Judgment and Decision- Making

Opening Activity I have a rule in mind that applies to the sequencing of three numbers. You have to try to guess the rule using the following table. I will give you one sequence that fits my rule. Also, as you generate sequences of your own to try to figure out my rule, I will tell you whether your guess is consistent with my rule or inconsistent with my rule . When you get to 100% sure, you are done. Sequence Or  Your guess about the ruleHow sure are you? 2, 4, 6

Why Study Judgment? Principles based standards Movement toward fair-value accounting Accounting for leases Convergence toward a single set of high quality standards—greater judgment, fewer prescriptive rules. Greater emphasis on inspections—greater scrutiny Auditors subject to PCAOB inspections have to justify decisions made in the conduct of the audit. In order to provide such justification, auditors need to have clarity on how to reach important decisions.

The KPMG Professional Judgment Framework 4

McGladrey Professional Judgment Framework

Center for Audit Quality: Judgment Tools

Identify the Issue Evaluate the evidence Accumulate and Appraise Alternatives Decide and Document Embrace EthicsEmbrace Ethics Beware of BiasesBeware of Biases C o n s i d e r C o n s t r a i n t s M o n i t o r y o u r M i n d s e t

Factors affecting judgment Bounded Rationality Incomplete information Time and cost constraints Cognitive constraints Memory Intelligence Perception Attention Environmental Constraints (considered later in this presentation)

Dealing with Bounded Rationality Satisficing Heuristics Kennedy (1993) describes Heuristics and biases as follows: Heuristics: Biases:

Heuristics and Biases Availability— Heuristic: Resulting bias— Representativeness— Heuristic: Resulting biases: Anchoring—Usually numeric— Heuristic: Resulting bias—

The Problem with Biases-- Overconfidence Examples: “They couldn’t hit an elephant at this dist…” (last words of Union General John B. Sedgwick) Two phrases that signal overconfidence bias: “Watch this…” and “Hold my beer…” Overconfidence can lead to: What to do about it:

The Problem with Biases--Confirmation Examples Confirmation bias can lead to What to do about it:

The Problem with Biases--Anchoring Examples: Anchoring biases can lead to What to do about it:

The Problem with Biases: Availability Examples: Availability bias can lead to: What to do about it:

Other Tendencies Distorted or motivated reasoning—interpreting information the way you want it to come out Hindsight—We tend to attribute greater ability to have predicted uncertain outcomes in the past. So, we think we can predict the future better than we actually can. Rush to solve—With limited resources and tight deadlines, every accountant has to face this. Self-serving bias—It is almost impossible to discount how the expected outcome would affect us. As a result, we tend to favor the alternative that works out best for us (especially in the short-run).

Environmental Constraints on Decision- Making

Intuition and Decision-Making Intuition Fast, effortless, automatic, implicit, emotional, evolutionarily prior Decision-making Slow, effortful, conscious, explicit, rational, evolutionarily recent

Reasons Why Auditors Are Susceptible to Bias From Bazerman et Al. Ambiguity— Attachment— Approval— Familiarity— Discounting— Escalation—