说明教案成果msc fa2lecture

1、1MN50325Financial Accounting 2 Lecture 2David Bence1 - 2Learning ObjectivesTo examine the historical context of financial accounting To examine accounting under ideal conditionsTo examine decision useful accounting information See Scott (2012) chapters 1,2 and 3 for further information1 - 3Some Hist

2、orical PerspectiveEarly development of accountingEarly systems of double entry accounting: 13th C & 14th C in Northern ItalyFranciscan monk (Pacioli) first to document double entry accounting practice in 1494Included debits and credits and used ledgers and journals Accounting & financial words in En

3、glish are of Italian origin: bank, cash, debit, credit etc1 - 4The Inventor of Capitalism?1 - 5Some Historical PerspectiveIn the UK the South Sea Bubble led to 1844 Companies Act an audited balance sheet was required to show a true and fair viewThe concept of depreciation was introduced in the US in

4、 the 1880s following the introduction of railroad taxation.In the 1920s inflation was high. Some companies experimented with restating historical cost accounting in line with the change in inflation this approach still exists under IAS291 - 6Some Historical PerspectiveIn the US the great depression

5、of 1930s reinforced historical cost accounting1934 - US Securities Exchange Act required specific disclosures of financial information by organisations seeking to trade securities1938 - SEC only accepted financial statements prepared in accordance with GAAP of the accounting professionfrom 1939 Comm

6、ittee on Accounting Procedures (committee of the US accounting profession) commenced issuing statements on accounting principles1 - 7Financial Reporting Horror StoriesRoyal Mail scandal of the 1930s led to 1948 Companies Act requirement for consolidated financial statements.Collapse of Pergamon Pres

7、s in the 1960s led to the introduction of UK accounting standardsPolly Peck scandal of late 1980s led to Financial Reporting Standards in the UKEnron 2001 (Inflated e & asset values, hidden liabilities) and other scandals led to the Sarbanes-Oxley Act, increased disclosure and more US accounting rul

8、es on groups.Financial collapse of 2008 led to more rules on financial instruments 1 - 8Role of Information in a Market EconomyTo improve operation of capital marketsAdverse selection problemTo improve operation of managerial labour marketsMoral hazard problemBoth roles crucialResults of Enron colla

9、pse shows importance Collapse of share pricesRecession in U.S. economy, 2001 Increased regulation (SOX)1 - 9Role of Financial Reporting in a Market EconomyFinancial reporting controls adverse selectionReduces information asymmetryConverts inside information into public informationSupplies useful inf

10、ormation to investors 1 - 10Role of Financial Reporting in a Market EconomyFinancial reporting controls moral hazardManagers may blame bad firm performance on factors beyond control but accounting will provide evidence on whether this is trueControl manager shirking逃避卸责Improve corporate governance1

11、- 11The Fundamental Problem Of Financial Accounting TheoryThe best measure of net e to control adverse selection is not the same as the best measure to motivate manager performanceInvestors want information about future firm performanceForecasts are unreliable and of use to competitors therefore not

12、 published by firms. Fair value accounting brings HC up-to-date but is based on hypothetical events. ？ But Good corporate governance requires that managers work hardHC accounting & conservatism are then useful in controlling managements natural exuberance慷慨激昂的言行1 - 12Role of Standard SettingIs stand

13、ard setting needed? Market forces motivate firms to produce informationBut market forces subject to failure: Adverse selection & Moral hazardTherefore regulation tries to correct market failures (some argue that the cost of this regulation outweighs the benefits)Standard setting mediates调解 between c

14、onflicting interests of investors and managersInvestors want lots of useful informationManagers may object to releasing all the information1 - 13Ways to Mediate Between Conflicting InterestsDue process应循程序 in standard settingRepresentation of diverse constituencies选区Super-majority votingDiscussion d

15、rafts讨论稿Exposure drafts征求意见稿Standards Interpretation Committee1 - 14From Ideal e to Decision-UsefulnessIdeal eThere is one true eDominated accounting thinking until the 1970sDecision-Usefulness ApproachShare prices fully reflect all publicly available informationEfficiency is relative to a stock of

16、informationRole of financial reporting in improving/expanding the stock of informationTrue e cannot exist.Disclosure more important than recognition.Dominated accounting thinking since 1970s Economists view of e, capital and valueHicks (1939) view:Capital is the present value of future cash flowsCap

17、ital is measured at the beginning and end of the period e is the maximum consumption enjoyed by the individual without reducing the individuals capital stock股本/资本存量 as measured in present value terms.Measurement can be exante 事先预测or expost事后分析1 - 16The economists view of e only makes sense in perfec

18、t markets (and in perfect markets there is no need for accounting!)AssumptionsKnown future cash receipts & their probabilitiesOne given interest ratePerfect & complete markets; no info asymmetry & other barriers to efficient & fair working of marketsInvestor & manager have no disagreement over finan

19、cial reporting, thus no incentives to call for regulationBasis of Accounting based on such assumptionsAssets and liabilities valued on present value (value in use) e Recognition e occurs as changes in present value occurFuture cash flow known; net e perfectly predictable Ideal Conditions of Certaint

20、ySay we start a business with 100,000 of equity. The business will last for three years and then be liquidated. We require a 10% return on our money. We estimate the following business cash flows for three years starting at the start of year 1 i.e. time zero:ExampleThe present value at t0Present Val

21、ue at time 0 with a 10% discount rateThe present value at t1Present Value at time 1 with a 10% discount rateWe consume 10,000 and go overdrawn by 5,000!Assuming we withdraw 10,000 at the end of year 1:Illustration of owners e calculation for year 1 e = Cash Flow in year 1 +(Capital at time 1 Capital

22、 at time 0)10,000 = 5,000 from business plus 5,000 overdraft +(100,000-100,000) Maximum consumption enjoyed by individual without reducing the capital. Assuming that estimates turn out to be correct, under the economists view of e, 10,000 will be withdrawn from the business in all three years. e is

23、always 10% of 100,000.Under historical cost accounting, a profit of 5,000 would be shown in year 1. Paying a 10,000 dividend in year 1 would be against the Companies Act as realised profits were only 5,000.1 - 21Ideal Conditions do not ExistWe are unable to forecast the future with precisionState pr

24、obabilities are subjectiveMarkets are plete E.g. what is the market price of a companys oil reserves?SignificanceCannot always use market value as proxy for present valueSubjective estimates inevitable: lack of precision & possible biasReasons for pletenessthin markets成交清淡的市场 & information asymmetry

25、1 - 22Ideal Conditions of UncertaintyAssumptionsStates of nature: uncertain future eventsKnown set (e.g. State 1: economy bad; State 2: economy good)No one can control which state occursState realisation publicly observableState probabilities objective & publicly known; but conditional on states of

26、natureGiven interest rateBasis of Accounting: expected present value based on probabilities e Recognition: changes in expected PVDifferent to ideal certainty: under uncertainty, expected e & actual e may not be the same as states do not turn out as expectedFor example, we could rework the above exam

27、ple with actual cash flows in year 1 differing from expected cash flows Hicks expost1 - 23Relevance and ReliabilityRelevant informationInformation about future firm performanceReliable informationRepresentationally faithfulFree from biasVerifiable Under ideal conditions, complete relevance and relia

28、bility is attainedBecause future cash flows known with certainty & there is one fixed risk free interest rate in the economy1 - 24Trade-off between relevance and reliabilityGreater relevance requires more estimatesBut, more estimates decrease reliabilityRelevance and reliability must be traded offSe

29、e next slide 1 - 25Relevance v. Reliability TradeoffFair Value1 - 26Reserve Recognition Accounting for Oil and Gas CompaniesAn application of present value accounting when ideal conditions do not existSFAS 69Applies to proved reserves onlyDiscounted at mandated rate of 10%Revenue recognized as reser

30、ves are provedMajor adjustments to previous estimates usually needed1 - 27Reserve Recognition Accounting for Oil and Gas Companies - ExampleIn 20X3 an oil company discovers a new well井of 10m barrels of oil.Pumping can start in 3 years. The well will take a year to drain耗尽. Related pumping costs are

31、$67m.Oil is currently worth $100 a barrel.Revenue now 10m*$100/(1.13)=$750mCosts now $67m/(1.13)= $50mTherefore e in 20X3 is $700m1 - 28RRA - ConclusionRelevant information: enables investors to estimate the present value of future receipts (inflow) from oil and gas assets. Reliable information: oil

32、 reserves can be verified by a third party.However, management are very concerned about their legal liabilityRRA is an application of the present value model and gives us an insight into the usefulness of present value accountingHowever, there are severe implementation problems For example, Shell re

33、cently 1 - 29Comparing Different Measurement Bases (under real world conditions)Fair value accountingFair value is not normally present valueFair values are unreliable subject to changeRecognition lag is low therefore relevance highHistorical cost accountingAccruals concept brings the cash value tow

34、ards a fair valueRecognition lag is longer due to lack of fair valueCash flow accountingHighly reliableNot relevant due to long recognition lag e.g. an assets cost is not matched with revenues1 - 30The Mixed Measurement ModelTodays financial statements are a mix of different values:Present values oi

35、l and gas reserves, pensions, some provisionsFair values financial instrumentsHistorical cost inventories, long-term debtManagers can switch e.g. IAS 16, IAS 401 - 31The Mixed Measurement Model (continued)Why use different measurement bases?Information set approach it is OK to mix them upDifferent t

36、rade-offs between relevance and reliabilitySome assets and liabilities require more estimates than othersIf too many estimates, revert to historical cost to retain reasonable reliabilityIf reasonable reliability still not attained, revert to cash basisE.g., research costs written off as incurred1 -

37、32Conclusion to the search for true eTrue e does not exist, as a result of the real world conditions in which accounting operates Implications for accountantsJudgement required to estimate e and value assetsJudgement is the essence of the accounting professionAccountants are not needed if perfect co

38、nditions did exist, because e has no information content when conditions are ideal we know the future, all returns are normal etc.1 - 33The Decision Usefulness ApproachPerspective switched in 1970s away from the search for true e to a decision-usefulness or information set approach. If we cant measu

39、re e we can at least make accounting more useful.It is the investors responsibility to make investment decisionsThe main role of financial reporting is to supply information that is useful for this purposeTo prepare useful information, the accountant must know how investors make decisions Informatio

40、n is useful if it affects an individuals decisions1 - 34The Rational Decision Theory ModelA model of rational decision making in uncertaintyRationality: investors assumed to quickly form accurate estimates of unknown, underlying firm parameters, e.g. information system probabilities about states of

41、the worldAssume in decision theory that the high / low payoffs generated with the probabilities as given by natureNature: a random mechanism or an impartial forceAn investor assesses probabilities and revise them on receiving new informationA decision chosen by an investor would not affect the prior

42、 possibilitiesContinued1 - 35The Rational Decision Theory Model (continued) Role of the rational decision theory model in financial reportingHelps us understand how financial statement information helps investors to make investment decisionsHopes to model average investor behaviour1 - 36ExampleAn in

43、vestor can invest 10,000 either in government debt paying 2.25% or in company X shares. The investor believes that there is a 70% chance of future company poor performance leading to a zero return on shares and that there is a 30% chance of high future company performance leading to a return of 1,60

44、0 or 16% on the shares. Government debt pays the same regardless of the company performance.Assume that the investor is risk averse and expected utility is the square root of the expected payoff.Construct a payoff table.Which investment should be chosen?1 - 37AnswerExpected utility from debt = 0.3*2

45、25 + 0.7*225 = 15Expected utility from X = 0.3*1,600 +0.7*0 = 12Therefore invest in government debt as utility is higherStateHigh Future Performance (30%)Low Future Performance(70%)Invest in Government Debt225225Invest in Company X1,60001 - 38DiscussionWorking in utilities rather than money allows u

46、s to move between risk averse, risk neutral and risk seeking behaviour.Risk neutral in money (or 1=1 util) would give us a different decision in this example - 480 weighted return on shares compared with 225 on government debt.Question must give you investors attitude to risk, this cannot be assumed

47、.1 - 39Example - continuedSupposing you decide to wait for the financial statements of company X to be released before making a decision.Accountants (not the investor!) estimate that there is a 20% chance that accounts will show bad news even if the firm will do well in the future and that that ther

48、e is a 10% chance that the accounts will show good news even if the firm will do poorly in the future. This is due to conservative accounting, earnings management and so on.You read the accounts and decide they show good news. Would you invest now?1 - 40Bayes TheoremA device to revise state probabil

49、ities upon receipt of new evidencePosterior state probabilitiesm is message receivedP() is prior probability of P(/m) is the posterior probability of after m has been receivedGeneral Formula1 - 41Bayes Theorem Applied to Accounting Information is state of firm1 = H = high future firm performance2 =

50、L = low future firm performancem is evidence received from the financial statementsm1 = GN = net e shows good newsm2 = BN = net e shows bad newsSuppose GN is received:1 - 42The Information System Shows Evidence Probabilities, Conditional on Each State, for Input into Bayes Theorem Current Financial

51、Statement Evidence GN BNTotal H State ofNature L P(GN/H) P(BN/H) 1 P(GN/L) P(BN/L) 1An information system is a table giving, conditional on each state of nature, the objective probability of each possible financial statement evidence item1 - 43Example (continued) Current Financial Statement Evidence

52、 GN BNTotal H State ofNature L P(GN/H) = 0.80 P(BN/H) = 0.20 1P(GN/L) =0.10 P(BN/L) = 0.90 11 - 44Example - ContinuedThe posterior probability of the high performance state is:P(H/GN) = 0.30 * 0.80(0.30*0.80)+(0.70*0.10)= 0.77Therefore the posterior probability of the low performance state is 0.231

53、- 45Example - ContinuedExpected utility from debt = 0.3*225 + 0.7*225 = 15Expected utility from X = 0.77*1,600 +0.23*0 = 31Therefore invest in shares as utility is higherInvestor is still risk averse but has new informationStateHigh Performance (77%)Low Performance(23%)Invest in Government Debt22522

54、5Invest in Company X1,60001 - 46The Information System IIThe 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 informativenessEnables user to update his prior prob

55、abilities to reflect what he knows & affect decisionHighly informative financial statements also called:Transparent, precise & high quality (Scott, 2012) - Fair value accounting is seen as more informative and therefore more predictive but some would argue that smoothed historical cost earnings are more predictive!1 - 47The Information System IIIInformation system probabilities should be objectiveAs