Accounting Quality A View from Neuroscience (Joint Work with John Dickhaut, Sudipta Basu, and Kevin McCabe) Presentation AAA Doctoral Consortium Lake Tahoe,

Accounting QualityA View from Neuroscience

(Joint Work with John Dickhaut, Sudipta Basu, and Kevin McCabe)

Presentation

AAA Doctoral Consortium

Lake Tahoe, Nevada

Friday June 19, 2009

Greg Waymire

Organization of Talk

1) Motivation

2) Accounting Quality: A Definition

3) The human brain, exchange evaluation, & accounting principles by the human brain

4) Evidence

5) Concluding remarks

A Motivating Question:What is necessary for a brain to conceive these artifacts?

Marked envelope with matching tokens from Susa, Iran (3300 BC)

What is the Advantage of Larger Brains? “Scaling up” in social group size

× 3 125-200

From Dunbar (1998 Journal of Human Evolution)

The Advantage of Larger Brains (cont.)

Dunbar (2001, 181) writes:

What is High Quality Accounting?

• High quality accounting

• measures, records, and reports on economic exchange with fidelity while doing minimal disturbance to the underlying transaction.

• allows parties to the transaction and others to evaluate the consequences of economic exchange.

• is reflected in longstanding principles that are rooted in practices that originated centuries ago.

What does this definition emphasize?

• Fidelity: Accuracy derives from objective evidence from actual transactions.

• Minimal disturbance: Accounting follows from transaction, not vice versa.

• Understanding: Economic effects are communicated to facilitate exchange evaluation.

• Evolved rather than designed principles: Principles emerged without a single body responsible for defining them via some “Conceptual Framework.”

What are Accounting Principles?General Induction-Based Guides for Accounting Decisions

“In the development of any field, principles are discovered which represent the fundamental truths on which the field of knowledge rests. These principles are applied in the working out of problems that arise, and gradually, rules of practice evolve which, over a period of time, become accepted to a greater or less degree as reflecting the oft-recurring cases…

(I)nherent in accounting principles are business laws which must be obeyed if in the long run the enterprise is to survive… It should be apparent, however, that the basing of financial policies upon accounting statements which in turn are not prepared with fundamentally right accounting principles, may lead to courses of action which, if too long pursued, will adversely affect the health of business. It is in this sense that the fundamental principles of accounting may be said to be coercive and self-executory.” (emphasis in original italicized; emphasis added in bold)

Byrne, G., 1937, pp. 368-371. To What Extent Can the Practice of Accounting be Reduced to Rules and Standards? Journal of Accountancy November: 364-379.

Accounting Principles Support Exchange Evaluation within the Human Brain

Proposition

Culturally-evolved accounting principles identified through induction “stuck” because they are consonant with how the human brain has biologically evolved to evaluate exchange opportunities.

ImplicationThe evidence from neuroscience parallels those measurement conventions we refer to as “accounting principles.”

Exchange Evaluation Generates a Demand for Information with Specific Properties

ReciprocityNorms ofFairness

TrustPunishment

Receipt of:Potential Reward (Benefits)

Provision of:Potential Sacrifice(Costs)

Demand for Reliable& Precise Informationon Expected NetBenefits from anExchangeTransaction in aMulti-Period World

Leads to

Information Properties:(1) Focused on benefits & costs(2) Reliable information(3) Quantified data(4) Enables multi-period exchange

The Character of Pre-FASB Principles

Evolution & Anatomy of the Brain • Evolution has built on

existing structures for millions of years. The human brain’s most recent addition is the neocortex, the outermost sheath covering the brain.

• The control over functions of the body and basic emotions are found more in the inner parts of the brain while more rational evaluative functions are located to a greater degree within the neocortex.

• Humans have relatively large brains relative to other primate species when measured by the relative size of the neocortex.

Neurons: Cells Comprising the Human Brain• Neurons “fire” via

electrical charge when performing a task. This “firing” is the means of communication between neurons.

• Neurons in different parts of the brain fire when a task implicates alternative brain functions.

• Neuronal firing measured directly through single cell recording (invasive - not done with humans) or indirectly through neuroimaging (e.g., fMRI) during task performance.

Figure A portrays those parts of the neuron that play explicit roles in “firing.” Figure B depicts communication between two neurons at the opening between the neurons (i.e., the synapse).

Accounting Principles & NeuroscienceRevenue Recognition

Panel A (B) depicts Revenue Recognition for an installment sale where the probability of collection is relatively low (high). When the probability of collection is low, sales revenue is not recognized until cash is collected. Note the similarity of this behavior to neuronal firing in the ventral tegmental area of the cortex of the Macaque monkey shown in Panels C and D (Fiorillo et al. 2003). The stimulus here is a signal that a reward may be forthcoming. When the probability of reward is low, the monkey’s neurons fire only when the reward is received

(Panel C) whereas neuronal firing occurs at the time of the stimulus signal when the probability of reward is high (Panel D).

Accounting Principles & NeuroscienceExpense Matching

Expense Matching requires that expenses be recognized in the same period as the revenues those expenses generate. This requires an ability to be able to evaluate the extent to which

certain rewards result from particular sacrifices. DeQuervain et al. (2004) investigated brain activations associated with the implementation of punishments on trading partners who did not provide fair allocations of rewards in a trust game experiment (Left). They find that one area of the brain (prefrontal cortex) differentially activated when subjects received a reward

for punishing versus when they did not (Right).

Accounting Principles & NeuroscienceConservatism

Conservatism is represented by the principle of recognizing all losses and anticipating no gains. Knutson et al. (2001) studied differential brain activity in response to either losses or

gains of a subject’s wealth. The picture above indicates greater sensitivity to gains than losses in the mesial prefrontal cortex. In other areas of the brain such as the hippocampus (related to long-term memory), there is more activity for losses than gains. This evidence suggests that the brain was a precursor for the notion of accounting conservatism and this characteristic was transplanted to formal accounting systems early in the development of

accounting.

Accounting Principles & NeuroscienceObjectivity

Objectivity requires hard information and arms length exchange. Dickhaut et al. (2008) run an experiment where subjects choose between 27 dollars for sure and a 50/ 50 chance at 10 and 50 dollars. The brain captures an ordered line segment and both the certain 27 and the 50/50 gamble, are represented stochastically on an ordered line segment (Left). When the subject is visually presented with the choice of the certain outcome versus the risky one, the subject sees many representations of this stimulus that are sent to the brain from the retinae. Since the brain is stochastic, both signals are represented probabilistically on the ordered line segment with the difference in quality of information between the two stimuli reflected in a lower standard deviation for the certain stimulus. McCabe et al. (2001) provide evidence that the human brain has the ability to distinguish the nature of the partner in the paracingulate cortex, which is consistent with theory of mind (Right).

Where are we going with this?Sombart’s Hypothesis: Double entry enabled capitalism in part by changing cognitive focus of business owner. This hypothesis derives from the first edition of Pacioli (1494):

Where are we going with this? (cont.) Does accounting’s rational calculation transform a personal affront to a business

risk? If so, is accounting primarily located in the neocortex that controls evaluative functions versus the inner brain where emotions such as fear and

disgust are processed?

SUPPLEMENTAL SLIDES

Set Terms of and Consummate

Exchange

PRE-EXCHANGE SEARCH & EVALUATIONSEARCH Recognition of Desire to Exchange-Receipt of New Exchange Offer-Memory of Past Exchange History-Information from & to Third Parties

EVALUATIONTrustworthiness of Individual: Reputation-Memory of Past Direct Exchange with Individual-Memory of Past Exchange with Similar Individuals-Third-Party Information about Individual-Cues from Direct Interaction

Trustworthiness of Individual: Social Norms & Punishment Mechanisms-Established Norms of Cooperative Exchange-Social Mechanisms to Punish Cheaters

Valuation of Expected Net Rewards(Reward-Costs/Sacrifices) x pr(Cooperation)= Expected Net Gain

POST-EXCHANGE EVALUATIONComparison-Actual Net Rewards versus Expected Net Rewards

Updated Reputation/Image-Fairness of Chosen Partner-Desirability of Future Exchange-Desire to Invoke Punishment

Do NotExchange

Halt Search

Search Again

Exchange Search & EvaluationThis figure schematically organizes the wide set of human behaviors that the economic actor (buyer or seller) brings

to a single transaction. The economic actor searches, analyzes and stores multiple sources of information prior to and after exchange dynamically while making a number of economic evaluations. Exchange is sustained by trust, which

in turn depends on whether agents can acquire reputation for trustworthiness and the prevalent social norms and social mechanisms for punishing those who cheat on agreements to cooperate.

Accounting Principles Existed Long Before FASB Conceptual Framework

180015531300 CE8,000 BCE

8,000 BCE: First known origins of recordkeeping & accounting in Sumeria (present-day Iraq) coincident with further scale expansion in human communities. Homo sapiens dates from 175,000 BCE.3,200 BCE: First known invention of writing in Sumeria, which was for purposes of purposes of recordkeeping & accounting.Post-1,300 CE: Double-entry bookkeeping with its focus on Duality originates in Northern Italy; DE summarized in 1494 text by Luca Pacioli. First evidence of Conservatism in 1406 AD.1,553 CE: First joint stock corporations (foreign trading monopolies) formed in Britain. Corporate form of business grows exponentially. Sombart, Weber, Schumpter, & Mises argue in early 20th century that DE enabled capitalism.Post-1,800 CE: Modern corporate accounting begins to take shape spontaneously in Britain & U.S. Objectivity crystallizes from need to accurately reconstruct financial history of bankrupt firms. The move towards broad principles is promoted further by securities regulation in Britain & US as well as formation of accounting professions in both countries in late 19th century. The first private U.S. standard-setter recognized by SEC in 1939 (Committee on Accounting Procedure) and FASB established in 1973.

3,200 BCE

Character of Pre-FASB Principles (cont.)

1. Objectivity. Transactions are recorded when supported by hard verifiable evidence that an arms-length exchange has been consummated.

2. Duality. The dual effects of a reciprocal exchange are recognized when transactions are initially recorded in equal debits and credits. The resultant accounts articulate and provide a check on the accuracy of accounts.

3. Unit of Measure. Transactions are recorded in monetary units that yield homogeneous data that enable aggregation within accounts.

4. Historical Cost. Transactions are initially recorded on the basis of cost established through arms-length reciprocal exchange.

5. Going Concern Entity. Accounting is done for a distinct economic entity that is expected to operate for the foreseeable future.

6. Periodicity. Financial statements are prepared for separate units of time in order to evaluate a going concern’s performance on a regular basis.

7. Consistency. Accounting procedures are used that treat similar transactions in a similar fashion now and into the future.

8. Materiality. Consistency is applied in all cases except when the transaction is immaterial.

9. Conservatism. Do not overstate net assets and anticipate no profits.

10. Revenue Realization. The assignment of revenue to a particular period requires objective evidence indicating that services have been rendered or goods have been supplied as the result of consummated reciprocal exchange and that benefits have been received.

11. Expense Matching. Evaluating an entity’s performance in exchange requires simultaneous recognition of the expenses incurred to obtain revenues.

12. Auditing. Accounting data and methods applied to those data are subjected to third-party verification to attest that these data and their accounting treatment are valid and reliable.

Accounting Principles

Accounting Principles & NeuroscienceDuality

Behavior in a Typical Liability Account Task Performed by Macaque Monkey

Neuronal Activations for Right and Left Arrow Movements

Debits and credits in a specific liability account represent cumulative positive totals where

credits accumulate faster than debits to yield a positive liability balance. The Macaque monkey has a similar counting device in the lateral intraparietal sulcus, whose neurons record the right and left arrow movements that appear on the screen.

Accounting Principles & NeuroscienceUnit of Measure

2+2=5 T F

10 >14 T F

A. B

The typical unit of measure in accounting by U.S. businesses is the dollar. Numerical operations such as addition and subtraction are required for constructing accounts and

doing financial analysis (Panel A). These kinds of simple operations are typically performed by the horizontal intrapareital sulcus of the human brain (Panel B). This

finding resulted from a comparison of the computational ability of patients with lesions in the intraparietal sulcus relative to persons without such lesions (Dehaene et al. 2007). The area with lesions is represented by the darkened area in the brain sketch

of panel B.