Question

Financial statements analysts must ensure that their forecasts are objective, realistic, and unbiased. Some companies’ executives and managers can be too optimistic about their companies’ outlook. Some accounting principles tend to be conservative. Express how these different risks and incentives can lead financial analysts, executives and managers, and accountants to different biases when predicting uncertain outcomes

Answer 1

In the ideal world, financial analysts must focus on objectivity and realistic but in reality there are biases like optimism, favoritism, conflict of interest, and forecasting bias. The reason for these type of biases depend on the individual role and preferences. There are financial analysts who are associated with one of the sector or industry and they develop a hypothesis which let them focus on the facts which is in line with their hypothesis.

One of the common bias is the optimism bias. The decision made by the executives and manager is considering the scenario will be good. This leads to the huge investment which turns into vicious cycle and these executives are trapped with sunk cost. Therefore, this bias does not objectively predict the uncertain outcomes and does not able to manage the risk. This bias is most common in the regular trading industry where the trader is investing and doing trade based on his hypothesis and with the view that market will grow. This is because that trader has personal incentive.

There is also one of the uncommon bias of favoritism. This comes when decision are made on the persona bias like if financial analyst is influenced by his/her past experiences. For example, an analyst who is fan of Apple products, it will be difficult for him/her to write that Apple is in bad situation and are near to close the shop. Ideally, it has to be as concise and objective as possible but the report generated by analyst is clouded with emotions.

There is also risk of negligence which pushes the managers and executive to take decision which is not the reflection of pure facts. Many managers have long term relation with an organization, or an analyst who was working previously in that organization; it will be difficult to take hard steps against this organization. They would not like to break their personal relationship and thus will not predict the unrealistic outcomes.