CH-13 Behavioural research in accounting – Accounting Theory : Book Guide

Chapter 13: Behavioural research in accounting THEORY IN ACTION Theory in Action 13.1The power of interest group perceptions 1. On what type of information would the ASA decide that a company board or chairperson should be censured for poor performance? According to the article, the ASA rates the relative performance of management and directors on the basis of returns to shareholders. This ignores past performance, industry-wide issues and the manipulation of accounting information (through timing and other accounting differences) in the calculation of returns. The ASA would have considered the overall business performance of management and the expected future returns based on the decisions of current management. In more recent times, the ASA, among others, has also focused on the link between company performance to executive share options and other forms of reward to managers. It has publicly attacked several high profile cases where the rewards to senior managers do not seem to be justified by their company’s performance. 2. What is motivating shareholders to operate as a group to censure company boards which do not appear to be managing the company in an appropriate fashion? Within Australia there is a growing number of small investors. They see that acting as a group will have greater influence on companies than acting in isolation. Obviously there is strength in numbers and this is, in effect, the only way they can actually influence the company. They are joining forces with a lobby group that benefits from support from shareholders, and in effect they seek the power and control associated with any lobby group. Given recent high profile corporate collapses, acting as a group is one means of enforcing good corporate governance. 3. Is the ASA concerned about corporate governance or raising its own profile to increase its membership and relative power? What type of value judgements did you make to answer this question? The ASA is an organisation in its own right. It has employees and elected representatives. Its activities are the net sum of the resourcing and power plays that operate within any organisation. It is funded based on performance and its profile among sponsor groups, such as minority shareholders. Its actions will be influenced by how they will attract support. The students should be asked to discuss whether the motivation of the ASA is evaluation of the performance of companies or identifying the issues that will maximise publicity and ongoing survival. In this regard, are they any different to the management of the companies they seek to review? Can they be truly independent? On the other hand, it would be too extreme to summarily dismiss the notion that the ASA is not genuinely concerned about good corporate governance. QUESTIONS 1. Consider a decision task, other than a bankruptcy prediction task, that uses accounting information (for example making recommendations for share investors). Assume that you are intending to conduct a Brunswik lens model experiment on your selected decision task. List seven information cues you think would be important variables to use in making your decision. Why did you choose these cues? Compare and contrast your list of information cues with a colleague. Discuss with each other the similarities and differences in your choices. Example 1 Event Information Cues Decision Maker ‘Will the Company pay a dividend this period?’ • Past dividend payments • Past dividend payout ratios • Budgeted operating results • Liquidity — Quickratio, Cash flow budgets • Quarterly operating results released so far in the reporting period • Past operating results • Current claims on the company’s liquidity/current liabilities Investors, investment analysts and advisers Example 2 Event Information Cues Decision Maker ‘Sell or hold an asset’ • Estimated useful life of asset • Significance of asset to operations • Impact of new technologies • Alternative uses of the asset • Present value of expected cash inflows or savings from the current asset • Current selling price for the asset held • Legal requirements — for example, is the asset needed for occupational health and safety, or to satisfy environmental laws? Company management division managers in which asset held Example 3 Event Information Cues Decision Maker ‘Should we loan money to the company?’ • Past credit history and present credit rating • Outstanding liabilities (current or non-current) • Past profits and cash flow statements • Budgeted operating results and cash flows • Current and projected interest rates • Liquidity ratios — Quickratio, T.TA:TL, working capital • Saleability and expected proceeds from assets: inventory, receivables financial instruments Bank managers; debenture purchasers Students should be encouraged to explain and justify the causal links between the cues they selected and the event of interest. The question could be extended by asking students to rank the relative importance of these cues and to justify their ranking. 2. Most human judgement research is undertaken in an experimental setting. How would you respond to the assertion that experiments cannot be generalised to the real world? What are the weaknesses and strengths of this research method? (Hint: See R. J. Swieringa and K. E. Weick, ‘An assessment of laboratory experiments in accounting’, Journal of Accounting Research, vol. 20, Supplement, 1982, pp. 56–93.) Swieringa and Weick (1982) identify two types of ‘realism’ of interest in accounting laboratory experiments: • Experimental realism. Are the laboratory experiments ‘believed’ by the subjects? Are these experiments attended to and taken seriously by the subjects? • Mundane realism. Are the laboratory events similar to real world events? Swieringa & Weick argue that all experimental research should have present experimental realism. However, in terms of the correlation of events and results to the real world, they identify several reasons why mundane realism need not be a prerequisite for laboratory experiment research designs. The following reasons are also strengths of the experimental method: • Experiments can be undertaken to create conditions that do not presently exist in the ‘real world’ of accounting practice to deal with ‘what if?’ issues — for example, effect of a change in disclosure requirements, change in valuation of assets. • The experimental setting enables the isolation of specific variables affecting a subject’s decision. Such factors are often difficult, if not impossible, to detect and/or isolate by observing ‘real world’ practice. • The experimental setting may reveal relationships between variables that are not readily observable in the ‘real world’ because of the influence of many other forces that may cloud the visibility of such relationships. That is, by making settings more real world, the experiments may conceal or remove much of which researchers wish to observe. A definition of behavioural research in accounting: ‘The study of behaviour of individuals as they are influenced by accounting functions and reports’. Studies are undertaken generally by observing people (individually or in groups) in either the field (the real world) or in an experimental laboratory setting. Often, to be able to explain and predict the influence of accounting upon decision-making processes, certain non-accounting influences need to be controlled or removed. When such other (non-accounting) influences exist, experimental research designs are necessitated. Similarly, to study the effects of accounting influences not yet observed in the field, experimental settings are required. There is a danger, however, that the experimental setting is too far removed from conditions in which accountants and auditors operate. That is, the effect of non-accounting influences on individual behaviour is so great that an experimental setting, while explaining and predicting the impact of accounting, cannot explain or predict real world actions and decisions that are largely determined or influenced by non-accounting influences. Nonetheless, provided that experimental realism is present, the experimental research design is a strong indicator of behaviour influenced by accounting. That is, experiments generally give a good indication of how we could expect decision makers and members of the profession to behave under certain conditions and given certain assumptions. 3. Use the probabilistic judgement framework to describe an accounting or auditing related decision task Students should be encouraged to think of examples in accounting or auditing in which they have to assess the likelihood of some event occurring. This occurs all the time in financial reporting when we are required by the Statement of Accounting Concepts or relevant accounting standards to apply the recognition criteria — for example, ‘probable’, ‘virtually certain’. All sorts of examples suggest themselves in this context — for example, the recognition of various liabilities and provisions, the extent to which provision should be made for bad debts, whether assets have been impaired, should research and development costs be carried forward. Students should be asked to identify what decision rule is to be used and what evidence and information cues might be important in making the probabilistic judgement decision. Another example is given of auditors’ determination of control risk assessment pertaining to the valuation of inventory. Prior research has found: • Ten per cent of inventory items are not valued according to the lower of cost or NRV rule • Probability that the internal control pertaining to inventory valuation will prevent an incorrect valuation of an inventory item is 94% • Probability that the internal control will identify and prevent a valuation which is correct is 7%. What is the probability that if the internal control in question identifies and prevents an incorrect inventory valuation, the item is in fact valued incorrectly? Posterior odds = Likelihood ratio  Prior odds Posterior odds = 0.94  0.1 0.07 0.9 = 1.492 Probability = 1.492/2.492 = 59.87% 4. Explain the implications for accounting if decision makers in an accounting context display any or all of the representativeness, availability, or anchoring and adjustment rules of thumb. The key thing for students to recognise in this question is that although heuristics are a practical means of coping with a complex world, their uncritical use can lead to less than optimal decision making on the part of accountants and auditors. This in turn increases the risk of financial loss and unfavourable legal consequences. • Representativeness. The base rate or model provided to decision makers is misused in many instances, or even ignored altogether. This implies that the usefulness of such ‘base’ information to decision makers is largely ignored and rarely used. Rather, auditors and accountants employ their own judgements and rules when making decisions. • Availability. Decisions related to ‘sensational events’, and the probability assessments thereof, are likely to be overestimated. For example, consider a financial report of a company. Most information indicates the firm is profitable and liquid. Now assume that a news story is aired that suggests an individual is seeking to sue the company. Users of the reports, particularly shareholders, may weigh this piece of information very heavily and assess the company as being close to collapse — even though no writ has been issued, no disclosure of the amount claimed, nor an assessment made of the grounds on which the claim is alleged and the likelihood of success. • Anchoring and adjustment. In the light of changed circumstances, insufficient adjustments are made. Assume that an auditor’s prior period control risk assessment (as very low) is used as the anchor for the current period’s assessment. Changes in the internal control structure of the client indicate a higher assessment is needed, but the auditor, using an initial very low risk anchor, does not adjust upwards enough. This low anchor may lead to ineffective and/or inefficient auditing. 5. Describe how (and why) the information processing systems of expert accountants might be different from those of accounting students. How might the expertise of experienced accounting practitioners be effectively passed on to accounting students? Experts appear to increase memory capacity by employing ‘standard’ models, checklists, strategies and trends, or representativeness heuristics to recognise a familiar pattern and prompt the recall of one such standard model or prototype from memory. From this model, the information given to an ‘expert’ is then compared to isolate deviations from the standard or expectation. Thus, experts need only to know or remember such strategies, models or checklists, and the constant use of such models improves the experts’ memory recall and ability to integrate learned models with current situations and faults. Furthermore, the more situations such models are applied to, and the more experienced the expert becomes, the easier it becomes to recall such models and recognise more diverse situations in which to apply such models. Experts clearly have had more time and experiences to assist them in developing their ‘expertise’ relative to most accounting students. Experts can pass on their expertise to students by mentoring, formal training sessions, seeking opportunities to broaden the range of experiences available to students (for example, auditing firms in different industries), and regular supervision of the work of the novice. 6. ‘Most people are not good intuitive statisticians.’ Discuss this statement in an accounting context, drawing on research using the probabilistic model. Probabilistic judgement theory and research suggests that most individuals are not good intuitive statisticians because tasks employing probability assessments and reassessments require multiplicative rules, such as Bayes’s Theorem, to be used. However, individuals do not readily ‘think’ multiplicatively, but rather use additivity or employ heuristics to simplify the task at hand. Students might be asked to think of specific examples (not necessarily accounting examples) of the accuracy of their own likelihood judgements (for example, will it rain today?, ‘how well will I do in the exam or assignment?’). What factors influence the accuracy of these judgements? Research in the accounting context of probabilistic judgement, particularly auditing, indicates that probability revisions are made by employing the heuristics of representativeness, availability, and anchoring and adjustment. Furthermore, research suggests that auditors tend to revise probabilities to a lesser extent in the light of changed circumstances than Bayes’s Theorem suggests, due to the use of heuristics and judgement bias that are adopted to simplify complex judgement tasks. For example: • Representativeness. Joyce and Biddle’s (1981) study of auditors’ judgements regarding the incidence of management fraud. Auditors did not consider the ‘base rate’ (basis of using Bayes’s Theorem is to consider explicitly the base rate or prior odds) sufficiently. • Availability. Maser (1989) found some environmental event pertaining to a particular company that led to disproportionate news coverage may systematically affect or influence the predictive judgements of investors. • Anchoring and adjustment. Joyce and Biddle (1981) found no evidence of anchoring and adjustment in auditors’ adjusting the scope of the audit following changes in internal control systems. Kinney and Uecker (1982) found evidence of anchoring and adjustment in analytical review and compliance test tasks. 7. Compare and contrast the efficient markets hypothesis and human judgement theory. Are they inconsistent with each other? Explain. Both the EMH and HJT deal with the production of accounting information and reactions to information. However, this is where any similarity between the two paradigms ends. The EMH focuses on the utility or information content of accounting information whereas HJT generally deals with the usages of accounting information by focusing on the input perspective of accounting. That is, accounting as an input in human decision-making processes. Furthermore, the EMH differs from the HJT in that the EMH deals with aggregate (‘on average’) behaviour of the capital market, whereas HJT deals with individual or group decision-making processes of reaching a decision with given information. Also, EMH focuses on behaviour of capital market participants only. HJT applies to all users of information. Rather than saying that the two perspectives are ‘inconsistent’ with each other, it might be more useful to recognise that they are complementary. EMH identifies ‘new’ information and then the reaction (if any) of stock prices to that news, but not what goes on in between those two events. HJT offers the possibility of learning how decision makers take the ‘new’ information and process it to arrive at their share price or valuation decisions (as ultimately reflected in their share market activity). The assumptions underlying the two theories also differ, as shown below: EMH/CMR HJT • Homogeneity of users’ expectations • Rational users • Efficient impounding of information into share prices • Does not assume correct or perfect usage and/or interpretation and/or presentation of information • Does not assume nor suggest optimal decision making and trading  Is accounting information useful? • Heterogeneity of users’ assessments • Irrationality of users allowed and controlled for • Imperfect use of information • Seeks to identify the processes by which information is analysed and judgements formed  How is accounting information used? 8. Does consensus always imply accuracy in studies of accounting decision making? Justify your answer. In the absence of a correct or model solution to a judgemental task, researchers within the sphere of accounting, and in particular auditing, assess accuracy in terms of a level of consensus achieved by subjects in a given judgement task. Consensus is argued to be indicative of accuracy, especially in auditing where a high degree of consensus is a desired characteristic between members of the profession. However, since accuracy in the absolute sense cannot be readily determined, the question of whether consensus will equal accuracy in judgement tasks is arguable. Studies such as Campisi & Trotman (1985), which looked at the level of auditor consensus in going-concern judgements, justify the use of consensus as a measure of the quality of the audit decision-making process. That is, even though consensus may not always mean accuracy, it is suggested that consensus, at a given point in time with a given set of facts among auditors, indicates that the judgement made at the time was ‘correct’. However, there is always a risk that consensus can mean consistently incorrect judgements as well as consistently ‘correct’ judgements. For instance, it may be that a group of auditors has all been taught the same methods for making internal control assessments. When asked to make their assessments in a particular case, all the auditors may apply the same method and arrive at the same judgement. However, if the method is flawed in the first place (for example, it consistently understates internal control risk), there may be a consensus but the auditors will be consistently wrong! 9. Why is a ‘model of human behaviour’ generally superior to human judgements? A model of man is essentially a mathematically developed decision-making model based on individual patterns of information use. Such a model is then applied to various analytical or judgement tasks. Because this model of man consistently applies the decision rules and weightings of information cues (it doesn’t tire or become bored and distracted), studies have found that such a model consistently outperforms the human ‘experts’ on whom it is based. This outperformance stems from the model of man being free from inherently ‘human factors’, which see inconsistent application of decision rules and emphasis or weightings placed on various pieces of information. Note, however, as in the solution to question 8, the superiority of the mathematical model relative to human judges does not necessarily mean that the model is error-free (if it consistently applies the ‘wrong’ rule). 10. What alternatives exist for improving the format and presentation of accounting information? What is the research evidence regarding the merit of the various alternatives? • Chernoff Faces. Moriarty (1979) found subjects using financial information represented diagrammatically by Chernoff faces outperformed a well-accepted financial distress model. However, Chernoff faces are not yet seen in practice as a ‘serious’ alternative form of presentation. • Tables and colour graphics. Blocher, Moffie and Zmud (1986) found that the effectiveness of different forms of presentation of financial information is a function of the amount of information presented to and processed by the decision maker. Graphic reports are better suited to low levels of task complexity. Tabular reports are better suited to high levels of task complexity. • Davis (1989). No form of graphical presentation is superior/better in all situations. • Desanctics & Jarvenpan (1989). The researchers found only a small or modest improvement in the accuracy of forecasting judgements associated with the use of graph formats. They suggest that this indicates that users have to go through an adjustment or learning process before graphical information becomes meaningful. • The above results confirm Wainer and Thiessen’s (1981) findings that no well-developed and tested theory exists that can be used to determine the circumstances under which different forms of presentation are most appropriate at least in part. • These findings are more recently confirmed in the So and Smith (2002, 2003) papers. 11. Human judgement theory does not purport to penetrate the ‘black box’ of cognitive processing. Verbal protocol research, however, has that ability. What are the strengths and weaknesses of this research methodology? (Hint: See G. F. Klersey and T. J. Mock, ‘Verbal protocol research in auditing’, Accounting, Organizations and Society, vol. 14, no. 1/2, 1989, pp. 133–51.) Strengths Weaknesses • Can trace the connection between the decision makers, decision process and the actual decision made or action taken, thus enabling researchers to understand subjects’ cognitive processes. • Good description of decision-making process • Findings enable tentative conclusions and recommendations to be drawn regarding: – the quality of subjects’ decision making – identification of decision rules for use in expert systems or to be taught to others in the profession – why a decision is reached – influences on the decision, other than the process and information considered. • Information derived regarding deliberately selected decision-making strategies is useful, but not for more initiative decision-making processes • Predictive ability re the use of decision-making strategies is low • Subjects may fabricate answers as to ‘how’ they reached a conclusion and assessed the evidence using prior knowledge of how the task ‘should’ be performed • Questionable statistical validity as typically small sample sizes are used • Difficulty in coding verbal responses • Time consuming nature of codification dictates use of small sample sizes. The comments in the above table need to be seen in the context of the level of the decision maker’s familiarity with the decision task. Research suggests that verbal protocols are typically incomplete for tasks with which decision makers are highly familiar because some of the decision steps are so familiar that they do not even recognise them when asked to explain their decision. On the other hand, where the decision makers are asked to describe their decision steps in a highly unfamiliar task, they tend to give far more comprehensive and explicit descriptions. 12. Reconcile normative accounting studies and human judgement theory. Normative accounting theories seek to prescribe what should be, whereas HJT and associated research seek to explain what is and what could be. That is, HJT can focus on explaining the effect of information disclosures, formats and presentations on a decision maker’s assessment of the information and conclusion reached. HJT, however, also deals with as yet unobservable accounting practices to consider the issue of ‘what would be the impact on users if this requirement were to be changed’? Furthermore, normative theory seeks to develop a ‘theoretical blueprint’ or prescription of what ought to be done based on what information users should need. However, HJT can be distinguished from the normative paradigm in that it looks to users to explain what users’ needs are — and then to observe the impact of various accounting practices and changes thereof to observe such information fulfils this need. One point of reconciliation between these two schools of thought is that HJT studies can be undertaken to handle ‘what if?’ questions. If the effect of the change studied indicates an improvement to the satisfaction of users’ information needs (as perceived by users), then there may be a normative argument that emerges to prescribe what should be, based on the results derived from experimental research in HJT. In this sense, HJT research ‘informs’ the normative decisions of accounting regulators. For instance, accounting standard setters usually have to make rules about what disclosure provisions should be included in accounting standards — HJT research could help tell the standard setters what types of information are the most informative or that facilitate their decision-making processes. A normative argument may then follow that such practice should be adopted. 13. Why do individuals form lobby groups to influence companies’ behaviour and information disclosures? What types of information would shareholder groups require to determine whether company directors should be censured for poor performance? Lobby groups are formed to influence the behaviour of lobby group targets. This may directly focus on the individual companies, on an industry or through political means by way of government and government regulations. Often the formation of a lobby group is a sufficient signal to garner change on the part of those responsible for disclosures or the actions of target companies. The level of response will depend on the perceived capacity of the lobby group to affect the firm. Responses to lobby groups are not costless and are considered carefully by the management of a firm. Individuals form lobby groups as their individual concerns are not considered. They do not rate as a stakeholder of interest — but as a group they warrant attention. The information sought to evaluate management will depend on the focus of the group. If the focus is equitable behaviour toward all shareholders, the focus will be on management’s activities with respect to majority or institutional shareholders compared to the minority shareholders. The focus may be on overall performance and future returns; it may be on environmental issues; or it may be on contributions to the community through the tax system. Lobby groups have every right to sanction performance inconsistent with their objectives, just as management has the right of response. Again the definition of poor performance will depend on the focus of the lobby group. It is perhaps worthwhile recognising that it will usually be the case that shareholder (or other lobby) groups will be less informed than managers (except, perhaps, after the fact when it is too late — consider Enron, for example). The question could be extended to ask students whether the provision of information to shareholder groups can realistically improve corporate governance or whether other mechanisms are as, if not more, important — for example, role of auditors. 14. What is more important for an organisation — the ‘right’ physical assets or the ‘right’ people? Explain. Both physical and human assets are essential to the effective operation of organisations. Without any physical assets, firms have no means of production or service delivery. But, the assets are purchased, applied and maintained by humans. If the physical assets are appropriate, but human capital is underskilled or lacks motivation, then the firm will not operate as well as if it had a skilled and motivated workforce. The same applies with respect to the assets of a firm. If they are not a good fit with respect to the activities of the firm, then the best human intervention will normally result in less than optimal performance. The research literature has tended to focus on the investments by firms in physical assets and in returns on those assets. The class might like to consider how we could value and measure the return on investment in people. Answers to this question should also focus on the growing importance of intangible assets that might, for some companies, form the majority of the ‘assets’. Many of these intangibles represent intellectual capital, but conventional accounting is highly limited in how it ‘captures’ the value of these intangibles in financial statements — for example, capitalised costs do not represent ‘value’. This issue could open into a discussion as to how accounting could be modified to reflect the value of intellectual capital. 15. Accounting is a function of human behaviour and activity. As such, is not all accounting research behavioural? Justify your answer. The answer to this question is a matter of theoretical perspective. Most research in accounting and finance focuses on measuring the readily measurable, and ignoring or assuming away all else. The readily measurable is usually the net product of human activity and interaction, such as return on assets and share price. In this sense, all accounting research is behavioural — the performance of the firm, the information measured and disclosed is a function of human judgements and application. As such, perhaps more emphasis should be placed on understanding the decision processes and the performance of individuals in generating economic returns. In a sense, we are engaging in an exercise in historical studies in that we observe past performance and interpret the factors underlying the performance of firms and the factors motivating reporting and disclosure practice. Have the class discuss how we could improve on our current knowledge of accounting choice decision making and perhaps design a research project to consider the issues discussed. Alternatively, students could be asked to compare and contrast HJT with EMH and agency theory. The latter two models may be interested in the consequences of behaviour (for example, share price or choice of accounting policy), but they assume a particular model of behaviour (that is, rational wealth maximisation). As such, they do not explain behaviour at all and so could be argued not to be behavioural research. 16. List nine or more factors that will influence the accounting system adopted by a firm and the information disclosed. Which of these factors are a direct function of human behaviour? There are any number of factors that will influence the accounting system adopted including: • technologies available • industry • management performance and compensation schemes • historical practice and market expectations • government legislation • requirements of the accounting profession • requirements of the stock exchange • relationship to other entities, both foreign and domestic • organisational reporting and management structures • requirements of debt providers and funding institutions. All of these factors are a function of human behaviour. A management accounting focus could also be adopted here by considering more explicitly the internal factors that shape an accounting system — for example, the performance measurement and reward or sanction processes; budgeting; control and the assignment of responsibility. 17. What is an industry specialist auditor? Will an industry specialist auditor always perform better than a non-specialist auditor? Explain. An industry specialist auditor is an auditor who audits clients from one particular industry all, or most, of the time. Most research evidence suggests that specialist auditors outperform non-specialist auditors in the specialist’s industry. However, outside that setting, specialists are unlikely to outperform other auditors unless their knowledge is generalisable. For example, if the new industry is similar to the specialist auditors’ ‘home’ industry, then we would expect the specialists to be able to utilise more of their existing knowledge in the new setting. If we placed a financial services industry specialist auditor and a retail industry specialist auditor on an audit of a manufacturing client, the retail specialist could be expected to outperform the financial services industry specialist if we consider retail to be closer than financial services in ‘type’ to manufacturing. A second consideration which is not addressed in the chapter is the extent of task knowledge (such as reviewing lease contracts) which are utilised in the audit. If specialist auditors gain such task specific knowledge in one setting they are likely to be able to utilise it in a new setting, regardless of the industry type. 18. What is the difference between independence in fact and independence in appearance? Which is more important? Professional and legal rules (for example, APES 110 Code of Ethics for Professional Accountants) require auditors to comply with the fundamental principles of integrity and objectivity and identify them as essential to maintaining independence. The principle of integrity imposes an obligation to be straightforward and honest in professional and business relationships. Integrity also implies fair dealing and truthfulness. Objectivity imposes an obligation not to compromise professional or business judgment because of bias, conflict of interest, or the undue influence of others. To comply with the independence requirement and auditor must have an independent state of mind and maintain the appearance of independence. Actual independence, or having an independent state of mind, means that the auditor will express a conclusion without being affected by influences that compromise professional judgment. An independent auditor will not fail to report a discovered misstatement in the client’s financial reports. An independent auditor could appear to be affected by influences that compromise professional judgment without actually failing to be independent. For example, an auditor who receives substantial non-audit service fees from an audit client may not allow the existence of those fees and the threat of losing them in the future to affect the decision to qualify the audit report. However, despite this, an outside observer could believe that the auditor has compromised the audit report. If investors lose confidence in the independence of the auditor and therefore do not rely on the audit report, the auditor is not able to provide assurance to investors. In this case, the share prices will not carry the premium normally present when investors believe that the auditor reduces agency conflicts and provides assurance about the quality of the financial statements. Case Study 13.1 Telstra opts for David Thodey as replacement for Sol Trujillo 1. Why would the Telstra board appoint an internal candidate to the position of chief executive, rather than an external candidate? This question is a good opportunity for students to reflect on what constitutes ‘expertise’. On the surface of the facts, David Thodey may seem like an unusual choice given that his proposed management changes are unknown. However, when the facts are considered in more detail, his selection might be more understandable given that he is likely to move quickly to end the acrimonious relationship that has developed between the company and the government. The article notes that Mr Thodey does not have a close relationship with key government ministers and has the political advantage of not being associated with his predecessors aggressive strategy against government. 2. Why might David Thodey have been preferred to other internal candidates one of whom had finance experience and the second of whom had other telco industry experience? As implied in the answer to question 1, having no association with government minister would be a decided advantage when it came to negotiating the proposed $43 billion national broadband network. Mr Thodey would bring a ‘fresh’ perspective to the situation at Telstra and would not be burdened by an association with its past history. An internal appointment might also be a source of inspiration to Telstra employees if he was to offer hope of a successful financial turnaround. 3. The article reports that David Thodey had internal experience. How might his skills set have changed during his time with Telstra and what might have been his main means of learning new skills? Early in his career, Mr Tilton’s skills would likely have been relatively narrow. However, as he rose through the ranks, higher positions would have brought with them more responsibility and a requirement to take a more strategic and ‘broad brush’ approach to his job. As CEO, it is very unlikely that he would be concerned with the minutiae of the day-to-day running of a firm (although this may be necessary to some extent in the case of turning around a firm in financial crisis). Rather, he would be responsible for setting the broad strategy and direction of a company and overseeing its operations. As a result, his skills set would now be very different, with an emphasis on things like strategic management, planning and people management. Many of these skills he will have learnt on the job, either through direct experience or by being mentored (‘groomed’) by other managers. It is likely that he would also have developed some of these skills through formal professional development, such as an MBA or short courses. 4. Describe the complex environment in which Telstra is operating and identify the particular skills that the new chief executive might be able to use to influence that environment. Telstra is operating in a dynamic environment where it is facing enormous pressure from government to participate in the development of a national broadband network. It must balance this government strategy with the need to provide shareholders the best return on their investment and the public with an affordable and high quality service. Telstra is a large organisation and its performance is closely scrutinised by investors and the general public. Its chief executive office must be able to balance government, public and shareholder pressure. This would require the CEO to have technical experience or be able to select experts in the area on whom he could rely. Further the CEO would require excellent negotiating skills and much patience as the discussion between the firm and government are likely to be protracted and at times acrimonious. Case Study 13.2 Reporting season’s moment of truth 1. If cash is the best measure of success, why have the accounting profession and regulators persevered with analysing debt-to-equity ratios? There is far less discretion as to the timing of disclosures under the cash flow model. Adoption of cash flow can distort earnings and reduce the capacity of management to smooth income. Arguably however, accrual accounting may allow investors to form unbiased or more informed judgements about the long-term prospects of a company, or accrual-accounting-based information cues may be better predictors of future cash flows than current cash flows. The debt-to-equity ratio provides a different perspective that is still linked to cash flows. It considers the total level of debt compared to the total level of finance provided by equity and allows for an evaluation of the ability of the firm to service its level of debt. 2. What do the analysts mean by the term ‘nasty surprise’? A ‘nasty surprise’ is reported earnings or some other accounting measure that have not been anticipated (or fully anticipated) and have the potential to adversely affect the future cash flows or other aspects of the operations of a firm. 3. Why does the market so readily interpret a cash-flow problem as a sign that a company’s financial position might be deteriorating but was apparently prepared to focus on debt-to-equity ratios for a number of years? The literature indicates that the market is not ‘fooled’ by the debt-to-equity ratios – that the market adjusts in order to provide a measure of actual value. Markets can still be wrong (‘fooled’) in their assessments of companies of course — if there is fraud or unexpected risk. Focussing on the debt-to-equity ratio might lead some to interpret a company as being an efficient manager of financing opportunities. However, cash flow analysis is also important as it provides an opportunity to assess whether a firm is able to adequately service escalating levels of debt. 4. The article refers to the need to ‘sort the wheat from the chaff’ by focusing on companies that are coping well. How are such judgements made? Expectations about good or bad investments are based on a range of factors including: • industry trends and past performance • current and expected factors impacting on the industry and the individual firms • statements made by the firm about expected performance • media commentary • past performance of the firm • independent evaluations by analysts • statements by the ASX. Research has the potential to help us understand the process and information cues by which these expectations are formed (at least at the level of individual investors). Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152