Final Paper - Research Project The purpose of this assignment is to apply concepts and theories discussed in the course to practical issues. You will be required to prepare a research paper on Tesla,

Part 1 – Chapter 3 – Decision Usefulness Accounting in non-ideal conditions • Chapter 2 covered accounting under ideal conditions • As we move into non-ideal conditions: – it is difficult (often impossible) for accounting to be both reliable and relevant at the same time. – valuation based on future cash flows (eg. reserve recognition accounting) are problematic, largely due to concerns regarding reliability (= faithful representation) – income becomes an important concept, but it is difficult to measure Some Problems with income measurement • Income based on change in PV and MV would be unreliable • Income based on change in HC presents problems: – Leaves out elements that would be captured by MV or PV based income (human resource training, advertising, changes in value of assets, internally developed goodwill) – Income is affected by accounting choices, such as amortization, inventory costing, revenue recognition – When costs are incurred, must determine whether they are assets or expenses How to evaluate accounting? • Accounting is beneficial if it is useful in making decisions. In particular we concentrate on the investment (resource allocation) decision. • Decision usefulness = the ability of financial accounting information to help users make good decisions. • How do we determine whether information is useful or not? – theoretical models of decision making – empirical evidence Decision Usefulness • If decision usefulness is the ability of financial accounting information to help users make good decisions… what do we mean by "users"? Decision Usefulness • There are a diverse set of users to financial accounting information: Equity investors, debt investors, managers, unions, standard setters, and governments. What are the decision problems of these financial statement users? – …the answer is not an obvious process. For example, what information does an investor need to make a rational decision about whether to buy or sell certain shares or debt? Would this decision be helped or hindered by current value accounting? Conservative accounting? Decision usefulness • To answer these questions, we look to theories in finance and economics: The "theory of rational decision making" or the "decision theory" for short. • Accountants have decided that investors are a major constituency of users of financial accounting information and have turned to understand the type of financial statement information investors need. Single person decision theory • Accounting is useful when it provides information about future states of nature. • Financial statements can be useful to the extent that they enable a prediction that the good or bad news they contain will persist into the future. • Therefore, even historic cost based financial statements can be useful Single Person Decision Theory Information System for Decision Theory Given future Current period financial profitability is: statements will show: Good news Bad news High .80 .20 Low .10 .90 • If these probabilities provide additional information about future profitability, users will be able to update their expectations. Information systems • Financial statements (even those based on past information) have value. • The riskier a gamble is, the more “disutility” is incurred by a risk-averse investor, so investors need information about risk. • As risk increases the more information can increase utility (all other things being equal). Single Person decision theory: Wrap - up • To be useful, accounting needs to: – provide information about the extent to which future states are linked to current period financial results. They must provide more information than “noise” – provide information about risk. If a risk averse investor can decrease his risk, while preserving a given level of return, he will increase his utility. Increasing Decision Usefulness • Management Discussion and Analysis (MD&A) – A standard that requires firms to provide a narrative explanation of company operations to assist investors to interpret the firms financial statements. – Required for public companies – Managements comments on company performance, financial condition, risks, and future prospects. – Includes forward looking information – Non-GAAP measures Part 2 – Chapter 3 – Decision Usefulness Decision Usefulness • Under SPDT, people make decisions that maximize their utility • Utility is a function of wealth and risk (in Chapter 9, leisure is added in too). • Need information about cash flows and probabilities • Information that updates (changes) those cash flows or probabilities is useful Decision Usefulness • The information systems show the connection between the future states and what is reported in the financial statements • The diagonal elements show a “sensible” connection, while the off-diagonal elements are “noise” • The higher the diagonal elements, the more useful the system as there is a stronger connection Standard Setters Reaction • Framework objective: to provide information that is "useful to present and potential investors, lenders, and other creditors ("primary users") about providing resources to the entity." • "Primary users" need information about the amount, timing, and uncertainty of the firms future cash flows. • Assumes risk averse investors, risk neutral investors would not care about uncertainty. Standard Setters Reaction • Desirable characteristics of useful information: – Relevant – Reliable – Timely – Comparability – Verifiability – Understandability Chapter 3 - Summary • Accountants need to understand the decision problems of financial statement users • Single person decision theory tells us that users need information to help assess a securities expected return and the risk associated with the return • Financial statements are a cost effective (to the investor) source of information Chapter 3 - Summary • GAAP is an information system that helps investors predict future firm performance (and future investment returns) • Accountants need to find the most useful trade-off between relevance and reliability • Accountants also need to consider timeliness, comparability, verifiability, and understandability Chapter 3 - Summary • MD&A is a future oriented report on firm performance • MD&A focuses on relevance over reliability – non-GAAP measures are not comparable – not subject to audit