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 Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Brunswick Lens Model Used to explain behavioural research 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 (independent variables) to the criterion event of success (dependent variable) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Brunswick Lens Model (cont.) Right-hand side models how the individual uses cues to make an ultimate decision about the issue under investigation Left-hand side models the relationship between the actual phenomenon or event and the particular cues provided Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Types of issues to be considered At input level scaling characteristics of individual cues methods of presentation context At the level of processing the information characteristics of the person making the judgement characteristics of the decision rule At the output or decision level qualities of the judgement self-insight Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 disclosure The accounting profession is also interested in whether presentation (in financial statement or in a footnote) impacts decision Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 the provision of current cost information, subjects relied more on historical cost information (Heintz 1973; McIntyre 1973) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Decision-making heuristics Three main simplifying heuristics have been identified representativeness anchoring and adjustment availability Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 is that the subjects typically ignore the base rate of the population in question may overstate the number of cases in a particular category Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Decision making heuristics—availability Relates to whether recollections of related occurrence or events can easily come to mind The actual base rates of occurrence of an event are ignored Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 rule of thumb Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Limitations of behavioural research Research examining similar issues has generated conflicting 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 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan