accounting theory & practice fall 2011_ch4
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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
Copyright: Accounting 514 (Winter 2011) Nicolino Iannotti, CA, CPA, CMA3
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).
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA4
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)
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA5
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA6
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)
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA7
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA8
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA9
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?
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA10
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA11
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA12
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA13
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA14
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA15
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:
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA16
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)
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA17
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA18
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA19
Information Asymmetry (continued)Information Asymmetry (continued)
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA20
Information Asymmetry (continued)Information Asymmetry (continued)
Effect of estimation risk on share prices– Efficient market price includes a
“discount” for estimation risk i.e., investors demand a higher return
Copyright: Accounting 514 (Winter 2011) Nicolino Iannotti, CA, CPA, CMA21
A Graphical Illustration of Estimation A Graphical Illustration of Estimation RiskRisk
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA22
Information Asymmetry (continued)Information Asymmetry (continued)
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA23
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).
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA24
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA25
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
Copyright: Accounting 514 (Fall 2011) Nicolino Iannotti, CA, CPA, CMA26
Next ClassNext Class
Chapter 5: The Information Approach to Decision Usefulness
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