Financial accounting theory 5e scot ch03

Chapter 3
The Decision Usefulness
Approach to Financial
Reporting

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Chapter 3
The Decision Usefulness Approach to Financial Reporting

Copyright © 2009 by Pearson Education Canada

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3.2 The Decision Usefulness
Approach
• It is the investor’s responsibility to make investment
decisions
• Role of financial reporting is to supply information that is
useful for this purpose
• To prepare useful information, the accountant must know
how investors make decisions

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3.3 The Rational Decision Theory
Model
• A model of rational decision making in the face of
uncertainty
– Definition of rationality?

• A game against nature: “nature does not think”
• Other ways to make decisions?

» Continued

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3.3 The Rational Decision Theory
Model (continued)
• Role of the rational decision theory model in financial
reporting
– Helps us understand how financial statement information
helps investors to make investment decisions
– Captures average investor behaviour?

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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 (θ / m ) =

P(θ ) P( m / θ )
∑ P ( m / θ ) P(θ )
θ

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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 = net income shows good news
m2 = BN = net income shows bad news

• Suppose GN is received:

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3.3.2 The Information System I
Shows Evidence Probabilities, Conditional on
Each State, for Input into Bayes’ Theorem

Current Financial Statement
Evidence
GN
BN
H
State of
Nature

Total

P(GH/H)

P(BN/H)

1

P(GN/L)

P(BN/L)

1

L

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The Information System II
•

The higher the main diagonal probabilities, the better the investor
can predict the state of nature (i.e., future firm performance)
– The main diagonal probabilities capture financial statement
informativeness
– Highly informative financial statements also called:
• Transparent
• Precise
• High quality

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The Information System III

• Information system probabilities are objective
– Reflect quality of GAAP

– How known by investor?

• Prior probabilities are subjective
– Investor assesses them based on all information available
prior to the investment decision

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The Information System IV

• If prior probabilities are subjective, so are posterior
probabilities
– However, if financial statement information is informative,
posterior probabilities are better predictors of future firm
performance than prior probabilities

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3.3.3 Definition of Information

• Information is evidence that has the potential to affect an
individual’s decision

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Theory of Investment
• Points to note:
–
–
–
–

The rational investor
Risk aversion
Portfolio diversification
beta

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3.8 Do Professional Accounting
Bodies Accept the Rational Decision
Theory?
• SFAC 1
–
–
–
–

Oriented to investors
Oriented to rational investment decisions
Accepts that investors are risk averse
Financial statements provide information to help investors
assess (posterior probabilities of) the amounts, timing, and
uncertainty of investment proceeds (i.e., of future firm
performance)
• Note that Bayes’ theorem is implied
» Continued

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3.8 Do Professional Accounting
Bodies Accept the Rational Decision
Theory? (continued)
• SFAC 2
– To help investors, financial statement information should be:
• Relevant
– Can “make a difference”

• Reliable
– Faithful representation
– Verifiable
– Neutral

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Conclusions
• Rational decision theory provides a theoretical
underpinning for study of information needs of investors
• Conceptual framework SFAC 1 and SFAC 2 accept the
rational decision theory model

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