Making Informed Judgments
Part 6
Factors Driving the Dispersion of Measures
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Navigating Accounting, G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name].
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
Ideal measurement distributions
 Everyone is an objective expert
 No need for authoritative guidance

Actual measurement distributions
 Not everyone is perfect; Some preparers are dishonest
or stretch the truth; Others lack the requisite expertise
 Users can not perfectly determine preparers’ expertise
and/or objectivity
 There is a need for authoritative guidance and other
mechanisms that aim to discipline reporting

How the factors can inform accounting judgments

Closing thoughts
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Ideal Measurement Distributions
Things You Need to Know
 Measurement objectives specify qualitative features or
dimensions of an asset.
 Fair value
 The price a company would receive for an asset in an orderly
transaction between market participants on the reporting date.
 Depends on the future benefits an unrelated party would expect
to realize as of the reporting date by using the asset.
 Value in use
 The benefits the company expects to realize as of the reporting
date by using the asset.
 Historical cost
 An asset’s cost to the entity when acquired, possibly adjusted for
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benefits used up by the reporting date.
Ideal Measurement Distributions
Question
Answer the following question from the perspective of a
representative student in your group:

Compare the availability and reliability of information
objective experts would seek to measure the fair value
of your car to the information they would seek to
measure its historical cost adjusted for usage?

Assume you have owned the car for three years.
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Ideal Measurement Distributions
Take Aways
 To estimate the historical cost of your car adjusted
for usage, objective experts would mostly rely on
information they would get from you to:
 Determine or estimate its historical cost
 Estimate, at the acquisition date, the expected pattern of
the future benefits you expect to realize through usage
and disposal of the car.
 Possibly modify this pattern over time for changes in
expectations regarding future usage and disposal.
 To estimate the car’s fair value, the objective experts
would need information from you regarding the car’s
past usage and current condition and recent sales
prices for comparable cars from other sources.
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Ideal Measurement Distributions
Question
Answer the following question from the perspective of a
representative student in your group:

How, if at all, would you expect the dispersion of
objective experts’ estimates of the historical cost of
your human capital to differ from the dispersion of their
estimates of its value in use?
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Ideal Measurement Distributions
Take Aways
 The dispersion of objective experts’ estimates of the
historical cost of your human capital would likely be
considerably narrower than the dispersion of their
estimates of its value in use.
 To estimate its historical cost they would need to know
what it cost to support you up to this point in your life
and, more specifically, the portion of these costs that
helped you develop your human capital.
 This would not be easy but the uncertainty regarding the
inputs to this estimation would probably be considerably
less than the uncertainty associated with predicting the
way you will use this human capital to generate income
in the future.
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Ideal Measurement Distributions
Things You Need to Know

Once experts know a measurement objective, they must
select a measurement technique from acceptable
alternatives and locate the inputs needed to apply the
technique, including related assumptions.
 The average value of recent comparable sales would be a
technique for estimating the fair value of your car on a
reporting date: the price you would receive in an orderly
transaction with market participants (car buyers).
 The closing stock price on the reporting date for a share of
common stock you own would be a measurement technique
for estimating the stock’s fair value.
 The present value of the future net cash flows a factory is
expected to generate would be a technique for measuring its
value in use.
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Ideal Measurement Distributions
Things You Need to Know

Benchmark data consists of inputs providing a basis for
comparison.

Companies derive estimates by applying a formula or
technique to benchmark data.

Three types of benchmarks are widely used:
 Market prices for recent trades
 Comparable company (cross-sectional) data
 Historical (time series) data
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Ideal Measurement Distributions
Things You Need to Know
 The risks and uncertainties associated with the
measurement context tend to be:
 Directly related to the dispersion of objective experts’
estimates.
 Inversely related to the availability and reliability of
benchmark data:
 The number of benchmark observations and …
 The extent to which the business context associated with
these observations is comparable to the measurement
context.
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Ideal Measurement Distributions
Question
Answer the following questions from the perspective of a
representative student in your group:

If it exists, identify readily available and relatively reliable
benchmark data that could be used to estimate the
following measurement objectives:

The fair value of your car

The fair value of a patent you hold on an invention

The portion of year-end accounts receivable owed to a company
that are not expected to be collected in the future

When might you be most concerned about the reliability of
benchmark data that is readily available?

Why did banks find it difficult to reliably predict bad debts
associated with loans and other “toxic” assets in 2008?
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Ideal Measurement Distributions
Take Aways
 The dispersion of the ideal estimates depends on:
 the measurement objective
 the business risks and uncertainties associated with the
measurement objective
 the availability and reliability of benchmark data
 the availability and validity of measurement techniques
 the extent to which the business context associated
with the benchmark data is comparable to the
measurement context.
 The relative importance of these factors depends on
the measurement context.
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Ideal Measurement Distributions
Take Aways
 GAAP often restricts the measurement process when there
are too many opportunities for dishonest reporting or
unintentional errors.
 This tends to occur when the dispersion of objective
experts’ estimates becomes large.
 GAAP restrictions are a net benefit to society to the extent:
 The benefits of restricting preparers who would otherwise act
dishonestly or inadvertently make errors outweighs.
 The costs of preventing preparers who are objective experts
from reporting their best estimates when the related
measurement procedures do not conform with GAAP.
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Ideal Measurement Distributions
Take Aways
 Understanding the factors that drive the dispersion of
objective experts’ estimates can help you qualitatively
gauge the dispersion.
 This, in turn, can help you:
1. Understand the reasons GAAP restrictions exist and how
they evolve over time as the factors that affect the
dispersions change. For example, as reliable benchmark
data has become more readily available.
2. Gauge how close reported numbers are to the ideal
measures that would have been reported if there were no
GAAP restrictions and all preparers were objective experts.
3. Gauge the confidence you should have in reported numbers
when making decisions based on them.
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Actual Measurement Distributions
Things you need to know
 Generally, the factors that affect the ideal distributions of
objective experts’ estimates also affect the actual
distributions that occur under GAAP.
 However, several other factors affect the actual
distributions. These tend to have one or more of the
following effects on measurements;
 Help honest preparers avoid unintentional errors.
 Give preparers incentives to report dishonestly or otherwise
commit frauds. The mere presence of these incentives does
not mean preparers will necessarily act on them.
 Discipline preparers not to act on incentives to report
dishonestly when given opportunities to do so.
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Actual Measurement Distributions
Question
Answer the following questions from the perspective of a
representative student in your group:

What are some honest errors you could make when
estimating the following:

The historical cost of your car adjusted for usage?

The fair value of your car?

The value in use of you human capital?

What are some things you could do to reduce these errors?

GAAP requires companies to estimate accounts receivable
at the end of reporting periods that will probably not be
collected in the future.

What are some related honest errors that could occur
and how can companies try to control them?
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Actual Measurement Distributions
Take Aways
 Honest errors generally occur when:
 Preparers do not know what they should do: they lack the
requisite knowledge.
 They know what they should do but they do not know how to
do it: they lack the requisite skill.
 They know what they should do and how to do it, but they
inadvertently fail to do it: they lack the requisite focus.
 Here are some ways to control these errors:
 Training is the best way to ensure preparers have the
requisite knowledge and skills.
 Accountability, performance rewards and penalties, and
otherwise promoting goal congruence can motivate focus.
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Actual Measurement Distributions
Question
Answer the following questions from the perspective of a
representative student in your group:

What are some rewards you can receive for reporting the
values of your assets dishonestly or otherwise taking actions
that serve your self interests at society’s expense?

For example, what are some rewards you can receive by
misrepresenting your qualifications during a job interview or
cheating on exams to misrepresent your grades?
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Actual Measurement Distributions
Question
Answer the following questions from the perspective of a
representative student in your group:

What are some situations where you have particularly strong
incentives (reasons) to report dishonestly or otherwise behave
inappropriately to secure these rewards?

What are some situations where these same rewards can
motivate honest individuals to take actions that serve their self
interests and society’s interests?
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Actual Measurement Distributions
Take Aways
 Conflicts of interest exist when individuals have
opportunities to take actions that serve their own interests
at others’ expense.
 Conflicts of interest and opportunities to act on them
inappropriately are pervasive and they were likely the root
cause of the scandals that nearly collapsed stock markets
in 2001-2002 and credit markets in 2007-2009.
 During these tumultuous events, far too many of the
individuals who prepared financial reports, audited them,
regulated them, based recommendations on them, and
otherwise used them served their own interests, often
excessively, at the expense of society’s interests.
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Actual Measurement Distributions
Take Aways
 This excessive greed might lead you to conclude that
conflicts of interest should be eliminated. Sometimes this
is the best course of action, but not always:

In a capitalist economy conflicts of interest are often the
unintended side effects of financial incentives that create
tremendous social benefits.

Removing them by curbing or eliminating the incentives that
cause them throws out the baby with the bath water, so this
radical surgery should only be performed as a last resort.

An alternative approach is to create or refine disciplining
mechanisms that give individuals incentives (reasons) not to
act in their own interests at society’s expense when they
confront conflicts of interest. We will examine some of these
mechanisms next.
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Actual Measurement Distributions
Question
Answer the following questions from the perspective of a
representative student in your group:


What are some things that would motivate you not to act
inappropriately on the following conflicts of interest:

Cheating on exams or graded assignments to boost your grades
and ultimately misrepresent the value of your human capital?

Lying to a car salesman when he asks you whether a car you are
trading in for a new one has ever been in a serious accident and
thus misrepresenting the value of your car?
What are some things that would motivate a company not to
report inflated asset measures?
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Actual Measurement Distributions
Take Aways
 The figure below illustrates factors that affect accounting
judgments, including financial incentives that can benefit
or harm society’s interests and disciplining mechanisms
that can curb or eliminate inappropriate behavior:
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Actual Measurement Distributions
Take Aways
 These disciplining mechanisms all failed at Enron,
WorldCom, Tyco, and other companies during the 20012002 scandals when there was a perfect storm of
opportunities and incentives to commit fraud.
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Actual Measurement Distributions
Take Aways
 For the most part, Sarbanes Oxley and other reforms
passed in response to the scandals increased the
restrictions associated with the disciplining mechanisms:
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How the Factors Can Inform Judgments
Question
 How can understanding the factors below that influence
measurement when everyone is not an objective expert and
the additional factors that affect the dispersion of objective
experts’ estimates help preparers increase the credibility of
the measures they report?
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How the Factors Can Inform Judgments
Question
 How can understanding these factors help users assess the
credibility of the measures they are analyzing?
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How the Factors Can Inform Judgments
Question
 How can understanding these factors help you better
understand GAAP?
 For example, how can they help you better understand why research
costs are expensed rather than capitalized?
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How the Factors Can Inform Judgments
Take Aways
 When assessing the usefulness of reported numbers for
their decisions, outsiders can gauge how reliably the
numbers measure what they are intended to measure and
how relevant this measurement objective is to their
decisions.
 To assess reliability, they can assess the impact of the
factors that affected the measures, including factors that
affect the dispersion of objective experts’ estimates and
the additional factors that must be considered because
unfortunately some preparers are dishonest and others
lack the requite expertise.
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How the Factors Can Inform Judgments
Take Aways
 Recognizing that users make these assessments,
preparers can increase the credibility of reported measures
by disclosing accompanying information about the factors
that affect their reliability.
 These factors can help you understand GAAP. For
example:
 The reasons U.S. GAAP requires expensing research and
development costs and IFRS permits capitalizing development
costs when certain conditions are met.
 The reasons revenue recognition must be deferred when
companies do not have benchmark data that allows them to
reliably predict bad debts or product returns.
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Closing Thoughts
 The factors that affect measurement and other accounting
judgments are intertwined and contextual, often differing
significantly over time as globalization and technology
evolves and across countries, industries, companies, and
individuals:
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Closing Thoughts
 Considering the dramatic transformations that have
occurred in these contexts and will likely continue to
occur, the half life of facts you learn about current
standards, regulations, and institutions will probably be
quite short.
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Closing Thoughts
 For this reason, it is important that you understand how
these factors evolve and relate to each other.
 The related concepts have proven to be very durable:
 They survived and, in fact, help explain the near collapse of
stock markets in 2001-2002 and credit markets in 2007-2009.
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