Chapter 7 Making Decisions CHAPTER OBJECTIVES After studying this chapter, you will be able to: Define what is meant by the usefulness of information to individuals. Compare the different approaches to defining decision usefulness. Distinguish the several roles of accounting information. Discuss the assumptions underlying normative models of individual decision making. Describe the role of fairness in financial reports. Describe some of the findings of research into how people actually make decisions. Discuss the implications of human information processing research for the design of accounting systems. CHAPTER OVERVIEW A Prescriptive Approach Accounting theorists, building on the work of economists, have developed a theory of how rational individuals should make decisions. The theory encompasses uncertainty and situations involving more than one person. In essence, decision makers are assumed to maximize their expected utility functions and to revise their priors in accordance with Bayes Theorem. A Descriptive Approach Positive accountants have used the prescriptive approach to develop hypotheses about behavior at an aggregate level. Behavioral accountants have examined the assumptions of the Prescriptive approach. Empirical evidence is somewhat conflicting—it supports theMaking Decisions 199 Prescriptive approach at the aggregate level, but not at the individual level. An Ethical Approach The prescriptive approach depends on utilitarian theory for its ethical foundations. Rights theory and justice theory provide useful alternatives. Ethics define acceptable decisions and are, therefore, an important aspect of decision theory. Decision making plays a central role in accounting theory. Its importance has been stressed time and again in definitions of accounting. For in- stance, the American Accounting Association said accounting is “* . the process of identifying, measuring, and communicating economic in- formation to permit informed judgments and decisions by users of the information.”"! The Accounting Principles Board claimed that the func- tion of accounting is ‘‘. . . to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.”"? And the FASB asserted that the role of financial reporting in the economy is “‘to provide information that is use- ful in making business and economic decisions.">* It is apparent, therefore, that we need to study how users of accounting information make decisions. If we could determine how this takes place, we might be able to deduce what information would be of most value to them. For instance, as Chapter 3 pointed out, during the 1960s a price- earnings (PE) ratio approach to investment became popular. To compute a PE ratio, investors needed an appropriate earnings-per-share number. The APB obliged by issuing Opinion No. 15, which laid out the details of how the earnings-per-share computation should be done. It also insisted that the result appear on the face of the income statement because of its importance to investors.‘ By contrast, the FASB appears to have con- cluded that most investors are using a net-present-value model. As a result, they have stressed cash flows in their statement of objectives for eporting.* oe Studying the decisions that users make, and the impact those deci- sions have on the provision of information, accounting theorists have adopted a two-pronged strategy. One is to ask how people should make decisions, that is, a normative approach; the other is to ask how people actually do make decisions, that is, a positive approach. In first, i typically starts with an economic model and attempts to de a at information is necessary to make it work. In the second, one studies how + Emphasis added in each case.200 Chapter 7 individuals make use of financial data that are provided. It is impo 7 study the positive approach, because it gives insight into the informa” that is most useful. It is equally important to study the normatina™™ proach, because many financial accounting standards are based on the deductive logic from normative decision models. This chapter attempts to give an overview of the Tesearch that has been done using both the prescriptive and the descriptive approaches. (It jg overview only and presumes some familiarity with the details from Your other classes.) It begins with an analysis of the assumptions underlying the decision tools, such as present-value analysis, that are taught in typi. cal business programs, It continues with the normative model that many accounting researchers use today. The chapter proceeds to a discussion of the field of behavioral accounting in which the question of how People actually do make decisions is researched. That leads into a section on ethics which addresses the question of what is the right decision ina broader framework than is traditional. In particular, we ask what would be fair. A PRESCRIPTIVE APPROACH Partial Analysis How should people make decisions? This is an old question and has been answered at a variety of levels. There are the partial models of decision making familiar to business students; there are the more general economic models that academic researchers study in an attempt to provide under- innings for the partial models; and then there are the still broader philo- sophical issues that question one’s approach to analyzing decisions. This section addresses the first two of these questions; the section on ethics addresses the third question. ‘Most accounting students will be familiar with that form the staple diet of a typical BBA course. Examples of such tools are cost-volume-profit analysis, relevant cost analysis, regression analy- sis, linear programming, and cost allocation models. These tools af¢ called partial models because they attempt to analyze only one piece of @ large problem. Most of these models fll into the normative category since they are offered to the student as examples of how decisions should be made. They are often accompanied by discussions of how managers fal tO use these models, that is, by descriptions of the models that managers actually appear to be using. Many of these models also assume certainty: although some analyses end by saying that one should consider issues of tisk, Perhaps the most widely used ofall these models is present-value analy- sis, which became popular in the professional literature of finance in the a variety of decision toolsMaking Decisions 201 eed A typical problem Presents a student with a series of cash flows T time, asks the students to discount them at a rate of interest that is usually provided and which is typically standard across each of the cash ite and then calls for the student to select that cash flow producing the wighest net present value. Risk is taken into consideration by adjusting the interest rate to a required rate for a given level of risk. Alternatively, the expected dividend stream is adjusted by using a certainty equivalent (the amount the investor would be willing to take with certainty now instead of Waiting for the outcome). Simplified decision models involve a host of assumptions of which the user is usually unaware. They include the presence of constant risk across Projects (or the absence of risk); the ability to substitute cash flow for utility in the computations (or the risk-neutral stance of the decision maker); the ability to break the cash flow into periodic segments; and the ability to separate the investment from the financing decision. The intent here is not to take the reader through a Ph.D. course in the assumptions underlying such models, but to make the point that no decision models are assumption-free. Usually the simpler the model, the more “horrifying” the assumptions that have to be made to make the model work. As the British economist Lord Keynes once commented, “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’"7 Many, although not all, of these tools are used widely in practice. The fact that managers may not use all of the models espoused by academics is a matter of interest to researchers. One reason may be that simpler models work just as well as more complex models in the face of the rough data that are often all that one has. Thus, practice underlines the often- stated maxim that the purpose of modeling is not realism, but prediction. That being the case, one can fall back on models which, while admittedly unrealistic in parts, enable one to gain some insight into what information might be preferred by users. Another reason some models are not used may be a function of education. Managers use models that they learned in school; new models take time to diffuse into the community. The rate of diffusion of new ideas is itself a matter of research.‘ A third reason is probably the fact that some of the models that have been developed are not rich or complex enough to capture those facets of decisions that are of interest to managers. This suggests that, as models are further developed, they might diffuse more widely in the community. —_— CHECKPOINTS . Give three examples of partial decision analysis. 5 Explain ‘why the models used are called partial models.202 Chapter 7 Choice Theory The purpose of a general theory of decision making is to provide a Setting within which one can examine the assumptions underlying models, jixg those examined above. It should also provide a framework within Which one might develop new models. Such a general theory of decision making begins with the notion of actions which are open to individuals; Outcomes or consequences of their actions; and preference functions that determine how they will choose among the actions open to them. Textbooks often describe consequences in cash flow terms, but they could be perfectly general. For example, when President Truman was considering whether to permit the dropping of the bomb on Hiroshima, there was a whole range of international and long-lasting consequences that had to be con- sidered. Such consequences are sometimes called scenarios. A change in any one detail in a scenario produces a new consequence from the point of view of general choice theory. Economists typically assume that people’s preferences are complete and transitive, that is, they have an opinion on everything in their choice set, and they can order these preferences. For instance, everyone is as- sumed to have a definite opinion on automobile manufacturers. Those who prefer Ford to Chrysler and Chrysler to General Motors are expected to prefer Ford to General Motors. At a given point in time the transitivity assumption is probably relatively trivial, but over a period of time it assumes that people’s preferences are stable, which is a considerably larger assumption. Advertising, for one, has as its aim the disturbing of people's preference functions. Individuals are assumed to sort through all the alternatives open to them and to choose those actions which are most preferable. For exam- ple, an individual might be considering where to save $1,000, The follow. ing alternatives are open: ee ry Consequences Save with a bank at 5% interest $1,050 Save with a money fund at 8% interest ye Notice how every action has a known conse: assumed a world of perfect certainty. Individuals are assumed to do the computations necessary to determine the consequences and to base their Preferences on them. In this case, they should choose the mones firs Given a finite set of alternatives, the assumptions of a com; ete and transitive preference function are sufficient to enable one to trovidena numerical measure of an individual's preferences, that is, the movie) ferred consequences can be given higher weights than the legs nore PTS: ‘quence because we haveMaking Decisions 203 ones. For example, on an ex Post basis one might give the money fund a Weight of 8 and the bank a weight of 5 to indicate that the fund is preferred to the bank. These measures form the basis of utility theory in which each individual is assumed to behave as if he or she has a built-in set of weights, termed a utility function, guiding him or her to those conse- aliences with the highest utility. (The measures were once called utils.) Choic theory then reduces to maximizing utility. Utility functions enable one to treat other aspects of decision making. For instance, a typical assumption is that one’s utility for a product de- clines as one accumulates more of it—the first hot fudge sundae tastes better than the third or fourth. This assumption enables theorists to model observed Consumer behavior that shows a preference for collections of different items rather than single items, that is, a sundae and a coke rather than two sundaes, Carnegie-Mellon professor and Nobel prizewinner Herbert Simon questioned the optimization assumption in traditional choice theory. He Suggested that if search is costly, individuals might satisfice rather than optimize. They would achieve this by taking the first ‘‘satisfactory”’ con- sequence.’ For instance, individuals might deposit money in a bank at 5 Percent interest because they lack the time to find a money fund that pays a higher rate of interest. While Simon’s work is undoubtedly more realis- tic, it is also logically inconsistent in this particular context, because in a world of perfect certainty there can be no costly searches. This follows because everything is already known or instantaneously available. This points up a major dilemma for accounting theorists seeking to understand decisions: The simple world described above assumes that all is known. If this were true, accountants would not be needed. Information Economics To find a theoretical home for accountants, one has to “enrich” the choice model by adding additional further layers of complexity. In partic- ular, it is necessary to build into the model the uncertainty in the world. We do this by introducing the concept of states of the world that are descriptions of possible outcomes. To continue our previous example, in an.uncertain world the economy might rise or fall in the year ahead. Each of these possibilities constitutes a possible state of the world. Our inves- tor’s choice then might look like this: se States Acts Economy Rises Economy Falls il $1,050 $1,050 Save with bank ae sins ‘Save with money fund204 Chapter 7 | Actions no longer have known consequences because Uncertainty Now | intervenes. Economists analyze situations like this by attaching aprobe | bility to each state and computing the expected value of each action, gay | one thinks the likelihood of the economy rising is 80 percent ang of itg falling 20 percent. The expected value of each action is then: - 20% x $1,050 = 5 Save with bank: 80% x $1,050 + cK 1,050 Save with money fund: 80% x $1,080 + 20% x $1,030 = $1,979 Ss Ithas been shown that this methodology, that is, people maximizing the expected value of their actions, can be justified if the following four condi. tions are met. 1. Preferences are complete and transitive. 2. Given identical outcomes, the one with the higher probability will be selected. 3. Complicated gambling situations can be broken down into simpler ones. This is called the no-fun-in-gambling assumption. 4. There exists a certain gamble to which the individual will be indiffer- ent. This is called the certainty-equivalent assumption." Given these assumptions, we have a model of choice that includes uncertainty. There is, therefore, now a logical necessity for a theory of information that can explain how this uncertainty might be resolved. Early work in the area of information analysis under the heading of infor- mation economics concentrated on how information enabled individuals to revise the probabilities they attached to the Possible occurrence of Save with banl 20% x $1,050 + 80% x $1,050 = $1,050 Save with money fund: 20% x $1,080 + 80% x §1'030 = $1,040 //One could reasonably expect the investor, aware of the potential risk, 10 PaY UP to $10 (Le, $1,050 ~ 1,040) for this information we aenig cing stuck with the wrong choice. More generally, the expected cannes et mation is measured by the increase in value one might expect hem hwo that information.* * This revision process is assumed to occur through the working of Raves Theorem,Making Decisions 205 The expected utility approach can be extended to the consideration of an €ntire information system, for example, to the question of whether one should purchase an ongoing Subscription to the economic report. As- times. Ifone can assume that 800d times occur 80 percent of the time, and bad times 20 Percent, then over time one can expect to make: 80% x $1,080 + 20% x $1,050 = $1,074 Without the information, and sticking to the strategy of investing in the money fund only, one could expect to make: 80% x $1,080 + 20% x $1,030 = $1,070 One should pay, therefore, no more than $4 per year for this service. Risk Aversion, Cash values were used in the above examples. Given certain assumptions about human behavior, one could have substituted utility functions. This substitution enables us to refine the concept of attitudes to risk. The risk-neutral are assumed to be indifferent to it; the tisk lovers are the gamblers; the risk-averse seek to avoid it. For instance, consider individuals presented with the following options: A: $1,000 for sure B: A 50/50 chance of either $500 or $1,500 Risk lovers will choose B: the risk-averse will choose A; the risk-neutral will be indifferent. At first glance one might assume that everyone is risk- averse, but the millions who gamble against the odds each day cannot be risk-averse—the expected value of entering a state lottery is considerably less than the cost of playing. The same is true for insurance: the cost of coverage exceeds the expected value of that coverage. The difference between the expected value of a lottery and the price that one is prepared to pay for it is called the risk premium. Risk lovers are prepared to pay for the privilege of gambling, presumably because they derive nonmonetary pleasure from it. Contributions. Information economics has sharpened accountants" views of what makes information valuable by stressing the relationship of information to its users: It is from their utility functions and only from their utility functions that a value for information arises. By contrast, the FASB stresses a series of qualities that supposedly give en value: These include characteristics such as relevance, timeliness, aa reliability, all of which were discussed in Chapter 5. Thus far, research in f information economics has shown no necessary connection pence the value of information and these qualities. This does not imply Qe206 Chapter 7 Agency Theory that no connection can ever be found; merely that information econo found one to date. ae information economies approach has also proved valuable in gn, ply stressing the fact of uncertainty. Most accounting proceeds as thoy, the world were perfectly certain. Depreciation expense, just to name one instance, is computed each period as though the life of the Asset Were g given instead of a guess. Information economics was certainly Not the first to insist that accountants pay more attention to the uncertainties inherent in accounting. New York professor Richard Brief, for instance, argue more than a decade ago that accountants would not be fulfilling thei responsibilities completely until they acknowledged how uncertain their estimates were in financial statements."! Information economics has taken a lead role in making this important point ever since’ its establishment, Unfortunately, positive, generalizable findings in the area of informa. tion economics have been disappointingly few. It can be shown, for in. stance, that when information is free, more information is preferable to less. More information is defined in terms of *‘fineness."’ One information set is said to be finer than another if one contains all the information contained in the other. For instance, a detailed list of expenses is finer than a single total of expenses. The preferability of a finer information set holds only for free information that can be discarded if ‘‘useless.”’ It may fail if one has to pay for it. It is also apparent from our preceding numeri- cal example that information has no value unless it changes, or might change, one’s choices. Apart from these two facts, not much more can be said at a general level about decisions. Still more structure has to be added to wring more insights out of the model. Mics parry es nT ee CHECKPOINTS 1, Define risk premiums. How might one use the concept? 2. Define fineness and explain when and how finer information sets are preferable. 3. What makes predecisional information valuable? One way in which more insights can be gained from information €¢0” nomics is to extend the model from a single individual to two individuals- One of these individuals is an agent for another called a principal—hence the title of agency theory. The agent contracts to perform certain dutiesMaking Decisions 207 for the principal; the principal contracts to reward the agent. An analogy may be drawn between owners of a business and the management of that business. Owners are called information evaluators in this particular context; their agents are called decision makers. The information evaluators are assumed to be responsible for choosing the information system. Their choice must be made in such a way that the decision makers make the best decisions in the owners’ interests in light of the information available to them. In other words, the actions are those of the agent, while the utility function of ultimate interest is that of the principal. The problem is made more complex by the need to consider the agent’s utility function as well because this is what drives the agent’s actions." Given that principals will always be interested in the outcomes gener- ated by their agents, agency theory provides the underpinning for an important role for accounting in providing information after an event: a so-called postdecisional role. This role is often associated with the stew- ardship role of accounting in which an agent reports to a principal on the events of the past period. This is what gives accounting its feedback value in addition to its predictive value.* Several insights are available from this model and its extensions. These extensions relate mostly to the way the two parties share risk and infor- mation. For example, in the standard economic story, risk-averse owners are assumed to carry the risk of the business, while managers act as risk- neutral agents. The dilemma of this story is that it can be shown, using the machinery of agency theory, that if management is indifferent to risk, but owners are risk-averse, then management and not owners will carry the risk—for a fee. This rather spoils the story that capitalists are rewarded by profits because they bear all the risk! Economists have responded by assuming that managers are risk-averse too. It is the interplay of relative risk aversion between managers and owners that creates some of the most interesting issues in agency theory for accountants. Information is one means to reduce uncertainty, giving accountants an important role in risk sharing between managers and owners. Information Asymmetries. Recent work in the area of agency theory has focused on the problems engendered by incomplete information, that is, when not all states are known to both parties and, as a result, when certain consequences are not considered by both. Such situations are known as information asymmetries. For example, owners may not know managers’ preferences, making it difficult for them to do the computation referred to above. * See Chapter 5 for more discussion of these two terms.Chapter 7 A particular example of incomplete information exists in ABENCY theo when an owner is unable to observe all the actions of the mana, er, Ty ie actions may differ from those the owners would have Preferred, tithe because the manager has a different set of preferences, or bee let the manager is deliberately attempting to shirk or to cheat the ow This creates what is known as a moral hazard Problem. One Possibje solution is for the owners to hire a firm of auditors to check on What management is doing. Another is to provide Management with incep, tives, such as shares in the company, to align their preferences With the owners. The secondhand car market was the subject of a celebrated paper illus. trating the nature of information asymmetries.'> The seller of a secong. hand car knows more about the car than the buyer; if the seller does not share the information about the expected future of the car, it may not be possible to agree on a price, because the buyer will offer an average price for the car, while the seller might want top dollars. Even if the seller does share information, the buyer may be suspicious from previous purchases of secondhand cars. The buyer may discount the information the seller provides, even though it is true. In the extreme. information asymmetries can lead to a complete breakdown of the market as good cars are with- held, because one cannot persuade buyers of their value. leaving only “‘lemons"’ for sale. This problem is called adverse selection because of the poor selection of cars that can result. One possible solution to adverse selection is for the seller to hire an independent “‘auditor’’ to check the car, and to provide the buyer with a certificate as to its quality. Another possible solution is for the govern- ment to regulate the sale of secondhand cars by insisting that all sellers Provide a prescribed list of information to would-be buyers. They als0 might prohibit those with superior knowledge from exploiting that know edge at the expense of the less knowledgeable, that is, by banning insider trading. A third possible solution lies in the marketplace itself. If good cars are being offered ata discount, there is an incentive for sophisticated car buyers to step in and arbitrage the market. Competition between sophisticated arbitragers could lead to appropriate market prices beilé set. Ina variation on the same theme, it could be cars have a natural incentive to disclose as much j i eit cars as possible. Buyers could infer, therefore, that ood alt ae willing to disclose had only inferior cars to sell. If this could te enown 10 occur, there would be no cause for auditing, Tegulation, o1 arbitration. The analogy between the secondhand car market, on tne ore an companies and their accountants, on the other, should be clear, ts interesting in this light to ponder on why accounting today ig cs neavil¥ regulated. More is said on this subject in Chapter 8 on Regulating, wher possible reasons for failures in the market are discusseq, i ase ners argued that sellers of goodMaking Decisions 209 caEGwroINS 1. Give an example of a principal-agent setting. Explain how the mineral might select an information system for use by the agent. * Pefine moral hazard and adverse selection. What is their signi ieee at is their significance 3. In what ways does agency analysis extend the work of information economics? - Explain why an agent might want to be audited. Multiperson Decision Theory Thus far our discussion of decision making and the resulting demand for information has focused on choices taken in isolation—even in agency theory one is focusing on an individual owner choosing an information system. What, if anything, can be said about choices by collections of individuals? The reason for our interest in this question is that policyma- kers like the FASB presumably attempt to take into account the desires of all their constituents. Technically speaking, they attempt to aggregate individual utility functions. One common way to attempt to capture the will of the people is by majority vote. Consider, however, the following scenario. A student sen- ate is called to vote on whether to recommend the building of a new student union. Some feel strongly it should include a pub; others feel equally strongly that it should be ‘‘dry."* Another group feels that it is a waste of time. The preferences among the three groups for the three options run as follows where the numbers correspond to rankings: Groups I I Mm ‘A: Union with pub 1 2 3 : Union without pub B: Union ‘ : i C: No union Given these rankings, a union with a pub is preferred to a union without a pub by groups II and III; the union without a pub is preferred to no union at all by groups I and II. This suggests that a union with a pub will be the choice. But, an examination of the rankings shows that groups II and III both prefer no union at all to a union with a pub! Denoting preferred by the greater than sign we have:Chapter 7 A>BandB>C-— Ais the choice of the majority, In fact, if one had arranged the vote slightly differently, so that the union with a pub was compared to no union at all in the first round, a vote of the no union at all against the union without a pub would have resulted in the choice of the latter! A check of the rankings shows that: C > Aand B > C— Bis the choice of the majority. In other words, one can determine the outcome simply by arranging the order of the votes. Majority votes are not conclusive, therefore. Altera. tively stated, majority votes do not lead to an aggregate utility function that can then be used by regulators to determine whether a particular decision would meet the desires of the populace. They might vote today for A over B and for B over C, but they might also vote for C over A ifitis presented in an appropriate order. Such strategies, sometimes called log rolling, are well known to politi- cians who specialize in parliamentary procedure. They utilize their exper- tise to guide legislation through the voting process to gain the result they desire. Stanford economist and Nobel prizewinner Kenneth Arrow dem- onstrated that voting strategies can be generalized to the rather startling result that, a. If everyone’s vote is to count, and b. Only available opportunities are to be considered, an appropriately rational group preference function cannot be constructed unless, c. Everyone is unanimous, or d. Group preferences are dictated by one person.'* Stated otherwise, given these assumptions it is impossible to arrive at a utility function that will consistently reflect society’s wishes. This rather disconcerting result has drawn the attention of many re- searchers who have sought to escape Arrow’s strictures. In particular, Yale professor Joel Demski translated its strictures into terms appropriate for accounting.!5 At the outset it must be appreciated that the theoretical problem is more severe than the practical. Both individuals and societies make inconsistent choices all the time, blissfully unaware that academics consider that irrational. The theoretical problem is genuinely severe, though, because it does hamper our ability to develop models of group behavior in the decision-making area. As a result, research into society's information requirements is slowed, and regulators lack theoretical justifi- cation for their necessary actions. Arrow’s theorem is particularly awkward for a body like the FASB, since it suggests that, despite all their best efforts to be democratic, they will inevitably impose their own wishes on their constituents, unless they can build unanimous consent for their proposals—a very unlikely event. The Conceptual Framework, though, was an attempt to do this. It beganMaking Decisions 211 my listing the large number of potential users, such as investors, creditors, al Ghee ee eeunent, employees, and the public. It then suggested that business Potential users are “generally interested”’ in the ability of a enterprise “to generate favorable cash flows because their deci- ions Telate to amounts, timing, and uncertainties of expected cash flows. 'S They concluded that users were homogeneous and would have identical preferences for types of accounting information. The last chap- ter suggested that this is too optimistic; potential users are a more hetero- geneous group than the FASB might prefer. The FASB, therefore, has not escaped Arrow’s theorem, A DESCRIPTIVE APPROACH The previous section focused on attempts to construct a normative model for decision making involving utility theory. This section focuses on at- tempting to understand how decisions are really made. The discussion centers on two of the questions that researchers have considered: 1, How do companies decide which information to release? How, in other words, do they decide their financial reporting policies? How do individuals process the information they receive in making their decisions? Do processing techniques differ systematically across individuals? There have been two major thrusts in accounting research in attempting to answer these questions. One approach draws on the psychological literature and seeks to understand how individuals use given sets of infor- mation. It is known broadly as behavioral accounting—the two branches of behavioral accounting that are of particular interest here are human information processing and cognitive theory. The other approach draws on the literature on information economics, agency theory, and efficient markets to build hypotheses for how accounting standards are set. This approach tends to deal with individuals in the aggregate. It is more con- cerned with the decisions of organizations than with those of particular users. It has chosen to call itself positive accounting. ‘The title has been severely criticized for several reasons. One is that it appears to imply that other areas of accounting research such as behav- ioral accounting are not equally positive or descriptive in their approach. The other is that it seems to suggest that it is an entirely non-normative approach to accounting when, in fact, itis based upon a number of quite Stringent normative judgments about individual behavior.” The theory assumes, for instance, that individuals are utility maximizers, with all the ‘assumptions that involves. In particular, work is assumed to have nega~ tive utility. None of these assumptions has been proven. The point is not to dispute this view of the world or to decry the very real contributions of Nv22 Chapter 7 pest HE I cma only one avenue of positive research ant a © iN its ow, way as are other areas of research in account! 7 aa a There is, as yet, little integration between behavioral and positive ao, counting. They differ in the level of analysis—the one examines aggregate behavior, the other individual behavior. We lack, almost entirely, a moda of how individual decisions are aggregated to produce corporate deci. sions. They differ also in their assumptions about the cognitive abilities of human beings. The standard economic model makes much use of rational. ity and assumes that human beings have unlimited computational powers in maximizing their utility. The standard behavioral model is more in- clined to accept irrational behavior because it takes as its premise that human beings have quite limited computational powers. Behavioralists tend to accuse economic theorists of being unrealistic. Economists claim that the only criterion by which a model should be judged is its predictive power. The most unrealistic models may be quite acceptable, therefore, Behavioralists reject this argument in favor of the need for greater under- standing. In short, the two approaches have been quite antagonistic to- ward each other. This has led to some quite spirited arguments between accounting researchers. This section attempts to describe the thrusts of each approach and their implications for accounting. Corporate Reporting Policies As already noted, one of the questions that accounting researchers have attempted to explore empirically is how companies select the accounting procedures they use. Of course, to a certain extent these choices are made for them by the FASB, but there are still sufficient alternatives left at management's discretion to make it an interesting question. Positive accountants have made this question their particular preserve. They found their hypotheses on the normative decision theory discussed in the Previous section. From this they have produced a series of relatively Provocative hypotheses that they have tested. For the most part these hypotheses appear, at this stage, to be supported by the data. The language used in positive accounting is that of contracts or cove- nants. Investors, consumers, management, employees, and others are assumed to enter into explicit or implicit contracts with each other. For these contracts to be of any interest, one must assume that they are costly to construct and destruct, or else the parties would make and break them with impunity. The questions then become: 1. Which parties to the contract reap the return? 2. Which parties bear the risks? 3. On what outcomes are these results based?Making Decisions 213 mation asymmetry, might be resolved by market forces. Equally, individ- ual investors are not making their decisions in isolation, but in the company of a host of other investors, One result is that a decision not to invest does not ensure the Status quo, because others are investing all the time. Another result is that solutions to various investment problems must be sought in association with already present market forces. Contracts between Management and Owners. One area that has been widely studied in Positive accounting involves contracts between manage- ment and owners." This area is very closely related to that of agency theory. Owners are understandably concerned that management make decisions that are consistent with the wishes of the owners, that they are honest and efficient, and that their decisions produce for management the greatest increase in value possible. One way to motivate management to do this is to give management shares in the company. Another possibility is to give managers performance bonuses attached to the share price. One also observes performance bonuses for managers that are a function of accounting numbers such as net income and revenue. The use of account- ing numbers enables performance to be tied more closely to specific com. ponents of net income such as increasing revenue or decreasing expenses, But if it is to be in the interests of owners, increases in net income should generate increases in market value. This is not always true. Managers who are rewarded for high net income numbers have a clear incentive to increase those numbers by either deciding to manipulate given rules or, more interestingly for accounting theory, by deciding on accounting rules that favor them. Specifically, one can expect managers. whose performance bonuses are tied to net income to manipulate or choose accounting rules that will increase income in this period at the expense of later periods. This is called the bonus plan hypothesis. Taking a “big bath”” is an example of manipulating the rules: In this process, managers write off everything they can when earnings are down so as to increase the probability of positive net incomes in the future. Choosing straight-line depreciation rather than accelerated depreciation is an exam- ple of deciding on an accounting rule. Contracts between Management and Creditors. Another area that has been widely studied concerns debt covenants. It can be shown that a utility-maximizing management, particularly if they have shares in the24 Chapter 7 company, may not always make decisions in the ee interests ota holders. Creditors, therefore, often ask aki nt to sign a acd protecting the interests of the creditor. For ins| ns, management he natural incentive to issue new debt that is senior to ol id lebt, because 7 action, by lowering the risk of the new debt, lowers its price, The : nie ity of the debt, while of no personal interest to management, is of area interest to debt holders who will want to write contracts with Managemen, to ensure that this does not happen. } As with the bonus hypothesis, management also has an incentive to shift income from future periods to the present because this decreases the debt-to-equity ratio. This is described as the debtlequity hypothesis Many debt covenants take the form of holding certain financial ratio, above a certain level. For instance, the corporation may be required by it, creditors to keep its current ratio (i.e., its current assets to current liabjli. ties) above a certain level. Contracts between Management and Society. Positive accountants have studied the relationships between corporations and the various polit. ical bodies, and the effect this has on corporate decisions. They have hypothesized that large and, therefore, politically visible firms have an incentive to defer income to future periods. This is known as the size hypothesis. This hypothesis goes in the opposite direction from the bonus and the debt/equity hypotheses. It suggests that large firms will base their accounting-related decisions on income-reducing strategies in an attempt to avoid being noticed by politicians. The hypothesis appears to be true for very large firms and, in particular, the oil and gas industry. Positive accountants have said relatively little about contracts between management and the general public and management and employees. Clearly, it would be possible to extend the theory to take into consider- ation questions such as whether management is bound to provide safe working conditions for employees or whether management is bound t0 avoid polluting the atmosphere by its activities and how, if at all, these contracts affect decisions related to financial reporting. It may be, for instance, that social policy could be advanced by obliging management 0 include estimates of external costs in their annual statements. The Corp0- rate Report that was referred to earlier, for instance, could be discussed in this context, Individual Financial Analysis The second question to draw the attention of accounting researchers has been how users analyze the information they receive in making thelt decisions. A related question is whether the processing methods in US® differ systematically across individuals. For instance, do sophisticatéMaking Decisions 215 hoe use a different information set than unsophisticated investors? questions are Potentially important because if companies knew could rccisely what information investors and others want cad use, they esl design their financial reports more specifically to facilitate their sion making. Unfortunately, experimental results are still fragmen- ‘ary and confusing, with only a few apparently conclusive findings. One finding that does appear to emerge consistently is that individuals have a limited ability to process information. The evidence in this regard appears to be unassailable. Some would even consider the matter self- evident. Limitations reveal themselves in a variety of ways. _ One line of research has examined the ability of individuals to cope with Increasing quantities of data. The general finding is that decisions improve with increased information until a point is reached where the information Provided becomes too great for the individual to analyze. At that point, Where the individual begins to experience what is termed information overload, decision making begins to deteriorate again." A related finding is that individuals appear to prefer a limited amount of information on which to make a decision. This may be the result of the fact that most People’s short-term memory is limited to carrying no more than seven items.” Thus, People tend to omit information, claiming that it is insignifi- cant or irrelevant. They also tend to use information in aggregated form. This accounts, in part, for the popularity of indexes, such as stock price indexes, and earnings and earnings-per-share figures. The point at which overload occurs varies among individuals. It is also mitigated by the use of technical assistance such as computers. More importantly still, it must be recognized that people seldom make decisions in isolation. Generally they are part of an organization where the role of each individual is to make inputs into a joint decision. The organizational literature is replete with discussions of how decisions made by leaders of corporations depend on the nature of the information fed them by their subordinates, by the structure of the organization, by the performance measurement system, and by the strategic thrust of the organization.?! The information overload problem does not go away, therefore, but the concept does have to be translated to an organizational level. Studies have revealed also that people who rely on subjective statistical procedures act in a biased manner.” For example, people feel more com- fortable selecting their own random numbers for state lotteries. They also prefer betting on coins before they are tossed rather than afterwards. Studies have shown too that individuals attribute greater certainty to unreliable information than is warranted. They respond more to vivid events such as stories about prominent individuals. Also, individuals tend to base estimates and predictions on recent or available observations, even though these may be neither representative of long-run conditions nor reflect objective probabilities. For instance, a run of heads often persuades people to call heads. In other words, individuals do not appear26 Chapter 7 to be making decisions in line with the n | first section of this chapter. | Given that individuals are limited in their abilities to process informa, | tion in a complex environment with uncertain probabilities regarding ture events, it is natural that they should wish to simplify the complexit of the situation as they perceive it and reduce the uncertainty, The typically achieve this by using rules of. thumb or what are termed heuris. tics. One heuristic that has drawn the attention of accounting Tesearcher, is termed anchoring. jormative theories outlined in ic Anchoring. It has been observed that individuals select particular piece, of information as a starting point and, using other available information, make adjustments to form predictions. For example, an investor might use the prior period's earnings or earnings per share for an anchor, add to it current information about specific economic conditions for the firm, an then make a prediction of the current year’s earnings. As a second exam. ple, a couple attempting to place a value on their home might use the original cost as an anchor and then make adjustments for changes in building costs and selling prices of homes in the neighborhood. The difficulty with the anchoring process is that individuals generally fail to adjust fully to the new information. that is, they do not follow Bayes’ rule in revising their prior probabilities. If an upward adjustmentis required in light of new information, the estimate or prediction is likely to be lower than is realistically warranted. On the other hand, if the new information indicates a downward adjustment, the prediction is likely to be too high. This concept is important for accounting because, generally, individuals are not aware of this bias, and most persons do not know that they are using an anchoring process. What then can be done in publishing financial reports to reduce the anchoring bias? First, it is important that accounting numbers have s¢- mantic interpretation. If the economic events measured by the accounting numbers are correctly understood by investors, there should be less op- portunity for anchoring bias. Second, this appears to provide an argument for the use of current market prices as much as possible instead of histori- cal costs. The older the information that may be used as an anchor, the sreater the adjustment process and, therefore, the greater the likelihood of bias. These suggestions are made with considerable caution, however pcegunney ie not been sufficient ‘Tesearch on the anchoring bias #* ‘now how it can be eliminated or even reduced. Functional Fixation. Perhaps as a result of anchoring, individuals tend to display behavior known as functional fixation.®® This means that ind Viduals assume that the symbols, aggregations, or surrogates that they 4 using in making judgments regarding the future maintain the same mea ‘ng and relevance over time, regardless of changes in what they represet™Making Decisions 217 or in the Way they are computed. In accounting, it implies that investors Use accounting numbers (such as earnings per share) consistently over time without making full adjustments for changes in accounting tech- niques. For example, if the firm changes from capitalization of R&D ¢xPenses to current expensing, functional fixation on the reported earn- ings would result in an incorrect judgment, since the change in reported earnings resulting from the accounting change would not reflect funda- mental economic changes (assuming no income tax effect). The general finding is that investors do adapt to the changes in accounting procedures over time, but they do not readily change the way they interpret the meaning and importance of the earnings figure in making a judgment regarding the value of the firm. These findings are significant for financial reporting because they imply that consistency in the use of accounting procedures is important. When material changes in procedures are made, figures computed under both methods should probably be reported during the adaptation period. There is also an implication that accounting classifications and aggregations should permit as much semantic interpretation as possible, that is, ac- counting numbers should be interpreted in terms of economic realities wherever possible. A third implication is that decomposition of financial data may be desirable in order to avoid functional fixation on aggregate figures, which may fail to disclose fundamental economic relationships. Conclusion. Modeling “‘realistic’’ human behavior is extremely diffi- cult—mathematical models do not deal easily with irrational behavior or even with behavior that exhibits bounded rationality. In spite of the diffi- culties of studying individual decision processes that can guide account- ing policy, there are many reasons for learning as much as possible about individual decision making in an accounting context. These include: 1. The possibility of improving the quality of individual decisions and decreasing the cost of processing information by both accountants and investor: 2. The possibility of improving the set of information available to the individual and to the market, although the relationship to the market is unclear at this time. ‘These objectives may improve the allocation of resources in the econ- omy as well as improve the welfare of individuals. As a first approxima- tion, improving the welfare of individuals is desirable if in so doing the welfare of no one else is decreased (Pareto optimality). Three methods of reaching these goals are discussed in the following paragraphs. 1. Research on individual decision processes may provide clues regarding what information should be included in financial reports. There may be no limit to the amount of information that can be utilized by the market as a whole, but individuals do have limitations; therefore, it may218 Chapter 7 A Synthesis ve desirable to publish different statements for different group, see The eapital asset pricing model can be used to test the efi’s bs security prices of certain information, but there must be some Means of determining which information to publish before the market test can made. Making a random selection of potentially relevant information would be an expensive way to proceed. Therefore, a knowledge of ing. vidual decision processes would permit improvements in the set Of infor. mation provided to decision makers. Although the market may be eff, cient with the existing set of information (or with any set), an alternative set may provide an improvement in the allocation of Tesources and mini. mize the possibility of monopoly returns through the use of insider infor. mation. E 2. The capital asset pricing model assumes a given state of technol. ogy in the use of information. That is, the ability of decision makers to Use information is assumed to be constant. Research on the individual deci- sion-making process might improve this ability. By improving the quality of investment decisions, resource allocation would also be improved, and investors would be better off because they would be holding portfolios closer to the optimum. The education of investors in the new technology would take time, but the market would Teact to the new methods quickly, uld attempt to exploit the new Opportunities immediately. However, there is evidence that learning is not efficient, Which raises a question regarding the ability of the market to utilize new technology.” 3. A third method of improving the quality of investment decisions and reducing the cost of. Processing the information is the possibility of consideration by the individual investor, Section is considerable Conflict between the way decisions and the way ther i io " . i ne scribes rational behavior. For instance aracteistic off ‘ onal | » disturbing characteristic of func- tional fixation is that, on the face of it, it is inconsistent with rational behavior. Rationality suggests that one should Not react to accounting changes that have no substantive Sconomic implications. But there are What emerges in this people actually makeMaking Decisions 219 rounds for believin, more apparent than eal on ernest me First, behavioral Studi descriptions of Potential ‘es are done at an individual level. Heuristics are biases in the individual investment decision pro- way to know how i market price. It is so that the market short, because the individual biases work out in the aggregate to affect a Possible that the biases are offsetting in the aggregate does reflect fundamental economic relationships. In One analysis is done at the individual level and the orner at the aggregate level, they do not necessarily speak to one another, oe does not imply that the. anchoring bias is unimportant for accounting © aggregate level. The biases may affect individual welfare and permit a less than optimum distribution of securities among investors. Second, there are also considerations of cost. As noted above, many contracts are signed on the basis of accounting numbers. Managerial bo- nuses, for instance, are often based on net income. These contracts, because they are costly to make, are not necessarily changed when ac- counting rules are changed. This being the case, what appears at first glance to be functional fixation might simply reflect the realities of the individual's economic situation. Stated otherwise, what has no substan- tive economic implications for a company might still have substantive economic implications for an individual. The conflict should not be discounted entirely, though. There are two quite distinct views of human behavior present in the studies discussed in this section. One begins with a rational human being with superhuman computational powers, but then allows that there are costs to doing those computations. The other begins with a less rational and very fallible hu- man being, relying on rules of thumb—regardless of costs. Science pro- ceeds by rejecting theories. That means that theories have to be stated in such a way that they can be rejected by evidence. If we attempt too much synthesis, we run the danger of so oe om theories that they become i reject. Science then becomes dogma. een might be noted that positive accounting has a to be associated with the so-called Chicago school of economics which ie i conservative and opposed to government intervention. has appeared to their critics Lean Veen ential to be a great deal broader approach, Bea ere “research aimed at explanation and its essence it simply fh whose objective was prescriptive." It could eae som : the hisights of behavioral accountants as laid out a eal could also include the insights of radical accountants suc been politically c Much of their worl = The sectio: on ethics suggests that they are modern-day Whigs. AYy 20 Chapter 7 | essors Marilyn Neimark and Tony Tinker, andy a heh Lehman.” This would mean dropping those norma behavioral and political assumptions that are part of present positive hay | eating in favor of a thorough-going positive approach to all phases coals: The result could be a unified field of accounting research whog, any commitment is to follow the evidence wherever it leads. prime ren APES Tae Tempewwonns 1. Briefly describe what information processing characteristics of users have been found by behavioral accounting researchers, 2. Explain the interrelationship between fineness and information overload. 3, Explain the significance of satisficing in the light of what we know about human decision making. AN ETHICAL APPROACH® How to make the right decision, or as Socrates phrased it, “How one should live,” predates business and constitutes the field of ethics. Ethical theorists have suggested many ways to guide decisions. These ap- proaches have been summarized in two broad categories: the “‘deontolog- ical’ which focuses on the motive to achieve the end and the “‘teleologi- cal’” which focuses on the end itself. Deontologists are sometimes said to stress what is right, while teleologists stress what is good. Deontologists argue that bad motives can never be justified by good ends, while teleolo- gists argue that bad ends vitiate good motives. Utilitarianism Traditional neoclassical economics of the kind that we have been discuss- ing is based on utility theory, which is an example of teleological theorY since it focuses almost completely on the consequences of our actions. In its classical form, utilitarians suggest that one should act so as to maXr mize one’s utility. Loosely speaking, one should maximize one’s happ ness. In its most general form, one’s utility can include concern for others. As used in most economic theories, though, one’s utility is based on one's own interests only. This ‘extremely important restriction on the preferences of consumers is referred to as the condition of selfishness 2 preferences” by economists; ethicists call it egoism.3! Even more restric- tively, most commonly utility is assumed to be simply a function of PoMaking Decisions 21 Sonal wealth. Clearly, this imposes a limitation on what economic models can say about total well-being. This is typically handled (like risk) by a stricture at the end of a problem that the user is advised to take ‘“‘qualita- tive factors” into consideration. In this view, the role of regulators is to maximize the utility of all members of society. An immediate dilemma is the difficulty, if not the impossibility, of comparing individual utilities. This has led economists to Suggest the concept of Pareto optimality. This is the point at which it is Not possible to improve the situation of one individual without harming that of another. The argument goes that as long as one can improve the situation of one without harming another, one should do so, that is, there will be unanimous consent to move to Pareto optimality but dissent there- after. This suggests that regulators will find assent from society as long as they are moving to a Pareto optimal point but can expect much argument thereafter. Pareto optimality leaves a number of unsolved problems in its wake. For instance, although it can be shown that in a perfectly competitive economy, individuals will trade to a Pareto-optimal point in a process Adam Smith named the “‘invisible hand,” the precise Pareto-optimal point that one reaches is a function of one’s starting point. If Robinson Crusoe has all the fish and Man Friday all the bread, they can be expected to trade until each has some of both; however, no amount of trading can improve the situation if Robinson Crusoe has all the fish and all the bread and Man Friday nothing. This latter situation is as Pareto optimal as the first, yet many find it an unsatisfactory definition of utility maximization. A second problem emerges from the first: There is no guarantee that society will prefer a Pareto-optimal solution, It may be that society would want to equalize the fish and bread across the population. Stated other- wise, Pareto optimal solutions might not be socially preferable. This last is particularly problematic for accounting. It appears that few decisions that the FASB has to face involve choices that will improve the lot of some in society and hurt the lot of none. Most choices involve the provision of information that has the potential to transfer wealth from one group to another. Financial reporting, in other words, has definite eco- nomic consequences. It is these consequences which cause groups to lobby before the FASB in favor of, or against, various proposals. As Rice professor Stephen Zeff noted, questions such “‘as accounting for research and development costs, self-insurance and catastrophe reserves, develop- ment-stage companies, foreign currency fluctuations, leases, the restruc- turing of troubled debt, domestic inflation and relative price changes, and the exploration and drilling costs of companies in the petroleum industry have each provoked intensive lobbying.» In many cases, the “Basis for Conclusions” section of the relevant standard describes some of these efforts and the attention the FASB paid to an economic consequences argument.222, Chapter 7 Human Rights .m for accounting with a strictly utility approach to infor. indeed there can be, no sense of objective tru, ia formation is a commodity to be traded like any Joel Demski: ‘Another problem f. mation is that bod this setting. Instead, int other good. To quote Yale professor information economies) ae that (1) information i isition, li ties, constitute, uisition, like that of other commodities, oe problem by viewing information issues within the formal structure of the ecg. isi 3 nomics of uncertainty, or decision theory. Given that there is a great diversity of preferences on commodities like cars and clothes, it is not surprising to those who hold this view of infor. mation that there is no consensus here either. Others feel more uncomfor. table with this conclusion. The basic premises (of Analternative approach to addressing questions regarding what financial information to provide potential users begins with deontological theory which, it will be recalled, ignores consequences. Deontological theories have been subdivided in a variety of different ways. The most useful distinctions for our purposes contrast theories of human rights on the one hand with theories of justice on the other. Rights theorists maintain that we all have natural rights simply as a result of being human beings. Among them is the right to know. Government has an obligation to dis- close its actions to the public, not because it necessarily increases social welfare, but simply because it is the right of voters. By the same token, the public has a right to financial information about companies, because they exist only with the consent of that public. This approach led the English Accounting Standards Steering Committee to conclude that: the fundamental objective of corporate reports is to communicate economic ‘measurements of and information about the resources and performance of the reporting entity useful to those having reasonable rights to such information. A reasonable right to information exists where the activities of an organiza ‘on impinge or may impinge on the interest of a user group . . . Rights theorists argue that only * confidentiality” should limit this fu ti Practical considerations of cost and indamental right to know. Neutrality. “The language of rights enables one to reexamine some of the ‘SB has taken. For instance, one of the FASB's dilem