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are the users of the financial statements? Investors, lenders, managers, unions, government and standard setters (invisible)
What are the decision problems of the users? whether to invest or lend funds make company decisions see if companies are complying to regulations
State
Formal
PAYOFF TABLE
ACT High Buy shares Buy bonds $ 1,600 $ 225 STATE Low $0 $ 225
DECISION TREE
high performance - .30 Payoff (Utility) $1600 (40) shares Invest --------($10,000) low performance - .70 $0 performance high or low 1.00 (0)
bonds
$225
(15)
ALTERNATIVE 2 CONTD...
Posterior State Probabilities (Bayes Theorem):
High Performance: Performance: P(H/GN) = .30 x .80 (.30x.80) + (.70x.10) = .77 Low
Expected Utility :
Under
non-ideal conditions the financial statement does not give direct information about expected future firm performance However, FS information is still useful Under the assumption good or bad new will continue in the future
Higher
the main diagonal probabilities the more useful the FS information becomes Thus investors can better predict the expected future firm performance Noise: represents the weakening of the relationship between the current FS information and future firm performance NOTE information system concept is decisionspecific
conclusion Once information is gathered an individuals conclusions may change FS, if reliable and relevant, are important source of information
is used to come to a
expected utility A model of how the average investor should make decisions
Does not imply that all investors make decisions this way
Investor
When faced with 2 choices with the same expected payoff, would prefer the one with lower risk. Risk costs something, causing trade-off between risk and return
How
to model?
Choices
State
Probability of Payoffs
High
A (Shares)
B (T-bills)
Low
High
Low
$225
$100
$0
$100
60%
-
40%
RISK NEUTRAL
Risk
does not cost anything Reasonable assumption when payoffs are small and inconsequential Linear function of payoff: U(x) = bx
U(x)
Slope = b
X (Payoff)
Utility increases with expected rate of return, decreases with risk of return Principle of Portfolio Diversification o Holding expected rate of return constant, more than one investment spreads risk and increases utility, provided the returns are not perfectly correlated o Market-wide factors affecting returns Non-diversifiable o Firm-specific factors affecting returns Diversifiable
EXAMPLE 1
Toni,
If
Variance
$230
$180
0.74
0.26
0.1110
-0.026
EXAMPLE 1 CONTD
Assume
Utility
from this investment is: (2 x 0.085) 0.012 = 0.1580 Can Toni do better?
EXAMPLE 2
Buy 2 Investments instead, Investment A and B
States GG Payoff $230 Rate of Return (230 200) / 200 = 0.15 Probability 0.5742 Expected Rate of Return 0.0861 Variance (0.15 0.085)2 x .5742 = 0.0024
GB
$214
(214 - 200) / 200 = 0.07 (200 - 200) / 200 = 0.00 (184 - 200) / 200 = -0.08
0.1658
0.0116
(0.07 0.085)2 x .1658 = 0.0000 (0.00 0.085)2 x .1008 = 0.0007 (-0.08 0.085)2 x .1592 = 0.0043
BG BB
$200 $184
0.1008 0.1592
0.0000 -0.0127
Her
desired risk-return trade-off, depending on investors risk-averseness Does not undo the benefits of diversification
measures the changes in the price of a security in relation to changes in the market A high beta stock's price will fluctuate by a large margin in response to changes in the market
Using
Expected rate of return and variance need to be calculated for the mean-variance utility function Expected rate of return on a portfolio:
Variance of portfolio:
securities in portfolio increase, systematic risk increases rapidly Most of the benefits of diversification can be attained with relatively few securities in the portfolio Entire market portfolio does not need to be purchase to adequately diversify
Adopted by most of the major professional accounting bodies FSAB adopted as part of the Conceptual Framework project, specifically mentions investors needs for information about the uncertainty of future investments and their expected values Section 1000 does not mention the risk factor Statement of Financial Accounting Concepts 1978 states the purpose of the project is (SFAC 1)
to set forth fundamentals on which financial accounting and reporting standards will be based
SFAC 1
Objective 1 on financial reporting: to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.
SFAC 1
Objective 2 on financial reporting: provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans.
SFAC 2
Relevant accounting information is capable of making a difference in a decision by helping users to form predictions about the future outcomes of past, present and future events or to confirm or correct prior expectations. Also important is timeliness.
CICA and FASB have accepted the decision theory model as a guide to the preparation of useful financial statement information Sections 1000 and 1100 of the CICA Handbook, contain evidence of the decision theory model Adherence to GAAP is essential so as to make rational investor decisions relevant Deviation from standards renders the single-person decision theory useless
EXPENSE IT
Main
By John Lorinc
Issue: what is the proper accounting treatment for employee stock option compensation? companies didn't have to expense the value of these items immediately after being issued governing bodies such as the FASB, IASB, and AcSB introduce regulations forcing companies to recognize these items once they are issued
Before:
After:
EXPENSE IT
Secondary
How
By John Lorinc
Issues:
do we effectively measure the value of these expenses to be recorded on the financial statements? Most employee stock option compensation packages come loaded with a range of conditions and restrictions that make them difficult to measure Options cant be sold or traded (only exercised); employee must forfeit all unexercised options when leaving the firm, etc.
EXPENSE IT
What
By John Lorinc
value:
Taking into consideration all related factors that might influence the reasonable cost of these items. Estimating the expected life of the option and the ratio between stock price and exercise price the employee would seek before exercising the options
Questions?