Chpt_3_presentationscoot.ppt

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CHAPTER 3

The Decision

UsefulnessApproach to

Financial

ReportingNicole 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 theDecision 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 toregulations



3.3 SINGLE PERSON DECISION THEORY

Decisions made under conditions ofuncertainty

State probabilities are no longer objective

Formal procedures are set up to assist inmaking the best decision.



3.3.1 DECISION THEORY APPLIED

Bill Cautious has $10,000 to invest in either shares of X Ltd or government bondsyielding 2 ¼ %.

State 1: X Ltd future performance high

net return is $1,600

State 2: X Ltd future performance low

net return is $0



PAYOFF TABLE

probability of state 1 = .30

probability of state 2 = .70

ACT STATE

High Low

Buy shares $ 1,600 $ 0

Buy bonds $ 225 $ 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 2FINANCIAL STATEMENT PROBABILITY

High state firm:

P(GN/H) = .80P(BN/H) = .20

Low state firm:

P(GN/L) = .10P(BN/L) = .90

Where:

GN = Good newsBN = 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 .80 1.00 - .77 = .23

(.30x.80) + (.70x.10)= .77

Expected Utility :Shares = (.77 x 40) + (.23 x 0) = 30.8Bonds = 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 statementdoes not give direct information about expected

future firm performance

However, FS information is still useful

Under the assumption good or bad new willcontinue in the future



3.3.2 THE INFORMATION SYSTEM

"An information system is a table giving, conditional oneach 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 moreuseful the FS information becomes

Thus investors can better predict the expectedfuture firm performance

Noise: represents the weakening of the relationshipbetween the current FS information and future firmperformance

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 aconclusion

Once information is gathered anindividuals conclusions may change

FS, if reliable and relevant, are importantsource of information



3.4 THE RATIONAL, RISK-AVERSEINVESTOR

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 expectedpayoff, would prefer the one with lower risk .

Risk costs something, causing trade-off between risk andreturn

How to model?

Concave utility function for payoff



MODELING RISK AVERSION WITH

CONCAVE UTILITY FUNCTION

Choices State Probability of Payoffs

High Low High Low

A (Shares) $225 $0 60% 40%

B (T-bills) $100 $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 oneinvestment spreads risk and increases utility, provided the returns

are not perfectly correlatedo Market-wide factors affecting returns

Non-diversifiable

o Firm-specific factors affecting returns

Diversifiable

+ -



EXAMPLE 1Toni, 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)

Payoff Rate of Return Probability Expected Rate

of ReturnVariance

$230 (230 – 200) /

200 = 0.15

0.74 0.1110 (0.15 – 0.085)2 x .74

= 0.0031

$180 (180 - 200) /200 = -0.10

0.26 -0.026 (-0.10 – 0.085)2 x .26= 0.0089



EXAMPLE 1 CONT’D

Assume that Toni’s utility function is:

Utility from this investment is:

(2 x 0.085) – 0.012 = 0.1580

Can Toni do better?



EXAMPLE 2

Her utility now is:

(2 x 0.085) – 0.0074 = 0.1626 (0.158 in Example 1)

States Payoff Rate of Return Probability ExpectedRate of Return

Variance

GG $230 (230 – 200) / 200= 0.15

0.5742 0.0861 (0.15 – 0.085)2 x .5742= 0.0024

GB $214 (214 - 200) / 200= 0.07

0.1658 0.0116 (0.07 – 0.085)2

x .1658= 0.0000

BG $200 (200 - 200) / 200= 0.00

0.1008 0.0000 (0.00 – 0.085)2 x .1008= 0.0007

BB $184 (184 - 200) / 200

= -0.08

0.1592 -0.0127 (-0.08 – 0.085)2 x .1592

= 0.0043

Buy 2 Investments instead, Investment A and B



3.6 THE OPTIMAL INVESTMENT DECISION(IGNORING TRANSACTION COSTS)

To maximize diversification, buy the marketportfolio

Firm-specific risks are diversified away

Only systematic (economy-wide) risks remain

To maximize utility, buy a combination of

market portfolio and risk-free assetAchieve desired risk-return trade-off, depending

on investor’s risk -averseness

Does not undo the benefits of diversification



OPTIMAL PORTFOLIOINVESTMENT DECISION



3.7.1 CALCULATING AND

INTERPRETING BETA

Beta measures the changes in the price of asecurity in relation to changes in the market

A high beta stock's price will fluctuate by a largemargin in response to changes in the market

Using beta helps to attain desired level of risk in aportfolio



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 THENUMBER OF SECURITIES INCREASES

As securities in portfolio increase,

systematic risk increases rapidlyMost of the benefits of diversification can

be attained with relatively few securities inthe portfolio

Entire market portfolio does not need to bepurchase to adequately diversify



3.8 PROFESSIONAL ACCOUNTING REACTION

TO THE DECISION USEFULNESS APPROACH

Adopted by most of the major professional accountingbodies

FSAB adopted as part of the Conceptual Framework project,specifically mentions investors’ needs for information aboutthe uncertainty of future investments and their expectedvalues

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 accountingand reporting standards will be based”



SFAC 1

Objective 1 on financial reporting:

“to provide information that is useful topresent and potential investors andcreditors and other users in making

rational investment, credit, and similar decisions.”



SFAC 1Objective 2 on financial reporting:

“provide information to help present and

potential investors and creditors and other users in assessing the amounts, timing, anduncertainty of prospective cash receipts fromdividends or interest and the proceeds fromthe sale, redemption, or maturity of securitiesor loans.”



SFAC 1

INFORMATION SYSTEM LINKAGE

“although investment and credit decisions

reflect investors’ and creditors’ expectations

about future enterprise performance, thoseexpectations are commonly based at least

partly on evaluations of past enterpriseperformance.”



SFAC 2Relevant accounting information is capableof making a difference in a decision by

helping users to form predictions about thefuture outcomes of past, present and futureevents 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 relevantDeviation from standards renders the single-person

decision theory useless



EXPENSE ITBy John Lorinc

Main Issue: what is the proper accountingtreatment for employee stock optioncompensation?

Before: companies didn't have to expense thevalue of these items immediately after beingissued

After: governing bodies such as the FASB, IASB,and AcSB introduce regulations forcingcompanies to recognize these items once theyare issued



EXPENSE IT By John Lorinc

Secondary Issues: How do we effectively measure the value of

these expenses to be recorded on the financialstatements?

Most employee stock option compensationpackages come loaded with a range ofconditions and restrictions that make them

difficult to measureOptions can’t be sold or traded (only

exercised); employee must forfeit allunexercised 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 optionswhen issued

Fair value:

Taking into consideration all related factors that mightinfluence the reasonable cost of these items.

Estimating the expected life of the option and theratio between stock price and exercise price theemployee would seek before exercising the options



Questions?

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