📒 Theories of financial accounting

Within Financial Accounting two mainstreams theories can be found. Normative and positive theories. Both are based on rationale motives.

Normative theories are descriptive; they recommend what should happen. It is not necessarily based on what actually happens in reality, but what it should be given its purpose. Typically normative theories are developed based on observations and research in the real world. The basis for this research comes from positive theories. Positive theories describe, explain or predict activities based on real observations.

Conceptual framework

For external reporting a conceptual framework exists. This framework, created by regulators, describe the rules for a valid and standardised report. It is a normative theory that describe the basic principles when creating an external report. It tries to answer the goal and most important users of the report, and what information they need.

Behavioural finance

The normative approach fits theoretically, but reality differs. Financial decisions made by managers might differ from the normative approach. Behavioural finance displays the behavioural influences that drive their decisions.

Kahneman and Tversky identified a series of behavioural pitfalls. Some of them are prevalent in the field of behavioural finance. Three categories of psychological phenomena are discussed:

• Biases
  • An aptitude toward error
• Heuristics
  • A rule of thumb
• Framing effects
  • Being influenced by the manner in which the decision task is framed.

Biases

• Excessive optimism
  • An overestimation how frequently they will experience favourable outcomes and underestimate how often they experience unfavourable outcomes.
• Overconfidence
  • People make mistakes more frequently than they believe and view themselves as better than average
  • There could be overconfidence about ability and knowledge
• Confirmation Bias
  • People attach too much importance to information that supports their views relative to information that runs counter to their views
• Illusion of control
  • People overestimate the extent to which they can control events

Heuristics

• Representativeness
  • People make judgments based on stereotypic thinking, asking how representative an object or idea is for the class it belongs
  • Example:
    • When you finally meet Sarah’s friends, John and Adam, you see that John wears glasses and is a bit shy, while Adam is more outgoing and dressed in a T-shirt and jeans. Without asking what they do for a living, you assume that John must be the mathematician and Adam must be the musician. You later find out that you were mistaken: Adam does math, and John plays music. https://thedecisionlab.com/biases/representativeness-heuristic/
• Availability
  • People overweight information that is readily available and intuitive relative to information that is less salient and more abstract, thereby biasing judgments.
• Anchoring and adjustment
  • People form an estimate by beginning with an initial number and adjusting to reflect new information or circumstances. However, they tend to make insufficient adjustments relative to that number, thereby leading to anchoring bias.
• Affect heuristic
  • Affect: an emotional feeling
  • Basing decisions primarily on intuition, instinct, and gut feeling

Framing effects

Framing is a critical aspect of prospect theory. Prospect theory is a general psychological approach that describes the way people make choices among risky alternatives.

• Loss aversion
  • Psychologically, people experience a loss more acutely than a gain of the same magnitude
• Aversion to a sure loss
  • People choose to accept an actuarially unfair risk in an attempt to avoid a sure loss.

Debiasing

The aforementioned phenomena are systematic and persistent. They are not only present in financial decision making, but in life in general. Debiasing turns out to be an enormous challenge. Recognising our errors and biases does not lead us to change our behaviour. People do can learn, but it happens slowly.

Groupthink

Groupthink is the tendency to seek concurrence in a group. By striving to avoid disagreements and debates within a group, particularly during decision making and discussions.. Irving Janis coined the concept in 1972.

The eight symptoms of groupthink are:

• an illusion of invulnerability, shared by most of all members of the group. Creates excessive optimism and encourages taking extreme risks.
• collective efforts to rationalise in order to discount warnings which might leads members to reconsider their assumptions
• an unquestioned belief in the group's inherent morality, inclining the members to ignore the ethical or moral consequences of their decisions
• stereotyped views of rivals and enemies as too evil to warrant genuine attempts to negotiate
• direct pressure on any member who expresses strong arguments against any of the group's stereotypes, illusions, or commitments, making clear this type of dissent is contrary to what is expected of all loyal members
• self-censorship of deviations from the apparent group consensus, reflecting each members inclination to minimise its own importance of doubts and counterarguments
• a shared illusion of unanimity concerning judgments to the majority view
• emergence of self-appointed mind-guards - members of the group that might shatter their shared complacency about the effectiveness and morality of their decisions.

Preventing groupthink can be done by:

• Assign the role of critical evaluator to each member, encouraging the group to air objections and doubts
• Assignments for policy-making groups should be given unbiased and impartial. Requiring the leadership to not state expectations and preferences when initiating the group
• Routinely follow the administrative practice of setting up several independent policy-planning and evaluation groups
• When alternatives are discussed the group should be split in subgroups to discuss the matter. Then coming together to hammer out differences
• Each member of the group should discuss the groups conversations with peer outside the group and bring back the reactions
• One or more outside experts outside the group should be invited to each meeting to challenge the views of the core members
• At every meeting one of the members should be appointed the role of Devil's Advocate.
• Reasonable time should be planned to survey warning signs from rivals.
• Before making a decisions, a new meeting should be planned where each member is expected to rethink the entire issue and recall all his residual doubts.