CHAPTER 3 The Decision Usefulness Approach to Financial Reporting

1
CHAPTER 3The Decision Usefulness Approach to
Financial Reporting

• Nicole Fitzmaurice, Eric Poolman, Lisa Landon,
  Pang Sing Koh Ping Zhou

2
Decision Usefulness Approach

• Topics
• Single Person Decision Theory
• The Information System
• Information defined
• Rational, Risk-Adverse Investor
• Investment Theory
• The Principle of Portfolio Diversification
• The Optimal Investment Decision
• Portfolio Risk
• Reaction of Professional Accounting Bodies to the
  Decision Usefulness Approach

3
3.2 Decision Usefulness Approach

• Who are the users of the financial statements?
• Investors, lenders, managers, unions, government
  and standard setters (invisible)
• What are the decision problems of the users?
• whether to invest or lend funds
• make company decisions
• see if companies are complying to regulations

4
3.3 Single Person Decision Theory

• Decisions made under conditions of uncertainty
• State probabilities are no longer objective
• Formal procedures are set up to assist in making
  the best decision.

5
3.3.1 Decision Theory Applied

• Bill Cautious has 10,000 to invest in either
  shares of X Ltd or government bonds yielding 2 ¼
  .
• State 1 X Ltd future performance high
• net return is 1,600
• State 2 X Ltd future performance low_
• net return is 0

6
Payoff Table
ACT STATE STATE
High Low
Buy shares 1,600 0
Buy bonds 225 225

• probability of state 1 .30
• probability of state 2 .70

7
Decision Tree

• high
  performance - .30 Payoff
  (Utility)
• 
  
• 
  
  1600 (40)
• shares
• Invest --------- low
  performance - .70
• (10,000)
  
  0 (0)
• 
  performance high or low 1.00
• bonds
  
  225 (15)
• Shares (.30 x 40) (.70 x 0) 12
• Bonds 1.00 x 15 15

8
Alternative 2 Financial Statement Probability

• High state firm

• Low state firm

• P(GN/H) .80
• P(BN/H) .20

• P(GN/L) .10
• P(BN/L) .90

Where GN Good news BN Bad news H high
performance L low performance
9
Alternative 2 contD...

• Posterior State Probabilities (Bayes Theorem)
• High Performance Low Performance
• P(H/GN) .30 x .80 1.00 - .77 .23
  (.30x.80) (.70x.10)
• .77
• Expected Utility
• Shares (.77 x 40) (.23 x 0) 30.8
• Bonds 1.00 x 15 15

10
Financial Statement Information Usefulness

• It is important for users to know why financial
  statement information is useful
• WHY
• Because the usefulness helps investors predict
  future investment returns/payoffs
• Under non-ideal conditions the financial
  statement does not give direct information about
  expected future firm performance
• However, FS information is still useful
• Under the assumption good or bad new will
  continue in the future

11
3.3.2 The Information System

• "An information system is a table giving,
  conditional on each state of nature, the
  objective probability of each possible financial
  statement evidence item."

off-main diagonal probabilities
main diagonal probabilities
12
3.3.2 The Information System

• Higher the main diagonal probabilities the more
  useful the FS information becomes
• Thus investors can better predict the expected
  future firm performance
• Noise represents the weakening of the
  relationship between the current FS information
  and future firm performance
• NOTE information system concept is
  decision-specific

13
3.3.3 Information Defined

• Information is evidence that has the potential
  to affect an individuals decision.
• Information is used to come to a conclusion
• Once information is gathered an individuals
  conclusions may change
• FS, if reliable and relevant, are important
  source of information

14
3.4 The Rational, Risk-Averse Investor

• Maximizes expected utility
• A model of how the average investor should make
  decisions
• Does not imply that all investors make decisions
  this way
• Investor is usually assumed to be risk-averse
• When faced with 2 choices with the same expected
  payoff, would prefer the one with lower risk.
• Risk costs something, causing trade-off between
  risk and return
• How to model?
• Concave utility function for payoff

15
Modeling Risk Aversion withConcave Utility
Function
Choices State State Probability of Payoffs Probability of Payoffs
High Low High Low
A (Shares) 225 0 60 40
B (T-bills) 100 100 - -
16
Risk Neutral

• Risk does not cost anything
• Reasonable assumption when payoffs are small and
  inconsequential
• Linear function of payoff U(x) bx

Slope b
17
3.5 Principle of Portfolio Diversification

• Now, will use mean-variance utility function to
  model risk aversion
• Utility increases with expected rate of return,
  decreases with risk of return
• Principle of Portfolio Diversification
• Holding expected rate of return constant, more
  than one investment spreads risk and increases
  utility, provided the returns are not perfectly
  correlated
• Market-wide factors affecting returns
• Non-diversifiable
• Firm-specific factors affecting returns
• Diversifiable

-
18
Example 1

• Toni, a risk-averse investor has 200 to invest
• Payoffs from firm As share
• If shares increase 230 (Probability 0.74)
• If shares decrease 180 (Probability 0.26)

Payoff Rate of Return Probability Expected Rate of Return Variance
230 (230 200) / 200 0.15 0.74 0.1110 (0.15 0.085)2 x .74 0.0031
180 (180 - 200) / 200 -0.10 0.26 -0.026 (-0.10 0.085)2 x .26 0.0089

19
Example 1 contd

• Assume that Tonis utility function is
• Utility from this investment is
• (2 x 0.085) 0.012 0.1580
• Can Toni do better?

20
Example 2
Buy 2 Investments instead, Investment A and B
States Payoff Rate of Return Probability Expected Rate of Return Variance
GG 230 (230 200) / 200 0.15 0.5742 0.0861 (0.15 0.085)2 x .5742 0.0024
GB 214 (214 - 200) / 200 0.07 0.1658 0.0116 (0.07 0.085)2 x .1658 0.0000
BG 200 (200 - 200) / 200 0.00 0.1008 0.0000 (0.00 0.085)2 x .1008 0.0007
BB 184 (184 - 200) / 200 -0.08 0.1592 -0.0127 (-0.08 0.085)2 x .1592 0.0043

• Her utility now is
• (2 x 0.085) 0.0074 0.1626 (0.158 in Example
  1)

21
3.6 The Optimal Investment Decision(Ignoring
transaction costs)

• To maximize diversification, buy the market
  portfolio
• Firm-specific risks are diversified away
• Only systematic (economy-wide) risks remain
• To maximize utility, buy a combination of market
  portfolio and risk-free asset
• Achieve desired risk-return trade-off, depending
  on investors risk-averseness
• Does not undo the benefits of diversification

22
Optimal Portfolio Investment Decision
23
3.7.1 Calculating and Interpreting Beta

• Beta measures the changes in the price of a
  security in relation to changes in the market
• A high beta stock's price will fluctuate by a
  large margin in response to changes in the market
• Using beta helps to attain desired level of risk
  in a portfolio

24
3.7.2 Portfolio Expected Value and Variance

• Expected rate of return and variance need to be
  calculated for the mean-variance utility function
• Expected rate of return on a portfolio
• Variance of portfolio
• Covariance between securities can be expressed
  as

25
3.7.3 Portfolio Risk as the Number of Securities
Increases

• As securities in portfolio increase, systematic
  risk increases rapidly
• Most of the benefits of diversification can be
  attained with relatively few securities in the
  portfolio
• Entire market portfolio does not need to be
  purchase to adequately diversify

26
3.8 PROFESSIONAL ACCOUNTING REACTION TO THE
DECISION USEFULNESS APPROACH

• Adopted by most of the major professional
  accounting bodies
• FSAB adopted as part of the Conceptual Framework
  project, specifically mentions investors needs
  for information about the uncertainty of
  future investments and their expected values
• Section 1000 does not mention the risk factor
• Statement of Financial Accounting Concepts 1978
  (SFAC 1) states the purpose of the project is
• to set forth fundamentals on which financial
  accounting and reporting standards will be based
  

27
SFAC 1

• Objective 1 on financial reporting
• to provide information that is useful to present
  and potential investors and creditors and other
  users in making rational investment, credit, and
  similar decisions.

28
SFAC 1

• Objective 2 on financial reporting
• provide information to help present and
  potential investors and creditors and other users
  in assessing the amounts, timing, and uncertainty
  of prospective cash receipts from dividends or
  interest and the proceeds from the sale,
  redemption, or maturity of securities or loans.

29
SFAC 1 Information System Linkage

• although investment and credit decisions reflect
  investors and creditors expectations about
  future enterprise performance, those expectations
  are commonly based at least partly on evaluations
  of past enterprise performance.

30
SFAC 2

• Relevant accounting information is capable of
  making a difference in a decision by helping
  users to form predictions about the future
  outcomes of past, present and future events or to
  confirm or correct prior expectations.
• Also important is timeliness.

31
CICA Handbook Sections 1000 1100

• The CICA and FASB have accepted the decision
  theory model as a guide to the preparation of
  useful financial statement information
• Sections 1000 and 1100 of the CICA Handbook,
  contain evidence of the decision theory model
• Adherence to GAAP is essential so as to make
  rational investor decisions relevant
• Deviation from standards renders the
  single-person decision theory useless

32
EXPENSE IT By John Lorinc

• Main Issue what is the proper accounting
  treatment for employee stock option compensation?
• Before companies didn't have to expense the
  value of these items immediately after being
  issued
• After governing bodies such as the FASB, IASB,
  and AcSB introduce regulations forcing companies
  to recognize these items once they are issued

33
EXPENSE IT By John Lorinc

• Secondary Issues
• How do we effectively measure the value of these
  expenses to be recorded on the financial
  statements?
• Most employee stock option compensation packages
  come loaded with a range of conditions and
  restrictions that make them difficult to measure
• Options cant be sold or traded (only exercised)
  employee must forfeit all unexercised options
  when leaving the firm, etc.

34
EXPENSE IT By John Lorinc

• What method of valuation is appropriate?
• Intrinsic value
• Based purely on the historic cost of the stock
  options when issued
• Fair value
• Taking into consideration all related factors
  that might influence the reasonable cost of these
  items.
• Estimating the expected life of the option and
  the ratio between stock price and exercise price
  the employee would seek before exercising the
  options

35
Questions?