decision usefulness theory

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.