Question

Explain the meaning of ‘heuristic’. How might the two heuristics’ anchoring and adjustment’ and ‘representativeness’ influence decision makers’ selection and weighting (importance) of accounting numbers?b) What is the importance of managers knowing what heuristics they are using? c) Explain how knowledge of common heuristics used by financial report users help standard setters.

Answer 1

A.

Heuristic is derived from the Greek word meaning “to discover”. These are simple, efficient rules which people use to form judgments and make decisions. They are shortcuts that involve focusing on one aspect of any problem. They produce good solutions given a limited time frame or deadline. Heuristics are a technique for quick decisions, particularly when working with complex data. Decisions made may not necessarily be optimal.

Anchoring and adjustment - It is used in situations where people estimate a number. It describes cases in which a person uses a specific target number as a starting point, known as an anchor, and adjusts that information until an acceptable value is reached. The value is generally in a range. People start from the anchor and adjust value upward or downward to reach some acceptable value. The upward or downward movement may be too big or too small depending upon the range in which a person deems fit the acceptable value exists. Anchoring is done on the basic or past numbers. Decision makers in accounting often use this to make budgets for various costs, sales etc to carry out production process and they see the previous numbers and forecast on the basis of them. Various factors such as economic and inflation etc affects their adjustments size.

Representativeness - It uses shortcuts to make decisions based on past events that represent similar situations. It is based on the numbers in the past. It gives high weights to the trends and numbers in the past. For example - A company is performing good in the past and is expanding going for a public issue. Accountants may directly say that the stocks are a good buy but others factors have to be studied with this like competition comin gin the market, new technology etc.

B.

The use of Heuristics is based on the problem it is being applied to. So, it is important for managers to know what heuristics they are using. Whether they are using availability, representativeness, anchoring and adjustment.

Different heuristics are suitable for different situations. Representativeness may be helpful in situtions where previous trends and dats clearly tells the figures that might be there in future or the current figures that might be there. Anchoring and adjustment might be helpful in situations where a lot of factors affect the current figures and they need to set a base value known as anchor and adjust it to reach some acceptable value. Availability is when different event can be brought to mind and probability of its occurence is determined. Short occuring events have a high probability of occurence such as during seasonal changes demand may be high due to high sales for a trending product.

C.

Knowledge of common heuristics used by financial report users help standard setters a lot in determining the forecasts for current or future figures. Knowledge of the heuristics can help in determining solutions to complex problems in a fast manner..Heuristics often tend to produce more successful choices and actions than complex rational analyses.

Anchoring refers to the heuristic of using a reference point and making adjustments to arrive at an estimate. It helps to set standards by financial report users by keeping in mind an anchor which is usually previous year performance and adjusting to current year based on economic conditions.

Representativeness is a bias where people judge on the basis of appearance instead of a base rate. In financial reporting, financial users are more likely to judge profitable company on the basis of size of revenues, operations rather than probability of a company to be profitable.