CHAPTER 3 The Decision Usefulness Approach to Financial Reporting Nicole Fitzmaurice, Eric Poolman, Lisa Landon, Pang Sing Koh & Ping Zhou

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

3.2 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

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.

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: State 1: X Ltd future performance high  net return is $1,600 State 2: State 2: X Ltd future performance low _  net return is $0

PAYOFF TABLE probability of state 1 =.30 probability of state 2 =.70 ACTSTATE HighLow Buy shares$ 1,600$ 0 Buy bonds$ 225

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

ALTERNATIVE 2 FINANCIAL STATEMENT PROBABILITY High state firm: P(GN/H) =.80 P(BN/H) =.20 Low state firm: P(GN/L) =.10 P(BN/L) =.90 Where: GN = Good news BN = Bad news H = high performance L = low performance

ALTERNATIVE 2 CONT’D... Posterior State Probabilities (Bayes’ Theorem): High Performance:Low Performance: P(H/GN) =.30 x =.23 (.30x.80) + (.70x.10) =.77 Expected Utility : Shares = (.77 x 40) + (.23 x 0) = 30.8 Bonds = 1.00 x 15 = 15

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

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." main diagonal probabilities off-main diagonal probabilities

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

3.3.3 INFORMATION DEFINED “ Information is evidence that has the potential to affect an individual’s 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

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

MODELING RISK AVERSION WITH CONCAVE UTILITY FUNCTION ChoicesStateProbability of Payoffs HighLowHighLow A (Shares) $225$060%40% B (T-bills) $100 -

RISK NEUTRAL  Risk does not cost anything  Reasonable assumption when payoffs are small and inconsequential  Linear function of payoff: U(x) = bx X ( Payoff ) U(x) Slope = b

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

EXAMPLE 1  Toni, a risk-averse investor has $200 to invest  Payoffs from firm A’s share:  If shares increase: $230 (Probability = 0.74)  If shares decrease: $180 (Probability = 0.26) PayoffRate of Return ProbabilityExpected Rate of Return Variance $230(230 – 200) / 200 = (0.15 – 0.085) 2 x.74 = $180( ) / 200 = (-0.10 – 0.085) 2 x.26 =

EXAMPLE 1 CONT’D  Assume that Toni’s utility function is:  Utility from this investment is: (2 x 0.085) – =  Can Toni do better?

EXAMPLE 2  Her utility now is: (2 x 0.085) – = (0.158 in Example 1) StatesPayoffRate of ReturnProbabilityExpected Rate of Return Variance GG$230(230 – 200) / 200 = (0.15 – 0.085) 2 x.5742 = GB$214( ) / 200 = (0.07 – 0.085) 2 x.1658 = BG$200( ) / 200 = (0.00 – 0.085) 2 x.1008 = BB$184( ) / 200 = (-0.08 – 0.085) 2 x.1592 = Buy 2 Investments instead, Investment A and B

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 investor’s risk-averseness  Does not undo the benefits of diversification

OPTIMAL PORTFOLIO INVESTMENT DECISION

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

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:

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

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”

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.”

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.”

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.”

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.

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

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

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 can’t be sold or traded (only exercised); employee must forfeit all unexercised options when leaving the firm, etc.

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

Questions?