Navigating the perils of cognitive bias in accounting

As one of the most notorious cases of accounting fraud in history, the Enron scandal serves as a cautionary tale about the importance of ethical leadership and accountability. It also highlights the role cognitive biases can play in decision-making and how easily those biases can result in a negative outcome.

The energy giant’s bankruptcy in 2001 was largely caused by aggressive accounting techniques that had been used to hide debt and inflate financial statements.

However, executives were also guilty of confirmation bias, overconfidence bias and anchoring bias, among others.

They selectively emphasised positive information while downplaying negatives.

This fostered overconfidence about their ability to maintain the company’s stock price despite risky financial practices.

The artificially inflated financial figures influenced the investors, analysts and employees who relied on these misleading benchmarks for financial decisions. The reliance on benchmarks is a form of anchoring bias.

While the Enron case is an extreme example, cognitive biases can be found in many businesses. If unchallenged, they may lead to negative results. It is important for accounting and finance professionals to avoid slipping into biased decision-making.

Cognitive biases

Cognitive biases are natural and often automatic mental processes that help people make quick decisions and navigate the complexities of the world. People use them every day, and, in some situations, they can save time. However, cognitive biases can become problematic when they lead to irrational or incorrect decisions, reinforce stereotypes or contribute to unethical behaviour.

Steven Asnicar, director at workplace specialist firm Diversity Australia, says cognitive bias in accounting can occur when professionals unintentionally favour information that aligns with their preconceived beliefs or judgements, potentially compromising the integrity of financial statements.

 

"Cognitive biases can lead to some potential distortions in terms of how people approach their decision-making."

 

“Cognitive biases can lead to some potential distortions in terms of how people approach their decision-making,” Asnicar says.

Common biases include overconfidence bias, confirmation bias, anchoring bias, sunk-cost fallacy and groupthink.

“From a financial perspective, cognitive biases should be recognised and managed properly. No one is immune to them. It comes back to accountability and people being prepared to interrogate data properly and seek external review,” he says.

Challenge decision-making

Given that cognitive biases are so risky, it is important to try to mitigate the impact of biased decisions.

Organisational psychologist Dr Amanda Ferguson says the key to mitigation is to continue to question your reasoning and stay up-to-date with new research and methodologies.

“Cognitive bias occurs as a result of taking a shortcut. We are trying to reduce the complexity of a decision, and when we need to act quickly, we might go through a certain way of thinking that we’ve used in the past,” Ferguson says.

“It is natural to create shortcuts because it makes life easier, but the consequence of that is that you’re not interrogating information in the way you probably should be, because you’re just defaulting to what your brain’s telling you is the easiest way.

“To mitigate it resulting in a biased decision, it is important to take the time to ruminate, to try not to make decisions under pressure and to get expert and outside independent advice,” she says.

Most importantly, Ferguson says people need to constantly challenge their own reasoning and adopt a growth mindset. “Good workplace psychosocial safety can help people recognise that being open to learning is a good thing.

It can help identify where biases may be influencing decisions and how to avoid that.”

Common cognitive biases in accounting

Confirmation bias 
A tendency to favour data or information that supports preconceived notions, such as about a company’s financial health, which could lead to financial reporting errors.

Sunk-cost fallacy
A tendency to keep investing in something based on how much has already been invested, such as hesitating to write off certain assets or investments that have lost value, which could lead to inflated balance sheets.

Groupthink
A phenomenon where a group of people prioritise consensus over critical evaluation of information, such as the collective failure to critically evaluate financial statements or audit procedures. This may lead to incorrect financial reporting.

Overconfidence bias
A tendency to overestimate one’s beliefs, predictions or ability to perform a task, such as believing that one can accurately estimate financial values or risks. This can lead to overly optimistic or pessimistic financial reporting.

Anchoring bias
A tendency to rely too heavily on the initial information, or “anchor”, when decision-making, such as assessing financial figures based on previously reported numbers or industry benchmarks rather than on recent reports. This can lead to errors if anchors are invalid or irrelevant.