1. 1 Economic Decision Making CHAPTER F2 © 2007 Pearson Custom Publishing

2. 2 What is Decision Making? The process of identifying alternative courses of action and selecting an appropriate alternative in a given decision situation. The process of identifying alternative courses of action and selecting an appropriate alternative in a given decision situation.

3. 3 © 2007 Pearson Custom Publishing Alternative Choices There must be more than one alter- native, otherwise there is no choice. There must be more than one alter- native, otherwise there is no choice. In 1914, the Ford Motor Company made 300,000 Model Ts: “any color so long as it’s black.” You still had a choice of buying a Ford or not, but no choice about the color. In 1914, the Ford Motor Company made 300,000 Model Ts: “any color so long as it’s black.” You still had a choice of buying a Ford or not, but no choice about the color.

4. 4 Learning Objective 1: Explain the concepts of extrinsic and intrinsic rewards, sacrifices, and opportunity costs as they pertain to routine and nonroutine decision situations. © 2007 Pearson Custom Publishing

5. 5 The reward is a goal, it is what you hope to attain. A college degree is one of the rewards you hope to attain while at school. The reward is a goal, it is what you hope to attain. A college degree is one of the rewards you hope to attain while at school. Sacrifices must be made in order to attain the reward. Sacrifices must be made in order to attain the reward. Reward and Sacrifice

6. 6 © 2007 Pearson Custom Publishing Discussion Questions What reward or rewards do you hope to obtain by attending college? What reward or rewards do you hope to obtain by attending college? 4 What sacrifices are you personally making to attend college?

7. 7 © 2007 Pearson Custom Publishing Opportunity Cost Definition: the benefit foregone from choosing one alternative over another. Definition: the benefit foregone from choosing one alternative over another. This is a benefit or reward that you have the “opportunity” to attain, but you are giving it up to pursue a different course of action. This is a benefit or reward that you have the “opportunity” to attain, but you are giving it up to pursue a different course of action.

8. 8 © 2007 Pearson Custom Publishing Opportunity Cost Examples of opportunity costs: By attending college, you are choosing to work less than you otherwise could, spend less time with family and friends, spend less time pursuing leisure activities, and other similar sacrifices. Examples of opportunity costs: By attending college, you are choosing to work less than you otherwise could, spend less time with family and friends, spend less time pursuing leisure activities, and other similar sacrifices.

9. 9 © 2007 Pearson Custom Publishing Extrinsic and Intrinsic Rewards An extrinsic reward is something that comes from others, usually in the form of material items, particularly money. An extrinsic reward is something that comes from others, usually in the form of material items, particularly money. An intrinsic reward comes from within, such as the feeling of accomplishment you have when you attain a goal. An intrinsic reward comes from within, such as the feeling of accomplishment you have when you attain a goal.

10. 10 Learning Objective 2: Use a general problem-solving model to make decisions. © 2007 Pearson Custom Publishing

11. 11 © 2007 Pearson Custom Publishing Uncertainty and Risk Uncertainty exists in business decision making due to a lack of complete information about the future. Uncertainty exists in business decision making due to a lack of complete information about the future. Risk is directly correlated with uncertainty. The greater the uncertainty, the greater the risk of making the wrong choice. Risk is directly correlated with uncertainty. The greater the uncertainty, the greater the risk of making the wrong choice.

12. 12 © 2007 Pearson Custom Publishing Uncertainty and Risk Decision making risk cannot be completely eliminated, but using all of the available relevant and reliable information helps to decrease the uncertainty. Decision making risk cannot be completely eliminated, but using all of the available relevant and reliable information helps to decrease the uncertainty.

13. 13 © 2007 Pearson Custom Publishing Routine Decisions Routine decisions are those that recur on a regular basis. Routine decisions are those that recur on a regular basis. Many companies have “rules,” “guidelines,” or “company policies” that control how the routine decisions should be made. Many companies have “rules,” “guidelines,” or “company policies” that control how the routine decisions should be made.

14. 14 © 2007 Pearson Custom Publishing Nonroutine Decisions When new and different circumstances arise, nonroutine decisions must be made. When new and different circumstances arise, nonroutine decisions must be made. Nonroutine decisions are not necessarily difficult, they are just unfamiliar. Nonroutine decisions are not necessarily difficult, they are just unfamiliar.

15. 15 © 2007 Pearson Custom Publishing Critical Thinking Quality of decisions is directly related to the way we process information. Quality of decisions is directly related to the way we process information. Critical thinking improves the quality of decisions we make because it helps us examine the way we think. Critical thinking improves the quality of decisions we make because it helps us examine the way we think.

16. 16 © 2007 Pearson Custom Publishing Information Processing Style Intuitive Style: Examine the overall situation, consider many possible solutions, and make a decision based on intuition. Intuitive Style: Examine the overall situation, consider many possible solutions, and make a decision based on intuition. “Gut-reactions” and “flying by the seat of your pants” are symbolic of intuitive style. “Gut-reactions” and “flying by the seat of your pants” are symbolic of intuitive style.

17. 17 © 2007 Pearson Custom Publishing Information Processing Style Systematic Style: Very detail oriented. Systematic Style: Very detail oriented. Might choose to break the problem into parts, concentrate on each part individually, then reassemble the parts into a whole. Make decisions in a methodical manner. Might choose to break the problem into parts, concentrate on each part individually, then reassemble the parts into a whole. Make decisions in a methodical manner.

18. 18 © 2007 Pearson Custom Publishing Reasoned Decision Making Step 1: Determine the decision to be made. Step 1: Determine the decision to be made. Step 2: Identify alternatives. Step 2: Identify alternatives. Step 3: Analyze each alternative critically. Step 3: Analyze each alternative critically. Step 4: Select the best alternative. Step 4: Select the best alternative. Step 5: Implement the chosen alternative. Step 5: Implement the chosen alternative. Step 6: Reevaluate the decision as new information becomes available. Step 6: Reevaluate the decision as new information becomes available. Step 7: Evaluate the final outcome. Step 7: Evaluate the final outcome.

19. 19 Learning Objective 3: Explain the importance of creativity and the roles of values and ethics in the decision-making process. © 2007 Pearson Custom Publishing

20. 20 © 2007 Pearson Custom Publishing Creative Decision Making Professor Parnes (Buffalo St. Univ.) believes that creativity can be taught. He suggests the problem solver should follow this progression: Professor Parnes (Buffalo St. Univ.) believes that creativity can be taught. He suggests the problem solver should follow this progression: Move from “what is” (analyze current facts) Move from “what is” (analyze current facts) To “what might be” (consider alternatives) then To “what might be” (consider alternatives) then To “what can be” (eliminate undesirables) then To “what can be” (eliminate undesirables) then To “what will be” (choose best alternative) then To “what will be” (choose best alternative) then Create a new “what is” (by implementing the choice). Create a new “what is” (by implementing the choice).

21. 21 © 2007 Pearson Custom Publishing Personal Values Our personal values shape the decisions that we make and the way we live our lives. Our personal values shape the decisions that we make and the way we live our lives. Different people have different values, which is one reason why there is such great diversity among the peoples of the world. Different people have different values, which is one reason why there is such great diversity among the peoples of the world. For most people, their personal values (and often their priorities) change as they grow older. For most people, their personal values (and often their priorities) change as they grow older.

22. 22 © 2007 Pearson Custom Publishing Ethics Virtues ethics (or character ethics) come primarily from the teachings of Socrates, Plato, and Aristotle. Virtues ethics (or character ethics) come primarily from the teachings of Socrates, Plato, and Aristotle. This is the “inward-out” approach, whereby the personal virtues come from inside the individual and are manifested outward when dealing with others. This is the “inward-out” approach, whereby the personal virtues come from inside the individual and are manifested outward when dealing with others.

23. 23 © 2007 Pearson Custom Publishing Rules ethics (or quandary ethics) is a more modern idea of ethical behavior and has its roots in organized religious practices. Rules ethics (or quandary ethics) is a more modern idea of ethical behavior and has its roots in organized religious practices. This is the “outward-in” approach, whereby the direction comes from outside the individual in the form of rules that dictate how we should act in various situations. This is the “outward-in” approach, whereby the direction comes from outside the individual in the form of rules that dictate how we should act in various situations. Ethics

24. 24 © 2007 Pearson Custom Publishing Good Ethics is Good Business!

25. 25 © 2007 Pearson Custom Publishing Good Ethics is Good Business! Do you agree or not? Why?

26. 26 Learning Objective 4: Describe the advantages and disadvantages of individual and group decision making. © 2007 Pearson Custom Publishing

27. 27 © 2007 Pearson Custom Publishing Individual Decision Making One person who strives to solve a problem may be better than a group: One person who strives to solve a problem may be better than a group: Advantages: 1) no scheduling conflicts, 2) no compromising is needed, 3) weak group members won’t slow you down Advantages: 1) no scheduling conflicts, 2) no compromising is needed, 3) weak group members won’t slow you down Disadvantages: 1) limited to your own knowledge and judgment, 2) no one to double check your work Disadvantages: 1) limited to your own knowledge and judgment, 2) no one to double check your work

28. 28 © 2007 Pearson Custom Publishing Group Decision Making Group decision making has a very different dynamic than individual decision making. Group decision making has a very different dynamic than individual decision making. Advantages: Advantages: 1) more people typically mean greater base of knowledge, 1) more people typically mean greater base of knowledge, 2) various perspectives typically lead to more alternatives, 2) various perspectives typically lead to more alternatives, 3) groups may be more “aggressive” in their decision making. 3) groups may be more “aggressive” in their decision making.

29. 29 © 2007 Pearson Custom Publishing Group Decision Making Group decision making also has a unique set of potential problems: Group decision making also has a unique set of potential problems: Information-processing styles Information-processing styles Domineering members Domineering members Social pressure Social pressure Goal replacement Goal replacement Differing personal values Differing personal values Unequal effort Unequal effort Groupthink Groupthink

30. 30 Learning Objective 5: Describe the two types of economic decision makers and explain the basic differences between management accounting and financial accounting. © 2007 Pearson Custom Publishing

31. 31 © 2007 Pearson Custom Publishing Internal Decision Makers Decision makers who work FOR the company. Their task is to make decisions that are in the best interests of the company. These managers and employees will have access to more company information than outsiders will. Decision makers who work FOR the company. Their task is to make decisions that are in the best interests of the company. These managers and employees will have access to more company information than outsiders will.

32. 32 © 2007 Pearson Custom Publishing External Decision Makers External decision makers make decisions ABOUT the company. They have limited financial knowledge about the company. Bankers, suppliers, potential employees, financial analysts, shareholders, govt., competitors, and others.

33. 33 Learning Objective 6: List the three questions all economic decision makers attempt to answer and explain why these questions are so important. © 2007 Pearson Custom Publishing

34. 34 © 2007 Pearson Custom Publishing Importance of Cash Flows Economic decision makers (both internal and external) are primarily attempting to predict future cash flows. Economic decision makers (both internal and external) are primarily attempting to predict future cash flows. “Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows…” ( Statement of Financial Accounting Concepts #1) “Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows…” ( Statement of Financial Accounting Concepts #1)

35. 35 © 2007 Pearson Custom Publishing Three Questions About Cash Will I be paid? Will I be paid? Relates to “uncertainty” Relates to “uncertainty” When will I be paid? When will I be paid? Relates to “timing” Relates to “timing” How much will I be paid? How much will I be paid? Relates to “amounts” Relates to “amounts”

36. 36 Learning Objective 7: Describe the importance of cash as a measure of business success or failure. © 2007 Pearson Custom Publishing

37. 37 © 2007 Pearson Custom Publishing Cash is the “Ball” In most sports, you have to “keep your eye on the ball.” In most sports, you have to “keep your eye on the ball.” In business, cash is the ball, and you must keep your eye on it. In business, cash is the ball, and you must keep your eye on it. Many business measures (such as net income, net worth, equity, etc.) are very important, but they DO NOT measure cash! Many business measures (such as net income, net worth, equity, etc.) are very important, but they DO NOT measure cash!

38. 38 © 2007 Pearson Custom Publishing Cash is the “Ball” Most bankruptcies occur not because the business has losses or poor management, but because it runs out of cash. Most bankruptcies occur not because the business has losses or poor management, but because it runs out of cash. In a period of rapid growth, cash flow is the most persistent and troubling problem for the business. In a period of rapid growth, cash flow is the most persistent and troubling problem for the business.

39. 39 Learning Objective 8: Define accounting information and distinguish it from accounting data. © 2007 Pearson Custom Publishing

40. 40 © 2007 Pearson Custom Publishing Is It Data or Information? Data on its own has no meaning. Only when interpreted by some kind of data processing system does it take on meaning and become information. Data on its own has no meaning. Only when interpreted by some kind of data processing system does it take on meaning and become information. Information is a message received and understood that reduces the recipient’s uncertainty and helps one make a decision. Information is a message received and understood that reduces the recipient’s uncertainty and helps one make a decision.

41. 41 © 2007 Pearson Custom Publishing Useful Accounting Information To be useful, accounting information must be understandable to non- accountants. This, however, is not always the case. To be useful, accounting information must be understandable to non- accountants. This, however, is not always the case. As business dealings have become more complex, so have accounting rules and guidelines. Complicated situations cannot always be described in the simplest of terms. As business dealings have become more complex, so have accounting rules and guidelines. Complicated situations cannot always be described in the simplest of terms.

42. 42 © 2007 Pearson Custom Publishing Who Decides What Accounting Information is Useful? Accounting users and the accounting profession work together to determine what makes accounting information useful. Accounting users and the accounting profession work together to determine what makes accounting information useful. The Financial Accounting Standards Board (FASB) is the organization primarily responsible for establishing accounting rules and guidelines. The Financial Accounting Standards Board (FASB) is the organization primarily responsible for establishing accounting rules and guidelines.

43. 43 © 2007 Pearson Custom Publishing Who Decides What Accounting Information is Useful? The materiality test: Does the information ultimately make a difference in the decision? The materiality test: Does the information ultimately make a difference in the decision?

44. 44 Learning Objective 9: Describe the qualitative characteristics of useful accounting information and apply them in decision-making situations. © 2007 Pearson Custom Publishing

45. 45 © 2007 Pearson Custom Publishing Qualitative Characteristics of Accounting Information To be useful, accounting information must have both relevance and reliability. These are known as “primary qualities.” To be useful, accounting information must have both relevance and reliability. These are known as “primary qualities.” Information is relevant if it pertains to the particular decision that is at hand. Information is relevant if it pertains to the particular decision that is at hand. Information is reliable if it is reasonably accurate. Information is reliable if it is reasonably accurate.

46. 46 © 2007 Pearson Custom Publishing Relevance in Accounting Information Relevant information must possess at least two characteristics: Relevant information must possess at least two characteristics: 1 - Timeliness - information must be available in time to influence the decision. 1 - Timeliness - information must be available in time to influence the decision. 2 - Either (or both) of the following: 2 - Either (or both) of the following: Predictive Value Predictive Value Feedback Value Feedback Value

47. 47 © 2007 Pearson Custom Publishing Predictive Value - the information contains features that allow the decision maker to make predictions about the amount and timing of cash flows. Predictive Value - the information contains features that allow the decision maker to make predictions about the amount and timing of cash flows. Feedback Value - the information contains features that allow the decision maker to assess the progress or outcome of the decisions already made. Feedback Value - the information contains features that allow the decision maker to assess the progress or outcome of the decisions already made. Relevance in Accounting Information

48. 48 © 2007 Pearson Custom Publishing Reliability in Accounting Information To be reliable, accounting information must have three qualities: To be reliable, accounting information must have three qualities: 1 - Verifiability - information is verifiable if different informed individuals, working independently, would arrive at approximately the same conclusions. 1 - Verifiability - information is verifiable if different informed individuals, working independently, would arrive at approximately the same conclusions.

49. 49 © 2007 Pearson Custom Publishing 2 - Representational Faithfulness - the accounting information must be based on what really happened. 2 - Representational Faithfulness - the accounting information must be based on what really happened. 3 - Neutrality - accounting information must be free from bias. It should not be slanted one way or another in an attempt to influence the decision maker. 3 - Neutrality - accounting information must be free from bias. It should not be slanted one way or another in an attempt to influence the decision maker. Reliability in Accounting Information

50. 50 © 2007 Pearson Custom Publishing Reliability Versus Accuracy Accounting information need not be perfectly accurate to be reliable. Accuracy is often difficult to determine or dependent on the instrument used for measurement purposes. Accounting information need not be perfectly accurate to be reliable. Accuracy is often difficult to determine or dependent on the instrument used for measurement purposes.

51. 51 © 2007 Pearson Custom Publishing Comparability Comparability describes the quality of information that allows users to identify similarities in and differences between two sets of accounting information. Comparability describes the quality of information that allows users to identify similarities in and differences between two sets of accounting information. =

52. 52 © 2007 Pearson Custom Publishing Consistency Consistency refers to conformity from period to period with accounting policies and procedures. Consistency refers to conformity from period to period with accounting policies and procedures. Comparing last year’s results with this year’s results would be futile if different methods were used in the two years. Comparing last year’s results with this year’s results would be futile if different methods were used in the two years.

53. 53 © 2007 Pearson Custom Publishing Accounting Reports and Economic Decision Making Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. (Statement of Financial Accounting Concepts #1 ) Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. (Statement of Financial Accounting Concepts #1 )

54. 54 End of Chapter F2 © 2007 Pearson Custom Publishing