Lecture 3ACCT 332 Accounting Thought and PracticeACCT 332 Accounting Thought and Practice

Decision Usefulness Approach to Financial Reporting

- Chapter 3p- FASB Concepts No. 8 Conceptual Framework for

Financial Reporting

Objectives for Todays Class

Concept of Decision Usefulness

Si l P D i i Th Single Person Decision Theory

Information System Concept

Links to Conceptual Framework

Decision Usefulness Overview

Review of what we learned in previous lectureW li i ld h diti id l We live in a world where conditions are non-ideal (what does that mean?) and, therefore, there is not a true net income number, which provides a role for , paccounting reports

if we cant prepare theoretically correct financial statements, at least we can try to make them useful.

The role of accounting depends on how users make d i i d h i f ti (i l didecisions and how users use information (including accounting reports)

Amos LimNo scientifically true net income number

Amos LimWho are considered the primary users of FS? - Investors & Lenders/Creditors

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Decision Usefulness Overview

We can motivate our study of this topic from two perspectives:perspectives:

- From a theoretical perspective: to understand the role of financial reporting in non-ideal settings.p g g

How does information help investors make more informed decisions?

- From a practical perspective: to understand the objectives and characteristics of financial reporting (C t l F k Ch 1 Ch 3)(Conceptual Framework, Ch. 1, Ch. 3).

This concept has already been adopted by standard setters to evaluate and improvestandard-setters to evaluate and improve reporting.

Single Person Decision Theory

Key elements: Context: Investment decision

Decision-maker: Rational (what does that mean?)

Non-ideal conditions:

Uncertainty about state probabilities.

May not know cash flows, discount rates.

As we will see information is useful because itAs we will see, information is useful because it can help decision makers to update their probability assessments.p y

Amos LimUtility-maximising

Amos LimWe also assume that they are risk-averse

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Single Person Decision Theory- Role of Risk Aversion

Risk aversion among investors is generally well accepted -- what does a risk-averse utility function lookaccepted what does a risk averse utility function look like?

Amos LimUtility = Square root of payoffs Option 1: Guaranteed 480E(X) = 480E() = 21.9Option 2: 30% of 1,600, or 0.E(X) = 480E() = 30% x 1,600 + 70% x 0 = 12

Single Person Decision Theory (contd)

Single Person Decision Theory E l 3 1 i th t tb k- Example 3-1 in the textbook

2 states

Prior probabilities (before information is received).

Posterior Probabilities -- using Bayes Theorem.

Choose an action that maximizes the expected utility.

- Possibly not the way all investors make decision, but the results are consistent with observed outcomes.

- Why is it important for accountants to take into account investor risk aversion?

Amos LimTheir risk aversion affects the information that would be useful to them

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Textbook Example 3.1

Bill Cautious has $10,000 to invest for one period. He has narrowed down to two choices: buy shares of X Ltd at current market price (1) or government bonds yielding 2.25% (2).

If he buys X Ltd shares, he faces risk since the firms future f i t k H d fi t t tperformance is not known. He defines two states:

State 1: X Ltd future performance is high (return = 16%)

State 2: X Ltd future performance is low (return = 0)

Payoff Table:

Act State

High LowHigh Low

1:Buyshares

2:Buybonds

Amos Lim$1,600

Amos Lim$225

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Amos Lim$0

Amos LimDone

Textbook Example 3.1 (contd)

Bills assessment of the prior probability of each state to be: P(H)=0.3 and P(L)=0.7.( ) ( )

However, Bill is risk averse, so we now assume his utility is the square root of the payoff to take into account risk aversion.

Therefore, his expected utility from each act becomes:

If Bill needs to make a decision now, what is he likely , yto choose?

Amos LimE(1) = 0.3 x 1600 + 0.7 x 0 = 12E(2) = 225 = 15

Amos LimBuy bonds.

Amos LimThese are subjective estimates

Textbook Example 3.1 (contd)

Now lets assume Bill decides to use X Ltds current year annual report before making a decisionannual report before making a decision.

He knows that if the true state is high, there is 80% chance the financial statements will show good news (GN) and 20% g ( )chance bad news (BN). Vice versa, if the true state is low, there is 10% chance the financial statements will show GN and 90% BN (Why dont the financial statements provide info on90% BN. (Why don t the financial statements provide info on the states with absolute certainty?)

We will denote these conditional probabilities as P(GN|H)=0 8We will denote these conditional probabilities as P(GN|H) 0.8, P(BN|H)=0.2, P(BN|L)=0.9, P(GN|L)=0.1

Now, assuming X Ltds current year financial statements report , g y pgood news, then Bill will update his posterior probabilities

Amos LimNote the role of conservatism reflected in these probabilities

Amos LimThese are objective estimates. Assume based on large sample

Textbook Example 3.1 (contd)

Amos Lim0.80

Amos Lim0.30 x 0.80

Amos Lim0.77

Amos Lim0.30 x 0.80 + 0.70 x 0.10

Amos Lim0.10

Amos Lim0.20

Amos Lim0.90

Amos Lim(0.77 x 40) + (0.23 x 0) = 30.8

Amos Lim1 x 15 = 15

Amos LimBill will now buy stocks.

Amos LimIncreasing reliability: Increasing P(GN | H) and P (BN | L)Increasing relevance: Helps him predict/confirm future returns.

Information System

Key pointsI th l th i f ti i th i t - In the examples, the information improves the investors ability to assess the probability of one or another outcome.

Conditional probabilities Diagonal elements are the key- Conditional probabilities -- Diagonal elements are the key

The higher they are relative to off-diagonal elements, the more informative is the accounting informationmore informative is the accounting information.

Reflect on referents for these probabilities within the conceptual framework: qualitative characteristics.p q

- Accounting information did not provide a direct assessment of the future returns, but provides information that helps the investor update their own subjective estimates.

Amos LimMain diagonal \ = Probability that the right prediction is given when the right event occurs, and vice versa.

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Decision Usefulness- Link Accounting Policy to Conceptual Framework

Relevance to Accounting Policy- How do these theories make sense of important features of

the conceptual framework?

Justification for Ch 1 information that is useful is Justification for Ch. 1 -- information that is useful is assessing the amounts, timing and uncertainty of future cash flows.

To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decision about providing resources to the

tit entity

Financial reports are based on estimates, judgments, and models rather than exact depictions p

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Decision Usefulness- Link Accounting Policy to Conceptual Framework

Relevance to Accounting Policy- How do these theories make sense of important features of the

conceptual framework?

Qualitative Characteristics what makes information useful?

Primary characteristics

Relevance: predictive value, confirmatory value

Faithful representation: complete, neutral, free from error

E h i h t i ti Enhancing characteristics

Comparability, verifiability, timeliness, understandability

The cost constraint The cost constraint

What are some of the costs?

Amos LimConfirm expectations

Amos LimA.k.a reliability

Amos LimCompliance costs in terms of money, time, etc.

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Summary

Understand and apply single-investor theoryl i t t d i i b d i- solve investment decisions based on prior or

posterior possibilities

- update belief based on information signal and- update belief based on information signal and information system

Understand the implications of information system toUnderstand the implications of information system to financial reporting

Understand the key points in the conceptual framework y p pon objectives and quantitative characteristics of useful financial information

Group Questions

40 minutes to complete group questions A i t f di i l di Assignment of discussion-leading groups

Term Paper Topics

1. Information Asymmetry

2 Mandatory Disclosure2. Mandatory Disclosure

3. Voluntary Disclosure

4. Earnings Management

5. Executive Compensation

6. International Accounting Standards

7. Market Efficiency