Decision Usefulness approach vs. Measurement Approach - Research Paper Example

Decision Usefulness approach vs. Measurement Approach Table of Contents Decision Useful Approach 3 The Single-Pearson Theory 3 The Rational Investor 4 The principal of portfolio Diversification 5 The Optimal Portfolio Investment 5 Portfolio Risk 6 Measurement Approach 7 Reasons for Market Response 7 Market Efficiency of Securities 8 Ohlson’s Clean Surplus Theory 9 Auditors’ legal liability 9 Asymmetry of investor Losses  9 Role of Financial Accounting on both Approaches 10 Works Cited 11 Decision Useful Approach This approach motivates the application of decision models. The approach is based on the concept that if financial statements cannot be prepared correctly, then financial statements must be presented in such a manner so as to reflect useful information focusing on users and the decision problems that they face. The approach assumes that if the financial and accounting is useful to investors, then trading volume of stocks should experience a surge and securities prices are also expected to increase or respond in predictable manner relative to publicly available accounting information (Schroeder, Clark and Cathey, 2011, p.43). The Single-Pearson Theory The Single-Pearson decision theory aims to understand how an investor makes rational decisions under circumstances of certainty. The theory appreciates the concept of information and enables decision makers to keep informed and modernize their beliefs. The concept uses the publicly available financial statements as source of information. Consider the following illustration to understand the concept, An investor X has $ 20000, and he has the option to invest in either in shares of ABC ltd or 2% Government bonds. The decision of X will depend on whether the future performance of ABC ltd. (good or bad). The decision tree of X is shown below, Act State   High Low Assigned   (Good) (Bad) Utility Buy shares $ 1,600.00 $ - 40 Buy Bonds $ 225.00 $ 225.00 15 Probability 0.3 0.7 1 In the above illustration X is assumed to be risk-averse and rational; and Utility = √ (Pay-off) Hence, the risk-averse behavior of X is justified considering the fact that overall risk has been minimized, and expected returns have increased by taking rational decision. The Rational Investor The decision making process of an investor depends on making choices that outcomes in the most optimal level of utility or benefit for the individual. A rational investor does not always absorb in getting material or monetary benefits as satisfaction depends on emotional factors. For instance, an investor will prefer to minimize risk of investment and maximize returns. So, if a rational investor will seek early retirement if he or she believes that benefits of retired life outweigh utility of receive paychecks during employment. The principal of portfolio Diversification The rationale or principle of portfolio diversification is as follows: Maintain a balance between risk and return Assurance that the different securities held for investment are negatively correlated which will give an assurance of protection in case of any market shortfall and an expectation of positive returns. Diversification of investment reduces the risk underlying the investment. Investment in a single stock of a particular company increases the substantial risk attached with the particular investment. The Optimal Portfolio Investment The concept of optimal investment falls under modern portfolio theory and assumes that investors prefer to minimize risk while striving for maximizing their expected returns. (Source: Spreadsheetml.com, http://www.spreadsheetml.com/finance/freeportfoliooptimization.shtml, 2013) The theory states investors will act rationally and thus they will always make decisions that will aim at maximizing their expected return for given tolerable level of risk. Portfolio Risk It is one of the concepts used in risk-return analysis that gives an estimate of actual returns relative to expected returns of an investment. Important factors which are considered in measuring portfolio risks are standard deviation (or variance); beta (measures stock volatility relative to market); alpha (measures stock volatility based on particular characteristics of security); Sharpe ratio (measures fund risk adjusted returns). Measurement Approach Accounting concepts have always kept performance measurement as its central theme. It is basically an accounting based approach where performance is evaluated by interpreting financial statements such as liquidity, profitability or solvency ratios. To financial analysts, economists, shareholders’ and other major decision makers, financial viability of a business is assessed on the basis of effectiveness of performance. The theory focuses on the following aspects, Accounting as the base of performance measurement Strategic management of organization considering both non-financial and financial measures that are designed, implemented and maintained by the firm Role of performance management system in creating and implementing strategies Identify when and how accounting measures relate to performance Reasons for Market Response The theory and evidence of securities markets are based on behavioral finance and information flow in efficient markets. The study of market response is very useful especially in distinguishing accruals from operating cash flows. Generally, efficient markets respond more strongly to unexpected anomalous earnings if it comes in the form of operating cash flows and not in form of accruals. There is existence of anomaly since differential responses are often found to be predicted by the theory of ‘efficient securities market’. With increasing usage of measurement approach in financial statements raises quality of presenting earnings information and increases reliability of information. The market response increases with the increase in relevance of data which is resulted from decreasing variability between recognition of value events (fair value of capital assets, investments, present value of long term debt, etc.) and actual occurrences. Market Efficiency of Securities The efficient market hypothesis assumes that in financial markets, the current prices reflect all the information available in the market and thus the true value of the stocks can be reflected from their past security prices. The theory assumes that the market participants behave rationally and try to maximize their returns by processing all information available to them. From above it can be said that the securities are correctly priced provided the information available to public. The EMH assumes that any financial market may be either strong form efficient, semi-strong form efficient, or weak from efficient (Hagin, 1979, pp.1-6). In a competitive market, prices are determined from the law of demand and supply. The price at the equilibrium level of demand and supply represents the consensus opinion about the market. At this price, the intrinsic value of stock and the equilibrium prices will be same. Whenever new information arrives at the market, the forces of supply and demand react to it. If the market factors in the new information quickly, it will show a new price different from previous one. Ohlson’s Clean Surplus Theory It provides tools of accounting method for forecasting model uses price as a function of expected returns, earnings, and changes in book value. When accounting for this method, generally all transactions of shareholders (such as share offerings, rights issue, dividends) are not taken into account. Hence, current accounting for financial statements is calculated by subtracting dividends from earnings from book value. This theory is primarily used to analyze the value of company’s shares. Auditors’ legal liability The legal liabilities for auditors arise from four major sources that are mentioned as follows: 1. Criminal liability 2. Liability from Fed Securities Law (under the securities acts of 1933 and 1934) 3. Liabilities to defenses and clients 4. Liabilities to defenses and third parties Asymmetry of investor Losses  The primary cause for asymmetry of investor losses arise from under or over valuation from financial statements contributed from conservatism and auditors liability discussed earlier. The main reason for conservative accounting is risk-averse nature of investors who rely on information provided by financial statements for investment decisions. Investors have been found to suffer from greater utility losses from overstatement of company’s net assets compared to understatement of equal amount. Role of Financial Accounting on both Approaches The ‘Decision Usefulness’ and ‘measurement’ approach discussed earlier are two perspectives of Accounting Theory. The objectives of these approaches aim to identify the purposes and goals of financial accounting. These concepts provide guidance and plays important role in determining the following areas of accounting: Selecting events/ transactions/ conditions to be accounted for To determine how selected events/ transactions should be measured To determine how to summarize and present financial results of events/ transactions/ and circumstances Works Cited Hagin, R. Modern Portfolio Theory. 1979. Web. November 26, 2013. . Schroeder, R., Clark, M., and Cathey, J. Financial Accounting Theory and Analysis: Text and Cases. USA: John Wiley and Sons. 2011. Print. Kihn, L. Comparing Performance Measurement Approaches in Accounting Research. 2005. Web. November 26, 2013. < http://lta.hse.fi/2005/2/lta_2005_02_a1.pdf>. Read More