Chapter 3

The Decision Usefulness

Approach to Financial
Reporting

Copyright 2009 by Pearson Education Canada

3-1

Chapter 3
The Decision Usefulness Approach to Financial Reporting

Copyright 2009 by Pearson Education Canada

3-2

3.2 The Decision Usefulness

Approach
It is the investors 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

Copyright 2009 by Pearson

3-3

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

Copyright 2009 by Pearson

3-4

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?

Copyright 2009 by Pearson

3-5

Bayes Theorem
A device to revise state probabilities upon
receipt of new evidence
is state of nature
m is message received
P() is prior probability of (subjective)

Formula
P / m

P P m /
P m / P

Copyright 2009 by Pearson

3-6

Bayes Theorem Applied to

Accounting Information
is state of firm
1 = H = high future firm performance
2 = 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:

Copyright 2009 by Pearson

3-7

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
H
State of
Nature

Total

P(GH/H)

P(BN/H)

P(GN/L)

P(BN/L)

Copyright 2009 by Pearson

3-8

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

Copyright 2009 by Pearson

3-9

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

Copyright 2009 by Pearson

3-

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

Copyright 2009 by Pearson

3 - 11

3.3.3 Definition of Information

Information is evidence that has the potential to

affect an individuals decision

Copyright 2009 by Pearson

3-

Theory of Investment
Points to note:

The rational investor

Risk aversion
Portfolio diversification
beta

Copyright 2009 by Pearson

3-

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

Copyright 2009 by Pearson

3-

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

Copyright 2009 by Pearson

3-

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

Copyright 2009 by Pearson

3-