DECISION USEFULNESS THEORY Chapter 3 – Group C
Feb 14, 2016
DECISION USEFULNESS THEORY
Chapter 3 – Group C
Agenda
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.
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.
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”:
Q1 What makes data informative?
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.
Flashback!
Relevancy vs. Reliability
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
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.
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.
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.
Risk Averse vs. Risk Neutral
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.
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
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
Q2 Diversification can reduce the ______ risk associated with a portfolio, but not the ________ risk.
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.
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.
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.