Understanding Investor Decision Needs: The Decision Usefulness

School: Northeastern University - Course: SCHM 6318 - Subject: Accounting

Chapter 3 The Decision Usefulness Approach of Financial Reporting MBA AF 691-Financial Accounting Theory and Analysis SPRING 2023 3 - 2 The Decision Usefulness Approach •Investors are an important constituency of accounting •It is the investor's responsibility to make own investment decisions •The theory of rational decision making helps the accountant to know investors' decision needs •Knowing investors' decision needs enables the accountant to prepare useful financial statements 3 - 3The Rational Decision Theory Model•Investors make decisions in a variety of ways •Their buy and sell decisions interact to form the market price of a security •The rational decision theory model does not claim to capture the decision process of an individual investor •It claims to capture the decision process of the averageinvestor -That is, it claims that investor decisions are, on average, rational -Arational investormakes decisions to maximize his/her expected utility 3 - 4 The Rational Decision Theory Model (continued) •Role of the rational decision theory model in financial reporting -Helps us understand how financial statement information helps the average investor to make investment decisions -Thereby helps the accountant to provide useful information for investment decisions 12 34

3 - 5Bayes' Theorem •A device to revise state probabilities upon receipt of new information - θis state of nature (e.g., good/bad firm performance; unobservabletrue performance) -m is information (message) received (observableperformance) -P(θ) ispriorprobability ofθ(subjective; differs by eachindividual)•Formula () ( ) () () ( ) =    PmPmPPmP///No need to memorize; proven by statisticians 3 - 6 Bayes' Theorem Applied to Accounting Information •θis state of firm (unobservable; true performance) θ1 = H = highfuturefirm performance (e.g., good firm; should buy) θ2 = L = lowfuturefirm performance (e.g., bad firm; should sell) •m is information received from the financial statements m1 = GN =currentfinancial statementsshow good news (e.g., net income is high) m2 = BN =currentfinancial statementsshow bad news (e.g., net income is low) •Now, suppose GN (i.e., new information!) is received, then: 3 - 7•P(H/GN): The probability of truly being a good firm when the financial statements just updated high net income •P(H): The probability of truly being a good firm before receiving the recent good news from the financial statements •P(L): The probability of truly being a bad firm before receiving the recent good news from the financial statements•P(GN/H): The probability of financial statements showing a high net income when the firm is indeed a good firm •P(GN/L): The probability of financial statements showing a high net income when the firm is indeed a bad firm Investors' subjective(posterior)probabilitythat the firm is a good firmafterreceiving high net income news from the financialstatements The degree of how useful the financial information system is; higher P(GN/H) indicates higher quality of financial statements Investors' subjective(prior)probability that the firm is a good firmbeforereceiving high net income news from the financial statements 3 - 8 The Accounting Information System Current Financial StatementInformation (m) GNBN Total HState of Nature(θ) L P(GN/H)P(BN/H)1 P(GN/L)P(BN/L)1 •The main diagonal (blue shape) captures the quality (usefulness) of financial statements; the higher, the better •If the financial statements are perfect, P(GN/H) and P(BN/L) are 1 and P(BN/H) and P(GN/L) are 0. •Themain diagonal probabilitiescan be increased by enhancing the relevance or reliability of financial statements