Chapter 3

1. Chapter 3 The Decision Usefulness Approach to Financial Reporting

2. Chapter 3The Decision Usefulness Approach to Financial Reporting

3. 3.2 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

4. 3.3 The Rational Decision Theory Model • A model of rational decision making in the face of uncertainty • Definition of rationality? • A game against nature: “nature does not think” • Other ways to make decisions? • Continued

5. 3.3 The Rational Decision Theory Model (continued) • Role of the rational decision theory model in financial reporting • Helps us understand how financial statement information helps investors to make investment decisions • Captures average investor behaviour?

6. Bayes’ Theorem • A device to revise state probabilities upon receipt of new evidence • Θ is state of nature • m is message received • P(θ) is prior probability of θ (subjective) • Formula

7. Bayes’ Theorem Applied to Accounting Information • 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:

8. 3.3.2 The Information System IShows Evidence Probabilities, Conditional on Each State, for Input into Bayes’ Theorem

9. The Information System II • The higher 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

10. The Information System III • Information system probabilities are objective • Reflect quality of GAAP • How known by investor? • Prior probabilities are subjective • Investor assesses them based on all information available prior to the investment decision

11. The Information System IV • If prior probabilities are subjective, so are posterior probabilities • However, if financial statement information is informative, posterior probabilities are better predictors of future firm performance than prior probabilities

12. 3.3.3 Definition of Information • Information is evidence that has the potential to affect an individual’s decision

13. Theory of Investment • Points to note: • The rational investor • Risk aversion • Portfolio diversification • beta

14. 3.8 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 uncertaintyof investment proceeds (i.e., of future firm performance) • Note that Bayes’ theorem is implied • Continued

15. 3.8 Do Professional Accounting Bodies Accept the Rational Decision Theory? (continued) • SFAC 2 • To help investors, financial statement information should be: • Relevant • Can “make a difference” • Reliable • Faithful representation • Verifiable • Neutral

16. Conclusions • Rational decision theory provides a theoretical underpinning for study of information needs of investors • Conceptual framework SFAC 1 and SFAC 2 accept the rational decision theory model