23-Apr-22 03The Decision Usefulness Approach to Financial Reporting 1
Topic 3 The Decision Usefulness
Approach to Financial Reporting
Topic 3 The Decision Usefulness
Approach to Financial Reporting
1. Overview
Decision Usefulness Approach
3. Objective of financial reporting
Decision Making
5. Single-Person Decision Theory
Rational, Risk-Averse Investor
Principle of Portfolio Diversification
Optimal Investment Decision
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1. Overview
23-Apr-22 01 Overview of Accounting Theory and its research (Qinggang Wang) 3
The most useful measure of net income to inform investors (to control
adverse selection) need not be the same as the best measure to motivate
manager performance (to control moral hazard). (Gjesdal, 1981)
Inform investors Motivate managers
Information that enables better
investment decisions, current
value accounting
Information that is highly
informative about their performance,
a less volatile and more conservative
income measure, such as one based
on historical cost
The fundamental problem of financial accounting theory is how to
design and implement concepts and standards that best trade off the
investor-informing and manager performance–evaluating roles for
accounting information.
Gjesdal(1981).pdf
1. Overview
Given that the mixed measurement model retains historical cost
accounting for major classes of assets and liabilities:
The present value model faces some severe problems in practices;
Historical cost accounting produces relatively reliable information, even
though historical is not as relevant as present value or market-based
approaches to current value.
How can financial statements be made more useful? This leads
to the concept of decision usefulness. To properly understand
this concept, we need to consider other theories from economics
and finance.
Decision theories; and
Capital market theories.
The main purpose of this chapter is to introduce you to some of
these theories and to discuss their relevance to accounting.
Decision Usefulness Approach
Historical Perspective
1966, AAA: A Statement of Basic Accounting Theory
1973, AICPA Trueblood Commission: Objectives of
Financial statements
Contrastive approach: Stewardship (Chapter 8)
In adopting the decision usefulness approach, two
major questions must be addressed:
Firs, who are the users of financial statements?
Constituencies
Second, what are the decision problems of financial
statement users?
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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
Information is evidence that has the
potential to affect an individual’s
decision
the GN or BN in the financial statements
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Decision Usefulness Approach
To prepare useful information, the
accountant must know how investors make
decisions
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?
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Decision Usefulness Approach
Prior probabilities are subjective
Investor assesses them based on all information
available prior to the investment decision
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
How is financial statement information useful?
Process of communicationProcess of communication
Company’s
activities
Financial
Reporting
User
perception
of Financial Statement
Essential characteristics of accounting are:
(1) the identification, measurement, and communication of
financial information about
(2) economic entities to
(3) interested parties.
Identification
of Users
User
Information
Needs
Accounting
System
Reports
Economic Data
and Activities
User
Decisions
Accounting — An Information Process Accounting — An Information Process
of financial reporting
Primary users: existing and potential
investors, lenders, and other creditors
buying, selling or holding equity and debt
instruments
dividends, principal and interest payments
or market price increases.
meet the needs of the maximum number of
primary users.
Regulators?
Management?
of financial reporting
provide financial information that is useful to
users in making decisions about providing
resources to the entity
are not designed to show the value of a reporting
entity; but they provide information to help users
to estimate the value of the reporting entity.
assessment of the amount, timing, and
uncertainty of future net cash inflows to the
entity
How to define the concept of assets, and liabilities?
of financial reporting
Useful information
the resources, claims, and changes in those resources
and claims
Financial performance
accrual accounting VS cash flows
Changes in resources and claims not resulting from
financial performance
Information about the efficiency and effectiveness of
the use of resources
do not and cannot provide all of the information
users need to consider pertinent information from other
sources, eg,general economic conditions and
expectations, political events and political climate, and
industry and company outlooks.
Illustration 2-2
Hierarchy of
Accounting
Qualities
Decision Making
Accountants have decided that investors are a
major constituency of users and have turned to
various theories of decision and investment:
Single-person decision theory
To understand how individuals may make rational
decisions under uncertainty.
Theory of investment
A specialization of decision theory to model the decision
processes of a rational investor; to understand the nature
of risk in portfolio investment context.
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-Making Environments
CertaintyCertainty refers to a decision environment in
which the results of selecting each alternative are
known before the decision is made.
UncertaintyUncertainty refers to a decision environment in
which the decision maker does not know what
outcome will occur when an alternative is selected
The goal of decision analysisgoal of decision analysis is to focus on
making good decisions, which in the long run
should result in an increased number of good
outcomes
making process
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Information
Prediction Decision Outcome
Confirmatory roleConfirmatory rolePredictive role
Accounting
Information
System
User
Prediction
Model
User
Decision
Model
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Decision Process
Identify
Goals
Identify
Decision
Need
Identify
Problem
Specify
Alternatives
Specify
Decision
Model
Choose
Action
Experience
Consequences
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-Person Decision Theory
It takes the viewpoint of an individual who must
make a decision under conditions of uncertainty.
state probabilities are no longer objective
sets out a formal procedure whereby the individual
can make the best decision, by selecting from a set of
alternatives.
Additional information can be obtained to revise the
decision-maker’s subjective assessment of the
probabilities of what might happen after the decision
is made.
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-Person Decision Theory
The rational investor
Optimal forecasts (the best guess of the future)
using all available information, but…..
Needs information about risk as well as expected
return
Can express clear preferences among
commodities
Prefers more to less
Preferences are always transitive
•A>B,andB>C, then A>C
•A<B,andB<C, then A<C
•A=B,and B=C，then A=C
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-Person Decision Theory
the Rational Investor
Maximizes expected utility
May be risk averse, Then, will diversify
Portfolio theory
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Real People
People can’t always express preferences among
commodities
People don’t always prefer the cheap to the
expensive
Preferences are not always transitive
Economic agents rarely, if ever, act on the basis of
complete information
Economic agents do not, in general, maximize
their preferences
Preferences are not stable over time
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Theory Model
Decision theory is important because it helps us to
understand why information is such a powerful commodity -
it can affect the actions taken by investors.
A model of rational decision making in the face of
uncertainty
Another example of “analytical research”
Makes simplifying assumptions
Rational “economic man” approach
Perfectly specified decision process
Concept of an “Information System” can be introduced and modeled
一切交易的
实质都是信
息的买卖
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Probabilities
Prior probability
先验概率：在试验或实验之前得到的概率，又称为数学
概率
Conditional probabilities
条件概率P(A|B)：在事件B已经发生的条件下，事件A
发生的概率
Posterior state probabilities
后验概率：在试验或实验之后得到的概率，又称为经验
概率
Bayes’ theorem
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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
Thomas Bayes
•Born: 1702 in London
•Died: 17 Apr. 1761
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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:
Information
has predictive
value
GN: Actual earnings >
Expected earnings
BG: Actual earnings <
Expected earnings
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Shows Evidence Probabilities, Conditional
on Each State, for Input into Bayes’ Theorem
Current Financial Statement Evidence
Total
GN BN
State
of
Nature
H P(GN/H) P(BN/H) 1
L
P(GN/L) P(BN/L) 1
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Consider an investor with $10,000 to invest in one of the
following mutually exclusive acts:
a1: buy shares of x Ltd. For $10,000
a2: buy Canada Savings Bonds (CSB) for $10,000
Let there be 3 “states of nature”:
θ1: shares fall 10% in market value
θ2: shares hold steady
θ3: shares rise 80%
Example
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Decision Problem
Think of the financial statements of X Ltd. as an information
system conveying information about probabilities of θ.
Assume the financial statements will give one of the following
3 mutually exclusive messages:
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Bayes Theorem (Rule)
The basic principle of Bayes' Theorem is that
additional information can change a decision
maker’s prior beliefs about the occurrence of an
event
Rational, Risk-Averse Investor
Risk Utility Function
To model risk aversion, decision theorists use the device of a
utility function, which relates payoff amounts to the decision-
maker’s utility
• 确定性决策：能取得确定结果的决策
• 不确定性决策：不能取得确定结果的决策
• 确定性等价：具有与某项决策的效用期望值相等
效用的确定性决策
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Risk Preference Attitudes
$0 $2,000 $4,000 $6,000 $8,000 $10,000
0
1
-$2,000
Risk-Neutral Preference Function
确定性等价的效用等
于确定性决策的效用
效用线是直线
不要求风险补偿，预
期收益率等于无风险
利率
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Risk Preference Attitudes
$0 $2,000 $4,000 $6,000 $8,000 $10,000
0
1
-$2,000
Risk-Averse Preference Function
确定性等价的效用小
于确定性决策的效用
在其它条件相同的情
况下，投资者将选择
标准差较小的组合
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Risk Preference Attitudes
$0 $2,000 $4,000 $6,000 $8,000 $10,000
0
1
-$2,000
Risk-Seeking Preference Function
确定性等价
的效用大于
确定性决策
的效用
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Are Securities Markets Fully Efficient?
Behavioural finance
Behavioural characteristics that question
market efficiency
Limited attention
Overconfidence
Representativeness
Self-attribution bias
Leading to momentum
成功归于自身能力
失败归于外在因素
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Prospect Theory
An Alternative Theory of Decision Making
Separate evaluation of gains and losses
Weighting of probabilities
Overconfidence: rare events underweighted
Representativeness: likely events overweighted
Leads to a disposition effect
Implications for financial accounting
Leads to earnings management to avoid reporting
small losses?
Prudence concept
出赢保亏：卖出赚钱的股
票、持有赔钱的股票
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Prospect Theory Utility Function
u(x)
Gain x loss
两种选择：A肯定赢
100万元，B50%可能
性赢200万元，50%可
能性什么也得不到？
大部分人会选A，这
说明人们是风险规避的
两种选择：A肯定损
失100万元，B50%可能
性损失200万元，50%
可能性损失为零
大部分人选B，这说
明人们是风险偏好的
在盈利和亏损两种状
态下，人们的风险态度
不仅不一致，且不对称
收益和风险分开评估
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Principle of Portfolio Diversification
systematic risk (general market risk) VS non-system risk (Unique risk)
Tries to maximize portfolio expected return for a given
amount of portfolio risk, or equivalently minimize risk
for a given level of expected return, by carefully
choosing the proportions of various assets
Collection of investment assets that has collectively
lower risk than any individual asset.
different types of assets often change in value in opposite
ways.
Four basic steps involved in portfolio construction
-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measurement
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Preference for Risk
The concept of risk aversion is important to
accountants, because it means that investors need
information concerning the risk, as well as the
expected value, of future returns.
Such investors need information to help them assess
securities’ expected returns and riskiness of these
returns.
Beta is an important risk measure.
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Beta
Definition
Standardized covariance between return on
share and return on market
Only relevant risk measure for a
reasonably diversified investor
Why? Because firm specific risk diversifies
away
Implication = investors don’t need
accounting info?
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Estimating Beta (continued)
Principle of Portfolio Diversification
Summary
Risk-averse investors can take advantage of the principle
of portfolio diversification to reduce their risk, by investing
in a portfolio of securities.
This is because realizations of firm-specific states of nature
tend to cancel out across securities, leaving economy-wide
factors as the main contributors to portfolio risk.
Regardless of the degree of risk aversion, we know that
utility increases in expected rate of return and decreases in
variance of the portfolio.
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The Optimal Investment Decision
Holding the market portfolio
The firm-specific risks tend to cancel out;
Such non-diversifiable risk is called systematic risk;
The return on the market portfolio can then be
proxied by the return on a market index for that
exchange.
Optimal portfolio investment decision
Sell some of the high-risk stocks?
The answer lies in the risk-free asset.
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Optimal Investment Decision
FIGURE THE OPTIMAL PORTFOLIO INVESTMENT DECISION
E
xp
ec
te
d
ra
te
o
f r
et
ur
n
0
0
Variance(risk)
Y
M
Z
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The Optimal Investment Decision
Summary
When transaction costs are ignored, a risk-
averse investor’s optimal investment decision is to
buy that combination of market portfolio and risk
-free asset that yields the best tradeoff between
expected return and risk.
This tradeoff is individual-specific – it depends
on the investor’s utility function.
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Conclusions
The decision usefulness approach to financial reporting
implies that accountants need to understand the decision
problems of financial statement users.
Single-person decision theory and its specialization to the portfolio
investment decision provide understanding of the needs of rational,
risk-averse investors – such investors need information to help them
assess securities’ expected returns and riskiness of these returns.
Beta is an important risk measure.
Financial statements are an important and cost-effective
source of information for investors, even though they do not
report directly on future investment payoffs.
Major accounting standard setting bodies such as the IASB
and FASB have adopted the decision usefulness approach.
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