Financial Accounting Theory Craig Deegan Chapter 11

Financial Accounting Theory Craig Deegan

Chapter 11 Reactions of individuals to financial reporting: an examination of behavioural research Slides written by Craig Deegan and Michaela Rankin

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a F i n a n c i a l A c c o u n t i n g T h e o r y 2 e by Deegan

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Learning objectives • In this chapter you will be introduced to – how behavioural research differs from capital market research – how different accounting-related variables can be manipulated in behavioural research – how the results of behavioural research can be of relevance to corporations and the accounting profession for anticipating individual reactions to accounting disclosures


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Learning objectives (cont.) – how the results of behavioural research can form the basis for developing ways to more efficiently use accounting-related data – the limitations of behavioural research


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Introduction to behavioural research • Behavioural research examines how individuals react to various accounting disclosures • Grounded in behavioural decision theory • Goal is to describe actual decision behaviour, evaluate its quality and develop and test hypotheses of the underlying psychological processes


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Brunswick Lens Model • Used to explain behavioural research • Perspectives Perspectives about the environment are generated (observed) through a ‘lens’ of imperfect cues • Statistical modelling is applied to determine the weighting (importance) of the various cues (independentt variables (independen variables)) to the criterion event of success (dependent variable)


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Brunswick Lens Model (cont.) • Right-hand side models how the individual uses cues to make an ultimate decision about the issue under investiga investigation tion • Left-hand side models the relationshi relationship p between the actual phenomenon or event and the particular cues provided


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Applicability of the Lens Model • Structure of the Lens Model can be applied to almost any decision-making scheme – e.g. lending decision – explicitly considers inputs (use of cues), the decision process and outputs (ultimate decisions)


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Types of issues to be considered • At input level level – scaling characteristics of individual cues – methods of presentation – context

• At the level level of processing processing the information – characteristics of the person making the judgement – characteristics of the decision rule

• At the output or or decision level level – qualities of the judgement – self-insight


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Input level—use of cues • How and whether particular cues are used in decision making is particularly relevant to the accounting profession • If information items in financial statements are not used, then they could be deemed not material and therefore not requiring disclos disclosure ure • The accounting profession is also interested in whether presentation (in financial statement or in a footnote) impacts decision


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Research evidence —the use of information items • In making predictions of financial returns, analysts are found to acquire earnings and sales information more often than other types (Pankoff & Virgil 1970; Mear & Firth 1987) • Studies questioned questioned the provision of current cost information, subjects relied more on historical cost information (Heintz 1973; McIntyre 1973)


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Research evidence —the presentation of information • Different presentation formats found to influence users’ decisions – including bar charts, line graphs, pie charts and tables

• Moriarity (1979) found students and accountants using Chernoff faces were able to outperform those using ratios in predicting bankruptcy, and models of bankruptcy


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Research evidence —the presentation of information (cont.) • Studies examining decision making by loan officers based on whether information is incorporated within the financial statements or included as footnotes found presentation made no difference (Wilkins & Zimmer 1983) • Provision of segment information reduced subjects’ reliance on past share prices (Stallman 1969; Doupnik & Rolfe 1989)


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Decision-making process • Studies have examined how the various cues are weighted • Judgements have been found to be consistent over time • Decision makers also have been found to employ simplifying heuristics when making a decision


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Decision-making heuristics • Three main simplifying heuristics have been identified – representativeness – anchoring and adjustment – availability


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Decision-making heuristics— representativeness • Decision makers often assess the likelihood of items belonging to a category by considering how similar the item is to the typical member of the category • An implication implication is that the subjects subjects typically typically ignore ignore the base rate of the population in question – may overstate the number of cases in a particular category


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Decision making heuristics —anchoring and adjustment • Individuals make an initial judgement or estimate and then only partial adjust their view as a result of additional information


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Decision making heuristics —availability • Relates to whether recollecti recollections ons of related occurrence or events can easily come to mind • The actual base rates of occurrence of an event are ignored


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Knowledge of heuristics in research • Useful to know of heuristics in use – if the heuristic results in inappropriate decisions being made, the tendency can be highlighted and action taken – the use of a heuristic by experts could be efficient relative to costly data-gathering and processing 

novices could then be advised to use the t he rule of thumb


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Decision output—decision accuracy • Research has considered how accurate the predictions are relative to the actual environmental outcomes – loan officers found to predict bankruptcy fairly regularly (Libby 1975) – bankers and accounting students also found to correctly predict bankruptcies (Zimmer 1980) – decision makers working in a team can outperform individual decision makers


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Protocol analysis • This form of behavioural research requires subjects to verbalise their thought processes while making decisions or judgements – common in auditing research

• Understanding how judgements are made is important in improving those judgements • Useful in examining information search


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Protocol analysis (cont.) • Disadvantages include – the process of verbalising can have an effect on the decision process – a considerable portion of the information utilised may not be verbalised – subjects may provide verbalisations which are parallel but are independent of the actual thought process – criticisms of the coding methods


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Limitations of behavioural research • Research examining similar issues has generated conflicting conflictin g results – difficult to determine causes of inconsistencies

• Settings of studies often different to real-world settings – implications for generalisability

• Very difficult to replicate cues available in the workplace • Students often used as surrogates • Small number of subjects often used


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Financial Accounting Theory Craig Deegan Chapter 11

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