chapter 8 review

Topics: Free cash flow, Income, Income statement Pages: 16 (7457 words) Published: October 26, 2014
Chapter 8: Usefulness of Accounting Information to Investors and Creditors

Instructor’s Manual

Chapter 8 is concerned with the usefulness of external accounting reports for decision making. The FASB emphasizes decision usefulness in both the conceptual framework project and in policy deliberations for specific standards. It focuses on the primary user groups, investors and creditors.

Earnings, dividends, and stock prices are inextricably linked. Dividends are the cash flows that investors receive from dividend paying stocks. Managers think of cash dividends as being paid out of earnings. As such, the dividend discount model is equivalent to an earnings model. Predictive value is a major argument for the relevance of accounting information, and earnings appear to have value in predicting future dividends. Since the value of a stock is equal to the present value of the expected future dividends, earnings can be seen to play an important role in stock price valuation.

Residual income models take a variety of forms. Regardless of form, residual income is the income generated in excess of that which was expected, given the amount of capital invested and the cost of that capital. Residual income is often used for valuation purposes and for determining compensation for management. With clean surplus accounting, residual income is equivalent to the dividend discount model. However, by incorporating non-accounting information, the residual income model allows investors to improve forecast accuracy. There are advantages and disadvantages to residual income models. Empirically, the jury is still out as to their usefulness. The efficient-markets hypothesis (EMH) states that capital markets fully and instantaneously reflect new information in security prices. If the hypothesis is correct, the value of new information is fully and completely demonstrated via the security’s price response. When this occurs, the item of information is said to have information content. The usefulness of accounting information to investors has been empirically investigated through tests of association between publicly released accounting data and changes in security prices. If there is a significant association, then there is evidence that accounting information is useful with respect to firm valuation. These studies also constitute tests of the efficient-markets hypothesis. Capital market research dominates the empirical literature. This is appropriate given its influence over the past 25 years. Other research is important, though it suffers from some methodological problems such as reliability (surveys) and lack of generality (experimental research).

It is increasingly clear that, in practice, there are limitations of the efficiency of capital markets. This realization arises in relation to post-earnings-announcement drift, which has been determined from empirical research and the incomplete revelation hypothesis which is a deductive hypothesis. The empirical studies reviewed demonstrate that the market is not as efficient as we might have previously thought, or as efficient as we would like to believe. This suggests that there is value in putting time and effort into improving accounting standards.

7th edition

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Chapter 8: Usefulness of Accounting Information to Investors and Creditors

Instructor’s Manual

Capital markets research in accounting provides a basis for evaluating the present usefulness of accounting. Furthermore, the research methods themselves represent techniques and approaches that may be applied in an ongoing way to assess the usefulness of future or alternative accounting policies. This is particularly true for event studies, the mechanics of which are briefly discussed.

While “benefits” are the focus of the chapter, questions of costs and the apportionment of costs are equally important. Some of the recent capital market research has focused on questions of how accounting policies...
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