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Behavioral Accounting Transforms Green Eye-Shades into Empathic Intuitors?

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So you haven’t heard of behavioral accounting? Wow you haven’t lived! It does exist and it has generally been defined as accounting for the differential impact of behaviors on the value of an organization.

But I have a different perspective on behavioral accounting. As in, how does the behavior of the preparer of an accounting document impact its results? And I am also talking not just about garden-variety accounting documents but also things such as budget forecasts and revenue forecasts.

Of course there is no accounting standard anywhere that says that you should account for the behavior of the preparer of a budget or forecast when reviewing it. But generally that’s exactly what experienced business people do. Generally they will take into account this factor albeit informally.

So for example a CEO looking at a particular estimate might think something like” Joe prepared that and he’s generally too high coz he’s an over-optimistic sales type so I am going to mentally reduce the estimate by 20% but I won’t tell Joe coz he’ll get annoyed by me doing that since it will show him I generally think he’s too over-the-top”.

In fact, financials, estimates, forecasts and budgets don’t come out of thin air. They are prepared by humans. And all we humans have cognitive biases of which we are generally unaware.

The new disciplines of behavioral economics and finance focus on these issues in preparing financial prediction frameworks. However most practitioners wouldn’t go so far as to say that even the basic accounting should be adjusted to account for these cognitive biases. That’s a very radical proposition. But there are some.

Yet that’s exactly what should be required if you follow a behavioral framework to the letter. Since accounting documents are indeed completed by real humans who do indeed always have some sort of bias, then it theory we should indeed adjust every estimate to take account of said fact.

Now I am not wide-eyed enough to think that that’s what going to happen tomorrow. For one thing the economics profession has already been way behind in even subscribing to the new-fangled areas of behavioral economics and finance so to go to an even more radical step towards behavioral accounting is probably a step too far.

But that doesn’t mean this step shouldn’t be taken or at least thought about. There was a time remember when we all thought that the only proper study of economics has to be based on the assumption that people always made rational decisions about economic and financial matters.

Now we might know better. But the realization hasn't yet sunk in that this also impacts our frameworks for economic and financial metrics that we take for granted as being “objective”. That’s something we really need to be questioning.

So let’s accept for the moment that human behavior impacts how different people measure and record economic and financial matters. What would that mean for the current profession of business and accounting? Here are a few implications:

  1. Any financial document for recording past or predicting future financial results should be subject to adjustment for the behaviors and cognitive biases of the individuals or teams that prepared them.
  2. All financial preparers should have their cognitive biases measured to enable them to become more aware of the systematic biases that their innate behaviors introduce into their figures.
  3. Even non-financial preparers would be affected, for example people who prepare estimates of things like sales and expenses before these actually get to the accounting and finance types.
  4. Computer systems that deal with these figures would be programed to automatically apply these weightings to estimates and budgets before they actually get to the powers-that-be so they can see the behaviorally-adjusted figures.
  5. You would need specialized people to identify and measure these biases in a company who could both interpret the figures, provide cognitive bias feedback to people who prepare forecasts and estimates, and these “behavioral” types would be an integral part of the finance team.
  6. Accounting bodies would need to prepare a new set of standards and accounting principles along the lines of a “GABAP” or “Generally-Accepted Behavioral Accounting principles” which would set out standards for identification and measurement of cognitive biases and for how to adjust estimates and forecasts.
  7. These behavioral principles would also show how to apply accounting rules such that they conform to GABAP as well as the normal GAAP rules.

Naturally this would also impact issues such as risk measurement and management in corporations and thus compliance and fraud prevention. It would certainly upset the financial and accounting as well as the business applecart.

But my guess is that at some stage these things will come to pass. The internal logic is there. It might sound radical now, but it wasn’t such a long time ago that the idea of considering irrationality at all in decision-making was also considered heretical.

 

 

 

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Monday, 20 November 2017

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