Copyright © 2009 by Pearson Education Canada 3 - 1 Chapter 3 The Decision Usefulness Approach to Financial Reporting
Copyright © 2009 by Pearson Education Canada 3 - 1 Chapter 3 The Decision Usefulness Approach to Financial Reporting.
Dec 28, 2015
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Copyright © 2009 by Pearson Education Canada3 - 1
Chapter 3The Decision Usefulness Approach to Financial Reporting
Copyright © 2009 by Pearson Education Canada3 - 2
Chapter 3The Decision Usefulness Approach to Financial Reporting
Copyright © 2009 by Pearson Education Canada 3 - 3
3.2 The Decision Usefulness Approach
• It is the investor’s responsibility to make investment decisions
• Role of financial reporting is to supply information that is useful for this purpose
• To prepare useful information, the accountant must know how investors make decisions
Copyright © 2009 by Pearson Education Canada 3 - 4
3.3 The Rational Decision Theory Model
• A model of rational decision making in the face of uncertainty– Definition of rationality?
• A game against nature: “nature does not think”• Other ways to make decisions?
» Continued
Copyright © 2009 by Pearson Education Canada 3 - 5
3.3 The Rational Decision Theory Model (continued)
• Role of the rational decision theory model in financial reporting– Helps us understand how financial statement
information helps investors to make investment decisions
– Captures average investor behaviour?
Copyright © 2009 by Pearson Education Canada 3 - 6
Bayes’ Theorem
• A device to revise state probabilities upon receipt of new evidence– Θ is state of nature– m is message received– P(θ) is prior probability of θ (subjective)
• Formula
PmP
mPPmP
/
//
Copyright © 2009 by Pearson Education Canada 3 - 7
Bayes’ Theorem Applied to Accounting Information
• θ is state of firmθ1 = H = high future firm performance
θ2 = L = low future firm performance
• m is evidence received from the financial statementsm1 = GN = net income shows good news
m2 = BN = net income shows bad news
• Suppose GN is received:
Copyright © 2009 by Pearson Education Canada 3 - 8
3.3.2 The Information System IShows Evidence Probabilities, Conditional on
Each State, for Input into Bayes’ Theorem
Current Financial Statement
Evidence
GN BN
Total
H
State of
Nature
L
P(GH/H)
P(BN/H) 1
P(GN/L) P(BN/L) 1
Copyright © 2009 by Pearson Education Canada 3 - 9
The Information System II
• The higher the main diagonal probabilities, the better the investor can predict the state of nature (i.e., future firm performance)– The main diagonal probabilities capture financial statement
informativeness– Highly informative financial statements also called:
• Transparent
• Precise
• High quality
Copyright © 2009 by Pearson Education Canada 3 - 10
The Information System III
• Information system probabilities are objective– Reflect quality of GAAP– How known by investor?
• Prior probabilities are subjective– Investor assesses them based on all information
available prior to the investment decision
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The Information System IV
• If prior probabilities are subjective, so are posterior probabilities– However, if financial statement information is
informative, posterior probabilities are better predictors of future firm performance than prior probabilities
Copyright © 2009 by Pearson Education Canada 3 - 12
3.3.3 Definition of Information
• Information is evidence that has the potential to affect an individual’s decision
Copyright © 2009 by Pearson Education Canada 3 - 13
Theory of Investment
• Points to note:– The rational investor– Risk aversion– Portfolio diversification– beta
Copyright © 2009 by Pearson Education Canada 3 - 14
3.8 Do Professional Accounting Bodies Accept the Rational Decision
Theory?• SFAC 1
– Oriented to investors– Oriented to rational investment decisions– Accepts that investors are risk averse– Financial statements provide information to help
investors assess (posterior probabilities of) the amounts, timing, and uncertainty of investment proceeds (i.e., of future firm performance)• Note that Bayes’ theorem is implied
» Continued
Copyright © 2009 by Pearson Education Canada 3 - 15
3.8 Do Professional Accounting Bodies Accept the Rational Decision
Theory? (continued)
• SFAC 2– To help investors, financial statement information
should be:• Relevant
– Can “make a difference”
• Reliable– Faithful representation– Verifiable– Neutral
Copyright © 2009 by Pearson Education Canada 3 - 16
Conclusions
• Rational decision theory provides a theoretical underpinning for study of information needs of investors
• Conceptual framework SFAC 1 and SFAC 2 accept the rational decision theory model
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