Accounting Theory

Chapter 3

The Decision Usefulness Approach to Financial

Reporting
 Objectives
—  Explain the decision-usefulness approach to financial
reporting.
—  Perform basic calculations to evaluate the expected utility
of decisions.
—  Explain the principle of diversification
—  Understand the concept of a securities beta, and be able to
explain why it is an important risk measure.
—  Trace and relate the objectives of financial reporting and the
qualitative aspects of financial statement information, as
given in the pronouncements of major professional
accounting bodies, to their roots in decision theory and
capital market theory.
If we can’t prepare theoretically
correct financial statements, at
least we can try to make
historical cost-based statements
more useful.
 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
The Rational Decision Theory Model
Role of the rational decision theory model
in financial reporting:
—  Helps us understand how financial
statement information helps investors to
make investment decisions
Example
—  10,000 to invest
—  2 options
—  Government Bonds @ 2.25% ($225)
Or
—  Shares in a company:
–  $1,600 return (high profits) 30% probability
–  $0 return (low profits) 70% probability

Utility – quantification of the satisfaction the return gives

the investor
This example assume square root of return
Decision:
EU(a1) = 0.30 × 40 + 0.70 × 0 = 12
EU(a2) = 1.00 × 15 = 15

Buy the Bonds

Continuation of Investment Example
—  Another alternative
◦  Wait for more information
—  Informationis evidence that has the
potential to affect an individual’s decision

—  Inthis example we wait for the company’s

Annual report
—  Looks like company had a great year
Link current performance to future
—  Ifthe future profitability of the firm is
really going to be high, there is an 80%
probability that the current year’s financial
statements will show good news (GN)
and 20% probability that they will show
bad news (BN).
—  Denote these probabilities by P(GN/H) =
0.80 and P(BN/H) = 0.20, respectively.
—  If
the future profitability of the firm is
going to be low, the probability that the
current year’s financial statements will
show GN is only 10%, giving a 90%
probability that they will show BN.
—  Denote these probabilities by P(GN/L) =
0.10 and P(BN/L) = 0.90, respectively.
Bayes’ Theorem Applied to
Accounting Information
—  A device to revise state probabilities upon receipt of new evidence

—  θ is state of firm

θ1 = H = high future firm performance
θ2 = L = low future firm performance
—  m is evidence received from the financial statements
m1 = GN = net income shows good news
m2 = BN = net income shows bad news
—  Suppose GN is received:
Now calculate posterior
probabilities

.30 x .80
.30x .80 + .70x .10
= .77 Good news will persist
.23 will not persist

EU(a1/GN) = 0.77 × 40 + 0.23 × 0 = 30.8

EU(a2/GN) = 1.00 × 15 = 15

We would now choose investment in shares

Why is Financial statement information
Useful?
—  For information to be useful to investors
it must help predict future investment
returns
—  Under historical cost accounting, the
financial statements do not show
expected future values directly but
statements will still be useful to investors
to the extent that they enable a
prediction that the good or bad news
they contain will persist into the future.
 The Information System
—  Shows Evidence Probabilities, Conditional on Each State, for Input
into Bayes’ Theorem

Current Financial Statement Total

Evidence
GN BN

H P(GH/H) P(BN/H) 1
State of
Nature
L P(GN/L) P(BN/L) 1
 Information System for our Example

Current Financial Statement Total

Evidence
GN BN

H .80 .20 1
State of
Nature
L .10 .90 1
—  Thehigher 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
Decision theory is important because it
helps us to understand why information is
such a powerful commodity — it can
affect the actions taken by investors.
Accountants, who prepare much of the
information required by investors, should
be aware of this powerful role.
Theory of Investment
—  Points to note:
◦  Risk aversion
◦  Portfolio diversification
◦  beta
—  Risk-averse investors can take advantage
of the principle of portfolio diversification
to reduce their risk by investing in a
portfolio of securities.
—  Firm-specific states of nature tend to
cancel out across securities
—  What is left are economy-wide factors as
the main contributors to portfolio risk.
Do Professional Accounting Bodies Accept
the Rational Decision Theory?
—  The major professional accounting bodies
have adopted the decision-usefulness
approach.
—  The earliest and most complete
statement of this adoption comes from
the FASB.
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
—  SFAC 2
◦  To help investors, financial statement
information should be:
–  Relevant
–  Can “make a difference”
–  Reliable
–  Faithful representation
–  Verifiable
–  Neutral
IASB
—  The objective of financial statements is to provide
information about the financial position, performance and
changes in financial position of an entity that is useful to a
wide range of users in making economic decisions
—  Information about financial position and past performance is
frequently used as the basis for predicting future financial
position and performance and other matters in which users
are directly interested, such as dividend and wage payments,
security price movements and the ability of the entity to
meet its commitments as they fall due. To have predictive
value, information need not be in the form of an explicit
forecast. The ability to make predictions from financial
statements is enhanced, however, by the manner in which
information on past transactions and events is displayed
—  The Framework is concerned with general purpose financial statements
… including consolidated financial statements. Such financial
statements are prepared and presented at least annually and are
directed toward the common information needs of a wide range of
users. Some of these users may require, and have the power to
obtain, information in addition to that contained in the financial
statements. Many users, however, have to rely on the financial
statements as their major source of financial information and such
financial statements should, therefore, be prepared and presented
with their needs in view
—  To be useful, information must also be reliable. Information has the
quality of reliability when it is free from material error and bias and
can be depended upon by users to represent faithfully that which it
either purports to represent or could reasonably be expected to
represent
—  In practice a balancing, or trade-off, between qualitative
characteristics is often necessary. Generally the aim is to achieve
an appropriate balance among the characteristics in order to meet
the objective of financial statements. The relative importance of
the characteristics in different cases is a matter of professional
judgement.