Public companies make earnings announcements every quarter. Over the years, there have been several academic studies that look at companies’ discretionary ability to avoid announcing earnings decreases and losses. Some of these studies show how a plot of earnings per share, or a plot of the change in earnings per share, shows a sharp discontinuity at zero. This means that companies are much more likely to report making a penny per share than losing a penny per share. There are many obvious economic incentives for a company and its employees to desire to report earnings and not losses. That said, large public companies are required to have internal controls with checks and balances. If there are multiple levels of review, proper segregation of duties, and external audits, then how does this earnings bias proliferate? The answer starts with the fact that management has a lot of discretion when it comes to accounting estimates. Back in 2012, I wrote about how JP Morgan was able to hit their earnings estimates in the quarter where they discovered a $5.8 billion trading loss incurred by a rogue trader. They were able to do this in large part by changing estimates related to loan loss reserves, mortgage servicing rights, and their effective tax rate. Prior to that, in the financial chaos of 2009, I did a financial analysis of many of the “too large to fail” banks and wrote in Ingram’s magazine about academic studies that speak to reasons for why these types of estimations might occur. That article referenced psychological and economic studies listed in the national bestseller “Stumbling on Happiness” by Harvard College Professor of Psychology Daniel Gilbert. Briefly, those studies:
- Reveal that humans have a tendency to ask questions that are subtly engineered to manipulate the answers they receive.
- Show that people intuitively lean toward asking the questions that are most likely to elicit the answers they want to hear and, when they hear those answers, believe them to be true.
- Show that when students from opposing schools watch the same football game, both sets of students claim the facts clearly and show the other school’s team was responsible for any unsportsmanlike conduct.
- Show that when Democrats and Republicans watch the same presidential debate on television, both sets of viewers claim that the facts clearly show that their candidate was the winner.
- Studies show that when pro-Israeli and pro-Arab viewers see identical samples of Middle East news coverage, both sets of proponents claim that the facts clearly show media bias against their side.
According to Gilbert, “Whether choosing information or informants, our ability to cook the facts that we encounter helps us establish views that are both positive and credible and … when people do encounter facts that disconfirm their favored conclusions, they have a knack for ignoring them, forgetting them, or seeing them differently than the rest of us.”
Traditional economics posits that humans are rational individuals that apply cost-benefit analysis in seeking pleasure and avoiding pain. In other words, what is given is netted with what is gained in making rational decisions. Traditional economists also understood that individuals have different preferences and tolerances when it comes to experiencing pleasure and avoiding pain, so they developed the word “utility” as a generic term to refer to the satisfaction received from an experience. From a traditional economic perspective, this root concept underlies all economic exchanges, from purchases of chewing gum to acquisitions of billion dollar companies.
In the 1960’s and 1970’s, cognitive psychologists Daniel Kahneman and Amos Tversky pioneered the fields of Behavioral Economics and Behavioral Finance. Briefly, Behavioral Economics is a method of economic analysis that applies psychological insights into human behavior to explain economic decision-making. Similarly, Behavioral Finance proposes psychology-based theories to explain stock market anomalies. In 2002, Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics. The work pioneered by Kahneman and Tversky was further developed by economist Richard Thaler. Many of the examples cited below come from the work of these three gentlemen.
In the late 1970’s, Kahneman and Tversky developed their “Prospect Theory” which posits that people value gains and losses differently. This theory evolved into what is known as the asymmetric value function, which can be demonstrated on the Cartesian plane as follows:
Prospect Theory
Prospect theory is essentially a bias that skews assessments of probability. It is why investors hold onto losing stocks for too long. It is also why people are risk seeking when a risk brings potential gains (think gambling) and risk averse when a risk brings potential losses (think insurance). It also explains why some of us spend hours and hours sitting in airports in order to avoid missing a flight. Building on the work of Kahneman and Tversky, evolutionary psychologists have developed theories regarding why the assessment of risks and odds are inseparable from emotion. The following is an excerpt from www.PsychologyToday.com (Google “10 Ways We Get the Odds Wrong”):
The above function demonstrates the difference in utility between a gain and a loss. As stated on www.Investopedia.com, “It is key to note that not everyone would have a value function that looks exactly like this; this is the general trend. The most evident feature is how a loss creates a greater feeling of pain compared to the joy created by an equivalent gain. For example, the absolute joy felt in finding $50 is a lot less than the absolute pain caused by losing $50. Consequently, when multiple gain/loss events happen, each event is valued separately and then combined to create a cumulative feeling. For example, according to the value function, if you find $50, but then lose it soon after, this would cause an overall effect of -40 units of utility (finding the $50 causes +10 points of utility (joy), but losing the $50 causes -50 points of utility (pain). To most of us, this makes sense: it is a fair bet that you’d be kicking yourself over losing the $50 that you just found. ”
“Risk and emotion are inseparable. Fear feels like anything but a cool and detached computation of the odds. But that’s precisely what it is, a lightning-fast risk assessment performed by your reptilian brain, which is ever on the lookout for danger. The amygdala flags perceptions, sends out an alarm message, and—before you have a chance to think—your system gets flooded with adrenaline. ’This is the way our ancestors evaluated risk before we had statistics,’ says Paul Slovic, president of Decision Research. Emotions are decision-making shortcuts.” Or, in other words, emotions are, at least in part, algorithms for dealing with threats that are programmed in our brains. Along these same lines, it is interesting to note that evolutionary theorists (such as E.O. Wilson) have suggested that our distant ancestors might have been generally inclined to worry more about avoiding losses than acquiring gains because they often lived close to the margin of survival (extra food would be nice, but insufficient food could mean death).
Viewed in this light, buying certain types of insurance (like life insurance) makes sense because you are considering the probability of death through the lens of your emotional desire to care for your loved ones. And, perhaps it also explains why companies (i.e., groups of people) can rationalize changing accounting estimates to conceal large losses. After all, protecting your job is part of how you protect your family, right? Certainly that has the potential to engage a lot of emotions. And we all know that emotions can transform rational behavior into rationalization.
Another interesting and related area of behavioral economics/finance is mental accounting. Accounting for financial reporting consists of written rules that are codified. However, as outlined above, these rules allow for a lot of latitude. Mental accounting allows for even more “flexibility”. One element of mental accounting is the assignment of sources of cash to specific mental accounts. An ordinary paycheck, an expected bonus, an unexpected bonus, or a cash windfall (whether from gambling or grandma) all may fall into different mental accounts. Money is fungible, which means it is perfectly homogenous and the source should not matter from a rational perspective. A classic example of mental accounting is having money set aside for a special trip or home improvement while carrying credit card debt and paying 20% interest. It’s illogical from a purely economic perspective, but perhaps starts to make sense when you consider the emotions that are in play. Knowing that money is set aside for the kid’s college fund might provide a degree of solace (if not pleasure) that makes paying 20% interest acceptable (if not logical). Other interesting observations regarding mental accounting (most of which come from economist Richard Thaler) are as follows:
- People tend to want to segregate gains and integrate losses. If you look at our Cartesian plane above, you will see that gains are concave (each new gain creates the steepest increase in joy) and losses are convex (each new loss creates the steepest plunge into pain). Therefore, it’s best to consolidate those plunges into one and take each gain separately. Because it is often difficult to combine losses in the real world, the discretion inherent in any accounting system (actual or mental) will be slanted towards avoiding losses.
- Holding onto investment losses keeps them as a paper loss, not a realized loss. So we are inclined to hold onto them in order to keep from “realizing” them.
- Do you own articles of clothing that you don’t wear and will never wear? Is it easier to give the less expensive stuff to Goodwill, even if you know that you are never going to wear any of it?
- Why do people that pay their semi-annual health club membership in January and June use the health club more frequently in the months of January and June? This is known as “payment depreciation” in mental accounting.
- Say that you bought a bottle of wine for $20 and it is now worth $75. You just drank the wine. How much did it cost you? According to Thaler, about 80% of us get the answer wrong (which is $75). Some people actually answer “zero”, which Thaler characterizes as “Invest now, Drink later, Spend never.” This is an example of how mental accounting often ignores opportunity costs.
- People often make the decision to pay a premium for smaller quantities of “sinful” or “guilty” pleasures. This practice was studied by Wertenbroch (1996) and his paper was entitled “To control their consumption, consumers pay more for less of what they like so much.”
- Studies show that betting on long shots increases on the last race of the day (because the mental account is closed at the end of the day). Today’s winnings influence the amount wagered, while cash won or lost the day before is often not included in the mental accounting math.
As forensic accountants, we are often reviewing data and piecing together records in order to understand the facts and circumstances around transactions and other economic events. We want to understand what occurred and why. Frequently, when it comes to human behavior, determining what occurred is often easier than understanding why. The latter often requires both an understanding of rational motivations, as well as insight into less rational emotion and bias that enters into our decision making.