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Lecture 20

BU457 Lecture 20: The Information System

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Bixia Xu

The Information System • For the financial statements to be useful, it must help predict future investment returns • Financial statements will be useful to investors to the extent that the good or bad news they contain will persist into the future • Financial statements can still be useful to investors even though they do not report directly on future cash flows by means of present value calculations • Lack of ideal conditions give the financial statements their information content • Information system – a table giving, conditional on each nature, the objective probability of each possible financial statement evidence item • Main diagonal probabilities: left to right, top to bottom • Off-main diagonal probabilities: right to left, bottom to up • Noise – weakening of the relationship between current financial statement information and future firm performance • Information system is informative, since it enables investors to update their prior probabilities to reflect on what they know, thereby affecting their decision • Financial statements that are highly informative, and the information system that underlies them, are often called transparent, precise, or high quality, since they convey lots of information to the investors • The extent of informativeness for investment decisions depends on the relevance and reliability of the financial statements o Ex. A move to value-in-use in accounting will increase informativeness only if its greater relevance outweighs the decrease in reliability • Supplementary current value information is one way to increase relevance without sacrificing reliability or vice versa • Informativeness also depends on the extent to which financial reporting is conservative o Conservatism: requiring a higher standard of verification to record gains than to record losses • The higher the main diagonal probabilities relative to the off- main diagonal ones, the
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