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Chapter 3_Notes

Chapter 3_Notes - Chapter 3 Notes The Decision Usefulness...

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Chapter 3 Notes The Decision Usefulness Approach Accountants have adopted a decision usefulness approach to financial reporting as a reaction to the impossibility of preparing theoretically correct financial statements. The decision usefulness approach takes the view that “if we can’t prepare theoretically correct financial statements, at least we can try to make financial statements more useful.” Decision usefulness is contrasted with another view of the role of financial reporting, namely stewardship, wherein the role is to report on management’s success or lack thereof in managing the firm’s resources. Two major questions that must be addressed in adopting the decision usefulness approach are as follows: 1. Who are the users of financial statements? There are many user groups, such as investors, lenders, managers and governments. These groups are called constituencies of accounting. Investors are the major constituency of users. 2. What are the decision problems of financial statement users? In the face of difficult questions like these, accountants have turned to various theories in economics and finance, such as the theory of decision and the theory of investment. By understanding these decision problems, accountants will be better prepared to meet the information needs of the various constituencies, and therefore financial statements will be more useful. Single Person Decision Theory Single person decision theory is a model of decision making of an individual in the face of uncertainty. It enables us to appreciate the concept of information, which enables decision- makers to update their subjective beliefs about future payoffs from their decisions. The theory 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
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Chapter 3 Notes a set of alternatives. This procedure allows additional info to be obtained to revise the decision- maker’s subjective assessment of the probabilities of what might happen after the decision is made. Payoffs are the amounts to be received from a decision. If armed with evidence from the current financial statements and the conditional probabilities, one can always use Bayes’s theorem to calculate one’s posterior state probabilities. To be useful, financial statement information must help predict future investment returns. The Information System Under non-ideal conditions, the financial statements do not show expected future performance directly. Nevertheless, the financial statements will still be useful to investors to the extent that the good or bad news they contain will persist into the future. The heart of the link between current financial statement information and future firm performance is the conditional probabilities (P(GN/H)) + P(BN/C). These probabilities are called an information system. Indeed, an information system is a table giving conditions on each state of nature, the objective probabilities of each possible evidence item.
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