DECISION USEFULNESS –
INVESTOR’S PERSPECTIVE
Accounting Theory
Lecture 2 – Summer 2004
Decision Usefulness
Investors make investment decisions
– how much, when to invest, how long
Need information to estimate probable returns
– choose among alternative investments
Financial information helps investors
– assess likelihood of future returns, cash flows,
dividends
Investors
Rational – want a reasonable return
Risk averse => diversify portfolio
– portfolio risk versus systematic risk
Financial information should help reduce
portfolio risk by estimating probabilities of
future returns
Investors & Cash Flows (Ch 2)
Value of the firm is PV of future dividends
– function of the firm’s cash flows & interest rate
Ideal conditions
– cash flows & interest rate are known with
certainty
Dividend policy is irrelevant
– value of the firm is known with certainty
Present Value
Present value financial statements
• Reliable
– precise & free from bias
• Relevant
– useful for predicting future cash-flows
– for predicting if good news or bad news will
persist into future periods
Is Historic Cost Useful?
Historic cost is reliable
– assets & liabilities are measured at cost (= PV)
May not be relevant
– as market changes, cost may not equal PV
Accountants trade-off relevance for reliability
– amortization
– lower of cost & market
Efficient Markets (Ch 4)
Prices fully reflect all publicly available
information (semi-strong)
Prices need not reflect underlying value
– poor quality, not enough, misinterpreted
Decision makers constantly revise their
predictions as new information is received
Financial reporting improves quantity &
quality of public information
Inconsistency
Prices reflect all publicly available info
But, information acquisition is costly
Cannot beat the market if prices reflect all
information
Therefore, no motivation to collect new info
Result => share prices self-destruct
Market Inefficiencies
Why don’t markets behave efficiently?
• Prospect theory
– high (low) payoffs are over (under) weighted
• Post-announcement drift
– investors don’t fully digest good/bad news
• Earnings fixation
– focus on EPS & ignore its components
Continuous Demand
Random elements in all markets
– trades not based on rational evaluation of info
Over time, on average, prices are efficient
At any point, prices can be over/under valued
Result => continuous search for private info
Note: there is no clear line between public &
private information
Adverse Selection
Sometimes it’s difficult to distinguish public
from private information
Insiders can take advantage of the market
using their private information
Problem reduced:
– penalties, fines for insider trading
– full disclosure, but reporting is costly
Decision Usefulness
Provide information useful in making
investing & credit decisions
Reflect expectations about the future
– often based on evaluation of the past
Financial reporting:
– focus on earnings & its components
– does not directly measure value
– provides information to estimate value
Implications
Accounting policies don’t matter, unless they
have a direct affect on cash-flows
Don’t worry about the naïve investors
Markets are interested in all relevant
information, not just accounting information
Disclose as much as is feasible