Introduction

Outline

• Role of accounting information

• Information vs measurement perspectives
• Approaches to equity valuation
Role of Accounting Information

Information Asymmetry

Non-ideal conditions characterized by information asymmetry

• Adverse selection
→ One party has more information than the other

• Moral hazard
→ One party’s actions cannot be fully observable by the other
Role of Accounting Information

• To help control Adverse Selection (Valuation role)

→ Convert insider information into useful information for outside
investors
→ Provide full and timely disclosure of relevant and reliable
information
→ E.g. Balance Sheet, Income Statements, Cash Flows Statement,
Changes to Equity, Notes to accounts, MD&A

• To help Control Moral Hazard: Agency Problem (Monitoring role)

→ Control manager shirking and improve corporate governance
→ Provide measures to encourage or restrict certain actions
→ E.g., Bonus plans based on target ROA/ROE; debt covenants
restricting dividend payouts based on net worth (or shareholder
equity)
Role of Accounting Information

But, the best information to control adverse selection may not be the
same as the best information to control moral hazard

• Investors want information about future cash flows and firm

performance
→ Fair value accounting?

• Shareholders want to know how hard the managers worked and how
capable they are:
→ Historical cost accounting based on realized transactions?
→ Stewardship reporting?

• Bondholders want estimate of worst case scenarios to assess

bankruptcy risks
→ Conservative accounting?
Role of Accounting Information

Conceptual Framework
Objective of financial reporting
Role of Accounting Information

Conceptual Framework
Objective of financial reporting
Information vs Measurement Perspectives

2 views to preparing financial reports:

• The information perspective

→ This approach assumes that the market is efficient and therefore
accounting policy does not matter as long as all information is fully
disclosed.
→ It recognizes investors’ responsibility for predicting future firm
performances.

• The measurement perspective

→ This approach recognizes an increased obligation to assist investors to
predict future firm performance by incorporating current values into
financial statements proper.
→ This resulted from an increased recognition of the existence of
information asymmetry and market inefficiencies.
Approaches to Equity Valuation

• Market approach (a.k.a relative valuation method)

→ Comparison with similar companies
→ Typically implemented using some financial metrics such as P/E,
P/sales, P/B, etc

• Income approach (a.k.a absolute valuation method)

→ Focuses on the cash flow-generating capability of a company
→ Expected cash flow used can be dividend, free cash flow to equity
holders, etc.
→ Need a discount rate to derive present value of future economic
benefits
→ Discount rate should reflect risk of expected cash flow

• Asset-based approach
→ Values individual assets/liabilities and aggregates them to arrive at
a company value
→ Also need to identify omitted assets/liabilities in balance sheet