Mark W. Nelson

Do Investors Overrely on Old Elements of the Earnings Time Series

This paper reports an experiment demonstrating that MBA students overrely on old earnings performance when predicting future earnings performance in a laboratory setting. In the experiment, MBA students relied too heavily on old annual ROE information to predict future annual ROE. The experiment shows how a common cognitive error (overreliance on unreliable information) interacts with the structure of the earnings time series to create particular patterns of prediction errors. The results also suggest directions for research on two well†known anomalies, long†run overreactions (De Bondt and Thaler 1985, 1987) and post†earnings†announcement drift (Bernard and Thomas 1990).

Audit category knowledge as a precondition to learning from experience

Abstract Prior research indicates that inexperienced auditors lack knowledge of basic auditing categories (e.g. transaction cycles, audit objectives), instead developing this knowledge over time. As a consequence, learning from early experiences may be hampered because these experiences are not stored with respect to the category structures that are needed for important audit decisions. We performed an experiment which demonstrates that: 1. (1) providing transaction cycle and audit objective category knowledge through instruction prior to experience facilitates one particular type of subsequent learning from experience learning of category-level error frequencies), and 2. (2) this learning advantage cannot be duplicated by providing listings and explanations of category memberships after experience. In addition, actual experience consequently has a greater influence on later audit decisions when category knowledge is acquired prior to experience.

Gathering Data for Archival, Field, Survey and Experimental Accounting Research

In the published proceedings of the first Journal of Accounting Research Conference, Vatter [1966] lamented that “Gathering direct and original facts is a tedious and difficult task, and it is not surprising that such work is avoided.” For the fiftieth JAR Conference, we introduce a framework to help researchers understand the complementary value of seven empirical methods that gather data in different ways: prestructured archives, unstructured (“hand-collected”) archives, field studies, field experiments, surveys, laboratory studies, and laboratory experiments. The framework spells out five goals of an empirical literature and defines the seven methods according to researchers’ choices with respect to five data gathering tasks. We use the framework and examples of successful research studies to clarify how data gathering choices affect a study’s ability to achieve its goals, and conclude by showing how the complementary nature of different methods allows researchers to build a literature more effectively than they could with less diverse approaches to gathering data.

Context and the inverse base rate effect

Recent categorization research set in abstract medical diagnosis contexts has demonstrated an ‘inverse base rate effect’, whereby subjects make diagnoses which are consistent with base rates when presented with some sets of symptoms, but inconsistent with base rates when presented with other sets of symptoms. This paper reports three experiments which demonstrate that whether or not the inverse base rate effect is observed depends on the context in which categorization takes place. Inverse base rate effects are replicated in the abstract medical diagnosis context used in prior research, but not in a relatively realistic financial auditing setting, a less realistic financial auditing setting, or a very abstract generic setting. These results indicate that the inverse base rate effect may not generalize to applied settings, suggesting that interventions designed to mitigate the inverse base rate effect should not be instituted without first determining the existence of the effect in the particular setting in question.

PCAOB Guidance and Audits of Fair Values for Level 2 Investments

We report an experiment that examines auditors’ adjustment decisions and management-bias assessments related to portfolios of investment securities. We first examine whether current PCAOB guidance leads auditors to correct different amounts of error in investment portfolios that have the same aggregate error, depending on how the error is distributed across securities within portfolios. We hypothesize and find that experienced financial-services auditors correct larger amounts of overstatement for some distributions than for others, holding constant aggregate error. We also find that auditors modify adjustments from what is indicated by standards in the direction that corrects aggregate error in a portfolio, but that they do so incompletely and asymmetrically. Based on prior research in psychology, we also predict and find that auditors identify certain patterns of error as indicative of management bias, but not others. However, management-bias assessments do not affect auditors’ correction decisions, even when auditors are prompted to consider management bias. These results suggest a tendency for auditors to focus on required numerical comparisons without incorporating management-bias assessments into correction decisions. They also highlight a potential deficiency in current auditing standards that managers could exploit by strategically locating errors within particular securities within a portfolio.

The Effects of Out-of-Regime Guidance on Auditor Judgments About Appropriate Application of Accounting Standards

Accountants making judgments with respect to a particular set of standards are increasingly aware of standards from other reporting regimes that offer additional or conflicting guidance. In fact, IFRS encourages reliance on out-of-regime standards when IFRS lacks guidance. This paper reports the results of two experiments which provide evidence that auditors in such circumstances are vulnerable to contrast effects, whereby reporting judgments under IFRS are systematically influenced away from the accounting treatment supported by standards from another regime (U.S. GAAP). Contrast effects are observed (1) when out-of-regime standards are considered before making a reporting judgment under IFRS and (2) when out-of-regime standards are applied as local GAAP for a subsidiary of a foreign parent that reports under IFRS. We also find that contrast effects are reduced when auditors believe IFRS lacks guidance. These results have implications for financial statement preparers and auditors in the current incomplete-convergence environment.