Mark Nelson, Comment: Evaluative Techniques in Consumer Finance--Experimental Results and Policy Implications for Financial Institutions, The Journal of Financial and Quantitative Analysis, Vol. 9, No. 2 (Mar., 1974), pp. 285-286

The performance of audit tasks has been modeled as a function of the auditor's ability, knowledge and experiences (Libby 1993). Thus, an important aspect of assigning audit tasks is identifying the levels of knowledge and types of experience an auditor must have to achieve a sufficiently high level of performance (Abdolmohammadi and Wright 1987). An objective of the current study is to determine whether auditors' knowledge of basic accounting principles and error frequencies improves over the course of their early careers so as to enhance performance of a common analytical procedure, ratio analysis. Research in psychology suggests that two characteristics of a task (say, analytical procedures) could diminish the accuracy with which auditors learn error frequencies from experience and apply their knowledge to a task. First, auditors' memories of financial statement errors are encoded while they perform other information-processing activities. These competing task demands could use enough of an auditor's information-processing capacity to diminish both the accuracy with which memory traces of errors are encoded and the accuracy of their knowledge of error frequency (Naveh-Benjamin and Jonides 1986). Second, auditors must consider a variety of evidence when performing analytical procedures. In diagnostic tasks like ratio analysis, inordinate attention is given to evidence that is highly diagnostic of low-frequency events, causing an "inverse base rate effect" in which auditors consider such events as more likely (Medin and Edelson 1988). Assessing the extent to which either of these characteristics of the analytical procedures context prevents auditors from learning and applying error frequency knowledge is a second objective of this study. To test hypotheses about these objectives, an experiment is conducted in which experienced auditors, accounting students, and nonaccounting students learn the frequencies of financial statement errors through their experience in solving a series of problems using ratio analysis. Subjects are then tested for their accuracy in using frequency information by having them diagnose novel combinations of the same evidence. Other subjects perform similar tasks for an abstract medical diagnosis to provide a benchmark for comparison. The results indicate that differences in accounting knowledge influenced the subjects' performance of ratio analysis, and that neither potential source of inaccurate learning of event frequency knowledge holds in this setting. That is, subjects learned frequencies in the presence of competing task demands, and the inverse-base rate effect was not observed. These results suggest that experienced, but not novice, auditors use both their superior knowledge of accounting and of error frequencies learned through experience. Another implication is that the performance of novice auditors may be improved by increasing their knowledge of basic accounting principles and error frequencies.

ABSTRACT This paper examines interpretation of accounting standards that provide implementation guidance via affirmative or counter examples. Based on prior psychology research, we predict that practitioners engage in “example‐based reasoning” such that they are more likely to conclude that their case qualifies for the same treatment as the example. We test our predictions in two experiments in which participants judge the appropriateness of income‐statement recognition. Experiment 1 uses Masters of Business Administration (MBA) students and varies example type (affirmative, counter) and case (revenue recognition, expense recognition) in a 2 × 2 design. Experiment 1 supports our predictions. Experiment 2 uses more experienced practitioners, and varies example type (affirmative, counter, both) in a 1 × 3 design. Experiment 2 supports the use of example‐based reasoning, and indicates that practitioners in the “both” condition respond as if they had only received an affirmative example. These results have implications for understanding how guidance that accompanies accounting standards can result in aggressive or conservative application of standards.

Loss contingencies, Expectation gap, Auditor judgment, Preresolution information

We report on an experiment in which experienced auditors (1) determine whether to allow a client to adopt an aggressive reporting method when the auditors have an incentive to do so, and (2) justify aggressive reporting by their interpretations of financial accounting standards. In the experiment, the appropriate reporting method depends upon whether an amount can be "reasonably estimated" as that term is used in an applicable accounting standard. The accounting standard relevant to determining the appropriate reporting method was manipulated between subjects (thus varying whether judging that an amount can be reasonably estimated would justify an aggressive or conservative method), as was engagement risk. The results indicate that the auditors responded to moderate engagement risk by permitting the aggressive reporting method and justified their choice with aggressive interpretations of accounting standards. When faced with high engagement risk, the auditors responded by requiring conservative reporting and justified their choice with conservative interpretations of accounting standards.

Dichev, Graham, Harvey and Rajgopal (DGHR, in this issue) survey chief financial officers (CFOs) to elicit their views on earnings quality, broader trends in financial reporting, and the prevalence of earnings management. They provide some interesting insights on these issues. We discuss how CFOs' incentives in the financial reporting process are likely to affect what we can learn from them about earnings quality. We also discuss how DGHR's methodological choices regarding survey sample and question design affect their inferences, including what we can infer about the prevalence and magnitude of earnings management.

ABSTRACT We report the results of two experiments that provide evidence that investors' risk judgments are affected by the numerical format used to describe outcomes within accounting disclosures. Consistent with prior research in psychology, investors assess higher risk in response to dollar-formatted disclosures than to equivalent percentage-formatted disclosures. Consistent with the Persuasion Knowledge Model (Friestad and Wright 1994), this effect is moderated when investors have both (1) awareness that management has discretion over format, and (2) sufficient cognitive capacity to consider its implications. Our results provide insight about the effects of current disclosure formats and suggest implications for managers who choose formats, investors who interpret formatted information, and regulators who consider whether to further prescribe the formats that are used in financial disclosures.

This paper reports the results of an experiment that examines the influence of uncertainty about the probability that a future loss will occur ("ambiguity") on auditors and financial statement users' judgments about appropriate reference to contingent losses in audit reports. Application of Einhorn and Hogarth's (1985) ambiguity model suggests that, with respect to losses of tow (high) probability, both auditors and users will act as if an ambiguous probability of loss is higher (lower) than a precise probability of the same magnitude, thus demonstrating a conservative (unconservative) reaction to ambiguity. In addition, since auditors may jeopardize client relations when they unnecessarily make audit report reference to contingent losses, auditors may react less conservatively to ambiguity than do users. The results of the experiment support these predictions.

This paper reports the results of an experiment that examines the influenceof uncertaintyabouttheprobabilitythatafuturelosswilloccur (ambiguity) on auditors' and financial statement users' judgments about appropriate reference to contingent losses in audit reports. Application of Einhorn and Hogarth's (1985) ambiguity model suggests that, with respect to losses of low (high) probability, both auditors and users will act as if an ambiguous probability of loss is higher (lower) than a precise probability of the same magnitude, thus demonstrating a conservative (unconservative) reaction to ambiguity. In addition, since auditors may jeopardize client relations when they unnecessarily make audit report reference to contingent losses, auditors may react less conservatively to ambiguity than do users. The results of the experiment support these predictions.