Financial Accounting Theory

Craig Deegan

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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-1
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
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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-2
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

Contrast to capital markets research which

examines reactions at a market level

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-3
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)

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-4
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-5
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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-6
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-7
Input leveluse 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 financial statement or in a
footnote) impacts decision

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-8
Research evidencethe 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)

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-9
Research evidencethe 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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-10
Research evidencethe 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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-11
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-12
Decision-making heuristics
Three main simplifying heuristics have been
identified
representativeness
anchoring and adjustment
availability

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-13
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-14
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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-15
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-16
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-17
Decision outputdecision 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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-18
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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-19
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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PPTs t/a Deegan, Financial Accounting Theory 3e 11-20
 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 individuals use of
particular cues (information items) will in part be
dependent upon the cultural background of the
individual

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-21
The relevance of differences
in culture (cont.)
Studies that investigate decision-making
processes in particular countries will perhaps not
be generalisable to other countriesparticularly 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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-22
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

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PPTs t/a Deegan, Financial Accounting Theory 3e 11-23