system#probabilities#are#objective#(the#table#with#4#different#probabilities#=# giving,#conditional#on#each#state#of#nature,#the#objective#probability#of#each#possible# financial#statement#evidence#item),#reflect#quality#of#standard#setters# Prior#probabilities#are#subjective# o Thus#posterior#probabilities#are#also#subjective,#but#if#information#is#informative,# posterior#probabilities#will#be#better#predictors#of#future#firm#performance# Off6diagonal#probabilities:#the#greater#they#are,#the#higher#the#noise,#lower#the#earnings# quality# o Noise:#information#system#doesn’t#have#much#explanatory#force# o Weak#relationship#between#new#information#and#future#firm#performance# FS#are#an#input#for#predicting#investment#returns,#hence#influences#investment#decisions# o Current#period#earnings#provides#information#to#predict#future#periods’#earnings,# which# o Provide#information#to#develop#expectations#about#dividends#in#future#periods,# which# o Provide#information#to#determine#share#value#–#PV#(expected#future#D)#
# (A#way#to#improve#relevance#without#sacrificing#reliability#would#be#through#supplementary)current) value)information#e.g.#RRA)# # If#we#use#conservatism#in#our#accounting,#then#BN|L#is#higher#than#GN|H#(since#losses#need#lower# standard#of#verification#than#gains)# # Note:#how#to#determine#the#information#system#probabilities:# • Use#research#e.g.#gather#past#data# • See#analyst#revision#(revision#coefficient)#of#their#forecast#after#earnings#announcement# o The#revision#coefficient#is#a#proxy#for#the#average#earnings#quality#of#their#sample# firms# o Reflects#the#magnitude#of#the#information#system#probabilities# o This#is#also#a#way#to#evaluate#information#system#informativeness## # Professional)Accounting)Bodies)and)the)Rational)Decision)Theory)(draft)IASB)Conceptual) Framework)) • Oriented#to#investors’#decisions#(primary#user#group)# • Framework#adopts#entity#view#=#financial#reports#reflect#the#perspective#of#the#entity#rather# than#the#perspective#of#entity’s#shareholders# • Accepts#that#investors#are#risk#averse,#BS#is#paramount#(current#value#accounting)# • FS#provide#information#to#help#investors#assess#(posterior#probabilities#of)#amount,#timing,# and#uncertainty#of#investment#proceeds,#which#implies#Bayes’#Theorem# o Expected#future#payoffs#important#–#accounting#information#need#to#provide#linkage# between#current/past#performance#and#future#prospects#(linked#through#the# information#system#probabilities)# • Role#of#accruals#in#the#Framework#is#to#help#predict#future#CF# • Accounting#information#should#be#relevant#and#reliable#(faithfully#represented)#
