Advances in Accounting Behavioral ResearchThe effect of bias on decision usefulness: A review of behavioral financialaccounting researchRuth Ann McEwen, Mary Jeanne Welsh

Article information:To cite this document: Ruth Ann McEwen, Mary Jeanne Welsh. "The effect of biason decision usefulness: A review of behavioral financial accounting research" InAdvances in Accounting Behavioral Research. Published online: 2001; 3-24.Permanent link to this document:http://dx.doi.org/10.1016/S1474-7979(01)04066-2

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THE EFFECT OF BIAS ON DECISIONUSEFULNESS : A REVIEW OFBEHAVIORAL FINANCIALACCOUNTING RESEARCH

Ruth Ann McEwen and Mary Jeanne Welsh

ABSTRACT

The current paper reviews behavioral research in financial accountingpublished in the decade 1990-1999. The review focuses on the usefulnessof accounting information and the propensity of users to improperlyintegrate accounting information into their decisions . Prior researchfindings are organized in terms of the behavioral finance model offinancialdecision-making. The review of accounting behavioral research studiessuggests that the findings of prior work are disjointed and perhapscontradictory. There does not appear to be a stream of research on aparticular task, such as bankruptcy prediction, or a dominant researchparadigm such as the lens model, which literature reviews on earlierperiods were able to trace . Yet there is a strong theoretical basis forconsidering the role of individual behaviors in explaining the inability offinancial statement users to predict earnings and cash flows with relativeaccuracy . Additional research that systematically examines individual biascould contribute to an understanding of usefulness of accountinginformation in a decision context .

Advances in Accounting Behavioral Research, Volume 4, pages 3-24 .Copyright © 2001 by Elsevier Science Ltd .All rights of reproduction in any form reserved .ISBN: 0-7623-0784-6

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INTRODUCTION

A primary objective of financial reporting is to provide information that is usefulto investors, creditors, and other users in assessing prospective earnings andcash flows (FASB, 1980). Yet, the popular press and the financial accountingliterature provide ample evidence that some accounting information is not useful(AICPA, 1994; McEwen & Hunton, 1999) and that users of accountinginformation cannot assess prospective information with relative accuracy(Maines, 1995 ; Schipper, 1991). Research suggests that apparent deficienciesin the usefulness of accounting information may be due to informationalinadequacies, user behaviors, and combinations of these factors .

Informational adequacy has been studied in empirical settings under the eventstudy paradigm. Ball and Brown (1968) initiated a series of studies providingevidence that, in the aggregate, accounting information is useful to the financialmarkets. Under this methodology, markets are assumed to be efficient toinformation and deviations from efficiency are anomalous . In contrast to the eventstudy paradigm is the behavioral paradigm, under which anomalies are posited tobe the result of individual and sometimes biased human behaviors that aresufficiently pervasive to affect aggregate market prices (Shefrin, 2000) . Raghubirand Das (1999) suggest that introducing psychological antecedents into theanalysis of anomalies does not negate rational markets ; instead, the examinationof individual behavior provides a basis for explaining why these events occur .

Human heterogeneity and idiosyncrasy underlie cognitive and motivationalbiases in financial decision-making behaviors (Raghubir & Das, 1999) .

Cognitive biases are viewed as systematic deviations from a norm because ofan inadequate ability or opportunity to collect or integrate information, whilemotivational biases are attributed to self-created incentives that interfere withobjective evaluation of opportunities or risks . These human limitations inprocessing ability or motivation affect financial decision-making and are positedto affect the functioning of aggregate rational markets (Raghubir & Das, 1999 ;

Statman, 1999 ; Shefrin, 2000) .Bamber (1993) suggests that behavioral research in financial accounting

can contribute to an understanding of capital market anomalies by focusingon individuals in experimental designs that can control for cognitiveand environmental variables . Such investigations might also guide accountingpolicy, although some researchers question whether research on individualdecision-makers should influence accounting policy (Maines, 1994, 1995) .Proponents of this latter view argue that accounting research should be doneat the market level since the primary concern of accounting is the allocation ofwealth to productive uses, not the allocation of wealth among individuals .

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However, others suggest that market prices can reflect at least some systematicerrors in individual judgment (Raghubir & Das, 1999), thus motivating the studyof individual behavior in financial markets .

Prior research suggests that cognitive and motivational limitations also affectindividual financial decision-making using accounting information . Maines(1995) reviews studies of decision tasks and decision-makers using financialaccounting information focusing primarily on 1970s-1980s . She suggests thatresearch during that period contributed to our knowledge of accounting byproviding insights that could potentially improve the decisions of investorsand creditors . For example, lens studies suggest that a linear model could bedeveloped as a decision aid for investment and credit decisions and researchon group decision-making suggests that judgment accuracy improves withmultiple decision-makers .

The current paper examines the results of other studies into behavioralresearch in financial accounting, focusing on the usefulness of accountinginformation and the propensity of users to improperly integrate accountinginformation into their decisions . We focus our review on behavioral researchin financial accounting published in the decade 1990-1999 and we organizeprior research findings in terms of the behavioral finance model of financialdecision-making. We selected articles from the primary outlets identified byBamber (1993) including Accounting Review, Contemporary AccountingResearch, Accounting, Organizations and Society, Behavioral Research inAccounting, Journal of Accounting Research . We add Accounting Horizons,which Beresford (1994) offers as an example of one of the few journals thatpublishes articles considering ex ante financial reporting questions that couldhelp direct accounting policy .' Bamber's (1993) review of behavioral researchfound that behavioral research in financial accounting is fairly limited (in asurvey of 240 articles from 1987-1991, only 26 dealt with financial reporting) .We identify 41 articles relevant to this review over the period 1990-1999, whichsuggests that the publication of behavioral financial accounting research has notincreased over the past decade since Bamber's review period .

THE AGGREGATE VERSUS THE INDIVIDUAL

Much of the behavioral research in financial accounting is based in thebehavioral finance literature . In the behavioral finance model of financialdecision-making, asset pricing is assumed to be set in the aggregate by rationalinvestors. Mispricing is posited to be a function of individual bias . Thaler (1999)suggests that observed market behavior is often not consistent with what wouldbe predicted in a rational efficient market, but the anomalies that have been

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identified are not so large as to enable active fund managers, as a group, toearn abnormal returns.

Behavioral financial accounting can certainly be informed by behavioralfinance, but accounting and finance often generate different research questions .Behavioral finance tends to examine patterns in stock prices and trading, withoutmuch attention to the effects specific types of information have on decisions,except for information on price, risk, and return. Accountants, as informationproviders, focus more on the effects of accounting information on decisions .For example, Maines et al . (1997) focus on how segment definitions in theFASB's and IASC's standards affect analysts' perceived reliability of segmentdisclosure, confidence in their earnings forecasts and stock valuations, and

strength of their stock recommendations . The authors find that analysts perceivesegment reporting to be more reliable when external and internal segments arecongruent and when similar products are combined. Their study directlyexamines the usefulness of accounting information and provides standard setterswith ex ante information about a proposed standard .

Further, since financial statement users include creditors as a primary usergroup, considerable behavioral financial accounting is directed toward credit lend-ing decisions . Ashton and Ashton (1995) categorize primary users of financialaccounting information as current and potential investors and creditors (and theiradvisors), non-professional investors, professionals including sell-side analysts

(who provide investment advice to others) and buy-side analysts (who manageportfolios for institutional investors) . Ashton and Ashton (1995, 6-8) categorizejudgments associated with financial accounting information use and theirconsequences in two general ways. First, decisions often have substantial financialconsequences and the results of such decisions can extend beyond the primaryparties involved. For example, the authors note that a loan officer's decision torestrict a previously available line of credit could affect not only the company, butalso its employees, suppliers, and customers . Second, markets can mediate theeffect of an individual decision, thus the effects of accounting information onstock prices results from the interactions and decisions of many individuals .

Conceptually, then, the primary objective of accounting information is decisionusefulness, and the general usefulness of accounting information to individualcreditors and investors in financial decision-making tasks has been the subject ofa number of studies . While Davis et al. (1991) and Gopalakrishnan and Parkash(1995) reinforce the importance of accounting information in the decisions ofindividual loan officers, Bouwman et al. (1995) and McEwen and Hunton (1999)provide evidence that GAAP-based information is important to financial analystsin the investment screening process (although Williams et al . (1996) note thatbuy-side and sell-side analysts consider different informational items important .)

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Bricker and DeBruine (1993) use a computerized investment simulation toinvestigate the implications of risk-aversion on information acquisition andinvestment strategy selection . Their results demonstrate that price-taking, riskaverse subjects are willing to exchange returns for risk-reducing information.Further, market activity declines with increased costs and decreased information .The authors suggest that if most individuals are risk-averse, governmental regula-tion of financial disclosure, although costly, might be an economically efficientmeans of enhancing investor welfare .

These studies, and others, provide behavioral confirmation to the archivalmarket findings that accounting information is useful to investors in assessingfuture earnings and cash flows. In a more general assessment, Harding andMcKinnon (1997) investigate the views of accountants and investment analystsconcerning the decision usefulness of accounting information as part of a study onthe importance of user involvement in the standard setting process . The authorsinvestigate whether accountants hold congruent views on decision usefulness withusers (in this case analysts), which would seem to be a precondition if accountantsare to represent user groups in the standard setting process . The authors posit thataccountants are less likely to be favorably disposed toward a proposed accountingchange and less likely to view such change as useful if the change simplifiesreporting and reduces the accountants' ability to exercise professional judgment .In contrast, users such as analysts should not be motivated by the desire tomaintain the `mystique' of accountancy as a profession through the promulgationof complex standards . Interestingly analysts and accountants are largely congru-ent in their evaluation of the usefulness of suggested accounting changes . Hardingand McKinnon suggest that analysts are also professionals and may also bemotivated to preserve information complexity .

Lipe's 1998 study is a direct attempt to test the capital asset pricing model ona micro (individual) level . She examines whether individual investors useaccounting information and/or market measures of return variance and covariancewhen assessing risk and making investment decisions . Users are found to assessvariance and covariance of returns in investment decisions, but when conflictingmarket and accounting data are presented, accounting data drives assessments ofrisk. Lundholm (1991) uses a laboratory market to investigate the effect ofinformation structure on market efficiency. He examines the effects of aggregateuncertainty and the number of traders on market efficiency in differinginformation structures . Aggregate uncertainty reduces efficiency in markets withdiffering information signals ; however, efficiency is not affected in markets withidentical signals. His results suggest that researchers should specify expectationsabout the type of information asymmetry present in the market because the natureof the information structure affects market efficiency .

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Tucker (1997) also uses an experimental market to document the effects ofpublic disclosure on the consumption of private information in a noisy tradingsetting . (Noise arises because of cognitive limitations and uncertainty aboutother user's cognitive limitations.) Tucker finds that increases in the level ofpublic disclosure tend to decrease spending on private information . Further,private information is successful only in limited settings . Similarly, King andWallin (1991) use an experimental markets design to examine the incentivesfor voluntary disclosures . They cite theoretical predictions that privateinformation will be fully disclosed when the disclosures are credible andreceivers know that the holders have private information . Yet, full disclosureis not always observed empirically . The authors assume value to undisclosedinformation and suggest that much debate remains on the value of mandating

disclosure. Using the informedness-dependent model, they find that when the

receivers of information do not know whether senders possess privateinformation, senders will not fully disclose their private information .

The results of these studies all provide behavioral evidence that accountinginformation is useful to decision-makers. In a general sense, these studiesexamine usefulness in a variety of contexts and find that the amount and timingof financial disclosures affect financial decision-making . Given the presumedusefulness of accounting information, why are financial report users unable topredict with relative accuracy? We believe studies examining the effects ofcognitive and motivational bias on accounting judgments provide insights into

this question .

THE BEHAVIORAL FINANCE PARADIGM

Under the behavioral finance paradigm, general information processing modelshave been proposed to identify where biases may enter the decision processand ultimately lead to biased decisions . These models are based in a belief thatpeople form biased perceptions of the risk and return of a financial asset . Theterm `bias' is not used in a normative sense, but instead refers to judgmentsthat deviate systematically from models of rational economic decision-making .

Raghubir and Das (1999) classify biases as cognitive or motivational . Cognitive

biases are those affecting the mental processes of perception, reasoning, andjudgment, while motivational biases arise from self-created incentives thatinterfere with an individual's objective evaluation of an opportunity or risk(Raghubir & Das, 1999, 69). Examples of cognitive biases include :

(1) Perceptual biases of existing information including anchoring, inadequateadjustment, and differential attention to different aspects of data .

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(2) Retrieval biases of long-term memory, which influence the decision-makerto include past information that must be recalled from memory into adecision if it is more frequent, recent, negative, and extreme .

(3) Information integration biases from multiple sources including impropersampling, integration heuristics, incorrect weighting, attribution, andinappropriate inferences .

(4) Judgment criteria biases, which arise when only a few criteria are usedin a decision . These biases include general decision heuristics such asinformation cascades, representativeness, availability and anchoring, andadjustment.

Motivational biases are further classified as either direct or indirect . Direct biasesare those related to maintaining a particular self-image (ownership effects, illu-sion of control, overconfidence) and those related to a need to improve ormaintain positive affective states (optimism, regret avoidance) . Motivationalfactors can have an indirect effect on decision-making as well, by moderatingthe effect of perceptual biases . For example, in conditions where there is a highmotivation to make a correct decision, a person is more likely to make theeffort to overcome perceptual biases, such as inattention to information .

Similar to Raghubir and Das, Shefrin (2000) classifies the behavioral influ-ences of financial decision as heuristic-driven biases, in which financialpractitioners make mistakes because they rely on rules of thumb whenprocessing data, and framing bias, in which practitioners' perceptions of riskand return are affected by how problems are `framed' . Shefrin suggests thatmarkets are inefficient because heuristic-driven biases and framing can causemarket prices to deviate from fundamental values . One source of heuristic-driven bias is availability, the tendency of people to rely on information thatis most readily available . Raghubir and Das (1999) discuss availability as amemory bias . When people need to retrieve information from long-termmemory, they will base decisions on a sample of the most readily availableinformation and will be more likely to recall events that occur frequently orrecently, or that are negative (because base expectations are for a positive event),or are extreme . Other sources of memory bias include representativeness inwhich people base judgments on stereotypes ; anchoring-and-adjustment (peopleare conservative when adjusting initial estimates to reflect new information),and aversion to ambiguity, which creates a preference for the familiar .

Shefrin (2000) also discusses motivational influences on financial decision-making, including frame bias . Traditional finance assumes frame independence ;that is, a decision will not be affected by the way a problem is stated . Behavioralfinance assumes that the frame is part of the substance of the problem . Frame

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dependence can explain why people are risk-seeking when a gamble is seen asa loss and risk-averse when the gamble is seen as a gain (Kahneman & Tversky,1979). Framing also includes hedonic editing (Shefrin, 2000) in which peopleare posited to organize `mental accounts' . Under this bias, if faced with a loss,people will combine loss position with other gains and evaluate net gain . Iffaced with just gain situations, each opportunity to gain will be evaluated sepa-rately and people will be more willing to gamble . Thus, people prefer to frameproblems in such a way as to obscure losses .

A review of prior behavioral research suggests that both cognitive andmotivational biases affect assessment of accounting information in financialdecision contexts . Similar to the conclusions of behavioral finance researcherswho suggest that individual bias contributes to market anomalies, we believethat individual bias contributes to the inability of users to predict future earningsand cash flows using accounting information .

EFFECTS OF BIASES ON DECISION-MAKING :EVIDENCE FROM THE ACCOUNTING LITERATURE

Findings of previous research in accounting are generally categorized by thetype of bias implicitly or explicitly tested. We choose to categorize these studiesof bias using a behavioral finance framework .

General Information or Perception Biases (Initial Anchoring,Inadequate Adjustment, Differential Attention)

Raghubir and Das (1999, 64) define a perceptual bias " . . . as a systematicdeviation in the manner in which a person perceives a string of data as compared

with an objective description of those data ." Perceptual biases arise asindividuals look for patterns and trends that will help them predict and controltheir environment . They may also reflect insufficient ability to process availableinformation . Raghubir and Das (1999) include initial anchoring, inadequateadjustment for additional information, and differential emphasis on elements ofan information subset as types of perceptual biases .

SalienceIn a financial reporting context, studies that manipulate presentation ofinformation could be considered tests of perceptual biases. "In addition toproviding new or clearer cues, accounting contexts can direct differentialattention among existing cues . . . [thus initiating] a salience effect where

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`salience' refers to contextual emphasis rather than clarity ." (Haynes &Kachelmeier, 1998, 107) Several studies published in the past decade haveexamined the contextual effect on decisions .

Harper et al . (1991) experimentally confirm an inappropriate weighting ofinformation for commercial lenders who are provided with different reportingmethods for the liability associated with unfunded postretirement benefits . Usersare more likely to perceive the obligations as a form of debt when it is presentedas a liability rather than discussed in the footnotes . Sami & Schwartz (1992)note a similar reaction to the accounting treatment of a pension liability, findingthat balance sheet disclosure is more easily integrated than footnote disclosure .

In contrast, Davis et al . (1991) find no evidence that lenders' credit termsare affected by whether a firm uses defeasance or traditional debt extinguish-ment. The conflicting results suggest a need to consider whether an experimentaldesign is capturing just salience, or also some information effect . In the Harperet al. (1991) and Sami and Schwartz (1992) studies, there may be an informationeffect associated with liability recognition if subjects believe recognition carriesdifferential information on the certainty of cash outflows relative to footnotedisclosure .

Hopkins (1996) examines whether the classification of a hybrid security(mandatory redeemable preferred stock) affects valuation of a security bybuy-side financial analysts . He suggests that the balance sheet presentation ofnew hybrid securities can affect valuation judgments even for relatively sophis-ticated users of accounting information . In fact, he finds that analysts who arepresented with mandatory redeemable preferred stock classified as debt predictsignificantly higher stock prices than prices predicted by analysts who receivean equity classification . Hopkins results could also be attributed to the use ofjudgmental shortcuts . Rather than systematically integrating information by itsdiagnosticity, analysts may have just used a simple rule-of-thumb on the effectof new debt vs . new equity on stock valuation . Since there were no financialconsequences to the decision, the analysts may have been more prone to use aheuristic (Haynes & Kachelmeier, 1998) . Systematic integration of informationis more likely to occur when people are highly motivated to make an accuratejudgment.

Hirst and Hopkins (1998) experimentally examine whether disclosure ofcomprehensive income under SFAS 130 facilitates detection of earningsmanagement and affects analysts' valuation estimates . Since SFAS 130 is onlya format change (instead of a change in recognition or measurement rules), inan efficient market, user judgments should be unaffected . However, Hirst andHopkins note that usability is affected by clarity and availability ; thus analystjudgment will be affected to the extent that SFAS 130 enhances information

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availability and clarity . Specifically, the authors compare valuation judgmentsacross two presentation alternatives: comprehensive income reporting on anincome statement and comprehensive income reporting on the statement of

changes in equity . They posit that clarity is enhanced with income statementpresentation, and may be less understood using equity presentation . In general,they find that presentation affects judgment associated with share prices whenearnings management exists.

In summary, the context in which information is presented frequently appearsto affect individual decision-making . What studies generally cannot determineis whether what appears to be a context effect is a result of context beinginterpreted as information by subjects .

Inappropriate WeightingOne form of perceptual bias is people's tendency to place more weight onsubsequent information and to underweight base rates, relative to the weightingprescribed by Bayes' theorem . A fundamental premise of behavioral finance isthat this sort of cognitive bias may influence asset prices (Thaler, 1999) .However, field and laboratory experiments are not necessarily designed to detectwhether individual biases affect aggregate outcomes . In contrast, studies usingexperimental markets offer a means of examining the relationship betweenindividual behavior and aggregate outcomes .' Ganguly et al . (1994) examinethe base-rate fallacy associated with probabilistic judgment in the context of itspersistence in a competitive market setting . The authors confirm the tendency

of individuals to underweight base rates in favor of subsequent informationrelative to what would be prescribed by Bayes' theorem . Further, these biasespersist in a market setting, resulting in biased prices .

Since behavioral financial accounting research is concerned with creditors'decisions as well as investors, an investigation of inappropriate weighting canalso be framed in terms of its effect on a lending decision . For example, Holtand Morrow (1992) investigate whether bank lenders and auditors conform toBayes' theorem in assessing risk. Using a risk assessment task, Holt andMorrow's results demonstrate that auditors are more Bayesian than lenders andbecome more Bayesian with increased experience. However, the research designlimits conclusions that can be drawn to suggestions for future research for acausal explanation .

Behavioral financial accounting research has looked at other types ofinappropriate weighting of information as possible explanations for capitalmarket research demonstrating under-reaction to earnings information (Ball &Bartov, 1996) . Maines and Hand (1996) document an inappropriate weightingof the time series properties of quarterly earnings numbers . They note that

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individuals (in this study, MBA students) typically underestimate correlation indata and cannot detect low levels of correlation . Their findings suggest thatusers do not adjust sufficiently when the actual relation to historical earningsdeviates from an average value for the impact of autoregressive components .

Calegari and Fargher (1997) use a similar methodology to examine whetherbusiness students underestimate the autocorrelation in quarterly earnings whenforming earnings' expectations and whether asset prices are consistent withexpectations . They find that forecasts fail to converge to those predicted byrational expectations, even after many trading periods, indicating that individualforecast errors can influence experimental market prices . Although the researchcould not identify the source of the forecasting bias, results are consistent withan anchoring and adjustment heuristic . 3

Inappropriate weighting of information in some cases is attributed to theeffect of source cues (Raghubir & Das, 1999) . The perceived reliability of theinformation is affected by the source transmitting the information . Kaplan etal. (1990) provide evidence that management manipulation can affect theindividual user's impression of the firm . In an experimental setting, MBAstudents are influenced by the content of the president's letter for a poorlyperforming firm. The form in which the information is presented affects financialdecisions .

King's (1996) study investigates the extent to which information sendersdevelop reputations for truthful reporting and the resulting reactions to theirreport in an experimental market . Although he finds that senders are more likelyto report truthfully when misrepresentations are costly to receivers, and thatreceivers are able to discern truthfulness of reports over time, he does not findany evidence that truthfulness is rewarded economically .

Ghosh and Whitecotton (1997) associate higher perceptual abilities andtolerance for ambiguity with performance in an earning forecasting task . Theyfurther examine whether a decision aid moderates the effect of ability in earningsforecasting. They find that perceptual ability and tolerance for ambiguity arepositively related to forecasting performance . Further, neither experience northe decision aid minimizes the effects of perceptual ability on forecastperformance .

Memory Biases or Retrieval Biases (Frequency, Recency,Negativity, Extreme Results)

Our review identified only a few behavioral financial accounting research studiesthat focused on memory/retrieval biases . In a field experiment, Beaulieu (1994,1996) examines whether loan officers recall more decision-consistent and

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risk-consistent information when making loan decisions . Memory bias suggeststhat when information must be retrieved from memory, recall will be biased infavor of decision consistent information . Both accounting information and infor-mation about the character (credibility) of the potential borrower was provided .Beaulieu finds that consistency of accounting facts with loan decisions affectsrecall for both experienced and inexperienced loan officers, but that characterinformation actually interferes with the processing of accounting informationby less experienced lenders .

Kida et al. (1998) examine the process of accounting information retrievalfor managerial users of financial accounting information. They note thataffective reactions to data are more readily retrievable than the numerical valuesthemselves . Financial decision-makers will use affect in combining data, evenwhen detailed information is available from other sources .

Information-Integration Biases (Inappropriate Selection of Information,Negative-Positive Asymmetry, Use of Heuristic, Inappropriate Weighting of

Information, Attribution Bias, Inferencing)

Several behavioral financial accounting studies in the 1990s have examined theeffect of information complexity on information integration . Stocks and Harrell(1995) find that the level of accounting information complexity affectsindividual's ability to integrate the information into a judgment task (in thiscase, financial distress prediction by bank loan officers) . Increasing complexityaffects the judgment of the individual and at some level of complexity, theamount of information processed will diminish . The authors also look at thequality of group and individual judgments, and find that, consistent with theirexpectations, groups outperform individuals at both low and high levels ofinformation complexity, with the gap widening at higher levels of informationcomplexity .

In a related study, Tuttle and Burton (1999) consider whether limitations oninformation processing might be related to the rate at which processing occurs,rather than just the amount of information presented . They find that monetaryincentives increase the time spent on the task, which in turn results in higherinformation usage .

Bloomfield and Libby (1996) use a laboratory markets design to examinewhether differential availability of information affects prices, i .e. whether marketprices increase when unfavorable information is made less widely available .The study experimentally examines the completeness of reactions toinformation. The authors' findings are consistent with archival studies of marketreactions to financial statement information . The basis for the study includes

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both: (1) the belief that prices change because decision-makers rely too heavilyon widely available information, and (2) the belief that markets may imperfectlyaggregate less available information . Their findings are consistent withmanagements' claims that requiring the presentation of unfavorable informa-tion on the face of financial statements may reduce share price, independent ofthe concerns over reliability of the information .

Judgment Criteria Biases (Representativeness, Informational Cascades,Cue Source, Availability, Anchoring and Adjustment) .

RepresentativenessThe representativeness heuristic posits that probability judgments reflectpeople's expectation that a particular event is representative of a larger domain(Tversky & Kahneman, 1974) . This often leads to a failure to consider priorprobabilities and the effect of sample size, as well as misinterpretation aboutregression to the mean . In the finance literature, the representativeness heuristichas been used to explain why investors will be too optimistic about past winnersand too pessimistic about past losers (DeBondt & Thaler, 1985, 1987) . As aresult, past losers (winners) will be under (over) valued relative to theirfundamental values .

In behavioral financial accounting, representativeness has been tested in thecontext of bankruptcy prediction . The issue most commonly considered iswhether subjects can incorporate low failure base rates into probabilityjudgments, or whether they will overstate the number of bankrupt companiesin a sample . Maines (1995) reviews a stream of research on therepresentativeness heuristic and bankruptcy prediction done in the 1980s .Results of the studies reviewed are mixed with respect to the degree to whichsubjects appear to use a representativeness heuristic .

This stream of research has slowed, at least in the journals that we reviewed .Only one study, Van Breda and Ferris (1992) (also discussed in the Maines,1995 review) was identified . Van Breda and Ferris investigate whether priorprobability disclosures and the representativeness of the sample base rate affectbankruptcy prediction accuracy. They find that only representativeness has asignificant impact on the accuracy of bank lending officers, which suggests thatexperienced lenders do incorporate population base rates into probabilityjudgments .

Anchoring and AdjustmentAnother heuristic that can bias the manner in which people make decisions isthe anchor and adjustment heuristic (Tversky & Kahneman, 1974) . Anchor and

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adjustment suggests that people simplify decision-making by selecting an initialanchor, to which they then make insufficient adjustments as they receiveadditional information .

Although Ackert et al. (1997) do not explicitly consider anchoring andadjustment, results of their study on the willingness of decision-makers to

purchase biased forecasts suggests that people can adjust for biased informationif the bias is systematic (and in this case, upward) . Ackert et al . use studentsto assess the willingness of decision-makers to purchase biased forecasts . Theirfindings suggest that individuals recognize the usefulness of unbiased forecastsquickly, acquire them more frequently, and learn to use them to trade to theiradvantage. However, they also find that individuals who persist in acquiringbiased forecasts can learn to use the information regardless of the degree of

bias. Although subjects who acquire unbiased forecasts outperform subjects who

acquire biased forecasts, the performance difference between no bias and lowbias groups disappears over time . Only the high bias group makes insufficientadjustments for the systematic bias .

Motivational Biases - Confidence

Raghubir and Das (1999, 69) define motivational biases as "biases that arisefrom self-created incentives that interfere with an individual's objective

evaluation of an opportunity or risk." People may be motivated by certain goalssuch as the need to maintain a certain self-image or to feel in control . Oneexample of a motivational bias is overconfidence . The bias manifests itself indecision-making when people overestimate their control over chance events andunderestimate risk. For example, Maines (1990) notes that redundantinformation increases decision-makers' confidence without a correspondingincrease in the accuracy of their judgments .

Bloomfield et al . (1999) explicitly examine the overconfidence of lessinformed MBA students and the effects of guidance in reducing wealth transfersto more informed subjects . The authors posit that less informed subjects maytrade too aggressively at prices that are not informationally efficient, thustransferring wealth to more informed subjects at steady state prices . They find

wealth transfers occur, but that guidance can reduce the effects ofoverconfidence .

Selling (1993) distinguishes between overconfidence in a judgment task andoverconfidence in tasks involving selection and processing of information . Heexamines the effect of information choice on confidence in a bankruptcyprediction task and investigates the factors that contribute to overconfidence .

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Noting that individuals are more confident in their decisions than can be justifiedby objective reality, Selling's results generally support these behavioral theoriesof confidence for users of accounting information, conditional on taskpredictability. Subjects in the low task predictability condition are relativelyunaffected by factors such as experience and task feedback .

The effect of confidence on subjects' reliance on decision aids has also beeninvestigated in several studies . Whitecotton (1996) investigates the effect ofexperience, confidence, and agreement with the decision aid's predictionstrategy on reliance on decision aids in financial forecasting . Consistent withprior research, Whitecotton finds an inverse relation between confidence anddecision aid reliance, even though an analysis of subject accuracy suggests thatmost would have benefited by greater reliance on the decision aid.

Whitecotton and Butler (1998) show that decision-makers will place morereliance on a decision aid when they have input on the development of the aid.The authors extend Ashton (1990) by allowing participants the opportunity tochoose three of five ratios used as a decision aid. Although information choiceincreases decision aid reliance, that does not result in improved task performancesince few subjects select the ratios that provide the optimal decision aids .

Herding behavior is sometimes cast as an example of a motivational bias . Ifpeople are concerned about their reputations, they may follow the crowd becausethat is the easiest behavior to justify (Raghubir & Das, 1999) . Cote and Sanders(1997) examine variables hypothesized to influence herding behavior in a groupof long-term investors using accounting information to construct growthportfolios . They find that the decision to alter private beliefs to conform topublicly expressed opinions is influenced by confidence and by concern overpersonal reputation .

Motivational Biases - Financial Incentives

Perceptual biases may be less prevalent when there is high motivation to makea correct decision. Raghubir and Das (1999) note that in a condition of highmotivation, perceptual biases may be moderated because people change theamount of information sampled, the type of information sampled, the amountof attention paid to the information, and attention paid to noise or trends in thedata. However, research results on the effect of financial incentives ondecision-making in behavioral financial accounting have not been consistent .

Although Ashton (1990) provides evidence that financial incentives,performance feedback and a justification requirement all increase theperformance pressure on a decision-maker, the positive effect on performance

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can be undermined by the availability of decision aids . His laboratory

experiment requires that subjects predict Moody's bond ratings, using threefinancial ratios statistically related to Moody's ratings . Interestingly, whendecision aids are made available under the experimental condition of financialincentive with feedback and justification required, subjects display decreasedreliance on the aid and decreased accuracy, relative to performance in theabsence of the three treatments. Ashton suggest the results may reflect the taskcharacteristics and cites previous research demonstrating that subjects with hightask knowledge rely less on decision aids than less knowledgeable subjects and,therefore, under-perform less knowledgeable subjects . Yet, these studies did notincorporate the `real world' task environment faced by decision-makers . Ashtonprovides a research paradigm in which performance-based incentives motivatebehavior, performance feedback exists, and justification of one's decision is

required. He notes that these factors do not always have a positive effect ondecision-making and he finds that the directional effects of the three pressureinducers are moderated by the presence of a decision aid . 4

The Tuttle and Burton (1999) study discussed previously demonstrates thesignificance of including a monetary incentive in a decision task. Theyinvestigate whether information overload is a function of time as well as amountof information . They find that incentives do not affect the amount of informationused per unit of time, but that incentives increase the amount of time on thetask, and, hence, the amount of information used .

It is also possible for financial incentives to exacerbate bias when financial

rewards favor a biased result. One example is in earnings forecasts, where

analysts may be more optimistic about a firm if their employer has anunderwriting relationship with the firm that they are evaluating . Hunton andMcEwen (1997) experimentally confirm the effect of financial incentives onanalysts using accounting information in an earnings-forecasting task . Theirresults confirm that financial incentives exacerbate the tendencies of financialanalysts to provide optimistic forecasts of earnings . This finding suggests thatimproved usability of accounting information might not improve assessmentsof future earnings if financial incentives exist to overestimate earnings .

Multiple Sources of Bias

The preceding discussion has treated studies as if each were examining a singlesource of bias . However, Peters (1993) correctly notes that a decision-makermight apply several heuristics to a task . Describing and predicting behavior,therefore, requires a theory of how various heuristics might be combined or

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when a particular heuristic might dominate. Actually designing an experimentaltask that would test complex theories would certainly be very difficult todo since there would need to be large sets of independent variables and acorrespondingly large sample size .

It should also be noted that accounting judgment tasks are embedded inpervasive institutional settings (Ashton & Ashton, 1995, 7). The institutionalsetting in which decisions are made should not be ignored when designingbehavioral accounting research, since decisions may be context-specific . Forexample, Maines (1995, 77-78) suggests that organized stock markets may leadinvestors to view investment decisions as a zero-sum game in which theycompete with other investors . She provides evidence that the institutionalenvironment of professional investors creates incentives for decision-makers .Specifically, analysts' earnings forecasts could be influenced by revenuegenerated from brokerage business done by their firms, and access to privateinformation might be affected by a buy/sell recommendation . In such a setting,smart analysts are assumed to dominate the market . While this may be a validassumption for buy-siders, McEwen and Hunton (1999) provide evidence thatthis assumption is not necessarily valid for sell-siders .

CONCLUSIONS

Our organization of accounting behavioral research studies suggests that thefindings of prior work are disjointed and perhaps contradictory . There doesnot appear to be a stream of research on a particular task, such as bankruptcyprediction, or a dominate research paradigm such as the lens model, whichprior literature reviews were able to trace (Maines, 1995) . Yet, we find astrong basis for the role of individual behaviors in explaining an inability touse accounting information to predict earnings and cash flows with relativeaccuracy . Additional research that systematically examines individual bias couldcontribute to our understanding of usefulness of accounting information in adecision context .

Future studies also can contribute by expanding the methods used to inferanswers to questions of decision usefulness . One approach to expanding ourknowledge is found using experimental economics (Moser, 1998) as analternative to experiments that rely on psychological theory . The use oflaboratory markets as a tool in behavioral financial accounting research appearsto have expanded in the last decade . Many of the studies we reviewed usedlaboratory markets as their experimental setting . This provides an abstractexperimental setting, which is appropriate in testing predictions derived from

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well-specified economic theory . The goal of such research would be to try todevelop a framework for evaluating impact of context on decisions and providea basis for determining whether research objective would be enhanced bycontextually rich design, or whether a more generic approach to the task wouldbe more effective. Does it matter whether the task is described withaccounting-rich terminology?

A contextually rich setting can provide information for achieving the taskobjective (Haynes & Kachelmeier, 1998) . Context can add cues, although aricher context raises the issue of information overload and effect of outcomeknowledge . Context can also clarify meaning, although this effect has not beendemonstrated extensively in accounting studies . One example cited, Ganguly(1994) does note that analysts are more likely to demonstrate base-rate fallacywhen decision context was conceptually rich than when it was more abstract .Lastly, context can direct attention to particular cues, as in the Whitecotton andButler (1998) study on the effects of involvement in developing decision aidsfor using financial ratios in a bond rating task .

Beresford (1994) calls for more behavioral research as input to the standardsetting process, especially in the early stages of standard deliberations whenBoard is attempting to identify and frame financial reporting issues . However,he notes that results of studies of the same topic have not been consistent,which limits their usefulness as a guide to policy . There are often multipledifferences in study designs (subjects, information provided and judgment tasks)so the cause of the conflicting results cannot be determined . Second,experimental settings are often very different from real-world decision settings,raising questions of external validity of results (use of student subjects andfailure to include institutional factors such as incentives in the design) .Consideration must be given to the effects of cognitive and motivational biaseswhen designing a research study, since such biases can affect outcomes andmay be one cause of conflicting results . For example, do alternative forms ofpresenting what appears to be the same accounting information actually changethe information content of the accounting signal, or merely the salience of thesignal?

Standard setters, accounting researchers, accounting educators, and users ofaccounting information all can benefit from understanding the effects ofcognitive and motivational bias on financial decision-making . Some types ofbias can be moderated with education or other intervention while other typesof bias appear to be innate and can only be removed from the decision-makingtask by reducing reliance on human judgment (Raghubir & Das, 1999) .Additional research into moderating the bias associated with the use ofaccounting information will also prove to be beneficial

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NOTES

1 . We have selected those papers we believed to be most relevant to our classifica-tion system, so some papers which might be classified as behavioral financial accountingare not included in the review . We regret any inadvertent omissions .

2 . For example, Bloomfield (1996) uses a laboratory market to examine how the levelof market efficiency affects manager's use of reporting discretion, and how in turn,reporting discretion affects market efficiency .

3. The authors note that some sort of informational limits on rationality could alsoexplain the results .

4. Consistent with studies on over-confidence, Ashton's subjects overestimate theirability to make correct choices, which suggests that they may not use a decision aidbecause they do not think that they need one .

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