1. Copyright © 2009 by Pearson Education Canada 3 - 1 Chapter 3 The Decision Usefulness Approach to Financial Reporting

2. Copyright © 2009 by Pearson Education Canada 3 - 2 Chapter 3 The Decision Usefulness Approach to Financial Reporting

3. Copyright © 2009 by Pearson Education Canada 3 - 3 3.2 The 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 To prepare useful information, the accountant must know how investors make decisions

4. Copyright © 2009 by Pearson Education Canada 3 - 4 3.3 The Rational Decision Theory Model A model of rational decision making in the face of uncertainty –Definition of rationality? A game against nature: “nature does not think” Other ways to make decisions? »Continued

5. Copyright © 2009 by Pearson Education Canada 3 - 5 3.3 The Rational Decision Theory Model (continued) 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?

6. Copyright © 2009 by Pearson Education Canada 3 - 6 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

7. Copyright © 2009 by Pearson Education Canada 3 - 7 Bayes’ Theorem Applied to Accounting Information θ is state of firm θ 1 = H = high future firm performance θ 2 = L = low future firm performance m is evidence received from the financial statements m 1 = GN = net income shows good news m 2 = BN = net income shows bad news Suppose GN is received:

8. Copyright © 2009 by Pearson Education Canada 3 - 8 3.3.2 The Information System I Shows Evidence Probabilities, Conditional on Each State, for Input into Bayes’ Theorem Current Financial Statement Evidence GN BN Total H State of Nature L P(GH/H) P(BN/H) 1 P(GN/L) P(BN/L) 1

9. Copyright © 2009 by Pearson Education Canada 3 - 9 The Information System II The higher the main diagonal probabilities, the better the investor can predict the state of nature (i.e., future firm performance) –The main diagonal probabilities capture financial statement informativeness –Highly informative financial statements also called: Transparent Precise High quality

10. Copyright © 2009 by Pearson Education Canada 3 - 10 The Information System III Information system probabilities are objective –Reflect quality of GAAP –How known by investor? Prior probabilities are subjective –Investor assesses them based on all information available prior to the investment decision

11. Copyright © 2009 by Pearson Education Canada 3 - 11 The Information System IV 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

12. Copyright © 2009 by Pearson Education Canada 3 - 12 3.3.3 Definition of Information Information is evidence that has the potential to affect an individual’s decision

13. Copyright © 2009 by Pearson Education Canada 3 - 13 Theory of Investment Points to note: –The rational investor –Risk aversion –Portfolio diversification –beta

14. Copyright © 2009 by Pearson Education Canada 3 - 14 3.8 Do Professional Accounting Bodies Accept the Rational Decision Theory? SFAC 1 –Oriented to investors –Oriented to rational investment decisions –Accepts that investors are risk averse –Financial statements provide information to help investors assess (posterior probabilities of) the amounts, timing, and uncertainty of investment proceeds (i.e., of future firm performance) Note that Bayes’ theorem is implied »Continued

15. Copyright © 2009 by Pearson Education Canada 3 - 15 3.8 Do Professional Accounting Bodies Accept the Rational Decision Theory? (continued) SFAC 2 –To help investors, financial statement information should be: Relevant –Can “make a difference” Reliable –Faithful representation –Verifiable –Neutral

16. Copyright © 2009 by Pearson Education Canada 3 - 16 Conclusions Rational decision theory provides a theoretical underpinning for study of information needs of investors Conceptual framework SFAC 1 and SFAC 2 accept the rational decision theory model