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DECISION USEFULNESS THEORY Chapter 3 – Group C
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Decision usefulness theory

Feb 14, 2016

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Decision usefulness theory. Chapter 3 – Group C. Agenda. What is the ‘Decision U sefulness’ Theory?. To make financial statements more useful we need to know what usefulness means WHO are the users of financial statements? WHAT are the decision problems faced by the users? - PowerPoint PPT Presentation
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Page 1: Decision usefulness theory

DECISION USEFULNESS THEORY

Chapter 3 – Group C

Page 2: Decision usefulness theory

Agenda

Page 3: Decision usefulness theory

What is the ‘Decision Usefulness’ Theory?

To make financial statements more useful we need to know what usefulness means

WHO are the users of financial statements? WHAT are the decision problems faced by the

users?

If we can answer these questions we will be able to make statements that will lead to improved decision making.

Page 4: Decision usefulness theory

Single person Decision Theory Decisions made under conditions of uncertainty –

state probabilities are subjective based on information.

Prior probabilities based on analysis of past financial statements, news, assessment and market price.

Posterior State Probabilities are adjusted probabilities after analysis of current financial statements.

Page 5: Decision usefulness theory

Information SystemExample 3.1

• The 0.8 and 0.9 are the main diagonal properties• The 0.2 and 0.1 are the off-main diagonal properties

Current Financial Statement Evidence

State Good News Bad News

High 0.8 0.2Low 0.1 0.9

Link between current information and future performance (quality of information) are the conditional probabilities in the following “information system”:

Page 6: Decision usefulness theory

Q1 What makes data informative?

Page 7: Decision usefulness theory
Page 8: Decision usefulness theory

Information system“Information is evidence that has the potential to

affect an individual’s decision” Enables the user to update prior probabilities. Noise: Weakening of relationship between

current financial information and future firm performance.

If main diagonal probabilities increase, it is the result of increased financial statement usefulness

The more informative an information system provides, the more decision useful it is.

Page 9: Decision usefulness theory

Flashback!

Relevancy vs. Reliability

Page 10: Decision usefulness theory

IASB/FASBReaction of Professional Bodies What is the ultimate goal of the

accounting framework?“provide financial information that is “useful to present and potential equity investors, lenders

and other creditors [constituencies – primary user group] in making decisions in their capacity as

capital providers” What types of information do they need?

Amount, timing and uncertainty of firm’s future cash flows

Page 11: Decision usefulness theory

CICA Handbook

Section 1000 - Financial Statement Concepts

Amendments to this Section focus on clarifying the criteria for asset recognition. These amendments are a continuation of the trend which places more emphasis on the balance sheet than the matching principle.

Page 12: Decision usefulness theory

Accounting Changes Section 1000

Intangible Assets“Frame Work for the preparation and

Presentation of Financial Statements” - helps distinguish assets from expenses.

Section 1100 Rate – Regulated operations

Allowance of the recognition and measurement of assets and liabilities arising from rate regulation was withdrawn.

Page 13: Decision usefulness theory

Rational/Risk Averse Investor

Review: Bayes Theorem

Risk aversion is when an investor who is faced with two investment options will choose the option with less risk.

Page 14: Decision usefulness theory

Risk Averse vs. Risk Neutral

Page 15: Decision usefulness theory

Example 3.2 - Utility Suppose a risk-averse investor has $200 to

invest and is considering investing it all in the shares of firm A, currently trading at $20. Assume there is a 74% chance the shares will increase to $22 and a 26% chance the shares will decrease to $17. Also assume that firm A will pay a $1 dividend. Your utility function is:

Required: Determine the investor’s utility for this investment.

Page 16: Decision usefulness theory

AnswerPayoff Rate of Return Probability Expected Rate of

ReturnVariance

$230 0.15 0.74 0.1110 0.0031

$180 0.26 0.26 -0.0260 0.0089

Total 0.0850 0.0120

Page 17: Decision usefulness theory

Optimal Investment Decision The optimal investment decision

includes holding the market portfolio. Two ways to adjust risk:

Invest in risk-free assets Borrow at the risk-free rate and buy more of

the market portfolio

Page 18: Decision usefulness theory

Q2 Diversification can reduce the ______ risk associated with a portfolio, but not the ________ risk.

Page 19: Decision usefulness theory

Principle of Portfolio Diversification By investing the same amount, spread

over different securities, investors can reduce the risk level for the same level of return.

Page 20: Decision usefulness theory

How to Diversify… In diversifying a portfolio , an investor

needs to consider the correlation of the shares. Market-wide factors vs. idiosyncratic (firm-

specific) factors When transaction costs ignored, diversify

with few securities instead of the market portfolio to optimize benefits.

Page 21: Decision usefulness theory

Portfolio Risk Beta measures the co-movement

between changes in the price of a security and changes in the market value of the market portfolio

Beta of A shares = Covar A & M/Var M Enables prospective investors to

compare portfolios and choose preferred risk-return tradeoff.