Chapter 3

The Decision Usefulness

Approach to Financial
Reporting

3-1
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 Chapter 3
The Decision Usefulness Approach to Financial Reporting

3-2
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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 Pm /  
P / m 
 Pm /  P 


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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 Total

Evidence
GN BN

H P(GH/H) P(BN/H) 1
State of
Nature
L P(GN/L) P(BN/L) 1

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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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