The Decision Usefulness Approach to Financial Reporting

1. The Decision Usefulness Approach to Financial Reporting Chapter 3

2. Decision Usefulness The Rational Investor Diversification Portfolio Risk Conceptual Framework AGENDA

3. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The Decision Usefulness Approach “If we can’t prepare theoretically correct financial statements, at least we can try to make the financial statements more useful” • Non-ideal conditions • Contrasted with stewardship • Two major questions: • Who are the users? • What decision problems do they face?

4. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Single person decision theory • Understand how individuals make rational decisions under uncertainty • Appreciate the concept of information • Allows decision makers to update their subjective beliefs • Financial statements are a source of information

5. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Example #1 Jane has $20,000 to invest in either • A1 = Shares of ABC Ltd. • A2 = 2% Government Bonds States of nature:

6. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Payoff Table • Jane is risk-averse • Utility = √payoff

7. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Decision Tree Act State (Probability) Payoff (Utility) High performance (0.30) $1,600 (40) A1 Low performance (0.70) $0 (0) Invest $20K A2 Performance high or low (1.00) $225 (15) EU (A1) = (0.3 X 40) + (0.7 X 0) = 12 EU (A2) = 1.00 X 15 = 15

8. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Conditional Probabilities • P(GN/H) = 0.80 • Probability of FS showing GN if ABC is a high state firm • P(BN/H) = 0.20 • Probability of FS showing BN if ABC is a high state firm • P(GN/L) = 0.10 • Probability of FS showing GN if ABC is a low state firm • P(BN/L) = 0.90 • Probability of FS showing BN if ABC is a low state firm

9. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Posterior Probabilities • Bayes’ Theorem P(H/GN) = P(H)P(GN/H) . P(H) P(GN/H)+ P(L) P(GN/L) = 0.3 x 0.8 (0.3 x 0.8) + (0.7 x 0.1) = 0.77 P(L/GN) = 1.00 – 0.77 = 0.23 • Updated expected utilities EU(A1/GN) = (0.77 x 40) + (0.23 x 0) = 30.8 EU(A2/GN) = 1.00 x 15 = 15

10. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Information Defined • Evidence that has potential to affect an individual’s decision • Net of cost • Continuous process

11. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The Information System • Conditional probabilities • P (GN|H) and P (BN|L)

12. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The Information System • Highly informative FS exist due to the underlying INFORMATION SYSTEM • Informativeness depends on relevance & reliability of the FS • Example: a new standard requires a company to switch methods of valuing capital assets. • Result= increased relevance since it is a better predicator of future firm performance but decreased reliability due to the need for estimates

13. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Rational Expectations • When ones assumes the information system probabilities are known • Investors are assumed to quickly form accurate estimates of unknown probabilities • How do they do this? 2 approaches: • Sampling the FS • Examining revisions by Value Line analysts of future quarterly earnings forecasts based on current states

14. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The Rational, Risk-Averse Investor • Rational Investor = typically Risk Averse • Risk aversion is important to accountants because it means investors need certain information concerning the risk of future returns • Utility Functions model risk aversion

15. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Utility Functions • Risk Averse Investor • Risk Neutral Investor

16. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The principal of portfolio diversification • Typical investor is risk averse • Investor will want lowest possible risk; in instances where they bear risk the highest expected payoff will be required • Tradeoff between risk and return  greater risk only if expected return is high • Diversification  lowers risk • Some but not all risk can be eliminated by proper investment strategy • General utility function is: • Ui (a) = fix̅ - σa2 • Ui represents utility of investment • fi represents the risk factor • x̅ represents the expected rate of return • σrepresentsthe variance • A more risk averse person will increase the variance by (for example) a factor of two ultimately lowering the utility

17. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Application of Portfolio Diversification • Assume a client wishes to purchase the following: • 8 shares of firm I valued at $10 per share paying a dividend of $1 per share with a 67.50% chance of the share increasing to $10.50 and a 32.50% chance of the share decreasing to $8.50 • 6 shares of firm II at $20 per share paying a dividend of $1 per share with a 74% chance of the share increasing to $22 dollars and a 26% chance of the share decreasing to $17

18. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework • With each different potential outcome the probability with independence is distinguished using the probabilities given • Due to economy wide/market wide factors it generally goes without saying that “if one stock is going up, there is a better chance that other stocks will also go up” or “if one stock is going down, there is a better chance that other stocks are going down” • This, as a result, explains the diversified probabilities as the UP,UP and DOWN, DOWN situation both increased their probabilities by the same 7.47% factor under diversified probability

19. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework • The utility according to our earlier equation (assuming a neutral stance) would then be Ui = 8.50% -0.74% = 7.76% • If you have invested in either of the stocks single handedly the utility would have been lower showing that there would have been more risk associated with investing in 1 particular stock

20. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework The optimal investment decision • The more shares your portfolio has the less risky it is; this is known as “holding the market portfolio” • Systematic risk is risk that that cannot be avoided by diversifying as it is the risk inherent to the entire market • If investor is more risk averse, they may consider purchasing a risk free asset (ex. treasury bills) lowering the risk

21. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Portfolio Risk • Calculating & Interpreting Beta: • Beta: Measures the co-movement between changes in the price of a security and changes in the overall market • Used to gauge a security’s risk

22. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Calculating Beta The beta of shares of firm A is calculated by: Where; Cov(A,M) measures how strongly return of security A varies compared to market, and Var(M) expresses the volatility of the market overall

23. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Some Examples

24. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Calculating covariance

25. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework BETA • Given that, • We obtain: • Low Beta = Low Risk

26. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Portfolio Expected Value and Variance • Recall, that an investors utility function for an investment looks like • Expected return of portfolio P: • Where X is the expected return of a given security and K is the proportion of that security in the overall portfolio

27. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Portfolio Variance • The variance of a portfolio with two securities is: • Variance of a portfolio is determined by the variance of each securities and the covariance between securities Firm-Specific Risk Firm-Specific Risk Systematic Risk

28. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Portfolio Risk as the Number of Securities Increases *assuming each security is an equal portion of the portfolio

29. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Firm-Specific risk

30. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework IASB & CICA IAS 1: “The objective of financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions.” CICA section 1000: “The objective of financial statements is to communicate information that is useful to investors, creditors, and other users in making their resource allocation decisions and/or assessing management steward ship”

31. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework What is useful information? • Help investors assess the amounts, timing, and uncertainty of future cash flows • Enhance relevance and reliability of accounting information

32. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Relevance and Reliability • IAS 8: “In the absence of an IFRS ...management shall use judgement in developing and applying an accounting policy that results in information that is: a) relevant to the economic decision making needs of users; and b) reliable” CICA Section 1100: “an entity shall adopt accounting policies and disclosures that are a) consistent with primary resources of GAAP, and b) developed through exercise of professional judgement and application of concepts described in Section 1000” Section 1000: outlines relevance and reliability

33. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework How is historical information useful? • Helps form expectations • Under non-ideal conditions: • Relevant Information  allows investors to form their own expectations

34. The Rational Investor Decision Usefulness Portfolio Risk Diversifica-tion Conceptual Framework Predicting future performance • Accruals • Match revenue and costs • Ex. Accounts Receivable  predict future sales proceeds • Earnings • Better for predicting poor performance • Accruals anticipate unrealized losses  future cash flow reductions

35. Summary & Questions?