THE DECISION USEFULNESS APPROACH Presented by:

Ayu Puspitasari (B2091181005)

TO FINANCIAL REPORTING Iin Rahmawati (B2091181011)
OVERVIEW
• Decision usefulness concept: the ability of financial accounting information to help
users make good decisions.

• To properly understand this concept, we need to consider other theories (other than
present value model) from economics and finance.

• Decision theories and capital market theories assist in conceptualizing the meaning of
useful financial statement information.

• The main purpose of this chapter is to introduce you to one of these theories: theory
of rational decision making and to discuss its relevance to accounting.
THE DECISION USEFULNESS APPROACH
Two major questions must be addressed:
1. Who are the users of financial stetements?
o Equity and debt investors
o Managers
o Unions Constituencies

o Standard setters
o Governments
2. What are the decision problems of financial statement users?
THE DECISION USEFULNESS APPROACH
• Tailoring financial statements information to the specific needs of the users of those
statements will lead to improved decision making.

• Accountants have decided that investors are a major constituency of users and have
turned to various theories in economics and finance: single-person decision theory and
theory of investment.
SINGLE-PERSON DECISION THEORY
• Single-person decision theory takes the viewpoint of an individual who must make a
decision under conditions of uncertainty.

• It recognizes that state probabilities are no longer objective, as they are under ideal
conditions, and sets out a formal procedure whereby the individual can make the best
decision by selecting from a set of alternative actions.

• Decision theory is relevant to accounting because financial statements provide

additional information that is useful for many decisions, as illustrated in Example 3.1.
Prior probabilities:
• A1; P(H) = 0.30
• A1; P(L) = 0.70
• A2; P(H) or P(L) = 1.00
If utility = the square root of the amount of the payoff, thus:
• A1; EU (H) = 40
• A1; EU (L) = 0
• A2; EU (H) or EU (L) = 15
• EU (A1) = [(40 x 0.30) + (0 x 0.70)] = 12
• EU (A2) = 1.00 x 15 = 15
SINGLE-PERSON DECISION THEORY
• Prior probabilities are based on information obtained:
o on an analysis of company’s past financial statements.
o the current market price of company’s shares.
• Therefore, it appears that Bill should choose A2 and buy the bonds since it
gives higher utility (15) than shares (12).
• However, Bill has another alternative: to obtain more information before
deciding.
SINGLE-PERSON DECISION THEORY
• When the annual report comes, Bill notes that net income is quite
high. In effect, the current financial statements show “Good News”
(GN).
• Bill knows that X Ltd. Really is a high-state firm (H), there is an
80% probability that the current year’s financial statements will
show GN and 20% probability that they will show bad news (BN).
o P (GN/H) = 0.80
o P(BN/H) = 0.20
SINGLE-PERSON DECISION THEORY
• Assume that if X Ltd. Really is in a low state (L), the probability that the
current year’s financial statements:
o GN = 10%; P(GN/L) = 0.10
o BN = 90%; P(BN/L) = 0.90
• P(H/GN) = 0.77
o EU (A1/GN) = [(0.77 x 40) + (0.23 x 0)] = 30.8
o EU (A2/GN) = 1.00 x 15 = 15
• Thus, the GN current financial statement information has caused Bill’s optimal
decision to change to A1. He should buy the shares of X Ltd.
THE INFORMATION SYSTEM
• It is important to understand why financial statement information
is useful here. To be useful, it must help predict future investment
returns.
• Under historical cost accounting, the financial statements do not
show expected future performance directly.
• Nevertheless, financial statements will still be useful to investors to
the extent that the good (GN) or bad news (BN) they contain will
persist into the future.
THE INFORMATION SYSTEM

Main diagonal probabilities

Off-main diagonal probabilities

THE INFORMATION SYSTEM
• Note that financial statements are not perfect, or “true” because P(BN/H) = 20%
o There is a 20% probability that even if the firm is in the high state the financial
statements would show BN.
o This weakening of the relationship between current financial statement information
and future firm performance is sometimes described as noise or as low earning
quality in the financial statements.
• The resulting increase in relevance would tend to increase the main diagonal
probabilities of the information system and lower the off-main diagonal ones.
THE INFORMATION SYSTEM
• The concept of informativeness of an information system is useful in understanding
the role of information in decision-making.

• The higher the main diagonal probabilities relative to the off-main diagonal ones,
the more informative the system or, equivalently, the higher its quality.

• The more informative an information system, the more decision useful it is.
THE INFORMATION SYSTEM
• The concept of an information system is one of the most powerful and useful concepts in
financial accounting theory.
o It is a powerful concept because it captures the information content of financial
statements, thereby determining their value for investor decision-making.
o It is a useful concept because many practical accounting problems can be framed in
terms of their impact on the information system.
• Easton and Zmijewski (1989):
o Analysts use current financial statement information to revise their beliefs about future
firm performance.
o EZ called the effect of current financial statement information on analysts’ next quarter
earnings forecast a “revision coefficient”. This coefficient is a proxy for earnings quality.
THE INFORMATION SYSTEM
• Information is evidence that has the potential to affect an individual’s decision.
o Notice that this is an ex ante definiiton. The crucial requirement for evidence to
constitute information is that for at least some evidence that might be received,
beliefs will be sufficiently affected that the optimal decision will change.
o The definition is individual-specific. Individuals may differ in their reaction to the
same information source. Their prior probabilities may differ, so that posterior
probabilities, and hence their decisions, may differ even when confronted with the
same evidence.
• The definition should really be interpreted net of cost.
• It should be emphasized that an individual’s receipt of information and subsequent
belief revision is really a continuous process.
THE RATIONAL, RISK-AVERSE INVESTOR
• In the decision theory, the concept of a rational individual simply means that
in making decisions, the chosen act is the one that yield the highest expected
utility.
• This implies that the individual may search for additional information relating
to the decision, usign it to revise state probabilities by means of Bayes’
theorem.
• If individuals do not make decisions in some rational, predictable manner it is
difficult for accountants, or anyone else, to know what information they find
useful.
THE RATIONAL, RISK-AVERSE INVESTOR
• It is also usually assumed that rational investors are risk-averse.
o To see the intuition underlying this concept, think of yourself as an investor
who is asked to flip a fair coin with your university or college instructor.
Suppose the coin is a penny.
o If the ante were raised, you would probably be willing to flip for dines,
quarters, even dollars. However, there would come a point where you
would refuse.
o Risk-averse individuals trade off expected return and risk.
RISK-NEUTRAL
• Despite the intuitive appeal of risk aversion, it is sometimes assumed
that decision makers are risk-neutral.
• This means that they evaluate risky investments strictly in terms of
expected payoff. Risk itself does not matter per se.
• Risk neutrality may be a reasonable assumption when the payoffs are
small.
• However, risk aversion is the more realistic assumption in most cases. The
concept of risk-aversion is important to accountants, because it means
that investors need information concerning the risk, as well as the
expected value, of future returns.
THE PRINCIPAL OF PORTOFOLIO
DIVERSIFICATION
• Thisprinciple has important implications for the nature of the risk
information that investors need.
•The risk reported on by many common accounting-based risk
measures, such as time interest earned or the current ratio, can be
reduced or eliminated a priori by appropriate diversification.
•Risk-averse investors can take advantage of the principle of
portofolio diversification to reduce their risk, by investing in
portofolio securities
THE PRINCIPAL OF PORTOFOLIO
DIVERSIFICATION
•This is because realizations of firm-specific states of nature tend to
cancel out across securities.
•Leaving economy-wide factors as the main contributions to
portofolio risk.
THE OPTIMAL INVESTMENT DECISION
•Be sure to understand why the same amount invested in a portfolio can yield lower
risk than if it were in a single firm for the same expected rate of return.
•When transaction costs are ignored, a risk-averse investor’s optimal investment
decision is to buy that combination of market portfolio and risk-free asset that yields
the best tradeoff between expected return and risk.
•Some investors may wish to reduce their investment in the marker portfolio and buy
risk-free asset with the proceeds and others may wish to borrow at the risk free rate
and increase their investment
•Either way, all investors can enjoy the full of benefits of diversification while at the
same time attaining their optimal risk-return tradeoff.
PORTFOLIO RISK
•The principle of diversification leads to an important risk measure of a security in the
theory investment. This is beta, which measures the co-movement between changes in
the price of a security and changes in the market of value of the market portfolio
•When transactions costs are ignored, a risk-averse investor’s optimal investment
decision is to buy relatively few securities, rather than the market portfolio.
•Information about securities’ expected returns and betas is useful to such investors
because:
To estimate the expected return nd riskiness of various portfolios that they may be considering.
To choose the portfolio that gives them their most preferred risk-return tradeoff, subject to the level of
transactions costs that they willing to bear.
INCREASING THE DECISION USEFULNESS OF
FINANCIAL REPORTING
•Management discussion and analysis (MD&A) is a standard that requires firms to
provide a narrative explanation of company operations to assist investors to interpret
the firm’s financial statements.
•MD&A represents a major step taken by securities commissions to set a standard that
goes beyond the requirements of GAAP.
•The reason why securities commissions become involved in MD&A disclosure
regulation, presumably, is that accounting standards relat to financial statements.
•Is MD&A Decision Useful?
THE REACTION OF PROFESSIONAL ACCOUNTING
BODIES TO THE DECISION USEFULNESS APPROACH
•Major professional accounting bodies have adopted the decision usefulness approach.
•According to IASB/FASB Conceptual Framework (2010), the objective of financial statements
is to provide financial the objective of financial statements is to provide financial information
that is “useful to present and potential investors, lenders, and other creditors about providing
resources to the entity.”
•The conceptual framework specifically mention investors’ need for informations about the
uncertainty of future investmenr returns as well as their expected.
•The primary decision addressed in SFAC 1 is the investment decision in firm’s shares or debt.
•The second objective is future oriented, it calls for information about ‘prospective’ cash receipts
from dividends or interest.
THE REACTION OF PROFESSIONAL ACCOUNTING
BODIES TO THE DECISION USEFULNESS APPROACH
•To be useful for investment decision purposes, the financial statements need not
involve a direct prediction of future firm payoffs.
•Rather, if the information has certain desirable characteristics, such as relevance and
reliability, it can be a useful input to help investors form their own predictions of these
payoffs.
•For maximum usefulness, the accountant must seek an appropriate tradeoff between
these characteristics.
CONCLUSIONS ON DECISION USEFULNESS
•Following from the pioneering ASOBAT and Trueblood Committee reports, the
decision usefulness approach to financial reporting implies that accountants
need to understand the decision problems of financial statement users.
•Financial statements are an important and cost effective source of information
for investors, even though they do not report directly on future investment
payoffs
•Management discussion and analysis (MD&A) represents an attempt to further
increase the informativeness of financial reporting. Its future orientation
provides increased relevance.
•Major accounting standard-setting bodies such as the IASB and FASB have adopted
the decision usefulness approach.