1/15/2021

AF5102
Accounting Theory

Lecture 2
The Decision Usefulness Approach to
Financial Reporting

Dr. Zhang Yong

Email: yong.zhang@polyu.edu.hk
Office: M1042

The Decision Usefulness Approach to

Financial Reporting

• Tailoring financial statement information to the

specific needs of its users will lead to improved
decision-making.
• Who are the users of financial statements?
• Investors, lenders, employees, suppliers, customers, governments,
public
• What are the decision problems of financial statement
users?
• What information do investors need to make investment
decisions?

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The Objective of Financial Reporting

(2010 IASB Conceptual Framework)

• The objective of general purpose financial reporting is

to provide financial information about the reporting
entity that is useful to existing and potential
investors, lenders and other creditors in making
decisions about providing resources to the entity.
Those decisions involve buying, selling or holding
equity and debt instruments, and providing or settling
loans and other forms of credit.

• [March 12, 2020]

• Luckin Coffee (Nasdaq:LK) joins a list of world-famous tech giants
including Snap, Tesla, and Apple on the 2020 “World’s 50 Most
Innovative Companies” list.
• Luckin ranks 17th on the list, even higher than Apple, which was listed
39th.

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From the beginning to …now

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The Investor’s Problem

Bond or Stock
• Total investment: $10,000
• Utility = square root of $ payoff
• Bond: risk-free interest of 2.25%
• Stock: risky payoff, depends on states of nature
• State 1: high future performance  16% payoff
• State 2: low future performance  0% payoff
• Subjective assessment of state probabilities
• Based on existing information
• Prob(State 1) = 0.3; Prob(State 2) = 0.7

• Maximizing Expected $ Payoff

• Expected $ payoff of buying bond
• $10,000 x 2.25% = $225
• Expected $ payoff of buying stock
• $10,000 x 16% x 0.3 + $10,000 x 0% x 0.7 = $480
• Decision: Buy stock

• Maximizing Expected Utility

– Expected utility of buying bond
• √(10,000 x 2.25%) = 15
– Expected utility of buying stock
• 0.3 x √(10,000 x 16%) + 0.7 x 0 = 12
– Decision: Buy bond
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The Bayesian framework

• Think of the world in terms of probability distributions.
• Important concepts:
Prior
Posterior
Bayesian updating

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

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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 = financial statements show good news
m2 = BN = financial statements show bad news
• Suppose GN is received:

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Updating Belief Using Information

• New financial information is released
• Good news or bad news
• The new information is correlated with future
performance
• Prob(Good News | High performance) = 0.8
• Prob(Bad News | Low performance) = 0.9
• These conditional probabilities are objective
• How should the investor revise his subjective
assessment of state probabilities based on this new
information?

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Bayes’ Theorem
• Bayes’ Theorem describes the relation between conditional
(posterior) and unconditional (prior) probabilities.

• The posterior probabilities of high performance given good

news and bad news are

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An Example
A cab was involved in a hit-and-run accident at night. Two cab
companies, the Green and the Blue, operate in the city. You are
given the following data:
• 85% of the cabs in the city are Green and 15% are Blue
• A witness identified the cab as Blue. The court tested the
reliability of the witness under the circumstances that existed on
the night of the accident and concluded that the witness correctly
identified each one of the two colors 80% of the time and failed
20% of the time.

What is the probability that the cab involved in the accident was
Blue rather than Green?

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• P(B)=0.15; P(G)=0.85
• P(WB|B) = 0.8 => P(WG|B) = 0.2
• P(WB|G) = 0.2 =>P(WG|G) = 0.8

• P(B|WB) = ?

• P(B|WB) = P(WB|B) x P(B) / P(WB)

• P(WB) = P(WB|B)xP(B) + P(WB|G)xP(G)
• P(B|WB) = 0.8*0.15 / (0.8*0.15 + 0.2*0.85) = 0.41

• Note the intuition here, prior probability P(B)=0.15,

posterior probability P(B|WB)=0.41. The evidence has
increased your probability assessment of B from 0.15 to
0.41.

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• Recall from slide #7 that P(H)=0.3, P(L)=0.7.

• Assuming the new information was good news, the
investor’s revised assessment of state probabilities
are

• Expected $ payoff of buying stock

• $10,000 x 16% x 0.77 + $10,000 x 0% x 0.23 = $1,232
• Decision: buy stock
• Expected utility of buying stock
• 0.77 x √(10,000 x 16%) + 0.23 x 0 = 30.8
• Decision: buy stock
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The Information System

Current Financial Information
Good News Bad News
State of High Performance 0.8 0.2
Nature Low Performance 0.1 0.9

• The relationship between states and signal

• Can be estimated by sampling historical data
• Reflect the quality of financial statements
 High main diagonal probabilities  more informative financial
statements to investors

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The Rational, Risk-Averse Investor

• Rational investor
• Maximize expected utility
• Update belief by Bayes’ theorem
• Risk-averse investor
• Prefer less risk for given expected payoff
• Concave utility function
• U(E[x]) > E[U(x)]
• Need information about both expected payoff and risk

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Risk-averse Investor’s Optimal Investment

Decision
• Mean-variance investor
• U lity determined by mean (↑) and variance (↓) of investment return
• The principle of portfolio diversification
• A diversified portfolio can generate better risk-expected return
tradeoff than a single stock
• The optimal investment decision
• Buy a combination of market portfolio and risk-free asset that yields
the best trade-off between expected return and risk

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The Mean-Variance Investor

• Cares only about mean and variance of random payoff of an investment

• Prefers investments with high expected return, low variance of return

e.g.

• Diversification and the optimal portfolio: a combination of market portfolio

and risk-free asset

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