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 • Simon’s 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 individual’s 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).

9. 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. Simon’s Model of the Decision Process • Phases of the Decision Process (Exhibit 7-4): • Intelligence • Design • Choice

12. Simon’s 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. Simon’s 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. Simon’s 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. Simon’s Model of the Decision Process • Decision Makers’ Attributes (Exhibit 7-6): • Knowledge • Psychological Traits • Cognitive Abilities • Decision Strategies • Task Analysis

16. Decision Aids and Simon’s 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

18. Knowledge Management • Components of KM: • Knowledge base • People • An information technology system • A process

19. Simon’s 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 Simon’s 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."

27. 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.

28. 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: Essex’s 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: Essex’s Financial Reporting • A review of several key financial ratios indicates cash flow problems: • Current ratio .44:1 • Acid‑test ratio .20:1 • 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: Essex’s Financial Reporting • In the actual case, the auditors concluded there was substantial doubt about Essex’s 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: Essex’s 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 auditor’s report.