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Decision usefulness theory

Decision usefulness theory. Chapter 3 – Group C. Agenda. What is the ‘Decision U sefulness’ Theory?. To make financial statements more useful we need to know what usefulness means WHO are the users of financial statements? WHAT are the decision problems faced by the users?

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Decision usefulness theory

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  1. Decision usefulness theory Chapter 3 – Group C

  2. Agenda

  3. What is the ‘Decision Usefulness’ Theory? To make financial statements more useful we need to know what usefulness means • WHO are the users of financial statements? • WHAT are the decision problems faced by the users? If we can answer these questions we will be able to make statements that will lead to improved decision making.

  4. Single person Decision Theory • Decisions made under conditions of uncertainty – state probabilities are subjective based on information. • Prior probabilitiesbased on analysis of past financial statements, news, assessment and market price. • Posterior State Probabilities are adjusted probabilities after analysis of current financial statements.

  5. Information SystemExample 3.1 • The 0.8 and 0.9 are the main diagonal properties • The 0.2 and 0.1 are the off-main diagonal properties • Link between current information and future performance (quality of information) are the conditional probabilities in the following “information system”:

  6. Q1 • What makes data informative?

  7. Information system “Information is evidence that has the potential to affect an individual’s decision” • Enables the user to update prior probabilities. • Noise: Weakening of relationship between current financial information and future firm performance. • If main diagonal probabilities increase, it is the result of increased financial statement usefulness • The more informative an information system provides, the more decision useful it is.

  8. Flashback! Relevancy vs. Reliability

  9. IASB/FASB Reaction of Professional Bodies • What is the ultimate goal of the accounting framework? “provide financial information that is “useful to present and potential equity investors, lenders and other creditors [constituencies – primary user group] in making decisions in their capacity as capital providers” • What types of information do they need? Amount, timing and uncertainty of firm’s future cash flows

  10. CICA Handbook Section 1000 - Financial Statement Concepts • Amendments to this Section focus on clarifying the criteria for asset recognition. These amendments are a continuation of the trend which places more emphasis on the balance sheet than the matching principle.

  11. Accounting Changes • Section 1000 • Intangible Assets “Frame Work for the preparation and Presentation of Financial Statements” - helps distinguish assets from expenses. • Section 1100 • Rate – Regulated operations Allowance of the recognition and measurement of assets and liabilities arising from rate regulation was withdrawn.

  12. Rational/Risk Averse Investor • Review: • Bayes Theorem • Risk aversion is when an investor who is faced with two investment options will choose the option with less risk.

  13. Risk Averse vs. Risk Neutral

  14. Example 3.2 - Utility • Suppose a risk-averse investor has $200 to invest and is considering investing it all in the shares of firm A, currently trading at $20. Assume there is a 74% chance the shares will increase to $22 and a 26% chance the shares will decrease to $17. Also assume that firm A will pay a $1 dividend. Your utility function is: Required: Determine the investor’s utility for this investment.

  15. Answer

  16. Optimal Investment Decision • The optimal investment decision includes holding the market portfolio. • Two ways to adjust risk: • Invest in risk-free assets • Borrow at the risk-free rate and buy more of the market portfolio

  17. Q2 • Diversification can reduce the ______ risk associated with a portfolio, but not the ________ risk.

  18. Principle of Portfolio Diversification • By investing the same amount, spread over different securities, investors can reduce the risk level for the same level of return.

  19. How to Diversify… • In diversifying a portfolio , an investor needs to consider the correlation of the shares. • Market-wide factors vs. idiosyncratic (firm-specific) factors • When transaction costs ignored, diversify with few securities instead of the market portfolio to optimize benefits.

  20. Portfolio Risk • Beta measures the co-movement between changes in the price of a security and changes in the market value of the market portfolio • Beta of A shares = Covar A & M/Var M • Enables prospective investors to compare portfolios and choose preferred risk-return tradeoff.

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