You are on page 1of 17

Lecture 3

ACCT 332 Accounting Thought and Practice


Decision Usefulness Approach to Financial Reporting
- Chapter
p 3
- FASB Concepts No. 8 Conceptual Framework for
Financial Reporting

Objectives for Todays Class


Concept of Decision Usefulness
Si l Person
Single
P
Decision
D i i Th
Theory
Information System Concept
Links to Conceptual Framework

Decision Usefulness Overview

Review of what we learned in previous lecture

W
We live
li in
i a world
ld where
h
conditions
diti
are non-ideal
id l
(what does that mean?) and, therefore, there is not a
No scientifically true
net income number
true net income number,, which provides
p
a role for
accounting reports

if we cant prepare theoretically correct financial


statements, at least we can try to make them useful.
The role of accounting depends on how users make
d i i
decisions
and
dh
how users use iinformation
f
ti (including
(i l di
accounting reports)
Who are considered the primary users of FS? - Investors & Lenders/Creditors

Decision Usefulness Overview

We can motivate our study of this topic from two


perspectives:
-

From a theoretical perspective: to understand the


p
g in non-ideal settings.
g
role of financial reporting

How does information help investors make more


informed decisions?

From a practical perspective: to understand the


objectives and characteristics of financial reporting
(C
(Conceptual
t lF
Framework,
k Ch
Ch. 1
1, Ch
Ch. 3)
3).

This concept has already been adopted by


standard setters to evaluate and improve
standard-setters
reporting.

Single Person Decision Theory

Key elements:

Context: Investment decision

Decision-maker: Rational (what does that mean?)


Utility-maximising

We also assume that they are risk-averse

Non-ideal conditions:

Uncertainty about state probabilities.

May not know cash flows, discount rates.

As we will see
see, information is useful because it
can help decision makers to update their
probability
p
y assessments.

Single Person Decision Theory


- Role of Risk Aversion

Risk aversion among investors is generally well


accepted -- what does a risk
risk-averse
averse utility function look
like?
Utility = Square root of payoffs
Option 1: Guaranteed 480
E(X) = 480
Option 2: 30% of 1,600, or 0. E(X) = 480

E() = 21.9
E() = 30% x 1,600 + 70% x 0 = 12

Single Person Decision Theory (contd)

Single Person Decision Theory


-

E
Example
l 3-1
3 1 iin th
the ttextbook
tb k

2 states

Prior probabilities (before information is received).

Posterior Probabilities -- using Bayes Theorem.

Choose an action that maximizes the expected utility.

Possibly not the way all investors make decision, but the
results are consistent with observed outcomes.

Why is it important for accountants to take into account


investor risk aversion?
Their risk aversion affects the information that would be useful to them

Textbook Example 3.1

Done

Bill Cautious has $10,000 to invest for one period. He has


narrowed down to two choices: buy shares of X Ltd at current
market price ( 1) or government bonds yielding 2.25% ( 2).
If he buys X Ltd shares, he faces risk since the firms future
performance
f
is
i nott kknown. H
He d
defines
fi
ttwo states:
t t
State 1: X Ltd future performance is high (return = 16%)
State 2: X Ltd future performance is low (return = 0)

Payoff Table:
Act

State
High

Low

1: Buy shares

$1,600

$0

2: Buy bonds

$225

$225

Textbook Example 3.1 (contd)

Bills assessment of the prior probability of each state


These are subjective estimates
( )
and P(L)=0.7.
( )
to be: P(H)=0.3
However, Bill is risk averse, so we now assume his
utility is the square root of the payoff to take into
account risk aversion.
Therefore, his expected utility from each act becomes:
E(1) = 0.3 x 1600 + 0.7 x 0 = 12
E(2) = 225 = 15

If Bill needs to make a decision now,, what is he likelyy


to choose?
Buy bonds.

Textbook Example 3.1 (contd)

Now lets assume Bill decides to use X Ltds current year


annual report before making a decision.
decision
He knows that if the true state is high, there is 80% chance the
good news ((GN)) and 20%
financial statements will show g
chance bad news (BN). Vice versa, if the true state is low,
there is 10% chance the financial statements will show GN and
90% BN.
BN (Why dont
don t the financial statements provide info on
are objective estimates. Assume based
the states with absolute certainty?) These
on large sample
We will denote these conditional probabilities as P(GN|H)=0
P(GN|H) 0.8,
8
the role of conservatism
P(BN|H)=0.2, P(BN|L)=0.9, P(GN|L)=0.1 Note
reflected in these probabilities
Now,, assuming
g X Ltds current yyear financial statements report
p
good news, then Bill will update his posterior probabilities

Textbook Example 3.1 (contd)


Increasing reliability: Increasing P(GN | H) and P (BN | L)
Increasing relevance: Helps him predict/confirm future returns.

0.80

0.20

0.10

0.90

0.30 x 0.80
0.30 x 0.80 + 0.70 x 0.10

(0.77 x 40) + (0.23 x 0) = 30.8


1 x 15 = 15

Bill will now buy stocks.

0.77

Information System

Key points
-

IIn the
th examples,
l
the
th information
i f
ti improves
i
the
th investors
i
t
ability to assess the probability of one or another outcome.
Main diagonal \ = Probability that the right prediction is given when the right event occurs, and vice versa.

Conditional probabilities -- Diagonal elements are the key

The higher they are relative to off-diagonal elements, the


more informative is the accounting information
information.

Reflect on referents for these probabilities within the


conceptual
p
framework: q
qualitative characteristics.

Accounting information did not provide a direct assessment


of the future returns, but provides information that helps the
investor update their own subjective estimates.

Decision Usefulness
- Link Accounting Policy to Conceptual Framework

Relevance to Accounting Policy


-

How do these theories make sense of important features of


the conceptual framework?

Justification for Ch.


Ch 1 -- information that is useful is
assessing the amounts, timing and uncertainty of future cash
flows.

To provide financial information about the reporting entity that


is useful to existing and potential investors, lenders, and other
creditors in making decision about providing resources to the
entity
tit

Financial reports are based on estimates, judgments, and


models rather than exact depictions
p

Decision Usefulness
- Link Accounting Policy to Conceptual Framework

Relevance to Accounting Policy


-

How do these theories make sense of important features of the


conceptual framework?

Qualitative Characteristics what makes information useful?

Primary characteristics

A.k.a reliability

Relevance: predictive value, confirmatory value


Faithful representation: complete, neutral, free from error

E h
Enhancing
i characteristics
h
t i ti

Comparability, verifiability, timeliness, understandability

The cost constraint

Confirm expectations

What are some of the costs?

Compliance costs in terms of money, time, etc.

Summary

Understand and apply single-investor theory

solve
l iinvestment
t
td
decisions
i i
based
b
d on prior
i or
posterior possibilities

update belief based on information signal and


information system

Understand the implications of information system to


financial reporting
Understand the keyy points
p
in the conceptual
p
framework
on objectives and quantitative characteristics of useful
financial information

Group Questions

40 minutes to complete group questions


A i
Assignment
t off di
discussion-leading
i l di groups

Term Paper Topics


1.

Information Asymmetry

2
2.

Mandatory Disclosure

3.

Voluntary Disclosure

4.

Earnings Management

5.

Executive Compensation

6.

International Accounting Standards

7.

Market Efficiency

You might also like