1. 2-1 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e F INANCIAL A CCOUNTING T HEORY Craig Deegan Slides written by Craig Deegan C HAPTER 11 Reactions of individuals to financial reporting: an examination of behavioural research in accounting

2. 11-2 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Learning objectives 11.1 Have a broad understanding of the nature of behavioural research and its relevance to accounting. 11.2 Understand some of the different approaches to undertaking behavioural research. 11.3 Understand that much of the insights in behavioural research have been developed in the discipline of psychology, and therefore behavioural research in accounting represents a situation where insights from one discipline can usefully be employed in another. 11.4 Know how behavioural research differs from, as well as complements, capital markets research and other research, such as that which applies agency theory and Positive Accounting Theory. continued

3. 11-3 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Learning objectives (cont.) 11.5 Understand how different accounting-related variables can be manipulated in behavioural research and appreciate the role that the Brunswik Lens Model has played in behavioural research. 11.6 Understand the meaning of a ‘heuristic’ and why knowledge of heuristics is important to the accounting profession. 11.7 Be aware of how the results of behavioural research can be of relevance to corporations and the accounting profession for anticipating individual reactions to accounting disclosures. 11.8 Know how the results of behavioural research can form the basis for developing ways to use accounting-related data more efficiently. 11.9 Understand some of the limitations inherent within behavioural research.

4. 11-4 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Assessing the impacts of financial reporting decisions There are different ways to assess the impacts that financial reporting decisions have on financial statement users, for example: 1. Determine what impact the release of information had on share price (capital markets research) 2. Determine the impact of the information on the decisions of individual information users (behavioural research)

5. 11-5 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Introduction to behavioural research Behavioural research in accounting 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 Contrast to capital markets research which examines reactions at the broad ‘market’ level continued

6. 11-6 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Introduction to behavioural research (cont.) According to Birnberg and Shields (1989), behavioural research in accounting can be defined as research that: –applies theories and methodologies from the behavioural sciences to examine the interface between accounting information and processes and human (including organisational) behaviour. In contrast to much research based on economics-based theories, behavioural research typically does not make broad- based simplifying assumptions about how all individuals behave Behavioural research typically concerns itself with improving the quality of decision making Borrows many insights from psychology continued

7. 11-7 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Introduction to behavioural research (cont) Behavioural research in accounting has been used to investigate a variety of decision making processes, such as: –the valuation of market shares by individual analysts, –the lending decisions of loan officers, –the assessment of bankruptcy by bankers or auditors, and –the assessment of risk by auditors.

8. 11-8 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e The role of behavioural research in accounting According to Trotman (2011), aims of the research include: –evaluating the quality of the judgments of auditors, preparers and users of accounting reports; –describing how the judgments are made; –determining which factors impact these judgments and why; –developing and testing theories of the underlying cognitive processes by which judgments are made; and –improving the judgments of auditors, preparers and users of accounting information. Answering these questions provides insights for suggesting remedies for any discovered deficiencies, as it is necessary to understand a decision process to improve it.

9. 11-9 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Behavioural research in accounting is typically undertaken in an ‘experimental setting’ According to Trotman (2011): –A major benefit of experiments is that the researcher creates the setting in which the experiment is carried out –The researcher manipulates the independent variables of their choice and examines the effect on the dependent variable while at the same time controlling for any potential confounding factors –The researcher can also measure intervening variables (including information search and cue usage) and the knowledge of participants –Experiments have the advantage of testing the effects of conditions that do not presently exist in practice as well as conditions that already exist but not in sufficient volume to examine archivally –Experiments can also be used to disentangle inter-related factors that co-exist in the natural environment to examine which of a number of factors cause a change in the dependent variable

10. 11-10 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Some differences between capital markets research and behavioural research Capital Markets ResearchBehavioural Research Focus of research Considers the aggregate effect on decision making by investors via an analysis of movements in share price Considers decision making at the individual level SubjectsInvestors in aggregate typically by way of archival (secondary) data A broad range of users often in a ‘laboratory’ setting Use of information Whether information is used by investors in aggregate – is there an aggregated reaction? How information is used by individual decision makers When is the research conducted? Typically undertaken after an accounting method applied or accounting standard released Before or after accounting method applied or standard released SimilarityBoth examine impact of financial reporting upon decision making by users 11/22/2016RMIT University©2008 Information Technology Services 10

11. 11-11 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Brunswick Lens Model A common way to conceptualise decision making processes –used by many researchers, particularly in the 1970s and 1980s 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) continued

12. 11-12 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Brunswick Lens Model (cont.) The right-hand side models how the individual uses cues to make an ultimate decision about the issue under investigation The left-hand side models the relationship between the actual phenomenon or event and the particular cues provided

13. 11-13 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Diagrammatic representation of the Brunswik Lens Model

14. 11-14 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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)

15. 11-15 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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

16. 11-16 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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 immaterial and therefore not requiring disclosure The accounting profession is also interested in whether presentation (in the financial statements or in a footnote) impacts decision making

17. 11-17 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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)

18. 11-18 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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 continued

19. 11-19 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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)

20. 11-20 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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 –a heuristic can be defined as a simplifying ‘rule of thumb’ –simplifying rules may be employed which take a lot less time but nevertheless generate acceptable predictions or solutions –it is useful to know about the use of heuristics – particular by ‘successful’ judges/decision-makers

21. 11-21 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Decision-making heuristics That is, rather than fully considering all the potentially relevant factors, a simplifying rule may be employed which takes a lot less time but nevertheless might generate a fairly acceptable (and cost-effective) prediction or solution. Three main simplifying heuristics have been identified –representativeness –anchoring and adjustment –availability continued

22. 11-22 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Decision-making heuristics (cont.) These heuristics have been heavily researched within the psychology literature Such heuristics reduce the cognitively complex task of assessing probabilities to simpler judgmental operations While these heuristics are quite useful and can lead to efficient decision-making, they can also lead to severe and systematic errors because they omit several factors that should affect the judgments of subjective probabilities

23. 11-23 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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 –the representativeness heuristic also tends to make decision makers ignore source reliability

24. 11-24 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Decision-making heuristics— anchoring and adjustment Individuals make an initial judgment or estimate and then only partial adjust their view as a result of additional information

25. 11-25 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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 The implication of this heuristic is that the probabilities associated with sensational or widely- reported events will tend to be overstated

26. 11-26 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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

27. 11-27 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Decision output—decision accuracy When looking at the actual output of the decision- making process (the decision or judgment), some research has considered how accurate the predictions are relative to the actual environmental outcomes –for example, Libby (1975) investigated the accuracy with which loan officers predict business failure. Research has considered how accurate the predictions are relative to the actual environmental outcomes –bankers and accounting students also found to correctly predict bankruptcies (Zimmer 1980) –decision makers working in a team can outperform individual decision makers

28. 11-28 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e Protocol analysis This form of behavioural research requires subjects to verbalise their thought processes while making decisions or judgements –common in auditing research According to Trotman (2011) –protocol analysis (or process-tracing technique) traces the actual decision-making process of users of financial information and is suited to studying ill-structured tasks. Protocol analysis allows the researcher to identify cues, the sequence in which the cues are utilised and determine their relative importance by the frequency of their use or process modification accounted for by the cue Understanding how judgements are made is important in improving those judgements Useful in examining information search processes continued

29. 11-29 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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

30. 11-30 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e The relevance of differences in culture We considered the issue of ‘culture’ in Chapter 4 and we learned that some cultures are considered to be more secretive than others; some cultures seek greater uncertainty avoidance than others; and so forth Differences at a national level were then related back to the international differences in accounting practices that existed prior to the international adoption of IFRS Culture has also been suggested as a factor in influencing organisational structures, legal systems and so forth It is reasonable to argue that an individual’s use of particular cues (information items) will in part be dependent upon the cultural background of the individual continued

31. 11-31 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e The relevance of differences in culture (cont.) Studies that investigate decision-making processes in particular countries will perhaps not be generalisable to other countries—particularly if the respective countries have significantly different cultural attributes Determining the validity of a particular decision-making model across different cultures would be an important area for future accounting research At this point in time there is very little behavioural accounting research which explores how the usage of cues in particular decisions is affected by specific cultural attributes

32. 11-32 Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e 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