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THE DECISION USEFULNESS APPROACH TO FINANCIAL REPORTING Chapter 3

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AGENDA 1.D ECISION U SEFULNESS 2.T HE R ATIONAL I NVESTOR 3.D IVERSIFICATION 4.P ORTFOLIO R ISK 5.C ONCEPTUAL F RAMEWORK

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THE DECISION USEFULNESS APPROACH “If we can’t prepare theoretically correct financial statements, at least we can try to make the financial statements more useful” Non-ideal conditions Contrasted with stewardship Two major questions: 1. Who are the users? 2. What decision problems do they face?

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SINGLE PERSON DECISION THEORY Understand how individuals make rational decisions under uncertainty Appreciate the concept of information Allows decision makers to update their subjective beliefs Financial statements are a source of information

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EXAMPLE #1 Jane has $20,000 to invest in either A 1 = Shares of ABC Ltd. A 2 = 2% Government Bonds States of nature: ABC future performance high State 1 ABC future performance low State 2

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PAYOFF TABLE ActState HighLow A 1 (buy shares)$1, 600$ 0 A 2 (buy bonds)$ 225 Prior probabilitiesP(H) = 0.30P(L) = 0.70 Jane is risk-averse Utility = √payoff

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DECISION TREE ActState (Probability)Payoff (Utility) Invest $20K A1A1 A2A2 High performance (0.30) Low performance (0.70) Performance high or low (1.00) $1,600 (40) $0 (0) $225 (15) EU (A 1 ) = (0.3 X 40) + (0.7 X 0) = 12 EU (A 2 ) = 1.00 X 15 = 15

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CONDITIONAL PROBABILITIES P(GN/H) = 0.80 Probability of FS showing GN if ABC is a high state firm P(BN/H) = 0.20 Probability of FS showing BN if ABC is a high state firm P(GN/L) = 0.10 Probability of FS showing GN if ABC is a low state firm P(BN/L) = 0.90 Probability of FS showing BN if ABC is a low state firm

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POSTERIOR PROBABILITIES BBayes’ Theorem P(H/GN) = P(H)P(GN/H). P(H) P(GN/H)+ P(L) P(GN/L) = 0.3 x 0.8 (0.3 x 0.8) + (0.7 x 0.1) = 0.77 P(L/GN) = 1.00 – 0.77 = 0.23 UUpdated expected utilities EU(A 1 /GN) = (0.77 x 40) + (0.23 x 0) = 30.8 EU(A 2 /GN) = 1.00 x 15 = 15

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INFORMATION DEFINED Evidence that has potential to affect an individual’s decision Net of cost Continuous process

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THE INFORMATION SYSTEM Conditional probabilities P (GN|H) and P (BN|L)

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THE INFORMATION SYSTEM Highly informative FS exist due to the underlying INFORMATION SYSTEM Informativeness depends on relevance & reliability of the FS Example: a new standard requires a company to switch methods of valuing capital assets. R ESULT = increased relevance since it is a better predicator of future firm performance but decreased reliability due to the need for estimates

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RATIONAL EXPECTATIONS When ones assumes the information system probabilities are known Investors are assumed to quickly form accurate estimates of unknown probabilities How do they do this? 2 approaches: 1. Sampling the FS 2. Examining revisions by Value Line analysts of future quarterly earnings forecasts based on current states

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THE RATIONAL, RISK-AVERSE INVESTOR Rational Investor = typically Risk Averse Risk aversion is important to accountants because it means investors need certain information concerning the risk of future returns Utility Functions model risk aversion

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UTILITY FUNCTIONS Risk Averse Investor Risk Neutral Investor

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THE PRINCIPAL OF PORTFOLIO DIVERSIFICATION Typical investor is risk averse Investor will want lowest possible risk; in instances where they bear risk the highest expected payoff will be required Tradeoff between risk and return greater risk only if expected return is high Diversification lowers risk Some but not all risk can be eliminated by proper investment strategy General utility function is: U i (a) = f i x ̅ - σ a 2 U i represents utility of investment f i represents the risk factor x ̅ represents the expected rate of return σ represents the variance A more risk averse person will increase the variance by (for example) a factor of two ultimately lowering the utility

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APPLICATION OF PORTFOLIO DIVERSIFICATION Assume a client wishes to purchase the following: 8 shares of firm I valued at $10 per share paying a dividend of $1 per share with a 67.50% chance of the share increasing to $10.50 and a 32.50% chance of the share decreasing to $8.50 6 shares of firm II at $20 per share paying a dividend of $1 per share with a 74% chance of the share increasing to $22 dollars and a 26% chance of the share decreasing to $17

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With each different potential outcome the probability with independence is distinguished using the probabilities given Due to economy wide/market wide factors it generally goes without saying that “if one stock is going up, there is a better chance that other stocks will also go up” or “if one stock is going down, there is a better chance that other stocks are going down” This, as a result, explains the diversified probabilities as the UP,UP and DOWN, DOWN situation both increased their probabilities by the same 7.47% factor under diversified probability

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The utility according to our earlier equation (assuming a neutral stance) would then be U i = 8.50% -0.74% = 7.76% If you have invested in either of the stocks single handedly the utility would have been lower showing that there would have been more risk associated with investing in 1 particular stock

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The more shares your portfolio has the less risky it is; this is known as “holding the market portfolio” Systematic risk is risk that that cannot be avoided by diversifying as it is the risk inherent to the entire market If investor is more risk averse, they may consider purchasing a risk free asset (ex. treasury bills) lowering the risk THE OPTIMAL INVESTMENT DECISION

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Calculating & Interpreting Beta: Beta: Measures the co-movement between changes in the price of a security and changes in the overall market Used to gauge a security’s risk PORTFOLIO RISK

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CALCULATING BETA The beta of shares of firm A is calculated by: Where; Cov(A,M) measures how strongly return of security A varies compared to market, and Var(M) expresses the volatility of the market overall

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SOME EXAMPLES CompanyBeta Apple1.26 McDonalds0.41 Johnson & Johnson0.52 AIG3.44

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CALCULATING COVARIANCE ReturnsJoint Probabilities AM High (0.15 - 0.0850)(0.10 - 0.0850) x 0.72= 0.0007 HighLow (0.15 – 0.0850)(0.0250 – 0.0850) x 0.02= -0.0001 LowHigh (-0.10 – 0.0850)(0.0250 – 0.0850) x 0.08= -0.0002 Low (-0.10 – 0.0850)(0.0250 – 0.0850) x 0.18= 0.0020 Cov (A,M)= 0.0024

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BETA Given that, We obtain: Low Beta = Low Risk

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PORTFOLIO EXPECTED VALUE AND VARIANCE Recall, that an investors utility function for an investment looks like Expected return of portfolio P: Where X is the expected return of a given security and K is the proportion of that security in the overall portfolio

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PORTFOLIO VARIANCE The variance of a portfolio with two securities is: Variance of a portfolio is determined by the variance of each securities and the covariance between securities Firm-Specific Risk Systematic Risk

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PORTFOLIO RISK AS THE NUMBER OF SECURITIES INCREASES Number of Securities Variance Terms Covariance Terms Firm-Specific Risk* Systematic Risk* 110100%0% 22150% 10 4510%90% NNN(N – 1)/2 *assuming each security is an equal portion of the portfolio

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FIRM-SPECIFIC RISK

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IASB & CICA IAS 1: “The objective of financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions.” CICA section 1000: “The objective of financial statements is to communicate information that is useful to investors, creditors, and other users in making their resource allocation decisions and/or assessing management steward ship”

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WHAT IS USEFUL INFORMATION? Help investors assess the amounts, timing, and uncertainty of future cash flows Enhance relevance and reliability of accounting information

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RELEVANCE AND RELIABILITY IAS 8: “In the absence of an IFRS...management shall use judgement in developing and applying an accounting policy that results in information that is: a) relevant to the economic decision making needs of users; and b) reliable” CICA Section 1100: “an entity shall adopt accounting policies and disclosures that are a) consistent with primary resources of GAAP, and b) developed through exercise of professional judgement and application of concepts described in Section 1000” Section 1000: outlines relevance and reliability

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HOW IS HISTORICAL INFORMATION USEFUL? Helps form expectations Under non-ideal conditions: Relevant Information allows investors to form their own expectations

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PREDICTING FUTURE PERFORMANCE Accruals Match revenue and costs Ex. Accounts Receivable predict future sales proceeds Earnings Better for predicting poor performance Accruals anticipate unrealized losses future cash flow reductions

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SUMMARY & QUESTIONS?

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