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Chapter 3

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Department
Business
Course
BU457
Professor
Bixia Xu
Semester
Fall

Description
FAT Chapter 3 – The Decision Usefulness Approach to Financial Reporting • Decision usefulness – financial statements should be useful The Decision Usefulness Approach • Constituencies of accounting: broad group of users of financial statements (equity and debt investors, managers, unions, standard setters, governments) • Tailoring financial statement information to specific needs of the users of those statements will lead to improved decision-making • Accountants have decided that investors are a major constituency of users and have turned to various theories in economics and finance – in particular, to theories of decision and investment – to understand the type of financial statement information investors need Single-Person Decision Theory • Single-person decision theory takes the viewpoint of an individual who must make decision under conditions of uncertainty • Decision theory is relevant to accounting because financial statements provide additional information that is useful for making decisions • Example o Payoff – the amounts to be received from a decision o Prior probabilities – subjective probabilities incorporating all that is known about the company to this point o Posterior state probabilities – subjective probabilities incorporating information posterior to the financial statement evidence P(H)P(GN∨H)  P H GN = ) P(H)P(GN ∣H )+P(L)P(GN∨L) 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 more informative the system • The more informative an information system, the more decision useful it is • Rational expectations – investors are assumed to quickly form accurate estimates of unknown, underlying parameters, in this case the information system probabilities • One approach to forming accurate estimates is by sampling recent financial statements in the same industry, and record the number of times GN is followed by high performance • The second approach involves the Value Line analysts’ revision of future quarterly earnings forecasts following the GN or BN in firms’ current quarterly earnings • Effect of current financial statement information on analysts’ next quarter earnings forecast a “revision coefficient,” which is a proxy for the average earnings quality of the sample firms and reflects the magnitude of the information system probabilities • EZ also found that the higher a firm’s revision coefficient is, the stronger was the effect of the GN or BN in current earnings on the market price of the firm’s shares Information Defined • Information is evidence that has the potential to affect an individual’s decision o Ex ante definition • Information needed for good investment decisions will in general differ from information to evaluate manager stewardship • Each individual’s prior probabilities and utilities may differ, so that posterior probabilities, and hence their investment decisions, may differ even when confronted with the same evidence • An information source may have the potential to affect an individual’s decision but, if it is too costly, it is not information since it will not be used • It can be argued that financial statements are a cost-effective information source (at least for investors, who do not pay for their preparation) since they are readily available and reasonably well understood by investors • There are many other information sources that can also effect decisions, not just financial statements The Rational, Risk-Averse Investor • In decision theory, the concept of a rational individual simply means that in making decisions, the chosen act is the one that yields the highest expected utility o Implies that the individual may search for additional information relating to the decision, using it to revise state probabilities by means of Bayes’ Theorem • Theory assumes that average behaviour of investors who want to make good investment decisions are rational • It is also assumed that rational investors are risk-averse o Risk-averse individuals trade off expected return and risk o This is modeled by utility function diagrams • It is sometimes assumed that decision-makers are risk-neutral o They evaluate risky investments strictly in terms of expected payoff – risk itself does not matter per se • Risk aversion is the more realistic assumption in most cases • The concept of risk aversion is important to accountants, because it means that investors need information concerning the risk, as well as expected value, of future returns The Principles of Portfolio Diversification • One way investors can lower risk for a given expected return is to
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