Executive Summary

Behavioral economics and finance have studied how markets work and the design of policies and regulation to help individuals who suffer from psychological constraints and biases. Experimental behavioral accounting has identified psychological biases in information processing and has provided normative proposals for improving accounting rules to protect investors from their cognitive limitations. A further nascent direction considers how psychological bias of political participants causes dysfunctional financial regulation.

We offer here the psychological attraction approach to accounting and disclosure rules, regulation, and policy as a program for positive accounting research. We suggest that psychological forces have shaped and continue to shape rules and policies in two different ways: (1) good rules for bad users — rules and policies that provide information in a form that is useful for users who are subject to bias and cognitive processing constraints; and (2) bad rules — superfluous or even pernicious rules and policies that result from psychological bias on the part of the “designers” (managers, users, auditors, regulators, politicians, or voters).

The role of regulators in rule setting is salient, but users are indirect designers of accounting policy. Firms that seek capital must follow policies that appeal to users; regulators are also pressured to choose policies that appeal to users and voters. We seek to explain the structure of existing accounting rules and regulation. We are not arguing that accounting is a dysfunctional failure; but that, as a human construct, it is imperfect and shaped by both imperfectly rational aspects of human psychology.

Little work directly addresses whether the bias of designers themselves has shaped accounting regulation. We offer some initial ideas about psychological origins for historical costs, conservatism, aggregation, and a focus on disclosures of downside risk outcomes. We also suggest that psychological forces cause informal shifts in reporting and disclosure regulation and policy, which can exacerbate boom/bust patterns in financial markets.

Limited attention offers a possible explanation for aggregation in accounting. Aggregation destroys information content. With modern information technology, listings of all transactions are feasible, but meaningless to users with limited cognitive processing capacity. Summary signals of much lower dimensionality are more useful.  

Even when alternative forms of aggregation (such as cash versus accrual accounting) are offered, users may self-standardize by focusing on just a few items. Under a conventional disclosure regime, investors focus their attention on one or a few key items (such as bottom-line earnings). In practice, firms and analysts accommodate and reinforce investors’ focus by disclosing and forecasting earnings and place less emphasis on earnings components.

A much-criticized aspect of the conventional earnings disclosure regime is earnings guidance provided by managers, which is alleged to cause an excessive focus on quarterly earnings, and more generally “short-termism”. Although manipulation is a genuine problem, critics often draw invalid causal links between share price maximization, underinvestment, and underinnovation. Emotional forces, such as the urge to moralistic judgment and misapplication of the norm of prudence, support an ideology of anti-short-termism. This ideology may have provided cover for bad firms to disclose less.

Accounting conservatism, the more timely recognition of losses than gains, is pervasive across many countries and time periods. Several possible explanations for conservatism have been offered and have received a degree of empirical support, but none seems complete.

We offer a different perspective drawing on the asymmetry in perceptions about upside versus downside relative to arbitrary reference points. Recognition of profits or assets involves forecast of the future. Conservatism is perceived (rightly or wrongly) as reducing the likelihood of future disappointments, so users who find the prospect of disappointment very unpleasant are attracted to conservative reporting. This suggests a topic for future experimental research on reporting games, to examine whether conservatism develops when rational contracting considerations are excluded.

Historical cost accounting may be psychologically attractive because of “mental accounting”. Under mental accounting, people pay little attention to intermediate gains or losses, or view them as not completely real, until the position is closed (or some other special trigger of reevaluation occurs). In other words, there is limited mental marking to market of unrealized gains or losses. Gains or losses are measured relative to historical purchase price (a type of reference dependence). Such thinking feels self-evidently correct, but causes irrational decisions.

In historical cost accounting, recognition comes with (virtually) completed transactions. Gains and losses relative to the original purchase price function as a reference point. The strong parallel between historical cost accounting and psychology of investors could reflect psychological influence on the evolution of the accounting system. Mark-to-market accounting has a legitimate realm of applicability, but historically was slow to catch on. The idea that a “paper” gain or loss is economically just as real as a “realized” one is unintuitive.

The required disclosure of derivative securities risk emphasizes downside contingencies. More generally, risk analysis in practice often takes the form of studying worst-case scenarios, rather than risk measures such as variance that reflect the full probability distribution of outcomes. Risk perceptions focus on the potential for loss, even among analysts and investors. The use of value-at-risk (VaR) by firms indicates that managers find this intuitive.

Limited attention causes conceptual discretizing into binary categories (“gain” versus “loss”). VaR and other downside-only reporting amplify pre-existing investor bias toward focusing on worst-case scenarios. Regulation requiring risk disclosures that emphasize downside outcomes rather than measures of overall dispersion therefore encourage inconsistent risk evaluation. Apparent investor preference for smooth performance may come from a misplaced extension of the desire for predictability in human evolution.

Market participants are influenced not just by formal reporting and disclosure rules but by how they are applied in practice. During financial crises, market players such as speculators, managers of failing firms, credit ratings agencies, and analysts are vilified. Finding scapegoats is psychologically attractive and creates a self-feeding process in which participants are pressured into (or find advantage in) tougher evaluations of firms. Troubled firms may manipulate to try to stave off bankruptcy, but some report more conservatively because of increased risk of vilification. As evaluators become tougher, more firms fail, which in turn puts more firms into distress. This leads to evaluation-driven overshooting in financial crises.

It also helps to explain why changes in formal disclosure and reporting regulation tend to come in spasms after major market upheavals. This is reinforced by overestimation of the ability and motivation of regulators to design optimal systems. Such overestimation is a result of overconfidence and biased belief that effects (such as good designs) come from direct design. We suggest that there is a rich set of possible directions for testing the psychological attraction approach. This is to develop predictions about different accounting and disclosure rules and policies based on known psychological biases. In addition, a wide set of comparative statics predictions could be developed about how we expect rules and policies to differ across different types of audiences with different concerns. This suggests looking across countries and cultures, time periods, public versus private firms, government versus private sector accounting, and tax accounting versus financial reporting.