Financial Accounting Theory Exam 1

1. expected CFs are fully realized 2. CFs are known by all parties *3. Discount rate is known to everyone

2 assumptions of certainty: (2) & we are also assuming (1)

1. weak form 2. semi strong form 3. strong form

3 efficient capital markets

scarce resources

Accounting Theory is important given the scarcity of resources in a capitalist society: •Critical to an informed allocation of __ __ by decision makers. •Critical to an informed assessment of how firms use existing __ __ and the current status of those resources [stewardship].

human behavior, social science

Accounting derives from __ __ rather than the laws of nature. Accounting theory and research fall in the realm of __ __

expected values

Adapt discounted CF approach replacing certain CFs with __ __

PV

Asset prices conform to the __ __ relation

economic conditions

BS and IS data will exhibit greater variation, but they reflect changing economic __

correlation of past income to other firm's past income plus those other firm's current income results in an expectation for that firm's current income SO new information in NI can be approximated by the difference in expected and actual income 1. estimate with OLS, the coefficient from the linear regression in the change in firm j's income on the change in the average income of all firms 2. this gives us the predicted change 3. the difference between the predicted change and actual change 4. this equals forecast error which is equal to the new information imbedded in present NI

Ball and brown expected and unexpected income changes

1. expected and unexpected income changes 2. market reaction

Ball and brown: 2 focuses

1. A market pirce exits for all assets 2. Asset prices are fully observable

Characteristics of complete markets (2)

1. Assets can be exchanged 2. No transaction costs 3. No opportunity to earn an abnormal return 4. Prices are unaffected by any individual's actions

Characteristics of perfect markets (4)

persistent and transitory

Current accounting earnings include relatively __ components and __ components

dividends

Earnings like any piece of information helps to alter beliefs about the ability to pay future __

tested, reference

Established theory derives from a body of knowledge that has been accumulated and __ over time and provides a frame of __

•Economic income (benchmark) is not well-defined absent certainty and perfect and complete markets. •Different users have different preferences for what is the best measure

Factors that lead to shift from stewardship perspective to informational perspective: (2)

FCFs

Financial information is still relevant in that it is predictive of __ __ __

cost

If the investor bears a __ to obtain a signal, it decreases the expected utility

PV of a dividend stream

MV of equity =

state, claims

Market prices exist for bundles of __ dependent __

presence of industry effects has not been accounted for in this model, which can account for 10% variability in a firms income

OLS assumption

CF / (1 + r)^t

PV formula (single CF)

discriminate, CF

PV is a clear way to __ among alternative __ __streams

dividend / (r -g*)

PV of a dividend stream formula=

risk or cost

Perfect and complete markets mean that any combination of claims to those FCFs can be exchanged without __ or __

economic income / Beginning PV

ROI=

30. future cash inflows - future development and production costs - future income tax expenses = future net cash flows x discount = standardized measure of discounted future netcash flows 31. if a significant portion of this calculation is attributable to a consolidated subsidiary(ies) in which there is asignificant noncontrolling interest, that fact and the approximate portion shall be disclosed. 32. if the financial statements include investments that are accounted for by the equity method, the enterprise's share of the investees' standardized measure of discounted future net cash flows shall be separately disclosed for the year, in the aggregate and byeach geographic area for which quantities are disclosed 33. The aggregate change in the standardized measure of discounted future net cash flows shall be disclosed for the year. If individually significant, the sources of change shall be presented separately - all changes except income taxes shall be reported pretax. 34. Additional information necessary to prevent the disclosure of the standardized measure of discounted future net cash flows and changes therein from being misleading also shall be provided.

SFAS69 30-34 describes the measure

55. There is no necessary correlation between the costs and the values of oil and gas reserves. 56. Predictive Value is limited 57. Attempts to standardize accounting for oil and gas have been unsuccessful 58-59. Other attempts have been made by the FASB and the SEC to develop disclosures to assist the user and those attempts have resulted in a great volumeof additional disclosures 60. primary objectives of this Statement are: a. To develop disclosure requirements that are useful b. To consider cost-benefit relationships of disclosure options 61. The Board considered four basic approaches to developing comprehensive oil and gas disclosures: A — Historical cost based information and reserve quantity information only B — A+ future estimated costs and reserve production information C — A + information about estimated future net cash flows relating to oil and gas reserves D — C+ an alternative measure of income based on changes in those future net cash flows. 64. A supporters: users can apply current costs and prices or their own estimates of future costs and prices to an extrapolation of historical production trends to estimate future net cash flows 65. In the Board's view, historical cost based financial information and proved oil and gas reserve quantity information are crude tools for any predictive analytical process for many reasons 67. Supporters of B this alternative generally suggest limiting the disclosure requirements for that information to a period encompassing the following three to five years. This alternative is intended to allow users of the financial reports of oil and gas producing enterprises to compute estimated near-termfuture cash flows using their own assumptions concerning future prices and risks. 68. lack of broad support for Alternative B: only the most sophisticated industry analysts can use it 71. Alternative C:The Board considered various means of providing relevant summary information: 73.a. Fair market value: would be the best value but there is not enough information to reasonably estimate the FMV due to the nature of oil and gas 75. b. Estimate of discounted net cash flows based on future prices and costs and an enterprise-specificdiscount rate: limiting to proved resumes would detract from estimation, highly subjective, not verifiable 77. * chosen option* c. Standardized measure of discounted future netcash flows with major factors separately reported: achieve some of the characteristics of a fair market value measure without the extreme subjectivity inherent in either direct estimation of market value or entity-specific discounted net cash flows. Although it can-not be considered an estimate of fair market value, the standardized measure of discounted net cashflows should be responsive to some of the key variables that affect fair market value, namely, changes in reserve quantities, selling prices, production costs, and tax rates. 79. One criticism of a standardized measure of discounted net cash flows has been that it is limited to proved reserves, omitting probable and possible reserves.

SFAS69 54 - 79 Basis for Conclusions

The dissenters believe that a requirement to disclose supplementary *historical* information about proved reserve quantities, capitalized and incurred costs, and results of producing activities by significant geographic area is adequate -standardized measure is completely lacking in reliability - users would not understand - depends too much on managements forecasts, not the objective of financial reporting to estimate future earnings

SFAS69 Dissenting Opinion

Future Dividends <> Security prices • Future Earnings <> Future dividends •Current Earnings <> future earnings

Standards refer to information about investment's future payoffs. Three-way conceptual relation:

limitations, redundant, valuation concept

The conditions of certainty also illustrate the __ of economic income. Earning provided no information beyond FMV so it is __. Earnings is purely a __ __ in this context

•Information to decision makers in capital allocation investors and creditors •Information for contracting parties where contract terms reference accounting information.

Two informational roles of financial reporting

asset BV PV of FCFs value in use exit value entry value

When operating under certainty, which amounts are all equal (5)

expected utility

When operating under uncertainty, the model is intended to show the value of accounting information by allowing the investor to enhance her __ __ in this decision context

FCFs

With the informational perspective, Providing useful information to help assess __ __ __ was the primary concern

normative, accrual, economic

With the stewardship perspective, Accounting theory was largely __ •__ accounting seen as superior •Desire to approximate __ income

steakholders, management

With the stewardship perspective, Financial statements were viewed as a means to report back to those __ so that they can evaluate __in this role.

economic reality

With the stewardship perspective, Primary concern was the measurement of assets, liabilities, equity, and income items, and how well they compared to __ __

semi-strong

__ form: market is effect with respect to all publicly available information but not necessarily private information

strong

__ form: market is efficient with respect to all information (private and public)

weak

__ form: market is efficient with respect to past security prices but not necessarily other forms of information

positive theory

__ theory: Based on certain assumptions and deductive reasoning, predict behavior •Compare predictions to observed outcomes to test theory

normative theory

__ theory: Not based on observation •Implies some value judgment by researcher

information content

accounting provides incremental information relative to all other publicly available information -unique

value relevance

accounting reflects information that is relevant to market prices. however it need not be the unique source of that information. - reporting does not necessarily represent news to investors

additional investment / ROR (%)

addition income =

complex security (bundle)

aggregation of primitive claims and valuation requires linking to possible states

acts

alternative choices available to a decision maker

permanet income

amount that received as a perpetuity reflects the remaining CFs of the asset

efficient

an __ securities market fully and immediately impounds relevant information into security prices.

ad hoc

an explanation of why a particular thing may be is substituted for an argument as to why it is; since it is therefore not an argument, it is not technically a fallacy, but is usually listed as one because it is a substitution for a valid argument

prediction

anticipating unobserved phenomenon (not necessarily future events).

Of all the information about an individual firm which be-comes available during a year, one-half or more is captured in that year's income number. Its content is therefore considerable. However, the annual income report does not rate highly as a timely medium, since most of its content (about 85 to 90 percent) is captured by more prompt media which perhaps include interim reports.

ball and brown conclusion

1. task of identifying the media by which the market is able to anticipate net income? 2. of what help are interim, reports and dividend announcements? 3. For accountants, there is the problem of assessing the cost of preparing annual income reports relative to that of the more timely interim reports.

ball and brown questions raised 3

11 months prior to the earnings announcement

ball and brown show that stock returns are correlated with earnings information. When is most of the earnings information impounded into stock prices?

They were trying to capture stock prices changes attributable only to IS information, while removing market wide earnings components

ball and brown use a residual measure of earnings in their study that they obtain by regressing either NI or EPS on a market index of earnings. What were they trying to capture in the residual and what are they trying to remove by taking the regression approach?

to assess the usefulness of existing accounting income numbers by examining their information content and timeliness

balla nd brown initial objective

Securities' valuation

concept of permanent earnings relates to __ __

Scientific theory

conceptual framework based on a assumptions and fundamental principles for a particular field of inquiry

decrease in asset's PV

economic depreciation =

positive theory

explains what is

normative theory

explains what should be (value judgments)

CFs less economic depreciation OR CFs less the decrease in assets PV

firm's perspective ** economic income =

additional income / previous income

g (growth rate)=

stewardship

how firms use existing scarce resources and the current status of those resources

FMV

if markets are complete, __ __ __ should correspond with PV, which should equal value in use

firm specific stock returns, net of market wide effects

in their analysis of stock returns, ball and brown are primarily interested in measuring

vanish

information advantage of an informed investor should quickly __

barrier

information costs and other market imperfections create a __

Does income statement information effect stock prices?

main question for ball and brown

fundamental, unbiasedly

market efficiency does not imply that prices equal __ value, rather they __ reflect information available at that time

1. double entry bookkeeping 2. profit and loss statements and statements of *balances* 3. temporary ventures to ongoing enterprises: periodically report performance 4. Owners separate from a managers 5. Audited BS (audit optional)

mini history of accounting

states

mutually exclusive and collectively exhaustive states of nature that reflect the uncertainty about future events

dividend irrelevancy phenomenon

no effect from dividends on a company's capital structure or stock price (initial market value has not changed)

partially, uninformed, prices

noise (liquidity) traders imply that prices are __ informative their trading is __ and it still effects __

stewardship perspective

perspective that emphasizes entity concept rather than proprietary

beliefs

probabilities associated with each state based on prior experience and information available

accretion

process of growth or increase, typically by the gradual accumulation of additional layers or matter

explanation

providing reasons for what we observe.

representational faithfulness verifiability

reliability relies on (2)

consequences

result of interest related to each state

ad hoc assertions

scientific theory is based on logical reasoning rather than __ __ __

testable/ falsifiable

scientific theory should support __ predictions

finance theory

stock prices impound information quickly and efficiently (unbiased)

dividends received +(-) capital appreciation (deprecation)

stockholder perspective ** economic income=

persistent

the ability to forecast future earnings is a function of the __ components. So in any given period, investors consider whether unexpected earnings are likely to persist

signal, utilities, conditional, probability

the value of a __ can be assessed by comparing expected __ without the signal. Further, we could compare this information signal to another information signal based on __ expected utilities. Consider disclosure of revenue or cash flows that is less discriminating in the conditional __it would not produce the same increase in expected utility.

decision maker

the value of information is specific to the __ __. Another user may infer different probabilities for each signal.

wealth maximization and firm performance , stewardship, value

under conditions of certainty, earnings is a straight forward measure of __ __ and __ __. Earnings is revenant for assessing management __ and firm __ and should be unanimously preferred by users over alternative measures

1. expected CFs are fully realized 2. CFs are known by all parties *3. Discount rate is known to everyone

what are "ideal conditions"? (3)

Why different entities choose different accounting and reporting practices? •What can users infer about firms given the reporting practices they employ? •How will users respond to different accounting and disclosure decisions?

what does accounting theory explain? (3)

Normative theory

which theory is not really a theory in a scientific sense?

valuation process, beliefs, preferences, transaction costs, exit value, entry value, and value in use

with imperfect and incomplete markets, __ __ is not well defined and markets are no rich enough to sort out individual __, __, and __ costs. (3?) are not necessarily equal .

FMV

with uncertainty, the distinction between actual and expected is important. Would the PV of the expected value be the __ __ __

Luca Pacioli

wrote a mathematics book introducing the notion of double entry bookkeeping

prior to 1940: emergence of the profession 1940s to mid 1960s: peak mid 1960s: dissent under stress

zeff history