Experimental research in financial accounting

Experimentalresearchinfinancialaccounting RobertLibby*,RobertBloomfield,MarkW.Nelson Johnson Graduate School of Management, 383 Sage Hall, Cornell University, Ithaca NY 14853 6201, USA Abstract This paper uses recent experimental studies of financial accounting to illustrate our view of how such experiments canbeconductedsuccessfully.Ratherthanprovideanexhaustivereviewoftheliterature,wefocusonhowparticular examples illustrate successful use of experiments to determine how, when and (ultimately) why important features of financial accounting settings influence behavior. We first describe how changes in views of market efficiency, reliance on the experimentalist’s comparative advantage, new theories, and a focus on keyinstitutional features have allowed researchers to overcome the criticisms of earlier financial accounting experiments. We then describe how specific streams of experimental financial accounting research have addressed questions about financial communication between managers, auditors, information intermediaries, and investors, and indicate how

future research can extend thosestreams.Wefocusparticularlyon(1)howmanagersandauditorsreportinformation;(2)howusersoffinancial information interpret those reports; (3) how individual decisions affect market behavior; and (4) how strategic inter- actions between information reporters and users can affect market outcomes. Our examples include and integrate experiments that fall into both the ‘‘behavioral’’ and‘‘experimental economics’’ literatures in accounting. Finally, we discuss how experiments can be designed to be both effective and efficient. # 2002 Elsevier Science Ltd. All rights reserved. 1. Introduction Financial accounting research is a broad field that examines financial communication between managers, auditors, information intermediaries, and investors, as well as the effects of regulatory regimes on that process. Much of this literature focusesonmanagers’andauditors’reportingdeci- sions and their relationships to analysts’ forecasts and value estimates, investors’ trading decisions, and resulting market prices. This clear focus on judgment and decision making led to the large number of experimental financial accounting studies published in major accounting journals in the1960sand1970s. Serious criticisms of this early research (e.g. Gonedes&Dopuch,1974)turnedexperimentalists’ focusawayfromfinancialaccountingissuesinthe 1980s and early 1990s. As discussed by Maines (1995) and Berg, Dickhaut, and McCabe (1995), major elements of these criticisms were: (1) the irrelevance of individual behavior in market set- tings, in which competitive forces will eliminate individual‘‘errors’’;(2)poormatchingofresearch methods to research questions; (3) the lack of psychologicaloreconomictheorytopredicteffects and specify the mechanisms through which they occur; and (4) failure to capture relevant aspects 0361-3682/02/$-see frontmatter#2002ElsevierScienceLtd. All rightsreserved. PII: S0361-3682(01)00011-3 Accounting, OrganizationsandSociety27(2002)775–810 www.elsevier.com/locate/aos * Corresponding author. Tel.: +1-607-255-3348; fax: +1- 607-254-4590. E-mail address:rl54@cornell.edu(R.Libby). of the decisions of interest, in particular, decision makerattributesandinstitutionalfeatures. Beginning in the mid-1990s, there was a resur- genceofexperimentalresearchaddressinganeven broader spectrum of financial accounting issues. This paper presents our view of how this new lit- erature has addressed prior criticisms, and how it cancontinuetoshedlightonfinancialaccounting questions. We argue that significant evidence of capital market inefficiency has renewed interest in how individuals make key accounting-related decisions and how these decisions affect market prices. Recent studies take advantage of the experimentalist’s comparative advantage at disen- tangling variables that are confounded in natural settings and measuring intervening processes to drawstrongcausalinferences.Theoriescombining psychology and economics have allowed experi- mentaliststospecifymore clearly the mechanisms affecting individual and market behavior. Finally, most of the new studies focus on issues of clear relevance to financial accounting, particularly the effects of decision-maker knowledge and motiva- tion, the complex information environment, reg- ulation,andstrategicinteraction. Thispaperisaimedprimarilyatthosewhoplan to conduct financial accounting experiments, and secondarilyatotherfinancialaccountantswhoare interested in what can be learned from experi- mental studies. Our primary goal is...

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