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Summary Judgment & Decision Making in Accounting (UVA)
Summary of 43 pages for the course Judgment & Decision Making In Accounting at UvA
[Meer zien]Voorbeeld 4 van de 43 pagina's
Voorbeeld 4 van de 43 pagina's
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Voorbeeld van de inhoud
Judgment & Decision Making in AccountingWeek 1: Introduction Normative Decision Making
- Normative versus descriptive models
o What does it mean to be ‘(ir)rational’
- Expected-Utility Theory
- Probability and Bayes’s theorem
Judgement & Decision making in accounting
- Judgment:
o Attaching a value to something
o Estimates, evaluations, opinions….
- Decisions:
o Choosing between alternatives
Both aspects decisions and judgments are closely related
The production of accounting information
- Depreciation method for a class of assets
- Residual value and lifetime of an asset
- Valuation of an intangible asset
- Classification of an asset or liability
- Reporting requirements for organizational units
- Layout of performance reports
The certification of accounting information
- Materiality
- Risk of material misstatement
- Analytical procedures
- Complex estimates
- Going concern
The Use of accounting information
- Owners and investors
o Estimate future cash flows
o Decide to sell or buy shares
- Financial Analysts
o Estimate future cash flows etc.
o Make Buy / Hold/ Sell recommendation
- Creditors
o Estimate default risk
, Judgment & Decision Making in Accounting
o Decide about loans, interest rates, etc.
- Managers and other employees
o Estimate the likely consequences of alternative courses of action
o Make business decisions
o Evaluate the performance of units, teams, and individuals
- Government
o Examples: Tax, regulation, licenses, permissions, the integrity of financial reports,
macroeconomic planning, etc.
- Suppliers and Customers
o Judge liquidity, solvability, etc.
o Contracting decisions
Judgment and decision making consists of three different types of decisions, These are:
1. Normative decision making
How people should be making judgments and decisions
2. Descriptive decision making
How people actually make judgments and decisions
3. Prescriptive
Practical suggestions on designing judgment and decision-making processes based on
normative and descriptive models
1. Normative decision making
- How we should make judgments and decisions
- How do we distinguish between a good and bad choice?
- A deeply philosophical question
o What should we be trying to achieve? “Moral intuition” (Rawls); religion;
o What does it mean to make a decision? Philosophical determinism
- A normative decision is a rational process, so how things should be done:
- Use all available information in an optimal way to maximize the expected net outcome
The most accurate judgment possible
The best choice possible
Baron (2004):
- Any normative model needs to start from the simple idea that some outcomes are better than
others.
- No claim about absolute truth, but “truth relative to assumptions” (the assumption that
something is better than the other thing)
- Normative models arise through the “imposition of an analytic scheme”
Six steps of a “rational” decision-making process
1. Define the problem. The problem has been fairly well specified in each of the four scenarios.
However, managers often act without a thorough understanding of the problem to be solved,
leading them to solve the wrong problem. Accurate judgment is required to identify and define
the problem. Managers often err by (a) defining the problem in terms of a proposed solution, (b)
missing a bigger problem, or (c) diagnosing the problem in terms of its symptoms. Your goal
should be to solve the problem, not just eliminate its temporary symptoms.
2. Identify the criteria. Most decisions require you to accomplish more than one objective. When
buying a car, you may want to maximize fuel economy and comfort while minimizing cost. The
rational decision maker will identify all relevant criteria in the decision-making process.
3. Weigh the criteria. Different criteria will vary in importance to a decision maker. Rational decision
makers will know the relative value they place on each of the criteria identified (for example, the
, Judgment & Decision Making in Accounting
relative importance of fuel economy versus cost versus comfort). The value may be specified in
dollars, points, or whatever scoring system makes sense.
4. Generate alternatives. The fourth step in the decision-making process requires identification of
possible courses of action. Decision makers often spend an inappropriate amount of time seeking
alternatives. An optimal search continues only until the cost of the search outweighs the value of
the added information.
5. Rate each alternative on each criterion . How well will each of the alternative solutions achieve
each of the defined criteria? This is often the most difficult stage of the decision-making process,
as it typically requires us to forecast future events. The rational decision maker carefully assesses
the potential consequences of selecting each of the alternative solutions on each of the
identified criteria.
6. Compute the optimal decision . Ideally, after all of the first five steps have been completed, the
process of computing the optimal decision consists of (1) multiplying the ratings in step five by
the weight of each criterion, (2) adding up the weighted ratings across all of the criteria for each
alternative, and (3) choosing the solution with the highest sum of the weighted ratings.
People do NOT make decisions like that. However, we tend to be ‘predictably irrational’ (Ariely)
We deviate from the normative framework in systematic, not just random, ways. How do we go to
this?
Utility
- The utility is whatever is maximized (“good”; “goodness”)
- Normative models do not tell us what we should be maximizing, they tell us what we should be
doing to maximize whatever it is that we try to maximize.
- The utility is a core concept in economics
- Humans are assumed to have “utility functions”, things contribute positively or negatively to
their utility.
- For example, agency theory assumes agents derive positive utility from wealth and negative
utility from the effort.
Comparing utility
Two core assumptions: transitivity and connectedness
- Transitivity:
o If A > B and B > C, then A > C.
- Connectedness:
o It is either the case that A > B, or that A < B, or that A = B.
o In other words: it is possible to compare A and B.
Expected-utility theory (EUT)
Theory underlies all theories we know (e.g. Agency theory) Individuals should choose the option with
the highest expected utility.
In absence of uncertainty, this is straightforward.
• If you can choose between €1 and €2, you should choose €2
• I am assuming money increases your utility!
When there is uncertainty, you should calculate which option has the highest expected utility.
Expected utility = Utility of outcome × Probability of outcome
, Judgment & Decision Making in Accounting
What should be the objective of decision-making in firms?
A textbook answer closely aligned with EUT is that people in firms should always take the action that
maximizes the expected net present value of all future cash flows.
- Utility = net present value of all future cash flows
- Maximize the value of the firm.
Can we be certain about which cash flows will result from an action?
- Typically not
- We need to base our decisions on probabilities…
Probability
Savage (1954): logical, objective, and personal probability
Logical / necessary:
- “a fair dice must land on one of its six sides”
Objective: relative frequencies:
- “a fair dice thrown 1 million times will land equally frequently on each of its sides”
Personal:
- “what will happen in my specific unique situation”
Personal probability
For most real-world decisions we need to rely on personal probability. Objective probability helps
determine personal probability, but not more than that:
- Your specific situation is unique in ways that are impossible to know.
- You face a one-off decision, not an infinite number of decisions.
If it is coherent, personal probability can still play an important role in normative models of judgment
and decision making.
Coherent personal probabilities
Coherence means that it satisfies two principles, that it's additive and there is multiplication possible.
Additivity:
- If A and B are mutually exclusive (Cannot that both happen, either one or the other),
then p(A) + p(B) = p(A or B)
- The probability of a statement being true and the probability of that same statement being false
are mutually exclusive and add up to one.
P(A) + P(not A) = 1
The probability of a dice landing on 5 or 6 = 1/6 + 1/6 = 1/3
Multiplication
- If A and B are both true, p(A & B) = p(A|B) × p(B)
(P(A|B) = Conditional probability: The probability of A given B)
- Two statements A and B are independent if knowing about the truth of one does not tell you
anything about the truth of the other.
- Thus, p(A|B) = p(A)
- Also, p(A&B) = p(A) × p(B)
Bayes’ Theorem
The additivity and multiplication rules together
imply a famous and important formula:
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