Tutorial 11

Q1. Explain the implications for accounting if decision makers in an accounting

context display any or all of the representativeness, availability, or anchoring
and adjustment rules of thumb.

Although heuristics are a practical means of coping with a complex world, their
uncritical use can lead to less than optimal decision making on the part of
accountants and auditors. This in turn increases the risk of financial loss and
unfavourable legal consequences.

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.
 The base rate or model provided to decision makers is misused in many
instances, or even ignored altogether.
 This implies that the usefulness of such ‘base’ information to decision
makers is largely ignored and rarely used.
 Rather, auditors and accountants employ their own judgements and rules
when making decisions.

Availability.
 Relates to whether recollection s of related occurrence or events can easily
come to mind.
 Decisions related to ‘sensational events’, and the probability assessments
thereof, are likely to be overestimated.
 For example, consider a financial report of a company. Most information
indicates the firm is profitable and liquid. Now assume that a news story is
aired that suggests an individual is seeking to sue the company. Users of the
reports, particularly shareholders, may weigh this piece of information very
heavily and assess the company as being close to collapse — even though
no writ has been issued, no disclosure of the amount claimed, nor an
assessment made of the grounds on which the claim is alleged and the
likelihood of success.

Anchoring and adjustment.

 In the light of changed circumstances, insufficient adjustments are made.
 Assume that an auditor’s prior period control risk assessment (as very low)
is used as the anchor for the current period’s assessment. Changes in the
internal control structure of the client indicate a higher assessment is
needed, but the auditor, using an initial very low risk anchor, does not adjust
upwards enough. This low anchor may lead to ineffective and/or inefficient
auditing.
Q2. Compare and contrast the efficient markets hypothesis and human judgement
theory. Are they inconsistent with each other? Explain.

Both the EMH and HJT deal with the production of accounting information and
reactions to information. However, this is where any similarity between the two
paradigms ends.

 The EMH focuses on the utility or information content of accounting

information whereas HJT generally deals with the usages of accounting
information by focusing on the input perspective of accounting. That is,
accounting as an input in human decision-making processes.

 Furthermore, the EMH differs from the HJT in that the EMH deals with
aggregate (‘on average’) behaviour of the capital market, whereas HJT
deals with individual or group decision-making processes of reaching a
decision with given information.

 Also, EMH focuses on behaviour of capital market participants only. HJT

applies to all users of information.

Rather than saying that the two perspectives are ‘inconsistent’ with each other, it
might be more useful to recognise that they are complementary.
 EMH identifies ‘new’ information and then the reaction (if any) of stock
prices to that news, but not what goes on in between those two events.
[For example in the capital market, due to Covid-19 pandemic, which may
be regarded as an event that affected the companies, hence we can see slow
trend in the capital market in the early period when the pandemic strike.
This shows that the market participants reacted to the ‘new’ information]
 HJT offers the possibility of learning how decision makers take the ‘new’
information and process it to arrive at their share price or valuation
decisions (as ultimately reflected in their share market activity).
 The assumptions underlying the two theories also differ, as shown below:

EMH/CMR
 Homogeneity of users’ expectations
 Rational users
 Efficient impounding of information
into share prices
 Does not assume correct or perfect
usage and/or interpretation and/or
presentation of information
 Does not assume nor suggest optimal
decision making and trading
 Is accounting information useful?
HJT
 Heterogeneity of users’ assessments
 Irrationality of users allowed and
controlled for
 Imperfect use of information
 Seeks to identify the processes by which
information is analysed and judgements
formed
 How is accounting information used?

Q3. Accounting is a function of human behaviour and activity. As such, is not all
accounting research behavioural? Justify your answer.

The answer to this question is a matter of theoretical perspective.

Most research in accounting and finance focuses on measuring the readily
measurable information.
 The readily measurable is usually the net product of human activity and
interaction, such as return on assets and share price.
 In this sense, all accounting research is behavioural — the performance of
the firm, the information measured and disclosed is a function of human
judgements and application.
 As such, perhaps more emphasis should be placed on understanding the
decision processes and the performance of individuals in generating
economic returns.
o As most researches observe past performance and interpret the
factors underlying the performance of firms and the factors
motivating reporting and disclosure practice.

Alternatively, when compare HJT with EMH and agency theory. The latter two
models may be interested in the consequences of behaviour (for example, share
price or choice of accounting policy), but they assume a particular model of
behaviour (that is, rational wealth maximisation). As such, they do not explain
behaviour at all and so could be argued not to be behavioural research.

Many research conducted in the capital market that particularly based on the
agency theory. Such as Earnings/return relation study, in which the basis of
reporting or announcing earnings is to meet agent’s responsibility to provide
entity’s performance (i.e. earning information) to the principal. Example study by
Ball and Brown (1968) tested whether firms with unexpected increases in
accounting earnings had positive abnormal returns, & firms with unexpected
decreases had negative abnormal returns. Examined data from 261 US firms.
 Found that information contained in the annual report, prepared using
historical cost was useful to investors
 85 to 90% of earnings announcement is anticipated by investors
 much of information is obtained from other sources
 The research is known as the earnings response coefficient
o examined relationship between the magnitude of unexpected
changes in earnings (EPS) & magnitude of abnormal returns
o Some research in this field found that a 1% unexpected change in
earnings associated with 0.1 to 0.15% abnormal return
 The relationship depends on whether earnings increases
expected to be permanent or temporary. If permanent,
expected result: increased in dividends, hence, increased
future cash flows, and this denotes change in the company’s
value. As such, influence a positive role in the capital
market. If temporary, expected result will be ignored as it has
different effect like permanent changes.