Judgement and decision making
WEEK 1
The production, certification and use of accounting information (still) requires human judgement and
decision making. Therefore, professionals engaging in these activities need to understand something
about the psychology of judgement and decision making.
Production of accounting information: managers, employees, controllers.
Certification of accounting information: auditors.
Use of accounting information: owners, investors, creditors, analysts, managers, employees,
government employees, suppliers, etc.
(changes in) assets, liabilities, and equity accounting information users
Judgement: attaching a (quantitative or qualitative) value to something – estimates, evaluations,
opinions.
Decisions: choosing between alternatives.
--- Judgements and decisions 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; estimate future cash flows, decide to sell or buy shares (owners
and investors), estimate future cash flows, make buy/hold/sell recommendations (analysts), estimate
default risk, decide about loans and interest rates (creditors), estimate the likely consequences of
alternative courses of action, make business decisions (managers and other employees), tax,
regulations (government), judge liquidity, contracting decisions (suppliers and customers).
Normative models: how people should be making judgements and decisions to achieve a certain
outcome.
Descriptive models: how people actually make judgements and decisions.
Prescriptive models: practical suggestions on designing judgement and decision-making processes
based on normative and descriptive models.
Actual judgements and decisions can deviate from what is optimal, and descriptive models often
explain such deviations (for example, focusing on cognitive limitations or the social setting in which
the judgement/decision is made).
Normative decision making
A rational process which uses all available information in an optimal way to maximize the expected
net outcome – the most accurate judgement possible / the best choice possible. It is rooted in
philosophy, mathematics and classic economics.
, How do we distinguish between a good and bad choice?
* What should we be trying to achieve? – moral intuition, religion.
* What does it mean to make a decision? – philosophical determinism.
Baron (2004): any normative model needs to start form the simple idea that some outcomes are
better than others. No claim about absolute truth, but ‘truth relative to assumptions’. Normative
models arise through the ‘imposition of an analytic scheme’.
Bazerman & Moore:
1) Define the problem
2) Identify the criteria
3) Weigh the criteria
4) Generate alternatives
5) Rate each alternative on each criterion
6) Compute the optimal decision
People do not actually make decisions like this. However, we tend to be ‘predictably irrational’. We
deviate from the normative framework in systematic, not just random, ways (biases).
Descriptive models of decision making
Explain how people actually do make decisions. Insights from cognitive psychology, social
psychology, neuroscience, biology, sociology, anthropology and behavioural economics.
Humans have evolved over millions of years. For 99.99% of that time, our ancestors faced a similar
set of relatively straightforward decisions. We are well prepared to make fast and simple decisions in
a stable, predictable environment with relatively few homogeneous actors and to spend no more
energy than strictly necessary.
We are not well prepared to make complex economic decisions, in a dynamic, unpredictable
environment with many heterogeneous actors. When we face such decisions, we should try dual
process theory.
Dual process theory
System 1 is our intuitive, fast, automatic, emotional, effortless, system of decision making: it is
employed when we interpret verbal language, process visual information, walk, talk, etc.
System 2 is slow, effortful, conscious and explicit: you are aware of your own thinking, you are
deliberately making a decision.
Both systems are always on, system 2 typically in a ‘comfortable low-effort mode’. System 1
continuously provides system 2 with impressions, intuitions, feelings, etc. System 2 is only mobilized
when system 1 runs into difficulties and therefore the division of labour is highly efficient.
System 1 is not designed for complex decision making, and it tends to make decisions that are
suboptimal. System 2 will often do a better job, but it relies on system 1 for input and system 1
cannot be switched off which can cause system 2 to not be employed frequently enough.
In sum, even if we try to be rational, we are unlikely to succeed. Our judgement and decisions will
deviate from normative benchmarks.
WEEK 1
The production, certification and use of accounting information (still) requires human judgement and
decision making. Therefore, professionals engaging in these activities need to understand something
about the psychology of judgement and decision making.
Production of accounting information: managers, employees, controllers.
Certification of accounting information: auditors.
Use of accounting information: owners, investors, creditors, analysts, managers, employees,
government employees, suppliers, etc.
(changes in) assets, liabilities, and equity accounting information users
Judgement: attaching a (quantitative or qualitative) value to something – estimates, evaluations,
opinions.
Decisions: choosing between alternatives.
--- Judgements and decisions 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; estimate future cash flows, decide to sell or buy shares (owners
and investors), estimate future cash flows, make buy/hold/sell recommendations (analysts), estimate
default risk, decide about loans and interest rates (creditors), estimate the likely consequences of
alternative courses of action, make business decisions (managers and other employees), tax,
regulations (government), judge liquidity, contracting decisions (suppliers and customers).
Normative models: how people should be making judgements and decisions to achieve a certain
outcome.
Descriptive models: how people actually make judgements and decisions.
Prescriptive models: practical suggestions on designing judgement and decision-making processes
based on normative and descriptive models.
Actual judgements and decisions can deviate from what is optimal, and descriptive models often
explain such deviations (for example, focusing on cognitive limitations or the social setting in which
the judgement/decision is made).
Normative decision making
A rational process which uses all available information in an optimal way to maximize the expected
net outcome – the most accurate judgement possible / the best choice possible. It is rooted in
philosophy, mathematics and classic economics.
, How do we distinguish between a good and bad choice?
* What should we be trying to achieve? – moral intuition, religion.
* What does it mean to make a decision? – philosophical determinism.
Baron (2004): any normative model needs to start form the simple idea that some outcomes are
better than others. No claim about absolute truth, but ‘truth relative to assumptions’. Normative
models arise through the ‘imposition of an analytic scheme’.
Bazerman & Moore:
1) Define the problem
2) Identify the criteria
3) Weigh the criteria
4) Generate alternatives
5) Rate each alternative on each criterion
6) Compute the optimal decision
People do not actually make decisions like this. However, we tend to be ‘predictably irrational’. We
deviate from the normative framework in systematic, not just random, ways (biases).
Descriptive models of decision making
Explain how people actually do make decisions. Insights from cognitive psychology, social
psychology, neuroscience, biology, sociology, anthropology and behavioural economics.
Humans have evolved over millions of years. For 99.99% of that time, our ancestors faced a similar
set of relatively straightforward decisions. We are well prepared to make fast and simple decisions in
a stable, predictable environment with relatively few homogeneous actors and to spend no more
energy than strictly necessary.
We are not well prepared to make complex economic decisions, in a dynamic, unpredictable
environment with many heterogeneous actors. When we face such decisions, we should try dual
process theory.
Dual process theory
System 1 is our intuitive, fast, automatic, emotional, effortless, system of decision making: it is
employed when we interpret verbal language, process visual information, walk, talk, etc.
System 2 is slow, effortful, conscious and explicit: you are aware of your own thinking, you are
deliberately making a decision.
Both systems are always on, system 2 typically in a ‘comfortable low-effort mode’. System 1
continuously provides system 2 with impressions, intuitions, feelings, etc. System 2 is only mobilized
when system 1 runs into difficulties and therefore the division of labour is highly efficient.
System 1 is not designed for complex decision making, and it tends to make decisions that are
suboptimal. System 2 will often do a better job, but it relies on system 1 for input and system 1
cannot be switched off which can cause system 2 to not be employed frequently enough.
In sum, even if we try to be rational, we are unlikely to succeed. Our judgement and decisions will
deviate from normative benchmarks.
