Accounting: The Language of Business - Vol. 2 (Intermediate: Part 19)

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James Belushi

Judgment and Applied Financial Accounting Research (Part D)

by

Charles Lamson

Judgement Obstacles in Preparing Financial Information

In preparing or auditing financial information, accountants face a number of potential impediments to the use of good judgment, such as:

• Factors that may influence management to intentionally bias their estimates.

• Cognitive biases.

• Complexity of the business environment and transactions.

An understanding and awareness of these obstacles prepares managers to overcome them in the financial reporting process as well as assists financial statement users in critically evaluating firm performance and condition.

Factors Influencing Management Behavior

Factors that influence management to intentionally bias estimates impede the use of good judgment. Areas of financial reporting that require significant judgment are particularly susceptible to management manipulation. For example, if management bonuses are tied to net income, management may have an incentive to bias reported income upward.

Analysts' forecasts may also influence management. Financial analysts use reported information to provide guidance to individuals and other entities in making investment and credit decisions. As part of this process, analysts release earnings forecasts. Because the stock price of a company tends to react negatively when actual earnings are less than this earnings forecast, management may have an incentive to bias earnings upward if it would otherwise miss the forecast. We will discuss earnings management in more detail in a later post.

To minimize management bias, auditors exercise professional skepticism, which is "an attitude that includes a questioning mind and a critical assessment of audit evidence" [Public Company

Accounting Oversight Board. Staff Audit Practice Alert Number 10, "Maintaining and Applying Professional Skepticism in Audits" (Washington D.C..: Public Company Accounting Oversight Board, 2012).

Cognitive Biases

Cognitive biases can also impact the way accountants make judgments. Cognitive biases are systematic deviations from rationality, to which we are all subject, that can impact judgments on a day-to-day basis. We discuss some of the types of cognitive biases next, followed by techniques that are useful in reducing the impact of these biases.

Types of Cognitive Biases. Examples of cognitive biases are the availability, overconfidence, confirmatory, groupthink, and anchoring biases.

1. The availability bias is the tendency to use the data that is most readily available or most easily recalled to make a decision, as opposed to considering all relevant data. For example, if you were deciding which computer to buy, you might rely on your friend's advice instead of taking the time to research consumer reviews.

2.  The overconfidence bias is the tendency to be more confident than your abilities and experience level would objectively warrant. For example, multiple research studies have asked study participants how confident they were in answers they provided to a set of questions. Research results repeatedly show that confidence systemically exceeds accuracy.

3.  The confirmatory bias is when decision makers under-weight information that is not consistent with their initial beliefs. For example, if individuals have strong political beliefs, they may not adequately consider positions held by someone in another political party.

4.  The groupthink bias is a phenomenon that occurs in situations where members of a group, in an attempt to avoid conflict, reach a consensus decision without considering all of the reasonable alternatives. For example, a group of students working on a case assignment may agree to a certain answer in order to avoid conflict with a dominant group member, even if everyone else in the group has not had a chance to express his or her views.

5.  The anchoring bias occurs when the decision maker focuses on one piece of information (often the first piece of data encountered), weighting it more heavily than other pieces of information. For example, when you buy a used car, you may anchor on the sticker price of the car and not consider carefully enough what the car is really worth to you.

Techniques to Mitigate Cognitive Biases. To mitigate cognitive biases, accountants must be as objective as possible, which entails being free from any bias or other influences. The following techniques may prove helpful.

1. Be organized and methodical in the decision-making process. In our discussion of applied financial research in an upcoming post, we will outline steps in the research process that are also useful in solving a judgment-based problem objectively.

2.  Generate alternatives, even when you think you have already arrived at the correct answer. Carefully consider each of these alternatives and reasons that it may be better than your initial assessment of the correct alternatives.

3.  Document your rationale about the alternatives. Often the process of documenting beliefs and thought processes---even if only in bullet form---challenges you're thinking.

4.  Delay your final judgment until you have gathered all of the facts and information and have considered all of the alternatives. This delay allows you to be more objective in your decision-making process.

Complexity of the Business Environment and Transactions

The increasing complexity of the business environment and related transactions also create an obstacle in the exercise of good judgment. Decisions related to complex transactions can often seem overwhelming, particularly to someone who is relatively new to the accounting profession. Even for experienced accountants, new issues arise all the time. For example, revenue recognition for virtual goods became a new accounting issue with the emergence of social media companies. Also, proper exercise of judgment often requires a substantial amount of research of the authoritative literature.

In these cases, it is helpful to follow an organized process that allows the accountant to stay focused on the issue at hand and make well-informed decisions. That is, the accountant does not need to know every answer, but she does need to understand the steps involved in determining the most appropriate accounting treatment. We will discuss this research process later in an upcoming post.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 62-64* 

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