The objective of valuation research is to relate accounting numbers to a measure of firm value to assess the characteristics of accounting numbers and their relation to value of the firm. (Barth, 2000).
The valuation research which aims at investigating the empirical relation between stock market values (or changes in values) and particular accounting numbers for the purpose of assessing an accounting standard are broadly categorized as the ‘‘value-relevance’’ literature (Holthausen and Watts, 2001).
Francis et al (2004) specify value relevance as one of the most important attributes of accounting quality. They argue that value relevance is a more important attribute of accounting quality than conservatism or timeliness.
A primary focus of the FASB and other standard setters is equity investment. Although financial statements have a variety of applications beyond equity investment, e.g., management compensation and debt contracts, the possible contracting uses of financial statements in no way diminishes the importance of value relevance research, which focuses on equity investment.
Investors represent a large class of financial statement users and thus most of the academic research addressing financial reporting issues especially relevant to practicing accountants, particularly standard setters, adopts an investor perspective.Since investors are primarily interested in information that will help them assess the value of the firm, valuation models are generally used to address the questions of value relevance. Further valuation theory also provides a vast academic literature to give a firm base to the research in this context (Barth, 2000).
Financial statements consist of balance sheet and income statement. The balance sheet and the income statement have divergent roles. The fundamental role of the income statement is for equity valuation, whereas a distinctive role of the balance sheet is to facilitate loan decisions and monitoring of debt contracts. The income statement fulfills its role by providing information about rents associated with the firms future growth opportunities and other unrecognized net assets. The balance sheet fulfills its role by providing information on liquidation values assuming book values approximate liquidation values (Watts ,1974).
Various academicians (Ou and Penman 1989; 1996; Harris and Ohlson 1990; Francis and Schipper, 1999; Barth 2000; Barth, Beaver and Landsman 2001; Holthausen and Watts, 2001) have given their interpretation (Appendix A) of the term value relevance. However the key commonality in all the definitions remains that an accounting amount is deemed to be value relevant if it has a significant association with equity market value.
The most comprehensive definition of value relevance is given by Barth, Beaver and Landsman (2001), value relevance is as an empirical operationalization of the criteria of relevance and reliability of accounting numbers as reflected in the equity value. This definition of value relevance conforms to the statement of the importance of value relevance of accounting information in the Framework for the Preparation and Presentation of Financial Statements (IASC, 1989). According to IASC, relevant information is such that “… influences the economic decisions of users by helping them evaluate past, present and future events”. From the investors´ perspective, relevant information is information which contributes to their equity investments decisions.
Value Relevance and Intangible Assets
The valuation of tangible and intangible assets falls under two perspective signaling and measurement. Signaling perspective is concerned with the change in the value of the firm measured by stock price to the announcement of the change in accounting number. Whereas the measurement perspective is broadly concerned with the characteristic of accounting number measured by its association with the stock price. The result of decline of value relevance has been mixed. Traditionally value relevance has been largely tested in the USA however since last decade (1994) there has been an increase in the studies in other parts of the world as well such china, Japan, Kuwait etc. The results vary from country to country, research suggest that macro economic factors such as market oriented financial system, use of auditors and tax structure are the common factors that are attributed for the difference in the results.
The research under value relevance is subject to major criticism .The criticism largely is dependent of the fact that the whole value relevance literature rests on the simple premise that the accounting standard is preferred if it has a significant association with the market value. Further the research in value relevance assumes that the investors are only users of financial statements.
Despite the criticism , value relevance research is quite beneficial as it at least gives some indication about the relevant information valued by the investors.Also Value relevance studies are gaining importance in light of increased investment in intangible assets which are not effectively reported by the financial reports.
Barth, M.E., (2000), “Valuation-based research implications for financial reporting and opportunities for future research”, Accounting and Finance, 40, 7–31.
Barth, Mary E., Beaver, William H., Hand, John R.M. and Landsman, Wayne R. (1998a), “Relative valuation roles of equity book value and net income as a function of financial health”, Journal of Accounting and Economics, 25, 1–34.
Francis,J etal (2004),”Cost of equity and earning attributes”, The Accounting Review 79(4),967-1010.
Francis, J. and K. Schipper (1999), “Have Financial Statements Lost Their Relevance?” Journal of Accounting Research, 37, 319—352.
Harris,X and J.Ohlson (1990), “Accounting Disclosures and the Market’s Valuation of Oil and Gas Properties: Evaluation of Market Efficiency and Functional Fixation,” The Accounting Review, 764-8
Holthausen,R.W., and Watts,R.L., (2001), “The relevance of the value relevance literature for financial accounting standard setting”, Journal of Accounting and Economics, 31.
Ou, J., And S. Penman (1989) “Accounting Measurement, Price-Earnings Ratio, and the Information Content of Security Prices”, Journal of Accounting Research, 111—52.
This article reviews both the economic concept of net income and the accounting procedure of specific business situation and then suggest a principle which is compatible with the economic theory and at the same time coordinates most current accounting practices.
When should Profit be Recognized???
Buying → Selling → Collecting
At point of time or it should be spread over cycle.
Profit is a result of making the most critical decision or the performance of the most difficult task in the cycle. E.g. inventory to accounts receivable.
The following section will analyze different business, what practices are being followed and the test of the applicability of critical foundation theory in business.
Steps involved in doing this business.
Practice: Recognize revenue at the time of selling.
Critical principle approach: selling is the critical activity for most of the merchandisers and the profit is recognized at that time.
Additional step of Purchased raw materials to saleable units.
Extra point of recognition is stated. i.e. stage of value addition.
Cases: Uncertainty of the sale price, recognition at the sale of products. Active markets such as precious metals or agro products., profit recognized at the time of manufacture. Contract manufacturing Main principle working is that of certainty alternative paradigm of critical event also is pertinent.
Practice: recognition in the period when magazines are distributed.
Certainty theory breaks down, the recognition should be at the time when subscription is sold.
Critical theory, editorial is the critical activity undertaken hence the practice.
Critical theory is all pervasive and closely matches the current practices of the business. It also enable good insight into the business. Theory has it’s ground in the fundamental economic theory. Rather than suiting the practice to the needs of different business.
Reference: John H.Myers, “Accounting review”
This article is devoted to an examination of this most important and most neglected aspect of the problem.
Why do We Identify Extraordinary Gains and Losses:
Both the evaluation of current earnings levels and the projection of future earnings rely importantly on the separation of the stable elements of income and expense from those which are random, non-recurring and erratic in nature.
Stability and regularity are important dimensions of the quality of earnings on which the forecaster relies in making his earnings projections. Thus, in order to separate the relatively stable elements of income and expense from the random or erratic elements it is important, as a first step, to identify those gains and losses that are nonrecurring and unusual as well as those which are truly extraordinary.
Significance of Accounting Treatment and Presentation :
The accounting for, and the presentation of, extraordinary gains and losses has always been subject to controversy. One of the basic reasons for the controversy is reporting management’s great interest in the manner in which periodic results are reported. This concern is reinforced by a widespread belief that most investors and traders accept the reported net income figures, together with the modifying explanations that accompany them, as true indices of performance.
Extraordinary gains and losses often become the means by which managements attempt to modify the reported operating results. Quite often the accompanying explanations are slanted in a way designed to achieve the impact and impression desired by management.
Analysis and Evaluation:
The basic objectives in the evaluation of extraordinary items by the analyst are:
1.To determine whether a particular item is to be considered “extraordinary” for purposes of analysis; that is, whether it is so unusual that it requires special adjustment in the evaluation of current earnings levels and of future earning possibilities.
2. To decide what form the adjustment for items considered “extraordinary” should take. Determining Whether an Item of Gain or Loss Is Extraordinary :
Common classification of items
1.Non-recurring Operating Gains and Losses.
Non-recurring Operating Gains and Losses:
By “operating” we usually identify items connected with the normal and usual operations of the business.
The concept of recurrence is one of frequency. There are no predetermined generally accepted boundaries dividing the recurring event from the non-recurring. An event occurring once a year can be definitely classified as “recurring”. An event, the occurrence of which is unpredictable and which in the past has either not occurred or occurred very infrequently, may be classified as non-recurring.
Non-recurring operating gains or losses are, then, gains or losses connected with or related to operations that recur infrequently or unpredictably. e.g. foreign operations give rise to exchange adjustments because of currency fluctuations or devaluations.
Depending on the type of business and other factors, a degree of variability and abnormality must be expected.
In considering how to treat non-recurring, operating gains and losses the analyst would do best to recognize the fact of inherent abnormality and the lack of a recurring annual pattern in business and treat them as belonging to the results of the period in which they are reported.
Objectives of a business has undergone considerable revision in modem financial theory, which considers the main objective of management to be increasing the capital of the owners, or enhancing the value of the common stock rather than “baking bread” or any other specific objective.
The analyst should not be bound by the accountant’s concept of “normal operations”, hence he can usefully treat a much wider range of gains and losses as being derived from “operations”— reinforcing our conclusion that he should consider most non-recurring, operating gains and losses as part of the operating results of the year in which they occur.
Some items require separation from the results of a single year. The relative size of an item could conceivably be a factor requiring such treatment. In this case the best approach is to emphasize average earnings experience over, say, five years rather than the result of a single year. This approach of emphasizing average earnings becomes almost imperative in the case of enterprises that have widely fluctuating amounts of non-recurring and other extraordinary items included in their results.
Recurring Non-operating Gains or Losses:
This category includes items of a non-operating nature that recur with some frequency. Examples interest income and the rental received from employees who rent company owned houses.
While items in this category are classified as “extraordinary” in published financial statements, the narrow definition of “non-operating” which they involve, as well as their recurrent nature, are good reasons why they should not be excluded from current results by the analyst. They are, after all, mostly the result of the conscious employment of capital by the enterprise and their recurrence requires inclusion of these gains or losses in estimates designed to project future results.
Non-recurring, Non-operating Gains or Losses:
Not only are the events here non-repetitive and unpredictable, but they do not fall within the sphere of normal operations. In most cases these events are extraneous, unintended and unplanned. Business is ever subject to random shocks, be they natural or man-made, including for example: substantial uninsured casualty losses, such as those arising from fires, storms, floods, etc.
Of the three categories this one comes closest to meeting the criterion of being “extraordinary”. Nevertheless, truly unique events are very rare. What at the time seems unique may, in the light of experience, turn out to be the symptom of a new set of circumstances that may continue to affect earning power.
Effect of Extraordinary Items on Resources:
Every extraordinary gain or loss has a dual aspect. When it records a gain (whether extraordinary or not) a business also records an increase in resources. Similarly, when a business records a loss it also records a reduction of resources.
Since return on investment relates net income to resources, incurring extraordinary gains and losses will affect this important measure of profitability.. In other words, if earnings and events are to be used to make forecasts, then extraordinary items have implications beyond past performance. If an extraordinary loss results in the destruction of capital on which a certain return is expected, for example, that return may be lost to the future. Conversely, an extraordinary gain will result in an addition to resources on which a future return may be expected.
This means that in projecting profitability and return on investment, the analyst must take into account the effect of recorded extraordinary items as well as the likelihood of the occurrence of future events that may result in extraordinary items.
Implications for Accounting Profession:
The present practice in this area is not useful to the professional analyst and may be downright misleading to others. It is useful in helping certain managements to divert attention from their mistakes, their failures and from the risks which are inherent in their operations.
It is high time for the accounting profession to abandon the notion that it can pre-analyze and interpret the income statement for the reader by means of the loose principles of identification of extraordinary items existing today. Even assuming that such built-in interpretation is desirable, it would require a major research effort by the accounting profession in conjunction with the informed users of financial statements.
*The above article is a summary of paper Extraordinary Gains andlosses, Their Significance to the Financial Analyst by Leopold A. Bernstein, FINANCIAL ANALYSTS JOURNAL / NOVEMBER – DECEMBER 1972*
by Tearney M.G. Journal of Accountancy.
Goodwill accounting is one area where outdated techniques still exist with the blessing of the Accounting Principles Board. With the exception of amortization,’ valuing and reporting goodwill arising in business combination has remained basically unchanged since 1944, and yet one of the primary social responsibilities of any discipline should be to discard old methods and techniques in favor of expanding parameters of work in order to benefit society.
This article will attempt to show that the existence and acquisition of goodwill is predicated on some identifiable condition or conditions present within the acquired entity and that failure to recognize these intangibles is a dereliction of duty by the accounting profession.
Conditions favorable for goodwill
Goodwill acquired in business combination represents a payment made by one entity to acquire another’s profitability.
There are many reasons why one corporation might wish to purchase another. Those most often cited by authors* writing on the subject include the following:
- Accomplishing a particular market objective.
- Saving time in expanding into a new area.
- Acquiring management and technical skills.
- Achieving product diversification.
- Achieving integration.
“. . when one entity acquires another and willingly incurs a cost greater than the fair market value of the other’s net identifiable assets, the latter company possesses some characteristics important to the acquiring company.”
It is apparent from the above that, when one entity acquires another and willingly incurs a cost greater than the fair market value of the other’s net identifiable assets, the latter company possesses some characteristics important to the acquiring company. These are usually of an intangible nature, g., personnel skills, distribution channels, product diversification.
Intangibles of this type are frequently the primary motivating factor in the acquisition decision, yet consolidated financial statements not only fail to disclose these assets but also lump them together as one asset called “goodwill.”
Failure of Financial statements:
Historically, goodwill has become known as the excess profitability of an entity above that considered normal in the circumstances.
The cost of goodwill, as specified by generally accepted accounting principles, is the difference between (1) the total cost paid to acquire another entity and (2) the fair market value of assets acquired (usually only those reflected on the acquired company’s balance sheet). Thus, goodwill is valued indirectly by assigning it the unallocated portion of the purchase price.
The term “goodwill” then represents all of the assets acquired but not specifically identified, regardless of whether or not the purchased company has excess profits.
Goodwill has consequently become a misleading and uninformative term which means different things on different financial statements.
A reason often stated for non-recognition of assets acquired in business combinations, such as human resources, marketing facilities, geographic areas and so forth, is that their value is too subjective to allow allocation of total cost. Using this argument to justify recognition of goodwill rather than other existing valuable assets is analogous to burying one’s head in the sand to avoid being seen.
Cost assigned to acquired goodwill, in current accounting practice, is as subjectively determined as possible.
There is no attempt made to value goodwill directly; rather, goodwill is determined by the “drop-out” method, i.e., whatever is left must necessarily represent goodwill cost. This procedure results in financial statements which fail to disclose any of the underlying assets that prompted the acquisition decision.
A less subjective method that certainly would result in more informative financial statements would be to identify and value these underlying assets. For example, if a particular entity was acquired in order to provide access to previously unavailable geographic areas, this asset, “geographic area,” could be readily identified.
Its value could be determined by experts in the field, e.g., independent appraisers, based on such criteria as estimated cost to develop the new market and/or increase in income due to earlier penetration of the area. The asset “geographic area” could justifiably be amortized over the estimated time saved by acquisition as opposed to internal growth.
Identify Assets Acquired:
Current accounting practices for goodwill, as well as all other tangible and intangible assets acquired in business combinations, need to be updated to allow the preparation of consolidated financial statements that provide users with more information.
Whenever an acquired entity does possess excess profitability (theoretical goodwill), the underlying reasons for this excess could be identified, valued and recorded, rather than ignored and arbitrarily labeled “goodwill.“
Independent appraisers, many of whom specialize in valuing assets acquired in mergers, could be consulted to identify and value “hidden” assets purchased by acquiring an entire going concern. Negotiations leading up to a final settlement between the parties to an acquisition probably offer the best evidence of undisclosed intangibles.”
Prominent assets such as marketing channels and unique personnel skills will likely be mentioned in the minutes of these negotiations.
Mention might also be made of the assumed value of the intangibles; if not, a review of past accounting records should disclose amounts incurred in their development.
The failure of accountants to require identification and valuation of so-called “hidden assets” is not because the task is impossible or impractical, but apparently because of a lack of interest when a generally acceptable and less time-consuming alternative exists—i.e., labeling the entire excess cost “goodwill.”
Current practices in this area not only negate the informative nature of financial statements but also could result in a disservice to clients.
Current accounting practices for goodwill as well as for other valuable assets not appearing on an acquired company’s balance sheet are not in conformity with available valuation techniques. By substituting the catchall account “goodwill” for many assets purchased in business combinations, such as personnel skills and marketing channels, accountants are not only ignoring the existence of expert appraisers but perpetuating a disservice to clients and the general public as well. It is high time that we accountants recognized our social responsibility in this area.
Valuation techniques have been developed to a point where goodwill no longer need appear on financial statements. All assets acquired in business combinations, regardless how intangible they may be and whether or not they appear on the acquired entity’s balance sheet, should be identified, valued and disclosed, thereby removing one of the thorns in the accountant’s side.
*This is a small write up of the paper by Tearney M.G. published in Journal of Accountancy.*
Research Designs: Experiments
Once the research objective is defined, the hypotheses explained and the variables are defined, the researcher has to test the hypotheses. There are some fundamental problems that arise while testing the hypotheses:
- Whom shall we study?
- What shall we observe?
- When will observations be made?
- How will the data be collected?
Research Design is the “Blueprint” that enables the investigator to come up with the solutions to the fundamental problems faced while testing the hypotheses and guides him / her in the various stages of research. In other words it is the program that guides the investigator as he collects, analyzes and interprets the observation.
The Classical Experimental Design: It consists of two comparable groups:
An Experimental Group
The assignment of the cases to either of the group is random.
Pretest is taken for all cases prior to the introduction of the independent variable in the experimental group .Post test is taken for all cases after the experimental group has been exposed to independent variable. If the difference in measurements between posttest and pretest is significantly larger than the control group, it is inferred that the independent variable is causally related to the dependent variable
Causal inference: It is an inference about the change an independent variable is expected to produce in the direction and the magnitude of the dependent variable. In practice, the demonstration of causality involves three distinct operations:
- Demonstrating co-variation
- Eliminating spurious relations
- Establishing the time order of the occurrences
Components of a Research Design: The classic research design consists of four components:
- Comparison: It is an operation required to demonstrate that two variables are correlated. e.g. If a researcher wants to demonstrate a correlation between cigarette smoking and lung cancer, a researcher might compare the frequency of cancer cases among smokers and non-smokers or alternatively might compare the number of cancer cases in a population of smokers before and after they started smoking.
- Manipulation: Manipulation helps a researcher in establishing the time order of events. Here, the major evidence is required to determine the time sequence of events i.e. the independent variable precedes dependent variable. e.g. If a researcher is attempting to prove that the participation in an alcohol treatment group decreases denial of drinking problems, he or she must demonstrate that a decrease in denial took place after participation in the treatment group. The researcher needs to establish some form of control over the assignment to the treatment group so that he can measure the level of denial drinking problems before and after participation in the group
- Control: Control enables the researcher to determine that the observed co variation is non-spurious. Control requires that the researcher rule out other factors as rival explanations of the observed association between the variables under investigation. Such factors could invalidate the inference that the variables are causally related. This issue is termed as ‘internal validity’.
In order to establish the internal validity, a researcher must answer the question of whether changes in the independent variable did infact, cause the dependent variable to change. The following are the factors that may jeopardize the internal validity.
(3) Experimental mortality
(6) Regression artifact
(7) Interactions with selections
Methods to counteract the effect of Existing factors:
Matching: It is the of equating the experimental group and control group on existing factors that are known to be related to the research hypotheses. Two methods can be used for matching:
Precision Matching: In this method, for each case in an experimental group, another case with identical characteristics is selected for the control group.
Frequency Distribution: In this method, the experimental groups and control groups are made similar for each of the relevant variables separately rather than in combination.
Randomization: Even if it were possible to avoid the effects of all the factors, investigator can never be sure that all of them have been isolated. Other factors of which the investigator is unaware may lead to erroneous causal interpretations. Researchers avoid this problem by using Randomization, another process whereby cases are assigned to the experimental group and control group.
4. Generalization : Most research is concerned not only with the effect of one variable on another in the particular setting studied but also with its effect in other natural settings and on larger populations. This concern is termed as external validity of research design.
The two main issues of external validity are:
- Representativeness of the Sample
- Reactive Arrangements
Conclusion: The classical experimental design is one of the strongest logical models for inferring causal relations. The design allows for pretest, posttest and control group-experimental group comparisons. It permits the manipulation of the independent variable and thus determination of the time sequence. It controls the most sources of internal validity by including randomized group.
The external validity of this design is weak and it does not allow researchers to make generalization.
Two variations of the classical experiment design are stronger in this respect. They are:
- The Solomon four-group design
- The posttest- Only control group design
* This is an excerpt of the notes taken in Research Methodology class*