Faculty Research: Pinning Down the Human Factor in Accounting

Though most of accounting research focuses on capital markets, Isenberg Accounting Professor and Dean’s Research Fellow Elaine Wang doesn’t follow the crowd. She specializes in an increasingly influential subfield of accounting research: judgment and decision-making in accounting and auditing.

“Most people don’t realize how much professional judgment plays a role in accounting,” says Wang, who grew up in the bustling coastal city of Dalian, China. She pursued accounting as an undergraduate, but was more interested in the thought processes prevalent in the field than numbers. “I’ve always been interested in why decisions get made and what the potential downsides are.”

When she spent a year abroad at Hong Kong Polytechnic University and got the chance to do some accounting research, she began considering the possibility of pursuing an accounting PhD and becoming a Professor.  She completed her doctorate at Nanyang Technological University in Singapore, where she ran decision-making experiments with human subjects and realized that accounting could encompass psychology. For the first time, the accounting piece and the judgment piece clicked..

Her recent research, “The Effect of Increased Audit Disclosure on Managers’ Real Operating Decisions: Evidence from Disclosing Critical Audit Matters,” published in The Accounting Review, explores the potential business impacts of new accounting regulations. In 2019, in a shift characterized as one of the most significant changes in accounting practice in more than 50 years, auditors became required to disclose “critical audit matters” (CAMs) in their final audit reports. CAMs are issues in a company’s financials that require the auditor to make “challenging, subjective, or complex” judgments. In general, investors view zero CAM disclosures as a green light to invest. CAM disclosures can be seen as potential red flags, requiring management to spend additional time reassuring investors and justifying their decisions. Some disclosures can even trigger enough market anxiety that a company’s stock price drops.

In their research, Wang and colleagues Jeremiah Bentley of Isenberg and Tamara Lambert of Lehigh University theorized that managers’ operational decisions would be influenced by a desire to reduce CAM disclosures. In multiple experiments, the research team found that managers would voluntarily close down riskier projects or choose more traditional operating approaches simply to avoid the possibility of triggering a CAM disclosure. While in some cases it is beneficial for the public to know if an auditor has discovered irregular or highly risky financial reporting practices, the overreaction to the CAM disclosure could prevent managers from making optimal economic decisions. In the long term, Wang notes, managers may quash innovation by avoiding more complex, creative, or uncertain prospects. “We may see organizations playing it safe in terms of not triggering auditor disclosures, but in the end potentially facing greater economic loss,” she says.

How Jargon Impacts Decisions

She’s also deeply interested in how the language used in financial disclosures influences investors and has published widely on the topic, including in The Accounting Review, Journal of Accounting Research, and Journal of Accounting and Economics. “What are the consequences of making something easier or more difficult to understand?” she asks. “How do investors react?” She has explored factors such as readability, tone, and the use of industry-specific jargon.

Among her findings: Novice investors are more positively influenced by upbeat tone and industry jargon (even if they don’t understand it), but more sophisticated investors—those who have direct industry knowledge—find companies less credible when managers use unnecessary jargon or language that is more positive than the results warrant.

“People think of accounting as always clear-cut but there are a lot of areas where judgment biases decisions,” she says. “The gray areas are the most interesting parts.”