Chapter 3

The Decision-Usefulness
Approach to Financial Reporting
Agenda
— Decision usefulness approach
— Single-person decision theory
— Information system
— Rational risk-averse investor
— Principle of portfolio diversification
— MD&A
— IASB/FASB conceptual framework
Decision Usefulness Approach
— Who are the users of financial
statements?
◦ Equity investors, debt investors, managers,
standard setters, governments, unions
(constituencies)
◦ IASB/FASB framework adopts investors as the
major constituency of financial statement
users.
◦ It is the investors’ responsibility to make
investment decisions.
Decision Usefulness Approach
— What are the decision problems of
financial statement users?
◦ To prepare useful information/financial
statements, the accountants must know
investors’ decision needs.
◦ Theories of decision and investment help
accountants to understand investors’ needs.
Single-person Decision Theory
— An individual must make a decision under
uncertainty.
— State probabilities are subjective.
— Additional information can be obtained to
revise the decision-maker’s subjective
assessment of the state probabilities.
Single-person Decision Theory
— Terminology
◦ Payoff: the amount to be received from a
decision
◦ Utility: worth to some end
◦ Prior probability
◦ Conditional probability
◦ Posterior state probabilities
◦ Bayes’ theorem
 Bayes’ Theorem
A device to revise state probabilities upon receipt of
new evidence
Θ is state of nature
m is message received
P(θ) is prior probability of θ (subjective)
Formula
P(q )P(m / q )
P(q / m ) =
å P(m / q )P(q )
q
Information System
— Information: Evidence that has the potential
to affect an individual’s decision.
— Under non-ideal conditions, although not
showing expected future performance
directly, financial statements help decision-
makers update subjective state probabilities
and predict investment returns.
— An information system gives the objective
probabilities of each possible financial
statement evidence item.
 Information System

Current Financial Statement Total

Evidence
GN BN

H P(GN/H) P(BN/H) 1
State of
Nature
L P(GN/L) P(BN/L) 1
Bayes’ Theorem Applied to Accounting
Information
θ is state of firm
θ1 = H = high future firm performance
θ2 = L = low future firm performance
m is evidence received from the financial statements
m1 = GN = financial statements show good news
m2 = BN = financial statements show bad news
Suppose GN is received:
Information System
— “Informative”
◦ The higher the main diagonal probabilities
relative to the off-main diagonal ones, the
more informative the information system.
◦ Transparent, precise, and high quality
— What characteristics of financial
statements are in favor of
informativeness?
◦ Relevant and reliable
◦ Conservatism
Information System
— Why are information system probabilities
objective?
◦ GAAP
— How do investors know the information
system probabilities?
◦ Rational expectations assumption
◦ Knowledge and experience
 Example
High (H) Low(L)
Common Shares $8,000 $1,000
Mutual Funds $5,000 $2,000
Prior Probabilities: 0.5 0.5
Conditional Probabilities:
GN BN
H 0.75 0.25
L 0.1 0.9
 Example
— Pr (GN) = 0.75 ´ 0.5 + 0.1 ´ 0.5 = 0.425
— Pr (BN) = 1 – 0.425 = 0.575

0.75 ´ 0.5
Pr (H | GN ) = = 0.882
0.425
0.1´ 0.5
Pr (L | GN ) = = 0.118
0.425
0.25 ´ 0.5
Pr (H | BN ) = = 0.217
0.575
0.9 ´ 0.5
Pr (L | BN ) = = 0.783
0.575
 Rational Risk-averse Investor
— A rational individual chooses the act that maximizes
the expected utility.

— The decision theory describes a model of how the

average investor should make decisions.
◦ Does not claim that all investors make decisions
this way.
Rational Risk-averse Investor
— Risk attitudes:
◦ Averse
◦ Neutral
◦ Loving
— Utility function – A utility functional is a
monotonic increasing correspondence of
a decision maker’s preferences.
If x1 < x2, then u(x1) £ u(x2).
Rational Risk-averse Investor
— Risk aversion: A decision maker is risk
averse if (s)he prefers the certainty
equivalent CE of any lottery to the
expected consequence EV of the lottery.

— Certainty equivalent: The amount that

the decision-maker is indifferent between
the lottery (uncertainties) and the
amount for certain.
Rational Risk-averse Investor
• A risk averse utility function
U(x)

U(x2)
U(E(x))
EU(x)
U(x1)

x
x1 E(x) x2
CE
• A decision-maker is risk averse if and only if his utility
function is concave.
U(tx1+(1-t)x2)>tU(x1)+(1-t)U(x2)
 Rational Risk-averse Investor
— Investor is usually assumed risk-averse.
— Risk-averse investor trades off risk and
return
◦ If risk increases, demands higher
return, and vice versa
— Risk premium is equal to the difference
between the mean of the lottery and
the certainty equivalent.
Example
— Return to the example, now with a risk
averse decision maker:
U (wealth ) = 2 ´ ln(wealth )
U ($8,000 ) = 2 ´ ln(8,000 ) = 17.9744
U ($1,000 ) = 2 ´ ln(1,000 ) = 13.8155
U ($5,000 ) = 2 ´ ln(5,000 ) = 17.0344
U ($2,000 ) = 2 ´ ln(2,000 ) = 15.2018
Example
— No information:
◦ EU (Common shares)
= 17.9744 ´ 0.5 + 13.8155 ´ 0.5 = 15.8950
◦ EU (Mutual funds)
= 17.0344 ´ 0.5 + 15.2018 ´ 0.5 = 16.1181 *
— With costless perfect information:
◦ EU (with perfect information)
= 17.9744 ´ 0.5 + 15.2018 ´ 0.5 = 16.5881
Example
— With costless imperfect information:
◦ When GN is observed:
– EU (Common shares | GN)
= 17.9744 ´ 0.882 + 13.8155 ´ 0.118
= 17.4836 *
– EU (Mutual funds | GN)
= 17.0344 ´ 0.882 + 15.2018 ´ 0.118
= 16.8181
Example
◦ When BN is observed:
– EU (Common shares | BN)
= 17.9744 ´ 0.217 + 13.8155 ´ 0.783
= 14.7180
– EU (Mutual funds | BN)
= 17.0344 ´ 0.217 + 15.2018 ´ 0.783
= 15.5995 *
Example
— EU with accounting report (imperfect
information)
= 17.4836 ´ 0.425 + 15.5995 ´ 0.575
= 16.4002
— EU with perfect information (16.5881)
³ EU with accounting report (16.4002)
³ EU without any information (16.1181)
Principle of Portfolio Diversification
— Mean-variance utility function

U i (a) = f i ( x a , d a )
2

• Utility increases with expected rate of

return and decreases with risk of
return.
U i (a) = 2 x a - d a
2
 Example
— Byron has $80 to invest, and his utility
function is
U i (a) = 2 x a - d a
2

• Company A
– Currently trading at $40 per share
– 40% chance price will rise to $80 per share
– 60% chance price will fall to $35 per share
 Example
Sec End Value Rate of Return Probability E(R)
A $160 ($160-$80)/$80=1.00 0.4 0.4
$70 ($70-$80)/$80=-0.125 0.6 -0.075
0.325
Sec Rate of Probability Variance
Return
A 1.0 0.4 (1 - 0.325)2 ´ 0.4 = 0.18225
-0.125 0.6 (- 0.125 - 0.325)2 ´ 0.6 = 0.12150
0.30375
Example
— Byron’s utility for investing in 2 shares of
Company A

U(2A)=2´0.325-0.304=0.346

— Should Byron accept the investment?

Example
— Think about adding Company B to the
investment
— Company B
◦ Currently trading at $20 per share
◦ 60% chance price will rise to $30 per share
◦ 40% chance price will rise to $21.25 per share
• What about 1A+2B?
 Example
— 1A + 2B
End Value Rate of Return Prob. E(R)
$80+$60=$140 ($140-$80)/$80=0.75 0.24 0.18
$80+$42.50=$122.50 ($122.50-$80)/$80=0.53125 0.16 0.085
$35+$60=$95 ($95-$80)/$80=0.1875 0.36 0.0675
$35+$42.50=$77.50 ($77.50-$80)/$80=-0.03125 0.24 -0.0075
0.325
 Example
— 1A + 2B
Rate of Return Prob. Variance
0.75 0.24 (0.75 - 0.325)2 ´ 0.24 = 0.04335
0.53125 0.16 (0.53125 - 0.325)2 ´ 0.16 = 0.00681
0.1875 0.36 (0.1875 - 0.325)2 ´ 0.36 = 0.00681
-0.03125 0.24 (- 0.03125 - 0.325)2 ´ 0.24 = 0.03046
0.08742
Example
— Byron’s utility for investing in 1 share of
Company A and 2 shares of Company B

U(1A+2B)=2´0.325-0.087=0.563
Example
• Comments:
• Holding expected rate of return constant,
more than one investment spreads risk
and increases utility, provided the returns
are not perfectly correlated.
Principle of Portfolio Diversification
— Divide all events affecting the returns on
firms’ shares into two types (factors)
◦ Market-wide factors
– E.g., central bank changes the interest rate
◦ Firm-specific factors
– E.g., GN or BN in a firm’s financial statements
◦ If investor buys a portfolio of securities, firm-
specific factors tend to cancel out
◦ A fully diversified portfolio is one where firm-
specific factors completely cancel out, leaving only
undiversifiable market-wide factors to affect
returns, called holding the market portfolio
Management Discussion and Analysis
— Management’s outline and explanation of
the firm’s operations
◦ To supplement the financial statements
◦ Forward-looking orientation
◦ Includes discussion of risks facing the firm
◦ Consistent with rational decision making
– Forward orientation and risk information may
increase main diagonal probabilities of information
system
◦ More relevant than the financial statements
 Is MD&A Decision Useful?
• Li (2010) studied the ability of MD&A to
predict future firm performance (earnings)
• 145,479 MD&As classified into their tones (positive,
negative, neutral)
• Does the tone of an MD&A predict earnings over the
following 4 quarters?
• Answer was yes, consistent with MD&A being decision
useful
• This study shows the potential of computer analysis of
large verbal data bases to increase our understanding of
accounting information
The Reaction to the Decision Usefulness
Approach: IASB/FASB Conceptual Framework
— The objective of financial statements is to
provide financial information that is “useful to
present and potential equity investors, lenders,
and other creditors about providing resources
to the entity.”
◦ Primary users
◦ Entity view: Financial reports reflect the
perspective of the firm as a whole, rather than
simply that of shareholders.
The Reaction to the Decision Usefulness
Approach: IASB/FASB Conceptual Framework
• Investors need information about the amount,
timing, and uncertainty of future cash flows.
◦ Investors are assumed to be risk-averse.
◦ Future-oriented
◦ Linkage between current/past performance and future
prospects: conditional probabilities and Bayes’ Theorem

Information about a reporting entity’s past [including current]

financial performance … is usually helpful in predicting the
entity’s future returns on its economic resources.
The Reaction to the Decision Usefulness
Approach: IASB/FASB Conceptual Framework
— Balance sheet is the primary statement. Income
statement provides,
…information about the effects of transactions… that
change a reporting entity’s economic resources and
claims [i.e., that change the balance sheet].

• Role of accruals: to include the effects of

transactions on the firm’s balance sheet in the
periods in which those effects occur, even if the
resulting cash receipts and payments occur in a
different period.
The Reaction to the Decision Usefulness
Approach: IASB/FASB Conceptual Framework
• Desirable qualitative characteristics of accounting
information
◦ Fundamental characteristics: Relevance and faithful
representation (complete, free from material error, and
neutral)
Relevant financial information is capable of making a difference in
the decisions made by users….
If financial information is to be useful, it must…faithfully represent
what it purports to represent.
◦ Enhancing characteristics: timeliness, comparability,
verifiability, understandability
The Reaction to the Decision Usefulness
Approach: IASB/FASB Conceptual Framework
— Summary
◦ The Framework adopts the decision usefulness
approach.
◦ Financial statements do not directly report on
future payoffs.
◦ Financial statements help investors form their own
predictions of future payoffs.