Applied Research in Financial Reporting: Text and Cases

1
Applied Research in Financial Reporting Text and
Cases

• Chapter 7
• Judgment and Decision Making in Accounting

2
Presentation Plan

• Objectives
• JDM Definition
• JDM in Accounting
• JDM Models
• Brunswik Lens Model
• Simons Model of the Decision Process
• Summary

3
Objectives

• Meaning of judgment and decision making in
  accounting
• Relevance of judgment and decision making for
  various types of accounting
• Usefulness of judgment and decision making models
  in accounting
• The Brunswik Lens Model as a conceptual learning
  model of judgment and decision making in
  accounting

4
Objectives

• Applications of Simon's Model of the Decision
  Process in accounting
• Relationship between task characteristics and
  knowledge base for judgment and decision making
  in accounting
• Knowledge management the relationship between
  task characteristics and knowledge base for
  judgment and decision making in accounting

5
JDM Defined

• Judgment is the formation of an opinion after
  consideration or deliberation of facts.
• Influenced by
• Knowledge
• Experience
• Cognitive abilities (e.g., intelligence)
• Skills (e.g., communication skills)
• Decision making is acting on the judgment

6
JDM Defined

• Also called
• Behavioral decision theory
• Human information processing
• It provides
• Descriptive models of behavior
• Normative models of behavior
• Measures of judgment quality

7
JDM in AccountingExhibit 7-1 7-2

• Applies to all areas
• Auditing
• Managerial
• Financial
• Systems
• Tax

8
JDM Models

• The Brunswik Lens Model
• A framework to describe JDM
• It represents an individuals judgement (Ys)
• Based on the utilization of information cues
  (Wsi)
• On various variables (Xi)
• Leading to a decision that can be compared with
  the actual result (Ye)
• Using the right weights for information cues
  (Wei).

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The Brunswik Lens Model
10
The Brunswik Lens Model

• Bankruptcy prediction is an example
• Information cues (Xi) are accounting data
• Cue utilization weights require
• reliable accounting information
• Cue validity weights require
• consistency of accounting information over time
• comparability between companies
• Comparing your cue utilization weights with
  recruiters cue validity weights is another

11
Simons Model of the Decision Process

• Phases of the Decision Process (Exhibit 7-4)
• Intelligence
• Design
• Choice

12
Simons Model of the Decision Process

• Decision Phases and task Characteristics (Exhibit
  7-5)
• Structured Tasks
• Intelligence Problem is well defined
• Design Alternatives are well-specified
• Choice Requires no judgment or very little
  judgment

13
Simons Model of the Decision Process

• Decision Phases and task Characteristics (Exhibit
  7-5)
• semistructured Tasks
• Intelligence Problem is reasonably defined
• Design Alternatives are limited, but specified
• Choice Requires some judgment

14
Simons Model of the Decision Process

• Decision Phases and task Characteristics (Exhibit
  7-5)
• Unstructured tasks
• Intelligence Problem is ill-defined
• Design Alternatives are numerous
• Choice Requires judgment and insight

15
Simons Model of the Decision Process

• Decision Makers Attributes (Exhibit 7-6)
• Knowledge
• Psychological Traits
• Cognitive Abilities
• Decision Strategies
• Task Analysis

16
Decision Aids and Simons Model (Exhibit 7-7)

• Complete Automation
• Decision Support Systems
• Knowledge-based Expert Systems
• Strictly Human Processing

17
Knowledge Management

• Defined KM is the discovery, documentation,
  dissemination, evolution, and application of
  knowledge
• An old concept with new importance because of
• Globalization
• Multiple offices of the company
• Information technology

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Knowledge Management

• Components of KM
• Knowledge base
• People
• An information technology system
• A process

19
Simons Model of the Decision Process as a KM
system (Exhibit 7-8)

• Structured tasks can be performed by staff
• some can be completely automated
• semistructured tasks require requisite knowledge
  of a novice
• some can be performed using DSS
• Unstructured tasks require expertise
• some can be performed using DSS KES

20
Essex Manufacturing Facts

• Closely-held company with the chairman, Mr.
  Agree being majority shareholder and his
  immediate family owning the rest
• Has internal control weaknesses and Mr. Agree
  draws money to support his extravagant lifestyle
• Significant operating loss for 20X1 as compared
  to marginally profitable prior year, but has
  plans to expand

21
Essex Manufacturing Facts

• Essex defaulted on its long-term debt, and was in
  violation of several long-term debt covenants,
  but re-negotiated the loan for 20X2
• Mr. Agree is concerned that cash flow from
  operations in 20X2 might not be sufficient to
  make additional principal payments to the bank as
  agreed

22
Essex Manufacturing Facts

• Essex is planning on a capital expenditure of
  300,000 in 20X2 to be funded by IRS refund from
  the 20X1 operating loss carry-back
• Depreciation expense for 20X2 is 500,000
• Financial statements indicate cash-flow problems.

23
Essex ManufacturingRequirement 1 The Going
Concern JDM

• Going Concern Task (GCT) is a complex task.
• It has two characteristics of the semistructured
  tasks in Simons Model of the Decision Process
  (Exhibit 7-5)
• Intelligence Phase the task is reasonably
  well-defined
• Design Phase Alternative courses of action are
  limited and well specified

24
Essex ManufacturingRequirement 1 The Going
Concern JDM

• The Choice phase requires significant judgment
  and insight, which indicates that the going
  concern task is an unstructured task
• In two separate research studies over an
  eight-year period, managers and partners from
  various accounting firms assessed the task at the
  border line of semistructured and unstructured
  tasks.
• Generally, partners with an average of 6.9 years
  of experience, and 5.8 times of supervised
  instances of practice are needed to perform the
  GCT
• Strict human processing (and may be expert
  systems) is needed to perform the GCT.

25
Essex ManufacturingRequirement 2 The GCT
Considerations

• Per ARB No.43, Chapter 3, Section A, paragraph 2,
  "financial statements of a going concern are
  prepared on the assumption that the company will
  continue in business."
• When there is uncertainty about an entity's
  continued existence, SAS No. 59 specifies the
  auditor's responsibility.

26
Essex ManufacturingRequirement 2 The GCT
Considerations

• According to SAS No. 59, paragraph 1,
  "Continuation of an entity as a going concern is
  assumed in financial reporting in the absence of
  significant information to the contrary
• The entity's inability to continue to meet its
  obligations as they become due without
  substantial disposition of assets outside the
  ordinary course of business, restructuring of
  debt, externally forced revisions of its
  operations, or similar actions."

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Essex ManufacturingRequirement 2 The GCT
Considerations

• SAS No. 59 uses the same examples as SAS No. 34
  to describe conditions and events that may
  indicate a going concern problem as well as the
  mitigating factors
• Examples are
• Negative trends such as recurring operating
  losses, working capital deficiencies, negative
  cash flows from operating activities, adverse key
  financial ratios.

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Essex ManufacturingRequirement 2 The GCT
Considerations

• SAS No. 59, paragraph 7 refers to management's
  plans to deal with the adverse effects of events
  and conditions such as
• Plans to dispose of assets
• Plans to borrow money or restructure debt
• Plans to reduce or delay expenditures
• Plans to increase ownership equity
• SAS No. 59 defines a reasonable period of time in
  paragraph 2 as "not to exceed one year from the
  date of the financial statements being audited."

29
Essex ManufacturingRequirement 3 Essexs
Financial Reporting

• Loss of 500,000 from a declining sale of
  10,000,000 in 20X1
• Fixed manufacturing costs increased in 20X1
• Essex is planning on adding another 300,000
  plant in 20X2
• January, 20X2 sales are below those of January
  20X1, Essex's leading month for sales volume.
• Essex had a negative working capital of 1.4
  million and was in violation of several long-term
  debt covenants with Bank.

30
Essex ManufacturingRequirement 3 Essexs
Financial Reporting

• A review of several key financial ratios
  indicates cash flow problems
• Current ratio .441
• Acid-test ratio .201
• Working capital deficiency 1,400,000
• Gross margin 28
• Debt to total assets 81
• It does not appear that Essex will be able to
  meet its short-term obligations unless it is able
  to restructure its bank debt and work out a
  payment schedule or obtain concessions from other
  creditors.

31
Essex ManufacturingRequirement 3 Essexs
Financial Reporting

• In the actual case, the auditors concluded there
  was substantial doubt about Essexs ability to
  continue as a going concern because
• Essex paid scant respect to internal control
  systems
• Lack of effective management of operating costs
  while faced with declining sales in a period of
  economic slowdown.
• Mr. Agree's commitment or ability to reverse
  Essex's present condition was in doubt.

32
Essex ManufacturingRequirement 3 Essexs
Financial Reporting

• SAS No. 59 requires an explanatory paragraph when
  auditors determine there is a substantial level
  of doubt about going concern
• The explanatory paragraph is placed following the
  opinion paragraph in the auditors report.