accounting theory & practice fall 2011_ch4

Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA1

Accounting Theory Accounting Theory & Practice (CCFC 514)& Practice (CCFC 514)

McGill University Continuing EducationCareer and Management Studies

Copyright: Accounting 455 (Winter 2011) Nicolino Iannotti, CA, CPA, CMA2

Chapter 4 Concept MapChapter 4 Concept Map


Adverse SelectionAdverse Selection People that have better information are at an

advantage when making business decisions As a result, all else being equal, the people with

better information will benefit at the expense of people with less information. Eg. Manipulating the timing of releasing important information, selectively release information to certain people (i.e. analysts, etc.)

How do we address Adverse Selection?– Provide a level playing field through full disclosure of

useful and cost effective information to investors and other financial statement users

– Information Approach (Chapter 3-5)

– Measurement Approach (Chapter 6-7).


Decision Theory modelDecision Theory model Decision based on prior probabilities without

analyzing any information other than past financial statements and other old news

What if current information is available on X Ltd and user is able to understand financial information and interpret the information as being positive or “Good News” which results in High Performance – This is referred to as posterior probabilities

since relevant information has been taken into account

GN/H = 0.8; BN/H =0.2 (if X is high-state firm) GN/L = 0.1; BN/L = 0.9 (if X is low-state firm;

conditional probabilities)


Decision theory modelDecision theory model Factors

– Acts: (e.g. which decision to take)– States of nature: (e.g. markets go up or markets

crashes)

– State probabilities In Chapter 2, we assumed that state probabilities were

objective and publicly known (i.e. chance of occurring is known based on past information)

In Chapter 3, state probabilities are subjective and are based on analysis of information

– Investors are either Risk Averse or risk neutral– Utility (or satisfaction) if risk averse = sq root of

payoff- Utility if risk neutral = to payoff


Decision Theory model Decision Theory model

Therefore revised state probabilities:P(H/GN) = P(H) x P(GN/H)

P(H) x (P(GN/H) + P(L) x P(GN/L)

P(H/GN) = 0.3 x 0.8 = 0.770.3 x 0.8 + 0.7 x 0.1

P(L/GN) = 0.23 (1.00 – 0.77)


The Information SystemThe Information SystemThe higher the main diagonal probabilities, the

better the investor can predict the state of nature (i.e., future firm performance)– The main diagonal probabilities capture financial

statement informativeness– Highly informative financial statements also called:

TransparentPreciseHigh quality


Efficient Securities MarketsEfficient Securities Markets Interaction of rational (risk averse) investors in a

securities market– Securities market = Exchange where securities (debt

or equity) are traded between parties Theory exists that financial markets are

“informationally efficient”– Securities prices reflect all known information, and

instantly change to reflect new information. – Where does this information come from?

Financial statements Press releases Media Analysts Tips/friends


Efficient Securities MarketsEfficient Securities MarketsMeaning of efficiency

– Is information really free in non-ideal conditions?

– How quickly is information processed and acted upon?

– Market is efficient when prices at all times fully reflect all publicly available information.

– Theory indicates that you cannot outperform the market in the long run in an efficient market

What about inside information?


Efficient Securities MarketsEfficient Securities MarketsMeaning of efficiency

– Efficiency is defined relative to a stock of information.

– If information is not complete, or accurate, the efficiency will not reflect real value


Accounting Implications of Securities Accounting Implications of Securities Market EfficiencyMarket Efficiency

Full disclosure is key so that investors have the same relevant information as management

Accounting policies do not matter since investors make necessary calculations to adjust for accounting policies which may show different results among companies

Financial information need not cater to the “Naïve” or “un-informed” investors because the majority of buy/sell decisions are made by knowledgeable investors – therefore price protection exists

Accountants in competition with other information providers to provide useful cost effective information– Financial statements are considered cost effective medium of

disclosure of financial information


The Informativeness of Share Price The Informativeness of Share Price

Fully informative share prices– No one would bother to gather information,

since can’t beat the market– If no one gathers information, share prices

will not reflect all publicly available information

– So it hence the logical inconsistency


The Informativeness of Share Price The Informativeness of Share Price

A way out of the logical inconsistency– Noise trading; investors buy/sell shares for

unpredictable reaseonsSecurity prices are said to be partially

informative in the presence of noise trading and rational expectations

Share prices still efficient, but in an expected value sense

Expected value of noise = 0


The Informativeness of Share PriceThe Informativeness of Share Price

Partially informative share prices– Share prices not fully informative since

market price may be “wrong” in presence of noise traders

– Share prices now only partially reflect publicly available information—they also reflect noise traders

– Investors now have an incentive to gather information because of noise traders


CAPITAL ASSET PRICING MODELCAPITAL ASSET PRICING MODEL Relationship between efficient market price of a

security, its risk and expected rate of return of a security– Capital Asset Pricing Model

E(Rjt) = Rf(1 - βj) + βjE(RMt)

– Reflects efficient market

– Risk-free asset (no risk)

– Only firm specific component is Beta Another way of looking at equation for

individual companies:


Capital Asset Pricing ModelCapital Asset Pricing ModelProvides important and useful way to model the

market’s expectation of a share’s returns and a firm’s cost of capital

Shows how new information affects current share price

In Equation (4.2), accounting information affects the numerator E(Pjt + Djt)

Thus Pj,t-1 (i.e., current share price) must change in the denominator of Equation 4.2 to keep E(Rjt) unchanged

Chapter 4, Problem 5 (page 137)


Information Asymmetry Information Asymmetry The fundamental value of a share

– The value of a firm’s share on an efficient market if all information about the firm is publicly available (i.e., no inside information)

Inside information– Information about the firm that is not

publicly available


Information Asymmetry (continued)Information Asymmetry (continued)

The adverse selection problemInsiders may exploit their information

advantage to earn profits at the expense of outside investors

Inside information a source of estimation risk for investors– This causes investors to be more cautious

when investing



Effect of estimation risk on share prices– Efficient market price includes a

“discount” for estimation risk i.e., investors demand a higher return


A Graphical Illustration of Estimation A Graphical Illustration of Estimation RiskRisk



Controlling estimation risk– Insider trading laws (Sarbanne Oxley Act)– Financial reporting

Role of financial reporting is to convert inside information into outside, thereby reducing estimation risk

Cannot eliminate all inside information. Why?

Markets that “work well”– Low estimation risk, share prices as close to

fundamental value as is cost effective


Social Significance of Markets that Social Significance of Markets that Work WellWork Well

In a capitalist economy, allocation of scarce capital to competing demands is accomplished by market prices– Firms with productive capital projects should be

rewarded with high share prices (low cost of capital) and vice versa

Capital allocation is most efficient if share prices reflect fundamental value– Society is better off the closer are share prices to

fundamental value (i.e., if markets work well) investing in the country’s economy (ex. Job creation).


Social Significance of Markets Social Significance of Markets that Work Well (continued)that Work Well (continued)

Social role of financial reporting– To help markets work well

Maximize amount of publicly available information

Securities market prices are efficient relative to publicly available information

Set accounting standards with penalties for violation

Firms reputation: a credible policy of full disclosure beyond the regulatory minimum


An Example of Full DisclosureAn Example of Full Disclosure

Management Discussion and Analysis– Forward-looking orientation– Concept of information system is implicit

Forward orientation and risk information increase main diagonal probabilities

– Reasonably consistent with decision theory


Next ClassNext Class

Chapter 5: The Information Approach to Decision Usefulness