Accounting for Investors

1
Accounting for Investors
2
The Economy (SFAC 1)

• Private businesses dominate
• Managed by professionals not owners
• Owners need reports on their investment
• Hence the income statement
• FASB says only one general-purpose statement is
  needed
• Intended primarily for owners
• Others can read it -- if they want!

3
Stakeholders versus shareholders

• Many people other than owners need info
• Banks, suppliers, employees, government
• Perhaps a value added statement would be better
• NI Revenue - cost of goods - wages - interest -
  tax
• Value added Revenue - cost of goods
• Value added Wages interest tax net income
  (profit)
• Perhaps a variety of statements would be better
• Contribution-type statements for managers

4
Capital markets

• Accountants role
• Enabling investors to buy sell is not enough
• That is a zero sum game for the economy
• Must enable effective resource allocation
• With good information the economy grows
• But, who knows whether we do that . . .
• Then the computer arrived!!!
• Center for Research into Security Prices (CRSP)

5
Academics hit it rich?!

• Academics unable to make a killing
• Puzzled and disappointed
• No investment strategy worked consistently
• Abnormal profits were not attainable
• Ordinary profits were very attainable though
• Discovered
• Price changes are uncorrelated
• Prices follow a random walk

6
Efficient markets

• All available information is impounded in stock
  prices
• Market behaves AS IF all available information is
  impounded in stock prices
• Weak form all prior prices are impounded
• Technical analysis was deemed useless
• Strong form insider information?
• If only we had the inside scoop -- and jail did
  not call
• One role of accounting is to reduce insider info

7
Semi-strong efficiency

• Is the market efficient with respect to all
  publicly available information?
• The Ball Brown experiment
• If we knew a year in advance
• Go long if NI goes up
• Go short if NI goes down
• Money to be made up to the point of disclosure
• Market is not strong efficient
• Market is semi-strong efficient

8
Implications

• Fundamental analysis is worthless
• Dont bother to read annual reports!!
• Other sources of financial information exist
• Annual reports are anticipated
• Markets will choose the cheapest source
• Cheap f(time, energy, difficulty, money)
• Markets are sophisticated - no functional
  fixation
• We can produce reports for the well-educated
• Markets are set on the margin by the active
  investor
• Be a couch potato -- you are protected
• The price is always right!

9
One outcome

• All financial assets are marked to market
• If available for sale, unrealized gains and
  losses go to other comprehensive income
• If (actively) traded, unrealized gains and losses
  go to net income
• Both end up in comprehensive income
• Initially FASB wanted them to be at a 3-year
  moving average -- shouted down!

10
Portfolio theory

• Harry Markowitz
• Diversification reduces risk
• Adding uncorrelated securities reduces the
  variance to the covariance beta
• Efficient portfolio curve
• Maximum return for a given risk
• Minimum risk for a given return
• Advice
• All investors should buy the market

11
So whence efficiency?

• If everyone
• Ignores annual reports
• Buys the market
• Is a couch potato
• Then how does the market become efficient?
• Answer appears to be stupidity
• Stupid people will waste their time and money
  trying to make a killing -- and we benefit?!

12
Market model

• Bill Sharpe (Markowitz protegee)
• Demonstrates that one can do even better
• Buy the market and ride the market line by using
  debt
• Capital asset pricing model (CAPM)
• Expected return combo of risk-free rate, the
  beta of the stock and the market return
• No return for bearing unsystematic risk
• Cf the Andersen partner whose pension was with AA

13
Role of accounting

• To enable investors and others to predict . . .
• The companys beta!!!
• No cash flow here!!
• Currently no effort to meet this goal.

14
CAPM research

• CAPM measures the true return
• Actual return - true return abnormal return
• Abnormal return f(experiment)
• Ball Brown
• If we knew in advance we could earn an abnormal
  return
• That abnormal return goes away once the annual
  report is published -- all publicly available
  information has been impounded

15
Dozens of experiments since

• Would knowing this in advance enable us to make
  an abnormal profit?
• For example, could we make an abnormal profit
  from knowing that these companies are using
  straight-line and those are using accelerated
  depreciation
• Answer is invariably no -- the market
  understands
• However, a growing number of anomalies

16
Earnings behavior

• If prices follow a random walk, what about
  accounting earnings I.e., net income
• Turns out that NI is also pretty close to a
  random walk
• With nothing more to say this line of research
  has died down

17
Valuation models

• If we know the book value of a company can we
  figure out its market value?
• What if we know the replacement cost of its
  assets?
• If we know the accounting earnings of a company
  can we figure out is market value?
• Can we take a PE ratio x EPS?
• Can we use the fact that E/P interest rate?

18
Some sad facts

• Most managers dont believe in efficiency
• The FASB by and large ignores efficiency
• The FASB has to set rules
• This requires making value judgments
• Most academics want to stay value neutral
• Academia thus has little to add to rule setting
• Companies raise very little equity money
• SOX may change corporate governance