11 Making Informed Judgments Part 3 Connecting Users’ and Preparers’ Judgments Navigating Accounting, ® G. Peter & Carolyn R. Wilson, © NavAcc LLC. Modified by [Your Name].

22Menu  Three-decision framework: Three-decision framework  Business decisions Business decisions  Accounting decisions Accounting decisions  User decisions User decisions  Consequences of user decisions Consequences of user decisions  Reporting incentives and challenges Reporting incentives and challenges  Closing thoughts Closing thoughts View in Slide Show Mode > click hyperlink.

33  Reporting entity insiders prepare accounting reports used by insiders and outsiders. Three-Decision Framework Things You Need to Know  For example, companies issue financial statements that investors use to make investment decisions.  Similarly, product development teams issue accounting reports that senior managers use to assess performance and determine the resources to commit to programs.  And companies issue tax reports that government agencies use to determine whether the company is complying with tax laws and regulations. Return to menu

44  Reporting entities make numerous business decisions.  These decisions, and other factors such as the general economic climate, lead to economic outcomes. Three-Decision Framework Things You Need to Know Return to menu

55 Three-Decision Framework  Students are largely in the business of creating human capital.  The financial value of this human capital, its earnings power, is mostly realized after college by working for others or through entrepreneurial activities.  Financially, students perform during college to the extent they increase their earnings power and communicate their value to parties who invest in their education, are prospective employers, or others who can help them realize this value. Things You Need to Know Return to menu

66 Three-Decision Framework Answer the following questions from the perspective of a representative student in your group:  Financing aside, what are some key business decisions you make during college that affect your earnings power?  Who are the prospective investors in your education that expect to earn a return on their investment in the future?  Measurement aside, what would these prospective investors like to know about your assets and liabilities?  Prior to investing  Periodically during college years  After graduation Questions Return to menu

77 Three-Decision Framework  You are a reporting entity that prepares and reports information to decision makers.  You may not formally create and distribute balance sheets.  But, you convey significant qualitative information about your assets and liabilities to parties whose decisions significantly affect your welfare, including communicating information about assets and liabilities that can not be measured reliably.  Regardless of your career path, at every job along the way you will likely prepare reports associated with financial statements for other users and use reports associated with financial statements prepared by others. Take Aways Return to menu

88  Accounting decisions determine how information about economic events is transformed into accounting reports. Three-Decision Framework Things You Need to Know Return to menu

99  Accounting reports and information from other sources are inputs to user decisions—decisions made by users of accounting reports that pertain to the reporting entity. Three-Decision Framework Things You Need to Know Return to menu

10  User decisions can affect business decisions to various degrees, depending on the reporting context.  These effects are the consequences of user decisions on the reporting entity. Three-Decision Framework Things You Need to Know Return to menu

11 Three-Decision Framework Things You Need to Know The consequences of users’ decisions connect business, accounting, and user decisions.  Each type of decision affects and is affected by the other two.  If you pursue a business career, you will likely specialize in one type.  For example, salespersons specialize in business decisions and accountants in accounting decisions. Return to menu  However, your mastery of the decision type you specialize in will be constrained by your mastery of the other two.

12 Three-Decision Framework Answer the following questions from the perspective of a representative student in your group:  Besides those who invest in your education, who makes decisions that can greatly affect your welfare, where the decisions are significantly influenced by information you provide about your assets and liabilities?  What are these decision makers deciding that has consequences for your welfare?  How do their decisions and your investors’ decisions affect your decisions? How do yours affect theirs? Questions Return to menu

13 Three-Decision Framework  Who makes decisions that can greatly affect Intel’s welfare, where the decisions are significantly influenced by information Intel provides about its business and accounting decisions?  What are these decision makers deciding that has consequences for Intel’s business decisions?  How do their decisions affect Intel’s decisions? How do Intel’s affect theirs? Questions Return to menu

14 Three-Decision Framework  Like start-up companies, a good deal of the information students convey relates to intangible assets that can’t be measured reliably enough to be recognized in financial statements.  Nevertheless, this information affects users’ decisions and these decisions can significantly affect students’ and companies’ welfares.  Similarly, companies’ accounting decisions affect and are affected by business and user decisions. Take Aways Return to menu

15 Reporting Incentives and Challenges Things You Need to Know  Insiders are often rewarded by users for communicating good news and punished for communicating bad news.  This creates good and bad insider incentives:  Anticipating the reward for performing well, insiders have incentives to work more effectively and efficiently, which aligns their interests with users’ interests.  Insiders have incentives to report honestly when they perform well.  Insiders have incentives to fraudulently misrepresent their performance when they perform poorly. In this case, their self interests are not aligned with users’ interests. Return to menu

16 Reporting Incentives and Challenges Things You Need to Know  The mere presence of a conflict of interest does not mean insiders who have performed poorly will fraudulently misrepresent their performance.  Their willingness to act on this incentive to misrepresent poor performance, depends on:  The extent to which they have opportunities to misrepresent their performance without being detected.  Whether their moral compass compels them to do the right thing when doing so may not, at least on the surface, best serve their self interests. Return to menu

17 Reporting Incentives and Challenges Things You Need to Know  Users challenge is to distinguish the honest preparers from the fraudulent and otherwise misleading preparers.  Meeting this challenge means:  Users benefit because they avoid losses that will ultimately be realized by the fraudulent/misleading reporting entity.  Honest preparers benefit because more resources are allocated to them. As a result, honest preparers have even more incentive to help users meet this challenge.  Society benefits because resources are allocated to entities that can use them most effectively and efficiently. As a result, society has an incentive to establish laws, standards, regulations, and enforcement agencies to help curb fraudulent reporting. Return to menu

18 Reporting Incentives and Challenges Things You Need to Know  To meet this challenge, users must make informed judgments grounded in healthy skepticism.  Skepticism is not the same as cynicism:  Skeptical users start with two competing hypotheses: (1) the numbers were reported honestly or (2) they were reported fraudulently or are otherwise misleading. They then apply the scientific method: collect as much information as possible to try to validate or refute these hypotheses.  Cynical users assume the numbers were reported fraudulently and only seek information to support this assumption.  More skepticism is needed when preparers have greater opportunities and incentives to report fraudulently. Return to menu

19 Reporting Incentives and Challenges Answer the following questions from the perspective of a representative student in your group: Compare decision makers’ skepticism about information you provide in the situations below and explain the reasons these differences exist:  A loan officer, assessing financial information you provide on a loan application.  A car salesman, assessing information you provide about a car you are trading in for a new one.  A prospective employer, assessing information you provide about the value of your human capital. Questions Return to menu

20 Reporting Incentives and Challenges Take Away Return to menu  Decision makers’ skepticism should increase in direct proportion to the dispersion of objective experts’ estimates and preparers’ incentives to report dishonestly.

21 Reporting Incentives and Challenges  Understanding the dispersion of objective experts’ estimates of the values of assets and liabilities can help users distinguish honest preparers from fraudulent and otherwise misleading preparers.  To see what we mean, we begin with a setting where you, as a representative student in your group, are trying to sell a used car to a prospective buyer.  Your car is in good condition; but you know the buyer will be skeptical if you simply claim the car is in good condition.  Your challenge is to provide information to the buyer that will greatly mitigate or eliminate this skepticism. Things You Need to Know Return to menu

22 Reporting Incentives and Challenges  To this end, you are considering hiring an objective expert to estimate the value of the car and prepare a report you can share with the buyer.  Before doing so, you are trying to determine the extent to which the report will mitigate or eliminate the buyer’s concern that the car might be in bad condition.  To convince you that your money will be well spent, the expert gives you a report about a recent study where 1,000 objective experts were asked to estimate the value a car similar to yours that was in good condition and a second car similar to yours that was in bad condition. Things You Need to Know Return to menu

23 Reporting Incentives and Challenges  On the left is the distribution of 1,000 objective experts’ estimates of the value of the car in bad condition.  On the right is the same experts’ estimates of the value of a similar car in good condition. Things You Need to Know  To begin, we assume the research study reported: Return to menu

24 Reporting Incentives and Challenges  Assume:  The prospective buyer of your car will trust the findings in the research report and the estimate provided by the expert you are considering hiring.  The experts’ fee is reasonable: it is considerably less than the cash you will forego if you can’t convince the buyer your car is in good condition.  Given the chart below from the research report, should you hire the objective expert to estimate the value of your car? Questions Return to menu

25 Reporting Incentives and Challenges  The x on the left is a single expert’s estimate of the value of a car in bad condition.  The circled x on the right is a single expert’s estimate of the value of a different car in good condition (possibly the same expert). Take Aways Return to menu

26 Reporting Incentives and Challenges  If car buyers and sellers set prices based on experts’ estimates, the price of a bad (good) car can fall anywhere under the distribution on the left (right).  Because the distributions are separated, good cars will always sell for higher prices than bad cars. Take Aways Return to menu

27 Reporting Incentives and Challenges  Maintain the same assumptions as before about the credibility of the research report and objective expert’s estimate and the reasonableness of the expert’s fee.  Would your decision to hire the objective expert change if the research report presented the graphic below rather than the earlier one? Questions Return to menu

28 Reporting Incentives and Challenges  The dispersion of experts’ estimates depends on several factors including the availability of useful information and measurement techniques.  When these factors are not available, the dispersion can increase to the point that the distributions overlap. Take Aways Return to menu

29 Reporting Incentives and Challenges  When the distributions overlap, the same objective expert can unintentionally value the car in bad condition higher than the car in good condition.  The wider the overlap, the more likely there can be unintentional pricing errors. Take Aways Return to menu

30 Reporting Incentives and Challenges  Overlaps in the objective experts’ distributions also create opportunities for dishonest sellers to misrepresent the condition of a bad car without getting detected. Take Aways Return to menu

31 Reporting Incentives and Challenges  When overlaps occur, buyers can not distinguish cars in good and bad condition.  In these situations, either:  All cars are sold for the same price, which falls somewhere between the prices for good and bad cars.  Or, in the extreme, the market collapses because buyers are too concerned about getting a car in bad condition and paying too much for the car.  When sellers know more than buyers about the quality of a product, we say there is adverse selection.  Adverse selection also occurs when investors can’t distinguish good numbers from fraudulent numbers. Take Aways Return to menu

32 Reporting Incentives and Challenges  Suppose you are a representative student from your group who is preparing for a job interview.  There are several good candidates for the job; but you believe you are the best qualified candidate.  Thus, you expect you will get the job if the interviewer can distinguish your value to her company from the values the other candidates would bring to the job. Things You Need to Know Return to menu

33  You and the interviewer have the same challenge: you want the interview process to maximize the likelihood that the best candidate (hopefully you) will get the job. Doing so will remove the overlap as shown below on the right.  What are some things you and the interviewer can do to move the interview process to the right? Questions Reporting Incentives and Challenges Return to menu

34 Ultimately, your earnings power depends on your ability to develop your human capital and convey its usefulness to prospective employers, or to prospective investors if you plan to become an entrepreneur.  What, if anything, happens to the value of your human capital if you can’t credibly communicate information about its value?  When do the values of assets tend to depend on the credibility of information communicated about them? Questions Reporting Incentives and Challenges Return to menu

35 Reporting Incentives and Challenges  Which of the following companies face communication challenges similar to yours? Their most valuable assets by far are the ones for which it is most difficult to credibly convey information. Yet, it is essential to communicate credibly for the assets’ value to be realized.  CVS Pharmacy  Facebook  Southwest Airlines  Wal Mart Questions Return to menu

36 Students have a good deal in common with start-ups:  Your future earnings power greatly depends on your ability to develop human capital, finance this development through savings, loans, scholarships, or gifts, and eventually provide services to employers whose hiring and promotion decisions depend on their assessments of the value of this human capital.  Throughout your lives, you must continually enhance and assess the value of your human capital and try to devise ways to credibly communicate this value to outsiders. If you fail to do so, you will not realize this value. Take Aways Reporting Incentives and Challenges Return to menu

37  Just as students intent on reporting honestly must work with prospective employers to ensure that interview processes identify the best job candidates, honest companies intent on reporting honestly must work with investors, standard setters, and others to move the reporting process as far to the right below as possible. Take Aways Reporting Incentives and Challenges Return to menu

38 Closing Thoughts  Preparers and users both make decisions associated with measurement.  Preparers determine how financial items should be measured and users assess the credibility, and more generally, the usefulness of measures.  These decisions require proportional judgment: the more judgment required by insiders when preparing numbers, the more judgment required by users when interpreting them and visa versa. Return to menu

39 Closing Thoughts  Users and preparers decisions affect and are affected by each other.  If companies can not credibly communicate relevant information about the value of their most important assets and other financial items relevant to investors’ decisions, they may not realize some or all of this value. Return to menu

40 Closing Thoughts  You now understand where many fascinating and challenging aspects of accounting come into play, in ways you likely never envisioned previously.  Like you, companies report financial statements and other information to investors and stakeholders that affect companies’ welfares.  The preparers and users of these reports make decisions that are tightly intertwined and have consequences for all involved, including society.  Companies are generally rewarded for performing well and thus have incentives to work as effectively and efficiently as possible towards this end. Return to menu

41 Closing Thoughts  Companies that succeed have an incentive to honestly report their performance.  Companies that perform poorly have an incentive to report fraudulently or otherwise mislead users.  Investors’ challenge is to distinguish companies that report honestly and correctly from those who report fraudulently or otherwise mislead users.  This challenge is shared by companies who are intent on reporting honestly and by lawmakers, standard setters, and enforcement agencies on behalf of the general public.  To the extent they succeed in this endeavor, scarce resources are assigned to companies that can use them most effectively and efficiently for the benefit of themselves and society. Return to menu