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Oct 28, 2014 - Decision Theory - The Core Building Block of Neuroeconomics ........... 15 ... Management Accounting Research Relevant to Neuroeconomics .
Understanding the interplay between cognitive and affective decision making processes: Implications for management accounting based on neuroeconomic evidence

Masterarbeit zur Erlangung des akademischen Grades Master of Science an der Fakultät Wirtschaftswissenschaften der Bayerischen Julius-Maximilians-Universität Würzburg

Eingereicht bei: Prof. Dr. Andrea Szczesny Lehrstuhl für Betriebswirtschaftslehre, insb. Controlling und Interne Unternehmensrechnung

Vézard, Aurélien 1608786 Master in Business Management, Fachsemester 4 Im Ibelnest 5, 92637 Weiden 28.10.2014

Erklärung

Hiermit erkläre ich, dass ich die Arbeit selbstständig verfasst, keine anderen als die angegebenen Quellen und Hilfsmittel benutzt und die diesen Quellen und Hilfsmitteln wörtlich oder sinngemäß entnommenen Ausführungen als kenntlich gemacht habe. Die Arbeit wurde keiner anderen Prüfungsbehörde vorgelegt.

Würzburg, den 28.10.2014

……………………………………. Vorname Nachname

Abstract (German)

I

Abstract (German) Diese Thesis untersucht den potenziellen Nutzen, Controlling und Neuroökonomie zu einer neuen Forschungsdisziplin zusammenzuführen. Neuroökonomie, das bereits selbst Verhaltensökonomie, Psychologie und Neurowissenschaften vereint, ist aus dem Willen entstanden, eine fundierte und einheitliche Theorie über menschliches Verhalten aufzustellen, die das weitgehend realitätsfremde Bild des Menschen als homo oeconomicus ersetzen sollte. Die Anwendung neurowissenschaftlicher Methoden hat bereits dazu beigetragen, Zustände und Prozesse innerhalb des menschlichen Gehirns vor, während und nach ökonomischen Entscheidungen genauer zu beschreiben und zu erklären. Es hat sich beispielsweise herausgestellt, dass affektive Prozesse bei ökonomischen Entscheidungen kognitive Prozesse überwiegen und Emotionen sogar eine wichtige Voraussetzung für rationales Handeln darstellen. In den letzten Jahren haben Marketing- und Finanzforscher begonnen, neuroökonomische Erkenntnisse auf ihre wirtschaftlichen Zweige erfolgreich zu übertragen. Nun stellt sich die Frage, ob solche Erkenntnisse auch für das Controlling relevant sein könnten, da menschliches Verhalten auch im Controlling eine wesentliche Rolle spielt. Vor diesem Hintergrund intendiert die vorliegende Thesis, wichtige Eckpunkte zur Neuroökonomie- und Controllingforschung zu präsentieren, sowie Implikationen einer Zusammenführung beider Disziplinen zu erläutern. Dabei wird insbesondere auf die Gestaltung von Anreizsystemen und die Rolle des Controllers eingegangen, bevor letztlich der momentane Entwicklungsstand kritisch gewürdigt wird. Die Thesis führt zur Erkenntnis, dass die Anwendung neurowissenschaftlicher Methoden auf das Controlling ein besseres Verständnis über das Verhalten von Managern vermitteln würde. Dies hätte zudem positive Auswirkungen auf die Gestaltung von Anreizsystemen und auf die Ausführung der Rolle des Controllers als „Business Partner“. Allgemein würden Erkenntnisse aus diesem neuen Forschungsfeld die Informationsasymmetrie im Unternehmen verringern und sich somit positiv auf das Unternehmen auswirken. Mit dieser Thesis wird insbesondere die Zielsetzung verfolgt, die Aufmerksamkeit von Controllern auf Neuroökonomie zu erhöhen. Zusammenfassend ist zu konstatieren, dass für das gerade entstehende Forschungsfeld des „Neurocontrollings“ zwar wesentliche Hürden bestehen, gleichzeitig jedoch ein erhebliches Erkenntnispotenzial existiert und eine Erweiterung von Theorien im verhaltensorientierten Controlling durch die Neurowissenschaften in Aussicht gestellt ist.

Table of Contents

II

Table of Contents Abstract (German) ............................................................................................................. I Table of Contents ............................................................................................................. II List of Abbreviations ...................................................................................................... IV List of Figures ...................................................................................................................V 1

2

Introduction ............................................................................................................... 1 1.1

Emergence of Neuroaccounting......................................................................... 1

1.2

Structure of the Thesis ....................................................................................... 4

Neuroeconomics ........................................................................................................ 6 2.1

2.1.1

Multidisciplinary Origins of Neuroeconomics ........................................... 6

2.1.2

Neuroeconomic Methodologies ................................................................ 10

2.1.3

Decision Theory - The Core Building Block of Neuroeconomics ........... 15

2.2

Neuroeconomic Research on Rationality and Emotion in Decision Making .. 18

2.2.1

Dual-Process Theory of Decision Making ............................................... 19

2.2.2

Affective Mechanisms of Decision Making ............................................. 21

2.2.3

Effects of Risk and Uncertainty in Decision Making ............................... 23

2.3

3

Foundations of Neuroeconomics ....................................................................... 6

Theoretical Implications of Neuroeconomics .................................................. 26

2.3.1

Active Topics and Key Findings in Neuroeconomics .............................. 26

2.3.2

Discussion about the Relevance of Neuroeconomics ............................... 30

Management Accounting ........................................................................................ 33 3.1

Nature and Scope of Management Accounting ............................................... 33

3.1.1

Foundations of Management Accounting ................................................ 34

3.1.2

Developments in the Role of Management Accountants ......................... 37

3.1.3

Challenges for Management Accountants ................................................ 41

3.2

Decision Making in Management Accounting ................................................ 43

3.2.1

Environmental Influences on Managerial Decision Making .................... 44

Table of Contents

3.2.2

The Decision-Making Process .................................................................. 45

3.2.3

The Influence of Cognitive Biases in Decision Making........................... 48

3.2.4

More Effectiveness through Evidence-Based Decision Making .............. 51

3.2.5

Management Accounting Tools Supporting Decision Making ................ 53

3.3

4

Management Accounting Research Relevant to Neuroeconomics .................. 56

3.3.1

Decision Making under Risk and Uncertainty ......................................... 56

3.3.2

Intertemporal Nature of Decisions ........................................................... 58

3.3.3

Motivation, Fairness and Other Social Aspects........................................ 60

Neuroaccounting ..................................................................................................... 63 4.1

The Emergence of Neuroaccounting ............................................................... 63

4.2

Potential Contribution of Neuroeconomics to Management Accounting ........ 67

4.2.1

Understanding the Decision-Making Process........................................... 68

4.2.2

Design Implications for Incentive Schemes ............................................. 71

4.2.3

Implications for Management Accountants .............................................. 75

4.3 5

III

Limitations and Challenges in Neuroaccounting ............................................. 77

Conclusion............................................................................................................... 80 5.1

Summary of the Thesis .................................................................................... 80

5.2

Future Research Opportunities ........................................................................ 81

References ...................................................................................................................... 83 Appendix: Abstract (English) ......................................................................................... 90

List of Abbreviations

List of Abbreviations BOLD

Blood Oxygenation-Level Dependent

Cf.

Confer to

CIMA

Chartered Institute of Management Accountants

DLPFC

Dorsolateral Prefrontal Cortex

EEG

Electroencephalography

et al.

and others (lat: et alia)

fMRI

Functional Magnetic Resonance Imaging

i.e.

that is (lat: id est)

IMA

Institute of Management Accountants

MEG

Magnetoencephalography

mPFC

Medial Prefrontal Cortex

MRI

Magnetic Resonance Imaging

NAc

Nucleus Accumbens

NAA

National Association of Accountants

OFC

Orbitofrontal Cortex

p.

page

pp.

pages

PET

Positron Emission Tomography

tDCS

Transcranial Direct Current Stimulation

TMS

Transcranial Magnetic Stimulation

vmPFC

Ventromedial Prefrontal Cortex

IV

List of Figures

V

List of Figures Figure 1: Structure of the thesis........................................................................................ 5 Figure 2: Brain regions and their main functions ........................................................... 12 Figure 3: Value-based decision-making phases ............................................................. 17 Figure 4: Process characteristics of System 1 and 2 ....................................................... 20 Figure 5: Value (left) and weighting (right) functions from prospect theory................. 24 Figure 6: Trends on roles of management accountants .................................................. 39 Figure 7: Role models of management accountants ....................................................... 40 Figure 8: Environment of managers in a management accounting context ................... 45 Figure 9: The decision-making process .......................................................................... 47 Figure 10: Sources of information in evidence-based decision making......................... 52 Figure 11: Integration of neuroeconomic factors to the environment of managers ....... 67

1

Introduction

1

1 Introduction This thesis investigates the potential benefits of merging management accounting research with neuroeconomics into a new interdisciplinary field of “neuroaccounting”1. First of all, it is necessary to understand where the idea comes from and why this topic should receive more attention, so that the results presented subsequently are comprehensible. The second part of the introduction describes the structure of the thesis.

1.1 Emergence of Neuroaccounting The idea of neuroaccounting is built on a recently emerged discipline called neuroeconomics, which is a new science of decision making that combines economics, psychology and neuroscience with the aim to build a unified theory about the way humans make decisions.2 Management accounting scholars are also increasingly interested in the fundamental nature of human behavior since their main function is to guide managers to an optimal decision. Although the provision and reporting of financial information is still at the core of the management accountant’s role, non-financial and behavioral components are receiving more attention.3 As many questions arise in this domain, it seems reasonable to take neuroeconomics into account.

Recent developments in neuroscience have improved the way brain processes can be analyzed during decision making allowing to identify more precisely which brain regions are activated when individuals effectuate a specific task. This led to the discovery of two systems used by the brain – an affective and a cognitive one.4 Neuroeconomic scholars are trying to understand the interplay of these systems as this might offer essential insights about the decision-making process. It has for instance been proven that emotional processes overweigh cognitive processes during decision making, which has significant implications for several research areas that are relevant to management accounting such as decision making under risk and uncertainty, intertemporal choice, and reward and punishment.5 Management accounting scholars have started research projects considering these findings with the intention to make first relevant contributions to their field. By 1

Birnberg and Ganguly (2012), p.1. Cf. Rustichini (2005), pp.203-204. 3 Cf. Kim et al. (2012), p.4. 4 Cf. Loewenstein et al. (2008), pp.649-650. 5 Cf. Slapnicar et al. (2012), pp.1-2. 2

1

Introduction

2

now, some conceptual papers discuss the probability of the emergence of neuroaccounting but no experimental study within this line of investigation has been published yet.

However, in accordance with the state-of-the-art of management accounting research, scholars in this field would do well in considering the opportunities neuroscientific methods offer to management accounting. The general aim of management accounting is to improve the company’s efficiency and hence the quality of the manager’s decisions. 6 In this regard, the existing information asymmetry between the deciding manager and the organization or the management accountant is a major problem. This so-called principalagent problem leads to a conflict of interests and it often happens that managers act in their own self-interest instead of the organization’s interest.7 To mitigate this dilemma, incentive systems play an important role in management accounting. However, it still happens that managers do not meet the interests of the company. This might rely on wrong incentives but also on the simple fact that humans are subject to cognitive biases when they make decisions. Such biases can lead to severe mistakes and in the worst case to the end of a company.8 Neuroscience gives us new insights into those cognitive biases like overconfidence or loss aversion and shows us where they can be seen in the brain. It is important to understand which cognitive biases exist in decision making, why they occur and how they affect our decisions. Understanding what happens in the brain of a decision maker during each stage of the decision-making process may provide useful insights to further improve the quality of the manager’s decisions and meet the interests of the organization more appropriately. Hence, neuroaccounting research might help organizations to reduce the effect of the principal-agent problem.

The purpose of this thesis is to arouse more interest among current management accountants in the innovative research area of neuroaccounting, thereby providing a basis for identifying its potential benefits. It serves as a guideline for future neuroaccountants and gives an overview on both superordinate research fields of neuroeconomics and management accounting. Overall, the analysis shows that decision making is a key aspect in neuroeconomics as well as in management accounting, so that it seems appropriate to unify those two very complex disciplines. Chapter four presents several benefits that might 6

Cf. Riahi-Belkaoui (2002), p.xi. Cf. Gong and Tse (2009), p.58. 8 Cf. Tversky and Kahneman (1974), p. 1124. 7

1

Introduction

3

arise from neuroaccounting. Understanding the interplay between affective and cognitive decision-making processes would throw light on cognitive biases and might implicate new designs of incentive schemes.9 Further, neuroaccounting studies might give support to the new role of management accountants by offering a new basis to report information effectively to managers and to further act as a business partner. However, neuroeconomics itself is still at its beginnings, so that early neuroaccountants are confronted with important challenges. To conduct a neuroaccounting study, the access to neuroscientific tools needs to be guaranteed and a multidisciplinary team with at least one neuroscientist skilled in analyzing brain images is required, which implicates rather high financial and intellectual startup costs. Moreover, by now, there is only limited evidence to draw on and interpreting results from neuroscientific studies is delicate.10 Hence, the development of this discipline might take some time but the challenges are likely to be overcome with a thorough training and external funding.

The emergence of neuroaccounting may have a significant impact on both the research and practice of management accounting. Behavioral accounting researchers face the problem to rely mostly on findings and theories from psychology and behavioral economics. The application of results from behavioral disciplines into the practice is rather arduous as people mostly prefer scientific results, especially individuals in the field of business and economics.11 Neuroscience may offer such a scientific basis to support or redefine existing theories and build new theories, which may be considered in organizations. As incentive schemes are crucial tools in the practice of management accounting, it would be of great interest for management accountants to adapt these tools to new neuroeconomic evidence in order to improve their impact on decisions of managers. Furthermore, although the role of management accountants is moving away from a “bean counter” to a “business partner”, reporting remains a key function.12 The way financial and non-financial information is presented to managers can be decisive. Hence, an improvement of reporting techniques by integrating new evidence gained from neuroscientific analyses is more than welcome.

9

Cf. Slapnicar et al. (2012), pp.12-13. Cf. Slapnicar et al. (2012), pp.18-19. 11 Cf. Glimcher et al. (2009), p.4. 12 Cf. Kim et al. (2012), pp.6-7. 10

1

Introduction

4

According to the current state of management accounting research and to the opportunities that neuroeconomics offer, the main purpose of this thesis is to answer the question:

Can the application of neuroscientific methods on management accounting improve managerial decision making?

1.2 Structure of the Thesis The remainder of the thesis is structured as follows. Chapter two introduces the field of neuroeconomics. It presents its foundations that are fundamental for understanding the added value provided by neuroeconomics. A brief historical overview is followed by a description of the brain and of neuroscientific techniques, and by a presentation of the decision theory, which is the core building block. Chapter two continues with an analysis of the role of emotions and rationality in economic decision making, thereby focusing on the dual-process theory, affective mechanisms and effects of risk and uncertainty. The chapter concludes with theoretical implications of neuroeconomics, discussing active topics and key findings, as well as its relevance for other fields of research.

Correspondingly, chapter three gives an overview of the management accounting discipline. Primarily, it focuses on the nature and scope of management accounting, thereby demonstrating its behavioral nature as well as current developments of the management accountant’s role and emerging challenges. Then it examines decision-making issues in management accounting research, starting with a description of the environmental influences affecting managers. Subsequently, the next section presents the decision-making process from the perspective of the Chartered Institute of Management Accountants (CIMA)13, before introducing the influence of cognitive biases in decision making. As these biases affect the organizational effectiveness, chapter three presents the concept of evidence-based decision making and several management accounting tools, which contribute to a reduction of systematic errors. Ultimately, it reviews research topics that are relevant to both disciplines, i.e. decision making under risk and uncertainty, intertemporal choice, as well as motivation, fairness and other social aspects.

13

Cf. Chartered Institute of Management Accountants (2008b), pp.12-15.

1

Introduction

5

Chapter four synthesizes the two previous chapters by presenting the emergence of a new sub-field that is likely to be called neuroaccounting. After having presented the emergence of neuroaccounting and having explained its roots, chapter four continues by determining some potential benefits of neuroaccounting that would lead to an improvement of managerial decision making. This amelioration would be the result of a better understanding of the decision-making process, specific design implications of incentive schemes and positive outcomes for management accountants, induced by neuroaccounting research. Chapter four finalizes the examination of neuroaccounting by discussing some limitations and challenges that early neuroaccountants might encounter. Ultimately, chapter five concludes the thesis by recapitulating the whole issue and results, before presenting opportunities for future research. Figure 1 gives a brief overview of the structure of the thesis. Figure 1: Structure of the thesis

(Source: Own representation)

2

Neuroeconomics

6

2 Neuroeconomics Since this thesis investigates whether it makes sense to merge management accounting research with neuroeconomics into a new interdisciplinary field, it is first of all necessary to be informed about the field of neuroeconomics, which has only recently emerged. Therefore, chapter two starts with an introduction of neuroeconomics, thereby clarifying its multidisciplinary foundations that are fundamental for understanding the added value provided by neuroeconomics. Here, a brief historical overview is followed by a presentation of neuroeconomic methodologies, including a portrait of the brain and neuroscientific techniques, and subsequently by a presentation of the decision theory, which is the core building block. After this introduction into the field, chapter two continues with an analysis of the role of emotions and rationality in economic decision making, thereby focusing on the dual-process theory, affective mechanisms and effects of risk and uncertainty. The chapter concludes with theoretical implications of neuroeconomics, discussing active topics and key findings, as well as its relevance for other fields of research.

2.1 Foundations of Neuroeconomics Most economic models still assume that humans are hyper-rational agents, although it is widely accepted today that the homo economicus has long since been outdated.14 For that reason, scholars from different disciplines came together and gave birth to a new interdisciplinary field of research, neuroeconomics. However, in order to understand in depth why neuroeconomics recently emerged, it is important to be aware of its roots, which are first of all described in this chapter. But an understanding of its methodologies is also essential to be able to conduct and understand neuroeconomic studies. Therefore, this chapter proceeds by portraying the brain and introducing neuroscientific techniques, as well as presenting the decision theory, which is the core building block of neuroeconomics.

2.1.1 Multidisciplinary Origins of Neuroeconomics Neuroeconomics is a field that is still at its infancy, but its historical background is already hundreds of years old. In order to understand why this interdisciplinary field emerged and

14

Cf. Santos and Chen (2009), p.82.

2

Neuroeconomics

7

why it may play an important role in the future, it is necessary to get an overview of the evolution of the two main disciplines, economics and neuroscience. Both have been significantly influenced by psychology in the last century.

Evolution of Economics Rustichini, an influential neuroeconomist within the economic community, explains, “the more ambitious aim of neuroeconomics is going to be the attempt to complete the research program that the early classics (in particular Hume and Smith) set out in the first place: to provide a unified theory of human behavior.”15 Following this idea, it is interesting to get a deeper insight of economic history, beginning in the classical period. It was Hume in 1739 who already set the path that would finally lead to neuroeconomics in his work ‘A Treatise of Human Nature’ by claiming that we would need to “march directly to the center of these sciences, to human nature itself”16 in order to understand our philosophical researches. The founding father of modern economics, Adam Smith, followed this path in his work ‘The Theory of Moral Sentiments’ in 1759, in which he analyzed how human societies can function properly with men being fundamentally selfish. According to Rustichini, the answer provided by Smith is that the innate affect of sympathy corrects the selfishness of human nature and hence makes human society stable. Smith’s analysis was prophetic and he might have been the first neuroeconomist if the state of psychology of the day had not been as limited.17 There were also some other early neuroeconomists who were dreaming about tools like a ‘hedonimeter’, a psychophysical machine that could register emotions, but none of them succeeded.18 With his next work ‘The Wealth of Nations’, Adam Smith set the beginning of the classical period of economic theory in 1776, a period that abandoned his own and Hume’s initial thought. The success of the idea of the Invisible Hand presented in his latest work, saying that society could function well without social inclination in human nature, led economists to follow the more restricted path set by Ricardo’s ‘On the Principles of Political Economy and Taxation’ in 1821.19 This led to the neoclassical revolution in the

15

Rustichini (2005), pp.203-204. Hume (1739), as cited in Rustichini (2005), p.204. 17 Cf. Rustichini (2005), pp.204-205. 18 Cf. Glimcher et al. (2009), p.2. 19 Cf. Rustichini (2005), pp.204-207. 16

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Neuroeconomics

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beginning of the 1930s and the independence of economics from psychology, an evolution which had been predicted by Pareto in 1897, when he noted, “pure political economy has (…) great interest in relying as little as possible on the domain of psychology.”20 At that time, Friedman, one of the most influential economists of the twentieth century, followed this path of rational economic thinking supporting the idea that the accuracy of the predictions of models would be more important than the representation of the true causal effects of the predictions. According to Glimcher Camerer, Fehr and Poldrack, he somehow “licensed economists to ignore evidence of when economic agents violate rationalchoice principles (…), a prejudice that is still widespread in economics.”21

So when Savage published the subjective expected utility theory, it offered a source of critique for several economists who believed that theories served as a base for thinking. Allais and Ellsberg gave birth to eponymous paradoxes by revealing some of Savage’s axioms. Consequently, new theories with the aim to “accommodate the paradoxical behavior in a way that is both psychologically plausible and formally sharp”22 raised, challenging the neoclassical models since they would only work under some limited circumstances. Subsequently, Kahneman and Tversky expanded the range of such phenomena in their seminal work on heuristics and biases. As a result, a group of economists and psychologists started in the late 1970s and 80s to collaborate as behavioral economists in order to improve economic analysis by incorporating psychological principles. Their ideas gave rise to a group of experimental economists who pretended that the incorporation of psychological methods would improve the testing of economic theory. These two groups of economists were crucial for the emergence of neuroeconomics.23

Evolution of Neurosciences At about the same time, neurosciences experienced a cognitive neuroscientific revolution. This revolution resulted from the fusion of the two traditional approaches – the neurological and physiological approach – that dominated during the classical period in neurology. The neurological approach tried to relate mental state affected by brain lesions to neurological damage, i.e. deficits in movement generation, but had a lack in theory. In contrast

20

Busino (1964), p.xxiv, as cited in Glimcher et al. (2009), p.3. Glimcher et al. (2009), p.3. 22 Glimcher et al. (2009), p.3. 23 Cf. Glimcher et al. (2009), pp.3-4. 21

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Neuroeconomics

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to that, the physiological approach used a more precise set of methodological tools to study the brain. However, such methods were too invasive and destructive. This is the reason why the two approaches needed to merge together over time and psychology started to gain more recognition in neurology. In the 1990s, Damasio, Bechara and their colleagues were the next to set a milestone that paved the way for the emergence of neuroeconomics. Their systematic study of decision making deficits was based on the most famous neurological case of Phineas Gage who showed significant changes in personality and decision making after his brain had been penetrated by a steel rod in 1848. Afterwards, the development of brain imaging techniques that were non-invasive was crucial for neurosciences.24 Measuring emotions of humans was not a dream anymore. However, according to Glimcher, Camerer, Fehr and Poldrack, “there was no clear theoretical tool for organizing [the] huge amount of information”25 gained by measuring the brain activity of humans during decision making. Such a theoretical framework could be found within economics. Hence, in the beginning of the 21st century, economics and neuroscience, both highly influenced by psychology, came together. In 2003, after a set of meetings and conferences, “a group of economists, psychologists and neurobiologists began to identify themselves as Neuroeconomists.”26 Subsequently, a stream of decision-making studies were conducted by the behavioral economic and cognitive neuroscientific community referring to this new neuroeconomic discipline.

Finally, from the point of view of the decision theory, which is the core building block of neuroeconomics, it is important to understand that the three individual disciplines are limited in their theoretical foundations. The decision theory of economics on its own is limited because of its rationality assumption. Psychology does include emotions but often tends to use circular reasoning as behavior is mainly explained by behavior, whereas neuroscience does not consider the social context in their experiments. Therefore, it was necessary to unify those different disciplines in order to build a new general theory of decision making. Furthermore, neuroeconomics even seems to be a natural evolution of its three main disciplines. According to Loewenstein, “despite the divergent worldviews of contemporary psychologists and economists, the two disciplines are essentially siblings

24

Cf. Glimcher et al. (2009), pp.5-6. Glimcher et al. (2009), p.6. 26 Glimcher et al. (2009), p.8. 25

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Neuroeconomics

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separated at birth. Both have a fundamental interest in understanding human behavior.”27 But none of them have the right tools to capture the essence of decision making. Neurosciences also have an interest in understanding how humans make decisions, but on the contrary they have a lack of formal theory.28 Hence, the required formal theory by behavioral economics and the necessary methodological tools to understand behavior more accurately could be provided by cognitive neuroscience. Those tools are presented in the next section, as well as a portrait of the brain.

2.1.2 Neuroeconomic Methodologies The objective of neuroeconomics is to understand how humans make economic decisions by looking at how their brain works. The human brain is without regard the most complex and sophisticated natural organ having evolved over millennia. Neuroeconomics assumes that the decision-making process takes place once sensory evidence has been accumulated by the brain. Thereafter, our brain makes decisions by comparing options and selecting certain behavioral patterns. In the last decades, neuroscientists developed several observation techniques to open this black box. Basically, such cognitive neuroimaging methods enable us to locate a neuronal signal in a specific part of the brain as a reaction to a particular stimulation.29 In order to understand the result of neuroeconomic studies, a brief anatomical overview of the human brain is necessary as well as a presentation of how neuroscience applies its observation techniques on economic principles to create a new theory of decision making.

Portrait of the Brain A common division of the brain is to distinct between the reptilian brain with its survival functions, the mammalian brain that is correlated with social emotions and the hominid brain which is unique to humans being responsible for more complex cognitive functions. If we compare the different brains, the difference in size is obvious and somehow reflects the evolutionary process. The most evolved brain part in humans compared to other living creatures is the endbrain or more specifically the cortex, which lies right beneath the

27

Loewenstein et al. (2008), p.648. Cf. Glimcher et al. (2009), p.6. 29 Cf. Sanfey and Dorris (2009), pp.67-69. 28

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Neuroeconomics

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skull.30 Nowadays, neuroscientists assume that the cortex, which is associated with cognitive processes like thinking and calculating, is one of the critical decision-making areas. Another important area in the decision-making process that is associated with affective processes, i.e. emotions, is the limbic system, which evolved already in earlier life forms and is situated further below the skull.31

The cortex has often been called the seat of consciousness because of its ability to adjust deliberately our reactions to external stimuli in an appropriate way. The cerebral cortex can be divided into four lobes – frontal, parietal, occipital and temporal – whereas many important brain areas involved in decision making are located in the frontal lobe. The decisive part of this lobe is the prefrontal cortex which can further be subdivided into several cortices. The dorsolateral prefrontal cortex (DLPFC) is a key area for cognitive processes being especially responsible for planning, as well as working memory and cognitive flexibility. Another important part is the orbitofrontal cortex (OFC) which influences our social behavior and also plays a critical role in the valuation process of decisions. Finally, the medial prefrontal cortex (mPFC) plays a critical role in the regulation of emotional responses.32

Likewise the limbic system as counterpart to the cortex could be named the emotional seat of consciousness. Nowadays, the limbic system is defined by the structures that are at the transition between cortex and interbrain, the latter being associated with unconscious and automatic processes. Key areas are the hippocampus and the amygdala, as well as some parts of the cortex like the cingulate cortex and the mPFC which are a moderate conjunction between both systems. The hippocampus contributes to our orientation in space, to our memory capacity and regulates incoming stimuli. The amygdala is the seat of emotional memory. It is among other things responsible for the processing of positive emotional reactions but also for negative affects like anger, fear or disgust. Furthermore, it is directly connected with the hypothalamus, which is the main regulator of the automatic nervous system, and receives information unconsciously from the main part of the interbrain, the thalamus. Besides, the cingulate cortex enables the hippocampus and the amygdala to communicate with the cortex and the mPFC interacts with the amygdala in 30

Cf. Dunbar (1998), p.3. Cf. Slapnicar et al. (2012), p.5. 32 Cf. Derouiche (2011), pp.23-33. 31

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Neuroeconomics

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order to regulate emotions.33 Of course, there are still many other important parts of the brain interplaying with those described above, but this overview suffices to understand results from neuroeconomic methods. Figure 2 summarizes the main functions of the relevant brain regions.

Figure 2: Brain regions and their main functions

Brain Region

Main Functions

Dorsolateral Prefrontal Cortex

Planning, working memory, cognitive

(DLPFC)

flexibility

Orbitofrontal Cortex (OFC)

Influences social behavior, derives an integrated value signal, learn values

Medial Prefrontal Cortex (mPFC)

Regulates emotional responses

Amygdala

Seat of emotional memory (e.g. fear)

Hippocampus

Orientation in space, memory capacity, regulates incoming stimuli (Source: Own representation based on Derouiche (2011), pp.23-37)

Neuroeconomic observation techniques rely on the neuronal activity, hence we need to look further into the brain. There we can identify billions of neurons which are responsible for the information processing and even ten times more glia cells that are essential for a fast information transmission. The neuron is the basic unit of the brain and consists of the cell body (soma), dendrites and axon. The dendrites accumulate information from other neurons or from sensory organs. The cell body integrates this information and produces an action potential, which is part of the process occurring during the neuronal firing. Subsequently, this action potential propagates down the axon and induces some neurotransmitters in the synaptic cleft that activates the next neuron or for example a muscle. Such a neurotransmitter can be for example glutamate, glycine, dopamine or adrenalin, with glutamate being the most common one in the brain. The whole process can be influenced externally for example by drugs or scientific methods.34 Moreover, a specific type of glia cells, the astrocytes, are important for neuroeconomics as they regulate the blood in the different brain regions depending on their activity. Observing the blood flow of

33 34

Cf. Derouiche (2011), pp.36-37. Cf. Derouiche (2011), pp.13-17.

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brain regions is the basis for brain imaging techniques. Another important point is the differentiation of grey and white matter in the brain. Basically, white matter consists of axons that create a connection between different brain regions and grey matter contains most of the brain’s neuronal cell bodies. The differentiation of grey and white matter enables a mapping of the complete surface of the cortex into different areas, which is also necessary for brain imaging.35

Neuroeconomic Methods As explained in chapter 2.1.1, Neuroeconomics was not only the product of behavioral and experimental economics but also of cognitive neurosciences. According to Camerer, “scientific technologies are not just tools scientists use to explore areas of interest. New tools also define new scientific fields and erase old boundaries.”36 And this is exactly the reason why neuroeconomics emerged. Today, the methods used in neuroeconomic research are very diverse. In the past, cognitive neurosciences began with more or less unsystematic examinations of patients with brain lesions or tumors and analyzed their behavior. The development of brain imaging techniques was like a revolution for cognitive neurosciences as it allowed to experiment in real-time with healthy human brains.37

Brain imaging consists in measuring brain activity during a cognitive task in order to reproduce a picture of brain areas that are activated. There exist several brain imaging techniques like the electroencephalography (EEG) which records electrical activity within the brain by attaching electrodes to the scalp, whereas magnetoencephalography (MEG) measures the magnetic fields produced by electrical activity in the brain. Today, the most popular technique used on humans is functional magnetic resonance imaging (fMRI). The reason for its success is its ability to measure and above all to visualize activity in the whole brain. The recording of the activity occurs by tracking the blood flow in the brain and determining the BOLD (blood oxygen level dependent) signal. This BOLD signal is based on the magnetic properties differing because of blood oxygenation. Despite its popularity, fMRI as well as the other brain imaging techniques have pros and cons, especially regarding the spatial and temporal resolution.38

35

Cf. Derouiche (2011), pp.17-19. Camerer et al. (2005), p.11. 37 Cf. Weber, B. (2011), p.42. 38 Cf. Weber, B. (2011), pp.44-50. 36

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Moreover, neuroeconomists conduct their experiments also with other methods. Some are restricted to animals as they might damage the human brain irreversibly like electrical brain stimulation, but are still helpful in understanding the human brain since many brain structures are similar. Another invasive technique is the single neuron measurement, which can measure a single neuron’s firing by inserting electrodes into the brain. Traditional techniques like the measurement of psychological indicators, i.e. heart rate, blood pressure, galvanic skin response and pupil dilation, or psychopathology and the investigation of brain lesions in humans are still very helpful in gaining information about how the brain works.39 Nowadays, scientific innovations permit to simulate such lesions in human brains. Kahneman declared, “A new era in neuroeconomics began with the introduction of experimental manipulations such as transcranial direct current stimulation (tDCS) or the inhalation of oxytocin to induce predictable behavioral consequences”.40 Moreover, the transcranial magnetic stimulation (TMS) is highly related to the tDCS. Both can temporarily activate or inhibit brain areas either by using constant, low current via electrodes or by using pulsed magnetic fields. According to Kahneman, a further method that can be combined with brain imaging is the use of pharmacological. As our knowledge about neurotransmitter systems is growing, our ability to influence human behavior specifically through the administration of particular substances like hormones is growing. Oxytocin seems for example to influence our risk-behavior. Finally, genetic studies also start to play a more important role since they might help to understand individual differences in behavior.41 According to Camerer, “neuroscientists often use a combination of methods together in a research program [since] [e]very method has a fundamental weakness, for which some other method compensates.”42 Therefore, it is essential to be aware of the strengths and weaknesses of each method, so that the best ones are selected to answer the research question. However, the probably biggest challenge in neuroeconomics is to interpret the results correctly. Moreover, the overall experimental framework should be kept simple and be well controlled. Because of the relatively high costs and the equipment involved, some researchers have the wrong tendency to answer several research questions within

39

Cf. Camerer et al. (2005), pp.12-14. Kahneman (2009), p.524. 41 Cf. Weber, B. (2011), p.51-55. 42 Camerer (2013), p.16.4. 40

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one experiment. Such experiments mostly use approaches derived from the game theory in behavioral economics like ultimatum games, trust games, the prisoner’s dilemma, gambles and lotteries.43 In addition to the costs and the difficulty to interpret results correctly, neuroeconomic research is also limited because of ethical boundaries. Since this field is still very young, there is still an important lack of knowledge which can have implications for the subjects being tested and by now it is unclear how neuroeconomic evidence will be used in the future. This is why the studies are regulated by the ‘Ethical Principles for Medical Research Involving Human Subjects’. Another personal issue is the question how to deal with incidental findings of brain damages or tumors. Finally, there are always some extreme scenarios of misusing future technologies that will evolved over the years, which may slowdown the development of new techniques. This sounds like science fiction, but the fear of being too transparent or remotely controlled exists.44

2.1.3 Decision Theory - The Core Building Block of Neuroeconomics In a previous chapter, the goal of neuroeconomics was defined as to build a general theory of decision making. Therefore, it is necessary to outline the neuroeconomic view on decision theory, especially decision under risk, i.e. with known probabilities, and uncertainty, i.e. probabilities are unknown. In neuroscience as well as economics, model-building and quantification have a high value. Hence, many neuroeconomic researchers believe that neurobiological and decision theoretic research can and will complement each other. However, there are still tensions regarding a methodological point of view.45

The basic notions of decision theory were set by Pascal in the mid-17th century, with expected utility maximization and subjective probability being two key components. Later, Bernoulli extended this idea introducing the expected utility hypothesis. This probabilistic quantification of uncertainty has been a matter of debate until today. However, the dominating methodology in economic decision theory was the axiomatic approach with expected utility maximization being a classical example. According to Gilboa, “the mainstream view among theorists is that expected utility maximization, with respect to a

43

Cf. Weber, B. (2011), p.44. Cf. Zichy (2011), pp.317-322. 45 Cf. Caplin and Dean (2009), p.21. 44

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subjective probability, is the only rational way of behavior.”46 Nevertheless, this idea has been challenged. In 1957, Simon disputed the very paradigm of optimization arguing that decision makers rather satisfice than optimize. He also coined the term bounded rationality, a term that has affected the way many decision theorists think and which has led to contradictory theories. For neuroeconomists, one of the most important theories that evolved is the prospect theory from Kahneman and Tversky. Herewith, they demonstrated that the classical theory of expected utility maximization could not explain many phenomena relative to a subjective probability.47

Overall, decision theory is concerned with goal-directed behavior in the presence of options. Camerer explains that fundamentalist decision theory and neuroeconomics both agree “that the goal of economics is to predict choices and comparative statics effects.”48 However, there is still a conflict since fundamentalists highlight the necessity of using revealed-preferences, whereas neuroeconomists believe that different systems are responsible for decisions between choices and thus emphasize the importance of understanding those systems. In other words, it is the evidence that multiple neural systems of valuation and choice exist that provokes a conflict.49 As we see, valuation is at the core of neuroeconomics. Montague defines valuation as “the way the brain values literally everything from internal mental states to experienced time (the neuroscience part), and why it should do so one way and not another (the normative economics part).”50 This definition indicates once more how important this new discipline of neuroeconomics is for understanding valuation processes and hence decision making.

Moreover, the valuation process can be seen as a stage of the decision-making process. This decision process has been divided into different distinct phases by several theorists, but whether these stages occur sequentially or parallel is still a matter of debate.51 Nevertheless, it is easier for our understanding to look at the processes sequentially. Rangel, Camerer and Montague offer such an overview of value-based decision making (see Figure 3). They established their categorization on theoretical models of decision making in

46

Gilboa (2009), p.3. Cf. Gilboa (2009), pp.1-5. 48 Camerer (2013), p.16.7. 49 Cf. Camerer (2013), pp.16.7-16.8. 50 Montague (2007), p.219. 51 Cf. Hansson (2005), pp.9-12. 47

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economics, psychology and computer science. According to their model, every decision process starts with the representation of the decision problem including the identification of the internal and external states of the subject and feasible courses of action. After this initial phase, the most critical stage for neuroeconomic studies takes place – valuation. Here, the subject assigns a value to the different possible actions by going through several cognitive and affective processes in order to make the most appropriate decision in stage three, action selection. Having implemented the decision, the outcome of the decision needs to be evaluated, so that the quality of future decisions can be improved by learning from this feedback in the final stage.52 Figure 3: Value-based decision-making phases

(Source: Rangel et al. (2008), p.546)

Since the valuation process is at the core of neuroeconomics, it is comprehensible that the question how value should be measured has always been at the center of many discussions. From a neurobiological perspective, the subjective value of an object is highly related to reward and punishment in the human brain.53 Furthermore, in the previous chapter neurons were defined as being key elements of neuroeconomic research. Dickhaut, Basu, McCabe and Waymire describe the researcher’s effort in two central points. First, they

52 53

Cf. Rangel et al. (2008), pp.545-546. Cf. Peters and Büchel (2010), p.137.

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focus on the identification of the firing neurons and the way their firing rate changes during experimental tasks. Second, they try to figure out the behavior of groups of neurons in specific parts of the brain and to understand the interaction between neurons in different locations.54 Overall, in a neuroeconomic way, we could define subjective value as the averaged firing rate of a population of neurons coding behavioral preferences. Different parts of the brain have been identified as critical players in decision making. The nucleus accumbens (NAc) seems to be decisive for the anticipation of gain magnitude and hence might represent expected subjective values. Besides, the OFC, which supervises the NAc, plays a key role in processing reward since it integrates multiple sources of information regarding the reward outcome in order to derive a value signal. This value signal is then transmitted to the DLPFC to reach the outcome by planning and organizing behavior. Furthermore, the dopamine system is also important during the valuation process as dopamine is involved in a prediction-error mechanism of reward learning.55

2.2 Neuroeconomic Research on Rationality and Emotion in Decision Making The use of innovative methods has opened new doors for neuroeconomic researchers. Through these new techniques, they can observe brain activity of interacting players who are playing economic games with real consequences. This has already helped neuroeconomists to figure out important aspects of the decision-making process and has also started to give some insights about how our emotions interfere with our rational judgments. However, the balance between rationality and emotions has not been found yet. Hence, understanding the interplay between rationality and emotion in economic decision making is still at the heart of neuroeconomic research. This chapter starts with a description of the dual-process view on decision making providing a basic understanding of decision processes in the brain. The subsequent part describes important affective mechanisms that are driven by motivation, reward and punishment, relying on Damasio’s somatic marker hypothesis, which was partly responsible for the birth of neuroeconomics. Finally, the following chapter introduces effects of risk in decision making, especially related to stud-

54 55

Cf. Dickhaut et al. (2009), p.224. Cf. Rangel et al. (2008), pp.546-553.

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ies of Kahneman and Tversky, since most of the decisions we make have unknown outcomes and are therefore biased. Their prospect theory offers an interesting theoretical background to understand decision-making processes.

2.2.1 Dual-Process Theory of Decision Making The previous chapters indicated that cognition and affect are an important issue in decision-making theory. In economics, rational decision making is often compromise through the occurrence of cognitive biases. Although the modern economic point of view still supports the idea of the homo economicus, behavioral economists like Kahneman and neuroscientists like Damasio have proven that such biases exist and that emotions play a decisive role in decision making. Neuroeconomics tries to understand the role of affect in decision making as it often leads humans to make suboptimal decisions. In order to do so, a major insight of neuroscience has been imported to neuroeconomics saying that when people face different types of problems, their brain do not act homogeneously, but “rather involves a melding of diverse specialized processes that are integrated in different ways.”56 This led to an interesting theoretical perspective in neuroeconomics called the dual-process view.

The idea of a dual-process model driving our behavior has already been examined by several researchers. One of the most influential studies for neuroeconomics is Kahneman’s ‘Maps of Bounded Rationality’ in which he explored, in collaboration with Tversky, the psychology of intuitive beliefs and choices, thereby examining the bounded rationality of economic agents.57 They identified two differently operating systems used by our brain to modulate our behavior. Figure 4 offers an overview of the process characteristics of the two systems. On the one side, Kahneman and Tversky assign system 1 to our intuition and characterize therefore the operations of this system as fast, automatic, effortless and emotionally charged. Furthermore, system 1 is very close to our perception and is hard to control or modify being governed by habit. On the other side, they associate system 2 with our conscious reasoning and describe its operations as slower, effortful and deliberately controlled, as well as flexible and rule-governed. One of the most important

56 57

Loewenstein et al. (2008), p.649. Cf. Kahneman (2003), p.1449.

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differences between both systems and that governs most of our decisions is the level of effort as our overall capacity for mental effort is limited.58

Figure 4: Process characteristics of System 1 and 2

System 1 – Intuition

System 2 – Reasoning

Fast

Slow

Parallel

Serial

Automatic

Controlled

Effortless

Effortful

Associative

Rule-governed

Slow-learning

Flexible

Emotional

Neutral

(Source: Own representation adapted from Kahneman (2003), p.1451)

The work of Kahneman and Tversky sets the basis for the development of the dual-process view in neuroeconomics. This theoretical perspective suggests that humans rely on an affective and a cognitive system. Interestingly, they indicate that affect dominates deliberate reasoning as driver of behavior. Slapnicar, Hartmann, Kramer and Bosman describe the two systems similarly to Kahneman. According to them, the affective system is “subconsciously activated, automatic and heuristic-based” and dominates the cognitive system that is “consciously activated, analytic and constrained by working memory capacity.”59 Camerer, Loewenstein and Prelec explain that humans tend to overestimate the role of control as we have far less introspective access to automatic processes. However, it has been proved that the rational, logical-deliberative system cannot function on its own if the affective system has been damaged. Thus, they conclude that the controlled and automatic processes or the cognitive and affective systems must interact, outlining that affect plays a dominant role in behavior.60

The dual-process theory elaborated by several behavioral economists can be seen as one of the principle alternative approaches that actually gave birth to neuroeconomics. The goal of behavioral economists has always been to minimally extend standard economic 58

Cf. Kahneman (2003), pp.1449-1451. Slapnicar et al. (2012), p.12. 60 Cf. Camerer et al. (2005), p.11. 59

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models by trying to incorporate new variables that might describe real-life situations and decisions more appropriately, even though the level of complexity would rise. From this point of view, although Glimcher challenges the dual-process theory by supporting a unitary system in decision making, he thinks that in economic models it might be a useful strategy to look at two independent agents or processes interacting instead of viewing a single agent maximizing a unifying utility.61 However, there is still a lack of neuroeconomic evidence about existing multiple systems and it is also still a matter of debate whether it makes sense to look at the activity of different brain areas in order to draw conclusions about affective and cognitive decision making.

2.2.2 Affective Mechanisms of Decision Making As explained in chapter 2.1.1, modern economic theory highlights the importance of rationality in decision making, although the initial thought of the founders of economic theory, Hume and Smith, gave a crucial role to emotions in the form of values. A reason why the role of emotions has largely been ignored in modern economics might be the difficulty to define and capture emotions in order to introduce them into economic models. However, the discussion about the role of emotions in decision making has started to regain more importance through neurosciences.

Damasio and Bechara, two of the most influential neuroscientists in neuroeconomics, followed the basic idea of economic theories, thereby defeating the idea of the homo economicus and highlighting utility, a term that initially tried to represent emotional factors of decision makers.62 Their research was based on the famous case of Phineas Gage who suffered from considerable brain lesions in the prefrontal cortex and acted completely different since then. The reason for his irrational decision making was that an important emotional part of his brain had been damaged. Based on this case, Damasio and his research group enhanced the number of experimental studies with several patients in order to validate significantly their idea that emotions might play a more important role in rational decision making than most economic theories suggest. Ironically, ‘unemotional’ patients could not react rationally. Their observations conducted Damasio to formulate the somatic marker hypothesis, which suggests that emotions play a key role in rational

61 62

Cf. Glimcher et al. (2009), p.7. Cf. Bechara and Damasio (2005), pp.336-337.

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decision making and that emotional processes can guide or bias behavior.63 Thus, he contradicted economic theories that ignored emotions and were only based on logical reasoning. According to Damasio, it is impossible to make fast and rational decisions in complex and uncertain situations without emotions. Hence, he claimed that emotions and feelings must play a crucial role in economic decision making, thereby challenging modern economic models.64 Although the somatic marker hypothesis has been challenged by several researchers, the study of Damasio, Bechara and their research group sets an important milestone in neuroeconomics highlighting the importance of emotions at a time when almost nobody offered attention to that issue.

However, the somatic marker hypothesis was just the beginning of a whole set of research on the role of emotion in decision making. Damasio himself indicated that there was much more behind his emotion concept. He assumed that the main factors influencing the decision process from a neural perspective are “the mechanisms of drives and motivations as well as those of reward and punishment, which are the fundamental constituents of the emotion machinery.”65 Subsequent investigations led to the discovery of key players of emotional processes, for example the amygdala as a main site for emotional learning related to fear and the ventromedial prefrontal cortex (vmPFC) for social emotions.66 According to Phelps, future approaches to the study of affect will need to be more sophisticated in order to better understand the role of emotions in decision making and the relation between value, emotion and choice.67 Nevertheless, the theory of the somatic marker hypothesis helps to understand decision making as well as other processes related with affect and motivation and offers a “basis for understanding how the most elevated of human abilities— the capacity to make decisions in the moral, social, and financial realms—are related to basic motivational and homeostatic processes that are shared among all mammalian species.”68

63

Cf. Bechara and Damasio (2005), p.346. Cf. Bechara and Damasio (2005), pp.337-339. 65 Damasio (2009), p.210. 66 Cf. Damasio (2009), p.210. 67 Cf. Phelps (2009), p.247. 68 Naqvi et al. (2006), p.263. 64

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2.2.3 Effects of Risk and Uncertainty in Decision Making It is a matter of fact that we are confronted with risk each day of our lives as we rarely know in advance what the consequences of our decisions will be. Neuroeconomic research is about examining major aspects of human decision making. Our decisions can often be biased by risk and context. Early economists developed different theories of rational behavior like the expected utility theory trying to create rational economic models that predict decision making under risk, assuming that people can objectively estimate value and probabilities of future outcomes. However, behavioral economists followed another path and tried to integrate behavioral factors like fairness, trust and altruism, thus deviating from these rational models. One of the major variations of Bernoulli’s expected utility theory that influenced neuroeconomics is the prospect theory which was formulated by Kahneman and Tversky in 1979. This descriptive model is a psychologically more accurate description of decision making, compared to the expected utility theory, as it tries to model real-life choices rather than optimal decisions. In the last decade, neuroeconomists demonstrated neural correlates of phenomena that lie at the heart of prospect theory, i.e. loss aversion, reference-dependence, probability weighting distortions and framing effects, in order to prove that anomalies in rational choice theories are real.69

An important difference between the expected utility theory and the prospect theory is that the latter adopted a value function over gains and losses relative to a reference point instead of the former utility function over states of wealth. The shape of the representative value and weighting functions from prospect theory illustrates some interesting phenomena with relevance for economic decision making (see Figure 5). The value function is concave for gains, contributing to risk aversion for gains, and convex for losses, contributing to risk seeking for losses. In addition to that, the value function is steeper for losses than gains and represents for this reason the phenomena of loss aversion.70 In other words, loss aversion means that a person requires a higher compensation to give up something that he owns than he would be willing to pay to get it. This can lead to an important effect when humans make decisions, the endowment effect, which describes that we give more value to objects when we feel owning them. Consequently, this should indicate economics that preferences of individuals between consumption goods do not stay constant but are

69 70

Cf. Slapnicar et al. (2012), pp.12-13. Cf. Fox and Poldrack (2009), p.149.

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consistently changing according to one’s reference point. Regarding the weighting function, prospect theory weights the value of an outcome with a decision weight instead of its probability, which gives rise to an inverse-S shaped function. This function shows that individuals tend to overweight low probabilities and underweight moderate to large probabilities, a phenomena that might explain the attractiveness of lotteries and insurances.71

Figure 5: Value (left) and weighting (right) functions from prospect theory

(Source: Fox and Poldrack (2009), p.149)

Another central phenomena of the prospect theory relevant to neuroeconomics is that the individual’s choice about alternatives is affected by the way they are presented. The perception of options can either be influenced by varying its description or by transforming and editing mentally the description unconsciously. This finding is contradictory to the description invariance assumption of the expected utility theory, which claims that preferences of decision makers are constant and rely on final states of wealth. Such an effect is called framing and results from the predominant loss aversion of humans in decision making described above. Prospect theory explains that a decision maker expresses his risk aversion by choosing the safe option if alternatives are framed as gains, and reverses his behavior to risk seeking when alternatives are framed as losses.72 A famous example of framing effects by Kahneman and Tversky is the “Asian disease”73 problem, in which

71

Cf. Fox and Poldrack (2009), pp.149-151. Cf. Fox and Poldrack (2009), pp.150-151. 73 Kahneman (2003), p.1458. 72

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two alternative programs are presented to combat an unusual disease that is expected to kill 600 people:

Alternative 1:

Program A: 100% probability, 200 saved.

Program B: 1/3 probability, 600 saved and 2/3 probability, 0 saved.

Alternative 2: Program A’: 100% probability, 400 will die. Program B’: 1/3 probability, 0 will die and 2/3 probability, 600 will die.

As we can see, both alternative descriptions of the problem are identical. However, the study of Kahneman and Tversky shows that a significant majority would choose Program A in the first alternative, indicating risk aversion, and Program B’ in the second one, the risk-seeking option. The reason for that is that the two versions stimulate different associations and evaluations. In this example, we can also see that certain outcomes are overweighted in relation to outcomes of high or intermediate probability.74

Neuroeconomic researchers are trying to explain why and how loss aversion biases the decision makers’ choices by studying the neural basis of the framing effect. According to Slapnicar et al., several studies have proved that it is not easy for individuals to determine objectively the magnitude of risk since feelings of fear deeply influence our perception of risk.75 As portrayed in chapter 2.1.2, the amygdala plays a central role in regulating emotions including fear. Hence, it seems that particularly the amygdala or more generally the affective system is responsible for the framing effect and several biases. The involvement of the amygdala could be demonstrated with fMRI and is consistent with the hypothesis that “such biases reflect the influence of basic emotional responses, or ‘affect

74 75

Cf. Kahneman (2003), p.1458. Cf. Slapnicar et al. (2012), p.13.

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heuristics,’ to guide behavior.”76 This finding reflects once more the domination of the affective system over the cognitive system in economic decision making. However, further investigation is still needed in future studies.

2.3 Theoretical Implications of Neuroeconomics So far, chapter two has tried to give a profound understanding of the neuroeconomic foundations and the role of emotions and rationality in economic decision making. Now, it looks at theoretical implications of neuroeconomics, thereby collecting key findings from different active research areas, such as risky choices, intertemporal preferences, motivation and social decision making. Here, it is shown that there is growing evidence that confirm former expectations of behavioral economists, who claimed that emotions play a dominant role in human decision making and that a multiple system that guides our decisions exists. Finally, this chapter discusses the relevance of neuroeconomics concluding it will modify the way we think about human decision making and change perspectives in economics as well as in psychology and medicine.

2.3.1 Active Topics and Key Findings in Neuroeconomics Neuroeconomic studies cover a broad range of themes that can be categorized in several ways. However, there are some major findings that are essential to all those categories. The most important insight that has already been discussed in previous chapters is that emotions are not irrational. On the contrary, they are even crucial for human decision making. As rational deliberation is a costly and time consuming process, we use heuristics and make most of our decisions unconsciously risking to let biases guide our decisions. This leads to one of the key observations of neuroscience that influences the different domains of interest according to Loewenstein – the differentiation of automatic and controlled processes. He suggests that when the brain is confronted with several issues, it does not act as a “homogeneous processor, but rather involves a melding of diverse specialized processes that are integrated in different ways.”77 Although there is already plenty of evidence confirming those results, some contradicting studies keep appearing. Thus, neuroeconomic researchers still need to prove how important emotions are in decision

76 77

Roiser et al. (2009), p.5985. Loewenstein et al. (2008), p.649.

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making and how such insights can be put into practice. This section provides an overview of the main research areas that deal with this matter and that in my opinion could particularly influence our business world, i.e. risky choices, intertemporal preferences, motivation and social decision making.

Decision Making under Risk and Uncertainty As presented in chapter 2.2.3, the theoretical basis of decision making under risk and uncertainty comes from behavioral economics and psychology, the prospect theory from Kahneman and Tversky being one of the major sources, as well as Damasio’s somatic marker hypothesis. Loss aversion is one of the central issues of prospect theory and its key components, i.e. reference-dependence, probability weighting distortions and the endowment, reflection and framing effect, seem to be encoded in neural circuits that can be linked to reward and emotion. At this point, there is at least one evidence from neuroeconomic research that can hardly be contradicted. It is the fact that risk and reward are dependent from each other being encoded in insula (risk) and striatum and medial OFC (reward), which supports Lowenstein’s idea of “risk as feelings.”78 Overall, many provocative observations have been made without having been integrated into any models yet. For example, several researchers came to the conclusion that we are more sensitive to differences between outcomes and reference points than on final levels because specific neural circuits in our brain have a hardwired tendency to respond to deviations from expectations. Furthermore, studies on the endowment effect show that specific brain regions that are targeted by dopamine projections respond asymmetrically to gains and losses. This might be a major contributor to the phenomena of loss aversion. Other researchers focused more on the somatic marker hypothesis. Although some of them found contradictory results, the majority could approve the hypothesis extending it to some degree.79 As we see, neuroeconomic research on decision making under risk and uncertainty is going in the right direction but there is still a lack of evidence supporting the multiple system view and the new emerging role of emotion in human decision making.

78 79

Loewenstein et al. (2008), p.652. Cf. Loewenstein et al. (2008), pp.652-657.

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Intertemporal Choice A further domain of interest in neuroeconomics is intertemporal choice or more precisely “decisions involving alternatives whose costs and benefits are distributed over time.”80 The dominant model in that area has long since been the discounted utility model which assumes an exponential discounting of the future. However, behavioral economics and neuroeconomics today have contradicted this model claiming that the future would be discounted hyperbolically. The more distant an outcome is, the less value it gets. Neuroeconomic research has focused on the limbic system, which is thought to be decisive to emotional processing. By now, evidence regarding this matter is inconsistent. On the one hand, first studies indicated that these structures of the limbic system such as the amygdala respond primarily to rewards which are available right away. Hence, this would have explained the hyperbolic discounting of the future. But on the other hand, recent research revise this observation declaring that the limbic system would respond to all delays and thus could not explain intertemporal issues on its own.81 Therefore, researchers have also thought of two different systems acting in regards of intertemporal decisions. One would especially tend to present rewards and the other more deliberative one would care more about long-term outcomes and discount consistently across time. The short-run system can be associated with limbic and paralimbic cortical structures that are rich in dopaminergic innervation and the long-run system with fronto-parietal regions since they support higher cognitive functions. Although plenty of evidence have been proposed supporting once more multiple systems, it is still a matter of debate in neuroeconomics.82

Motivation and Social Decision Making Further highly debated topics are motivation and social decision making. Neuroeconomic researchers try to understand how rewards trigger motivation. Therefore, they look at brain processes when rewards are involved. Motivation can be defined as “eliciting desired behavior due to anticipation of a possible reward or as the avoidance of a possible punishment.”83 Evidence from neurology has shown that dopamine neurons are responsible for this motivational process. Still, there are different perspective on motivational behavior in neuroscience with the most influential one being the reinforcement model.

80

Loewenstein et al. (2008), p.657. Cf. Loewenstein et al. (2008), pp.657-658. 82 Cf. Loewenstein et al. (2008), pp.660-661. 83 Slapnicar et al. (2012), p.15. 81

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This model predicts that individuals, humans and animals, adapt their behavior by comparing an expected reward or punishment for an action with the actual consequence. In this regard, research has demonstrated the importance of the idea of homeostasis, which entails the supposition that the physical state of an individual is decisive for the incentive value of a reward. However, by now, neurological studies of motivation have only provided fragmented evidence on the relationship of rewards with dopamine transmissions and brain activity.84 Furthermore, studies on motivation are highly related with social decision making. Results from behavioral economics and game theory indicate that social preferences, e.g. for donating money, rejecting unfair offers or even punishing people who violate norms, are other-regarding. Such studies reflect the idea that a sense of fairness is a universal human attribute.85 We are often confronted with moral dilemmas that can be personal or impersonal. In such situations, having social preferences often provokes a conflict between social motives and economic self-interest. Studies have shown that this conflict is solved by a specific part of the brain, the prefrontal cortex.86 According to Loewenstein, Rick and Cohen, most of the neuroeconomic literature supports “a dualprocess model of helping behavior in which a sympathetic but highly immature emotional system interacts with a more mature but uncaring deliberative system.”87 Hence, the prefrontal cortex, which represents the deliberative system, seem to regulate emotional impulses sent from other parts of the brain, for example the anterior insula, in order to resolve our inner conflict, so that we can make a judgment about the situation. This line of research reinforces the idea that social preferences are genuine expressions of preference.

Summing up, we can say that the key observations of neuroeconomic studies, i.e. the dominant role that emotion is taking in human decision making and the existence of a multiple system guiding our decisions, gain more and more support through new neuroeconomic evidence, confirming former expectations of behavioral economists. However, we still have a lot to learn and it is a matter of fact that most studies keep finding a counterpart that revises its results. But with growing evidence and interest, this gap will shrink soon and the pace of neuroeconomic research will accelerate.

84

Cf. Slapnicar et al. (2012), pp.15-17. Cf. Gowdy (2010), p.26. 86 Cf. Loewenstein et al. (2008), pp.661-665. 87 Loewenstein et al. (2008), p.661. 85

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2.3.2 Discussion about the Relevance of Neuroeconomics As neuroeconomics is a very young field, one may wonder whether new evidence gained from neuroeconomic research already have had an impact on other scientific disciplines or on our daily life and whether it makes sense to continue to follow this path of research. A main criticism of neuroeconomics is related to the design of neuroscience research regarding sample size and data quality. A well designed experiment on humans or also on primates is expensive and challenging. This has often been an issue in behavioral economics as well as in neuroscience. However, today, the costs for experimental tasks using neuroscientific methods are going down due to new technologies. Furthermore, the small sample size issue can be defended by arguing that a meta-analysis of several similar studies with identical results can be effectuated once enough samples have been accumulated. But the quality of the data obtained is still a matter of debate as subjectivity can be involved in the interpretation of brain scans. Another critique questions whether the benefits from neuroscience research for economics can justify the efforts. Here, Birnberg and Ganguly distinguish two main issues. First, they mention that the state-of-the-art of neuroeconomics is limited as it is still unclear whether actual methods can give us significant insights beyond detecting brain areas that are activated through cognitive processes and economic decision making. Second, they point out an important aspect by challenging the usefulness of having a “greater granularity in the broad cause-effect relationships we have already inferred.”88 This view is related to Friedman’s classical perspective arguing that an economic model only needs to make sufficiently accurate predictions instead of making correct assumptions. Supporters of this point of view claim that current economic models are already flexible enough to incorporate behavioral components and further suggest that neuroeconomics might be useful for macro issues like normative policy making but not for micro issues such as individual decision making.89

Despite the criticisms regarding the value of neuroeconomics, Kahneman, a supporter of neuroeconomics, is surprised about the “frequent finding of impressive correlations between psychological measures and measures of brain activity.”90 Loewenstein, Rick and

88

Birnberg and Ganguly (2012), p.6. Cf. Birnberg and Ganguly (2012), pp.5-6. 90 Kahneman (2009), p.523. 89

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Cohen further state it is clear that neuroeconomics has brought the once disparate disciplines of economics and psychology closer together, with economics having been inspired the most. The reason for that is that neuroeconomic studies mostly challenge rational economic models relying on perspectives within psychology.91 And there is an even greater number of supporters of this new discipline who relate the potential contribution of neuroeconomics to two determinants of human economic behavior – the internal order of mind and the external order of socioeconomic exchange. Above all, they claim that it makes sense to scan and map the brain first of all in order to identify relevant brain parts, so that processes can be analyzed correctly in further depth afterwards. In accordance with this, supporters hope that the brain-scanning stereotype will disappear and that future research will be more process-oriented. As Roth noted, “science often follows the development of new instruments and technology.”92 Hence, experiments including eye-tracking and skin conductance as well as the use of new methods such as tcDCS and the inhalation of oxytocin for example will play a key role in the change of the state-of-the-art.93 Furthermore, it is important to mention two subdisciplines that already emerged from neuroeconomics, i.e. consumer neuroscience or neuromarketing, and neurofinance. The latter has the long-term goal to improve forecasts in financial markets by taking neuroeconomic evidence into account.94 Consumer neuroscience studies examine the neuronal background of the marketing mix and branding, in order to gain a better insight of consumer behavior.95 Some companies like ‘Gruppe Nymphenburg’ already integrated insights of neuromarketing into their consulting strategy, so that evidence from neuroeconomic studies have already started to have an impact on our daily lives.

To sum up, we can say that at least neuroeconomics offers additional data through new experimental techniques confirming and challenging evidence gained from former traditional research on human behavior. But neuroeconomics is way more than this. Many researchers agree that we are only at the beginning of neuroeconomics and that the potential is huge as it will modify how we think about human decision making. It will not only change perspectives in economics but also in psychology and medicine. We should not forget that neuroeconomics is not only about improving economic theory but that 91

Cf. Loewenstein et al. (2008), p.649. Roth (2007) as cited in Birnberg and Ganguly (2012), p.7. 93 Cf. Birnberg and Ganguly (2012), pp.6-7. 94 Cf. Bürger and Weber (2011), p.264. 95 Cf. Hubert and Kenning (2011), p.196. 92

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there are other fields interested in neuroeconomic findings. The incorporation of experimental designs from economics is already helping and will further support neuroscientist and psychologist to find new solutions to defeat diseases that are related to brain dysfunctionalities. However, this thesis focuses on the economic perspective of neuroeconomics. In this regard, a discipline that did not get much attention so far is management accounting.

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3 Management Accounting Chapter three provides an overview of management accounting. Primarily, it focuses on the nature and scope of management accounting. Since the merging of management accounting and neuroeconomics is at the core of the thesis, fundamental connections needs to be made. Hence, this section creates a first relation between both fields by demonstrating the behavioral nature of management accounting, as well as current developments of the management accountant’s role and emerging challenges. Then it makes the second connection by examining decision-making issues in management accounting research, starting with a description of the environmental influences affecting managers. Subsequently, the following section presents a rational view on the decision-making process of managers, before introducing the role that cognitive biases play in decision making. As these biases affect the organizational effectiveness, the next part presents the concept of evidence-based decision making and several management accounting tools as both contribute to a reduction of cognitive biases and an improvement of managerial decision making. Ultimately, in order to further relate both fields, chapter three reviews research areas from management accounting that are relevant to neuroeconomics, i.e. decision making under risk and uncertainty, intertemporal choice, as well as motivation, fairness and other social aspects.

3.1 Nature and Scope of Management Accounting Management accounting is a complex and constantly changing field of study, built on multiple dimensions. Although, the nature of management accounting is very technical, other dimensions such as behavioral components need to be taken into account as they are crucial to economic success. A favorable interaction between management accountants, typically seen as providers of information, and managers, the internal decision makers, is essential.96 Therefore, this section focuses first on the foundations of management accounting, which offers a greater understanding of the new role of management accountants that will be described subsequently, as well as challenges arising from that new role.

96

Cf. Riahi-Belkaoui (2002), p.xi.

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3.1.1 Foundations of Management Accounting The demand for management accounting practices arose in praxis in the middle of the 19th century, when textile mills and railroads started to grow. This evolution entailed the development of accounting procedures that should help organizations in their extensive planning and control procedures. Those practices have been further developed during the next century, due to significant changes in organizations and an increasing competitive environment.97 Today, management accounting is in some way a more elaborate version of cost accounting. As there is still no unitary theory and definition of management accounting, this thesis focuses on the perspective of the National Association of Accountants (NAA), which started to develop a conceptual framework in 1981 in order to guide the development and use of techniques in management accounting. In their initial definition, NAA identified management accounting as: …the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information used by management to plan, evaluate, and control an organization and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies, and tax authorities.98

However, since this formulation, considerable developments have been made within the field of management accounting. The Institute of Management Accountants (IMA), former NAA, identified a shift in the role of management accountants from a transaction and compliance orientation to that of a strategic business partner. This development is mainly due to new emerging technologies like highly integrated ERP systems, so that today’s management accountants are increasingly responsible for the conceptual design of such systems that convert data into information. Therefore, management accountants may be in a better position today to support managers in their decision making.99 This shifting

97

Cf. Kaplan (1984), pp.390-392. Institute of Management Accountants (2008), p.1. 99 Cf. Institute of Management Accountants (2008), pp.1-2. 98

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role of the management accountant led IMA in 2008 to redefine management accounting as: …a profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy.100

Nowadays, it has become a big challenge to meet the needs of managers in such a competitive and changing environment, so that the role of management accountants has become very complex. Hence, in addition to the accounting dimension, management accounting needs to take several other dimensions into account, i.e. decisional, behavioral, strategic and organizational, in order to better serve those needs. Here, the focus is on the behavioral dimension. From this point of view, the goal of management accounting can be interpreted as to influence the decisions and behavior of individuals in a particular way. According to Riahi-Belkaoui, there are some essential characteristics that have an impact on the behavior and performance of individuals within an organization, as well as on the design of information systems. Hence, management accounting needs a good understanding of following behavioral concepts: the objective function or goal of an organization, motivation theories and models of decision making.101

The goals of organizations have been determined differently in several disciplines, so that a concept has not been defined clearly in the literature yet. There are three models that constitute satisfactory objectives relevant to management accounting, which have been influenced by the neoclassical approach in economics and by behavioral theories. One of the models that has been adapted to a management accounting context is the shareholder wealth maximization model. According to this perspective, managers have to act in the best interests of the owners of the company accepting budgeting and control standards, rejecting behavior like slack budgeting and adopting optimal techniques.102 Another view is the one of managerial welfare maximization that, in the contrary, explains how managers may act selfish having a lot of freedom in many organizations. They might maximize 100

Institute of Management Accountants (2008), p.1. Cf. Riahi-Belkaoui (2002), p.18. 102 Cf. Riahi-Belkaoui (2002), pp.19-20. 101

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factors of personal interest such as sales, rate of growth or managerial utility, instead of the shareholders’ interests explained above.103 The last perspective of social welfare maximization highlights the need for organizations and managers to adapt to social, human and environmental aspects, thus claiming for greater social responsibility. For management accounting, this means that a social reporting system would be necessary to measure for instance the social performance, including costs and benefits.104

While trying to reach the goals of an organization, individuals are driven by motivation, which reflects their needs and motives and guides their behavior. This motivation can be triggered directly by other people, e.g. managers, or through management accounting techniques. Motivation theories set the basis for developing appropriate techniques that could influence and coordinate the behavior of other individuals such as measurement and reporting systems. In the literature, there are several theories that deal with this matter. While the need theory and the two-factor theory examine how high performance is being induced, the expectancy theory tries to explain the whole process of human behavior. Furthermore, the achievement theory and the inequity theory also offer some additional aspects on motivation.105

In addition to that, management accounting also needs a good understanding of decision making as it favors an optimal adaptation of management accounting services to the real decision situation. There are five main perspectives in decision making that affect management accountants, i.e. the rational manager, the satisficing and process-oriented, the organizational procedures, the political and the individual differences view.106 It is important to consider the situation from different perspectives in order to gain a better understanding of the needs. While the rational model reflects very good economic thinking, the satisficing and process-oriented model is more representative to real-life issues from a behavioral point of view. The latter underlines the importance for management accountants to understand the heuristics used by managers in order to simplify their decisionmaking process and to improve their working relationship. Further, the organizational procedures and the political view suggests to take the exact position of managers within

103

Cf. Riahi-Belkaoui (2002), p.20. Cf. Riahi-Belkaoui (2002), pp.18-22. 105 Cf. Riahi-Belkaoui (2002), pp.22-27. 106 Cf. Riahi-Belkaoui (2002), p.27. 104

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the organization into account as it might influence his decisions. Finally, the individual differences perspective recommends to take care of the individual cognitive styles of managers, for example analytical. Management accounting reports, techniques and information should be adjusted to their styles, so that the decision-making process can be optimized.107 The decision-making process will be discussed in detail in chapter 3.2.2.

In this chapter, we focused on the accounting and behavioral dimension of management accounting in order to create a link to behavioral research, which is also an important foundation of neuroeconomics. Nevertheless, the other foundations that have not been explicitly described are equally important, i.e. the decisional, strategic and organizational dimension, and also have an impact on the evolving role of management accountants, which is discussed next.

3.1.2 Developments in the Role of Management Accountants The previous chapter focused on the behavioral foundations of management accounting but also indicated the shifting role of management accountants as formulated by the IMA in 2008 in their new definition of management accounting. As explained above, the theory of that discipline emerged from practice and not vice versa. Over the years, the expectations changed because of the dynamic working environment and thus the role that practicing management accountants believed to be true was not consistent any more with existing definitions. With their new definition, IMA tried to resolve this identity crisis from which suffered the management accounting profession.108 A crucial event that further influenced considerably the role of management accountants after the formulation of this new definition was the financial crisis of 2008-2009. Since then the demand for a more strategic role has increased in companies.109 This section reviews in more detail the development of the management accountant’s role from a number cruncher to a business partner or even change agent.

First of all, it is important to be aware that there is a dyadic interaction between managers and management accountants within the firm. As they have very diverging characteristics,

107

Cf. Riahi-Belkaoui (2002), pp.27-33. Cf. Institute of Management Accountants (2008), p.2. 109 Cf. Kim et al. (2012), p.3. 108

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conflicts of interests tend to emerge affecting negatively the objectives of the company, and increasing the already existing information asymmetry. Usually, management accountants are often seen as guardians of rationality with excellent analytical skills and a risk-averse behavior. In the contrary, managers tend to act more intuitive and emotionally, as well as opportunistic.110 This leads to a major issue in management accounting theory, the principal-agent problem, with the management accountant representing the interests of the firm and the manager following his own interests.111 From this point of view, the main function of management accountants is to reduce this information asymmetry and improve the manager’s behavior. The manager might act against the best interest of the firm for different reasons. He might either have time constraints or not have the competency or not have the will to comply with the company’s objectives. In order to solve this problem, the management accountant need to act in a releasing, supporting or restricting function, depending on the situation.112

Since its early days, management accounting professionals went through many different stereotypes that were never really accurate, but that reflected how they were perceived in the company. As the professional identity of management accountants has evolved over the years, the Chartered Institute of Management Accountants (CIMA) conducted a study in 2012 regarding the professional identity of management accountants, including their role within the firm and their qualities. As we can see in Figure 6, the researchers distinguished three inquiry groups in their study – current accountants, current management accountants and future management accountants.113 CIMA found out that the role of a professional expert will endure since it overlaps all these groups. Hence, management accounting seem to be based on the qualities related to this role, i.e. adhering to principles and values, achieving goals and results, knowledgeable and intelligent. Another enduring role is related to planner, manager and controller, and can be attributed to current management accountants. Here, the analytical qualities play an important role, but forward and holistic thinking are even more outstanding characteristics.114 According to CIMA, the group of current accountants is diminishing in the professional identity of management accountants. They are particularly excelling in their managing accounts, auditor and 110

Cf. Hirsch (2008), p.41. Cf. Gong and Tse (2009), p.58. 112 Cf. Weber, J. (2008), pp.4-5. 113 Cf. Kim et al. (2012), p.4. 114 Cf. Kim et al. (2012), pp.6-7. 111

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reporter role with qualities such as numerical, accurate and detailed, as well as conservative and cautious, which are still high-valued. Stereotypically, they are seen as number cruncher, which reflects the traditional but negative image of accountants.115 In the contrary, there are a lot of emerging roles for future management accountants such as commercial and entrepreneur, multi-skilled and business integrator, business focused partner and advisor, as well as the most challenging one that is leader, change agent, strategic thinker and decision enabler or maker. All these new emerging roles are in line with emerging qualities expected from future management accountants, i.e. creative and innovative, supportive and dynamic, people-oriented and communicative.116 Overall, this study indicates that management accountants should no longer be limited in their traditional number cruncher role but rather be integrated into the management process. In the literature, the most common terms used to describe the new role of management accountants are business partner and change agent. Figure 6: Trends on roles of management accountants

(Source: Own representation adapted from Kim et al. (2012), p.6)

115 116

Cf. Kim et al. (2012), p.7. Cf. Kim et al. (2012), pp.7-8.

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Due to the level of competencies required in these new emerging roles described above, many challenges arise complicating the pathway of management accountants. In this regard, there is an interesting study of Horváth & Partners that sums up the major role models of management accountants and indicates the logical and required development of competencies during a career as management accountant.117 According to this study, a management accountant should start her career with an operative focus as analyst being responsible for the evaluation and provision of information to the management. The next step would be to operate as controller by measuring and controlling performance indicators, as well as developing measurement techniques and instruments on one’s own responsibility. Once the operative skills have been acquired, a management accountant might proceed to a more strategic role as business partner and be an active consultant of the top management assisting in the decision-making process. The final step would be to act as change agent by initiating proactively change processes in the firm.118 Figure 7 illustrates the key findings of the study. Figure 7: Role models of management accountants

(Source: Own representation adapted from Gleich (2013), p.44)

117 118

Cf. Gleich (2013), p.42. Cf. Gleich (2013), pp.46-51.

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Of course, this is not a fixed career path, but a reasonable one since the study takes the required level of different competencies into account, i.e. know-how, methodological expertise, personnel and social skills. The level of competencies is increasing during the development from an analyst to a change agent with the highest progression being expected on the way to become a business partner.119 The challenges that emerge because of these new strategic roles of management accountants will be discussed in the following chapter.

3.1.3 Challenges for Management Accountants The professional world of management accountants has changed a lot since its beginnings. Investments in systems and process improvement have minimized the transaction costs, giving management accountants new roles that emphasis decision support. These new role models of business partner and change agent emerged over the past years and are very challenging for management accountants. Today, their excellent analytical skills and their qualities of honesty and integrity in their work do not suffice anymore in a very competitive and changing environment. The times of number crunching are over. If firms want to have a significant competitive advantage, they need to transform their finance functions and develop accounting professionals that can operate as business partners helping to improve the decision-making across the organization.120

In order be outstanding today and to remain successful in future, management accountants need to develop non-accounting qualities and become pro-active, approachable and people-oriented, while maintaining their professional expertise. They are expected to effectively communicate their knowledge, facilitate organizational change and innovation, and engage in decision-making processes.121 This reshaping of their professional identity is probably the biggest challenge they face. How can management accountants “sustain their technical expertise and at the same time meet the demand of diversified skills at work, while experiencing the misfit with the well-established image of accountants?”122 Regarding this problem, Weißenberger, Wolf, Giesen and Elbers pointed out that it is not only the challenge of management accountants to fulfill these new roles but also of the 119

Cf. Gleich (2013), pp.44-45. Cf. Simons (2007), p.36. 121 Cf. Kim et al. (2012), pp.4-8. 122 Kim et al. (2012), p.15. 120

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company. They claim that, in addition to the management accountant’s intrinsic motivation of developing new qualities, extrinsic motivation initiated by the top management is crucial for a successful implementation of the new roles into the firm’s culture. Furthermore, they suggest that business partnering needs to be integrated into the structure and processes of the company, so that the communication between management accountants and managers can be improved. By doing this, management accountants can effectively live their role as business partner within the firm, which has a proven significant positive impact on the company in comparison to management accountants who stick to their traditional roles.123

Acting as a business partner or change agent means to provide decision support across the organization. Being involved in the decision-making process is a greater challenge for management accountants as it seems at first glance. To meet this challenge, Simons states that, first of all, a shared vision of the future role of the function is required, which should be the start of a whole change management program within the company. Top performing companies are already giving more importance on decision support in their finance departments according to a KPMG study.124 Management accountants as business partners need to be able to collaborate empathically with their managers and speak their language, so that they can act as a sparring partner bringing accounting discipline to the decisionmaking process and challenging the manager’s assumptions. A valuable issue in this regard is that accountants tend to work in a comfort zone, to some extent, relying on their excellent technical and analytical skills. Hence the challenge is also to get them out of this comfort zone, so that they work alongside the management to support value creation more efficiently and effectively.125 To better be able to understand the emerging challenges for management accountants and organizations, it is crucial to understand the influence that business partners can have on the decision-making process in an organization. Simons explains that decision-making is a continuous process that helps achieving results. Management accountants can assist in the articulation of the business’s competitive position and objectives. Furthermore, decision-making can often be impaired because of the manager’s personal context. If management accountants act as business partners,

123

Cf. Weißenberger (2012), pp.331-335. Cf. Simons (2007), p.36. 125 Cf. Simons (2007), p.37. 124

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they can solve this issue by championing evidence-based decision making. Simons explains that, since management accountants are at the source of management information and thus have a deeper insight of the matter and know different alternatives, they can also help the decision-maker, the manager, by framing a decision.126

Finally, we can say that management accountants are facing many important challenges today that have to be met if they want to remain competitive and relevant in their organizations. Issues like the development of new required non-accounting qualities, such as leadership and communicative skills, can be solved through specific trainings, but should not be underestimated.127 Basically management accountants are guardians of rationality counteracting affective managers. Acting as a business partner might lead to a role conflict since they lose for this reason a certain distance to the manager. Interactions between people are always associated with emotions, so that the rational position of the management accountant will suffer. Now, their challenge is to make the best out of this situation and to adapt themselves to their new role. As the key aspect of their new role as business partner and change agent relies on improving the decision-making process of managers, the next section focuses on decision making issues in management accounting.

3.2 Decision Making in Management Accounting Globalization and competition reshaped the business world in the last decades enabling new technologies to emerge and converging several business processes on comparable standards. Hence, according to CIMA, decision making has become the key to superior performance and it is therefore crucial for companies to adapt themselves to this change in order to remain competitive.128 For that reason, this chapter focuses on decision making in the context of management accounting. First, it gives an overview of the environmental influences that affect the decision of managers, who are the final decision-maker in organizations. Then, the next part describes the decision-making process, so that the role that the management accountant might play during this process gets clearer. As most of our decisions are influenced by cognitive biases, the following chapter presents some biases that are relevant in a management accounting context. The subsequent part presents

126

Cf. Simons (2007), p.36. Cf. Simons (2007), p.37. 128 Cf. Chartered Institute of Management Accountants (2008a), p.7. 127

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the evidence-based decision-making model offering solutions regarding cognitive biases and the final section introduces tools that are used in management accounting to support decision making.

3.2.1 Environmental Influences on Managerial Decision Making Today, the role of management accountants has shifted from focusing on score-keeping and reporting to supporting managerial decision making. One may ask why managers, who have always been the final decision-makers, should need more help to make decisions. Well, on the one hand, it is in the company’s interests that an objective and more rational person guides the manager in his or her decision-making process, as managers tend to act in their own interests. This reflects more the controller role of management accountants. On the other hand, the complexity of the decision-making process of managers has increased significantly, so that support is necessary in order to improve the decisions of managers.

Managers are influenced by external and internal factors as we can see in Figure 8. When making complex business decisions, such as research and development (R&D) investments, capital budgeting or target setting, managers are highly affected by an extensive time span, social pressure and a high environmental and task uncertainty.129 This work environment has increased the need for fast decisions, making the issue of incomplete information become worse. Hence, managers often need to rely on simplified mechanisms and heuristics, thereby risking to make systematic errors in their decision making. In order to guide their managerial behavior to an optimal decision, management accountants can develop incentive systems and formalized control structures, and need to report relevant accounting information to the manager.130 As we see, the decision-making process of the manager is negatively influenced by her external environment and rather positively by the interplay of internal factors. However, as it is still the manager who takes the final decision, the internal instruments used by management accountants need to be adapted to each manager respectively. In addition to designing incentive systems like

129 130

Cf. Slapnicar et al. (2012), p.18. Cf. Slapnicar et al. (2012), pp.18-19.

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performance evaluation systems and to reporting relevant accounting information, management accountants need in their new role as business partner to cooperate during the whole decision-process of the manager, so that the influence of negative environmental factors can be minimized and the decision optimized.

Figure 8: Environment of managers in a management accounting context

(Source: Own representation based on Slapnicar et al. (2012), pp.18-19)

3.2.2 The Decision-Making Process If management accountants want to fulfill their new roles as business partners and change agents, they need to cooperate very closely with their managers supporting them in their decision-making and guiding their behavior towards the organizations’ interests. Hence, the decision-making process is a key component of their success and has to be understood.

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Strategy is one of the guiding principles in decision making.131 Normally, we make decisions in order to reach a certain goal in the future. Although the management accountant is rooted in reporting past information, the primordial step here is to focus on future goals and thus on the strategy of the company or department. As explained in a previous chapter, the decision situation should be considered under different perspectives, so that the needs and goals become clearer. The earlier the management accountant gets involved in the process and the better she understands future goals, the better she can refine the thinking of decision-makers and guide them toward a more productive and efficient decision.132

In the literature, the decision-making process is split in several different ways. However, the most significant difference is between rational and non-rational models of decision making. Although practical experience shows that rationality assumptions such as having complete information and making decisions without being affected by emotions are unrealistic, the rational model is useful since it simplifies the decision-making process in an analytical way.133 Furthermore, it provides a conceptual framework for newer models, including non-rational models. Such non-rational models explain in contrast to the rational model how decisions are actually made, i.e. under uncertainty, with incomplete information and influenced by affect. Here, the bounded rationality of decision makers is taken into account and leads to satisficing decisions instead of optimizing. In addition to this, non-rational models describe decision-making as a random and not as a sequential process like rational models suggest.134 However, both accept decision making as a continuous process. Now, the biggest challenge is to merge the two types of models, so that behavioral components become an integral part of a clear conceptual framework.

First of all, in a management accounting context, it makes sense to describe the steps of the rational model, so that a conceptual framework of decision making is given. Being aware of the problems that a manager faces when making decisions, it is important to place the management accountant at each stage of the process according to her new role,

131

Cf. Yates (2011), p.52. Cf. Yates (2011), pp.52-53. 133 Cf. Kreitner and Kinicki (2013), p.330. 134 Cf. Kreitner and Kinicki (2013), pp.330-335. 132

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so that she can guide and optimize the manager’s decisions. CIMA offers such a framework as we can see in Figure 9. According to CIMA, decisions are taken in a specific context mindset reflecting the organization’s strategy and the individual’s preferences. Within this context the first and crucial step of the decision-making process is to frame the issue regarding objectives and interests, so that the decision-maker can focus efficiently on the situation. Subsequently, relevant information such as the current financial and competitive position need to be assembled facilitating an evidence- and analysisbased selection of alternatives. Then the decision maker needs to take a decision choosing among the alternatives. Here it is important that he has enough authority, so that the decision can be reached efficiently. After that, a clear communication of the decision and a reflection of the expected outcomes are necessary in order to manage efficiently the implementation of the decision through to impact. Finally, a proper documentation of the whole process is crucial to allow meaningful feedback and optimize future decisions.135 Figure 9: The decision-making process

(Source: Own representation based on Chartered Institute of Management Accountants (2008b), p.12)

135

Cf. Chartered Institute of Management Accountants (2008b), pp.12-13.

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As already mentioned, management accountants can contribute significantly to an optimal decision by intervening at each step. They can help to frame the issue for instance by formulating strategic and operational plans and setting corporate objectives. By designing incentive and information systems, management accountants can further assist in the collection and provision of relevant information, so that the best decision can be taken among several alternatives. They can additionally support the manager at this stage of the decision-making process in communicating and interpreting financial and operating information. Management accountants can also play a decisive role once the decision has been taken by monitoring and controlling the outcomes for instance through performance evaluation systems.136

However, in order to intervene adequately at each of these stages, management accountants need to question themselves about the competencies and the character of their managers. How can management accounting information be reported in a comprehensible way to the manager, who is often a novice in this regard, making it difficult for him to interpret correctly the information provided? What kind of heuristics do managers use in order to select alternatives and take a final decision, and how can management accountant counteract negative habits? And finally, how do managers evaluate their decisions in comparison to management accountants and how can their evaluation be best supported? In order to find answers to these questions, it is necessary to be aware of the influence of cognitive biases in managerial decision making, so that the way management accountants report information and design incentive as well as performance evaluation systems can be optimized.

3.2.3 The Influence of Cognitive Biases in Decision Making Today, it is well known that we use judgmental heuristics or rules of thumb in our everyday life to make decisions under uncertainty. Tversky and Kahneman undertook a series of studies in this regard and came to the conclusion that “people rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors”.137 In a managerial context,

136 137

Cf. Chartered Institute of Management Accountants (2008b), p.14. Tversky and Kahneman (1974), p. 1124.

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the use of heuristics can also be very helpful as it leads to fast and efficient decisions in an uncertain and time constrained environment. However, if cognitive biases emerge so that systematic errors impact the business, the consequences might be disastrous. In order to prevent such a scenario, management accountants, in their new role as business partner, should make managers aware of cognitive biases that might affect their decision making or even reduce the occurrence of biases through optimal designed incentive schemes.

In their study, Tversky and Kahneman introduced three typical judgmental heuristics that might lead to biased decisions, i.e. representativeness, availability and anchoring. Under representativeness heuristic, they understand our habit to estimate the probability of an event based on our memory about comparable situations. Hence, if a manager takes a decision referring to a similar event in the past without taking the actual situation and information into account, this would bias his judgment and might lead to a wrong decision.138 The availability heuristic is highly related to representativeness as it also reflects a past situation. However it refers more to information that is easily available in memory, i.e. information associated to an event that happened recently, information that is salient or that stimulated strong emotions. This effect often biases the decision of managers as it leads them to overestimate the existence of events that are rather rare.139 Finally, anchoring describes our tendency to be highly influenced by the first information we receive, although it might not be relevant.140 In addition to those heuristics leading to systematic errors in our decision making, there are several other cognitive biases that have been at the center of behavioral research.

One of the most important cognitive biases in managerial decision making is the bias of loss aversion, which has already been described in more details in chapter 2.2.3. The effect of loss aversion can affect the decision of a manager significantly since too much importance is given to possible losses compared to potential gains. Hence, the manager might decide not to make an investment because of his greater sensitivity to losses, although the expected gains would have been significantly higher than the possible losses. Due to this predominant loss aversion of humans in decision making, we are also exposed to framing effects, which also bias our decision making. According to prospect theory, 138

Cf. Tversky and Kahneman (1974), pp.1124-1126. Cf. Tversky and Kahneman (1974), pp.1127-1128. 140 Cf. Tversky and Kahneman (1974), p.1129. 139

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we tend to be risk averse regarding expected gains but risk seeking if an alternative is framed as a loss. This demonstrates how crucial the first step of the decision-making process is to finally come to an optimal solution. By framing the problem in a different way, the manager might come to an opposite decision. Hence, to avoid this bias, problems should for instance be framed in alternative ways.141 Another prevalent bias in managerial decision making that has been identified is the overconfidence bias. Overconfidence is defined as the “overestimat[ion] of [one’s own] performance in tasks requiring ability, including the precision of [one’s own] information”.142 Most of the managers are very experienced and qualified individuals. Therefore, other economic actors tend to trust too easily in their competencies and believe they do not derive from rational choice. However, studies have demonstrated that the overconfidence of managers is a critical component of phenomena such as company underperformance, attractiveness of stock options to employees, overtrading, and gender differences in competitiveness. Furthermore, it has been shown that overconfidence do not diminish with increasing experience but in the contrary expertise would aggravate this cognitive bias.143 Other cognitive biases that can be found in the management literature are for instance the confirmation bias, escalation of commitment bias, primacy-recency-effect, mere-exposure-effect and cognitive tunneling.

To sum up we can say that using heuristics to make decisions have pros and cons. On the one hand, it enables the decision-maker to make a fast and efficient decision relying on her experience and intuition. On the other hand, using such shortcuts can lead to systematic errors biasing decisions and affecting significantly the quality of the decision. Management accountants have to be aware of this conflict and of the different cognitive biases arising, so that they can provide optimal decision support to managers, while guiding their behavior towards the best interest of the company. A concept that emerged through the desire do understand cognitive biases and thus to avoid them is evidence-based decision making, which is the focus of the next chapter.

141

Cf. Kahneman (2003), pp.1454-1460. DellaVigna (2009), as cited in Ifcher and Zarghamee (2014), p.125. 143 Cf. Ifcher and Zarghamee (2014), pp.125-126. 142

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3.2.4 More Effectiveness through Evidence-Based Decision Making Due to environmental and task uncertainty as well as time and social pressure, managers are often subject to cognitive biases. That means they make systematic errors by using heuristics in order to make fast decisions. Although these mental shortcuts can be very helpful for management since it allows to manage situations quickly and efficiently, they can lead to severe consequences when cognitive biases arise.144 Regarding this issue, a concept called evidence-based decision making emerged with the aim to minimize these cognitive errors. It rather offers a point of reference to improve managerial decision making and does not substitute the decision-making model presented in chapter 3.2.2.

The origins of this concept stem from research done on evidence-based medicine and it is believed that practicing evidence-based management in organizations enhances organizational effectiveness.145 Briner, Denyer and Rousseau define evidence-based management as follows:

Evidence-based management is about making decisions through the conscientious, explicit, and judicious use of four sources of information: practitioner expertise and judgement, evidence from the local context, a critical evaluation of the best available research evidence, and the perspectives of those people who might be affected by the decision.146

In this regard, a study of Francis-Smythe, Robinson and Ross shows that senior general managers principally use only one of these four information sources, i.e. practitioner expertise and judgment. This result is highly related to other studies that found out that managers mostly rely on bases like experience, formal power, incentives and threats in their decision-making process. However, in order to avoid personal biases, managers should be confronted with hard facts and view a problem from different perspectives instead of simply trusting their expertise. In order to gain more benefits from evidence-

144

Cf. Tversky and Kahneman (1974), p. 1124. Cf. Francis-Smythe et al. (2013), p.4. 146 Briner et al. (2009), p.19. 145

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based management that might enhance significantly the quality of the decisions and therefore the organizational effectiveness, managers should also consider other sources of information. Figure 10 gives an overview of the four sources of information that are relevant to evidence-based decision making and fundamental elements that should be considered according to each source. Figure 10: Sources of information in evidence-based decision making

Sources of Information

Practitioner expertise and judgment

Fundamental Elements 

Analyze situation



Consider past experience, intuition



Make an own opinion about causes and possible solutions



Gather information about similar present events



Question own experience



Find out facts/data and internal explanations

Evidence from the local



Control if current business is working

context



Ask other managers about the situation



Evaluate costs and benefits of an intervention



Consider internal and external elements



Compare local data to others



Understand the major cause according to re-

Critical evaluation of best research evidence

viewed research evidence 

Check relevance and applicability of evidence



Estimate the factor of success of interventions suggested by research evidence

Perspectives of those who



may be affected

Figure out opinions of employees and other managers about proposed interventions



Discuss alternatives

(Source: Own representation based on Francis-Smythe et al. (2013), pp.5-6)

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Looking at evidence from the local context, evaluating external evidence from published research in a critical way and contemplating perspectives of the stakeholders who may be affected by the decision, would clarify the decision-making context and improve the whole decision-making process.147

Nevertheless, in comparison to other disciplines like medicine or education, it is a greater challenge for managers to introduce such a practice. Evidence in a managerial context is often weaker and the size, form and age of companies differ reasonably, so that it is almost impossible to elaborate a one size fits all solution for similar problems.148 However, management accountants have always played a decisive role to master this challenge. Their fundamental role has long been to provide financial and management information in order to support evidence-based decision making as described above.149 But as we can see through the development of the management accountant’s role as business partner and change agent, this does not suffice anymore in today’s work environment. Understanding the concept of evidence-based decision making should be a basis for management accountants. But it needs to be further supported by specific management accounting tools, so that they can give more attention to their role as business partners and guide the behavior of managers towards the organizations’ needs, instead of being too concentrated on gathering information. Some of these tools are presented in the next chapter.

3.2.5 Management Accounting Tools Supporting Decision Making Management accountants use a wide range of management accounting tools to guide managers through their decision-making process. Depending on the specific context and on the organization’s needs, they need to select the best appropriate tool based on their technical knowledge, professional experience and judgment. In comparison to accountants who operate in a standardized environment and are only involved in financial reporting, management accountants act in a more complex and changing environment, which makes their choice for the right tool very difficult. CIMA conducted a study in 2009 to

147

Cf. Francis-Smythe et al. (2013), pp.5-19. Cf. Pfeffer and Sutton (2006), p.3. 149 Cf. Francis-Smythe et al. (2013), pp.4-5. 148

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figure out which tools were most commonly used in organizations and the tendencies of implementing new tools in the near future.150

In their study, CIMA found out that management accountants use on average 33 management accounting tools that are a mix of traditional and new tools across a range of operational, strategic and managerial functions. This demonstrates the large contribution that management accountants can make to the organizational performance by providing data.151 Operational tools are related to traditional operational tasks of management accountants such as budgeting, costing, pricing, profitability analysis, investment decision making, but also include other tools like total quality management (TQM), customer relationship management (CRM), benchmarking and 360 degree view.152 Strategic management accounting deals first of all with the reporting of profit and performance to senior management and to external stakeholders using performance reporting tools. In addition to that, several strategic tools are used to support strategic decision making with the most commonly used being strategic planning, SWOT analysis and risk management.153 Finally, the most relevant set of tools regarding the aim of this thesis is the set of managerial management accounting tools, which enables to measure, manage and reward performance. The most commonly used performance measurement tools are return on capital employed (ROCE), cash flow return on investment (CFROI) and profit before tax. The balanced scorecard, being very flexible and malleable across different organizations, is the most widely used performance management tool and its popularity is still growing. However, business process re-engineering (BPR), activity based management (ABM) and total performance scorecard also play a key role in many organizations. Furthermore, reward systems such as executive incentive schemes and management incentive schemes are especially important to large companies since they are effective tools to motivate the desired behavior. But profit sharing schemes and share options are also very often used in both larger and smaller companies.154 According to the study, the tools that are the most widely used across organizations are performance management and budgeting, although many practitioners claim they have become outdated. However, as there are no alternatives that are more effective by now, the majority of the respondents of the study 150

Cf. Chartered Institute of Management Accountants (2009), p.5. Cf. Chartered Institute of Management Accountants (2009), p.28. 152 Cf. Chartered Institute of Management Accountants (2009), pp.11-19. 153 Cf. Chartered Institute of Management Accountants (2009), pp.25-27. 154 Cf. Chartered Institute of Management Accountants (2009), pp.20-24. 151

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indicated they would introduce performance management tools, especially the balanced scorecard, and budgeting tools such as rolling forecasts in the near future.155

As we see, there is an important number of management accounting tools that support management accountants from information gathering to decision support, thus through the whole decision-making process. But this seems at the same time to be very timeconsuming and complex, so that the management accountant might fall back into her old stereotype as scorekeeper on the sideline. In this concern, the potential of business intelligence, which has matured as a technology that includes reporting, analysis and performance management tools as presented above, should be taken into account. Combined with current developments of the management accountant’s business partner function, this would release capacity to fulfill her new role and improve decision making since business intelligence technology assists the management accountant in providing information for decision making.156 Furthermore, today the expectations of the management information quality has drastically changed. Big data is for instance a current topic of huge interest. But also the demand for more forward-looking information has increased at all levels. In this concern, the development of business intelligence technology provides a broad range of financial and non-financial data. Business intelligence tools that provide this information are known as enterprise performance management (EPM), corporate performance management (CPM), enterprise information systems (EIS), decision support systems (DSS) and management information systems (MIS). Furthermore, Dashboards, scorecards and other tools render the access to the required data easier for several users and appropriate to their roles.157

Overall, management accounting tools offer numerous possibilities to management accountants to fulfill their roles as analyst and controller, which represent the more basic functions of management accountants. However, to succeed as business partners or even change agents, they might need more technological support for instance through further evolving business intelligence tools that integrate a wide range of standard methods used by management accountants. The use of such a technology can help to be more proactive in modelling the future, as well as be more productive in reporting the past and managing 155

Cf. Chartered Institute of Management Accountants (2009), pp.6-7. Cf. Chartered Institute of Management Accountants (2008a), pp.4-5. 157 Cf. Chartered Institute of Management Accountants (2008a), pp.34-38. 156

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performance. But it should not be forgotten that the design of the best appropriate tool and its correct implementation into an organization can be very complex, which creates even more challenges for management accountants.

3.3 Management Accounting Research Relevant to Neuroeconomics In order to figure out research topics that are relevant to neuroeconomics, it is first of all necessary to recapitulate some of its key aspects. Neuroeconomic research is currently on the right track to understand the neurological basis of affective and cognitive decision making. Important themes in this field of research are the role of emotions in decision making, effects of risk and uncertainty on human behavior, intertemporal choice and social decision making, with prospect theory being a central concept.158 Hence, relevant research topics in management accounting should deal with similar themes. Research in this discipline deal especially with the design of incentive schemes such as performance evaluation systems, which guide the behavior of managers. Risk and uncertainty are almost present in every management accounting context, which makes this line of research an important and relevant basis. Hence, the first part of this chapter focuses on decision making under risk and uncertainty from the perspective of prospect theory. The next two chapters discuss other research topics that are relevant to neuroeconomics and in which risk and uncertainty also play a key role, i.e. the intertemporal nature of decisions and other important topics such as motivation, fairness and other social aspects.

3.3.1 Decision Making under Risk and Uncertainty Many accounting decision contexts are affected by risk and uncertainty, which increases the complexity of business decisions that need to be made by managers. Due to a combination of high environmental and task uncertainty, social pressure and time constraints the level of risk and uncertainty enhances significantly for decision makers. This situation forces managers to rely on simplified mechanisms and heuristics to make fast decisions, which can lead to several cognitive biases that greatly influence their decision-making process and their behavior.159 In this regard, a number of accounting scholars researched

158 159

Cf. Slapnicar et al. (2012), p.12. Tversky and Kahneman (1974), p. 1124.

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how accounting structures can affect the decision-making process of managers relying on prospect theory.

Prospect theory, in contrary to standard economic models, attempts to model real-life choices instead of optimal decisions. According to prospect theory, in situations involving risks, decision makers choose among alternatives relative to a reference point. Outcomes are seen as gains if they are situated above their reference point and as losses if they are situated below it. A key aspect of this theory is the phenomena of loss aversion, which means that people are avoiding risks in winning contexts, but seeking risks when losses are involved. An interesting finding has been made by Vieider. He demonstrated that the bias of loss aversion is reduced by accountability since it induces a higher cognitive effort, “which triggers a rational check on emotional reactions at the base of loss aversion.”160 Hence, this finding proves that management accountants are less subject to such biases in comparison to managers, which promotes their decisive role during the decision-making process of managers in risky situations. Furthermore, loss aversion leads to several effects like the endowment effect or reflection effect. However, by now, framing effects have especially been at the center of many accounting studies. Framing means that the selection of an individual among different alternatives is influenced by the way they are presented. In relation with the phenomena of loss aversion, it is for instance possible to manipulate the risk preferences of the decision maker by presenting the situation in a specific context.161 Thus, framing effects play a substantial role in influencing human decision making or, in a managerial context, in guiding the manager’s behavior in accordance with the organization’s interests.

This line of research is relevant to the new field of neuroeconomics since decision making under risk viewed from the perspective of prospect theory also lies at the heart of neuroeconomic research. Neuroeconomics tries to figure out how the affective system of humans is involved in decision making under risk. Researchers in management accounting have also investigated a similar topic. They have tried to find out how the design of incentive systems may affect the behavior of employees.162 An interesting study regarding the fram-

160

Vieider (2009), p.96. Cf. Fox and Poldrack (2009), pp.149-151. 162 Cf. Slapnicar et al. (2012), pp.13-14. 161

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ing of incentive contracts was conducted by Hannan, Hoffman and Moser. They examined the influence of bonus contracts and penalty contracts on the effort of employees and their perceived fairness. While they could at first confirm previous studies by showing that employees prefer bonus-framed contracts, since they perceive them as fairer than penalty-framed contracts, they demonstrated that penalty contracts elicit a higher effort level. They concluded that although a higher perceived fairness increased the effort level of the employees, it was dominated by a stronger opposing effect, loss aversion.163 These results have been extended by Church, Libby and Zhang. They confirmed the results of Hannan, Hoffmann and Moser, but added that framing contracts only affects the employees’ performance if effective financial incentives are applied.164 Several other studies have been conducted to investigate the influence of the design of incentive systems on the behavior of individuals under risk and uncertainty, but this stream of research still needs to be further developed to have an impact on the practice of management accounting. In this regard, neuroeconomics could make an important contribution by combining management accounting frameworks with neuroscientific methods.

3.3.2 Intertemporal Nature of Decisions Loewenstein, Read and Baumeister define intertemporal choice as “what we do when we make trade-offs between costs and benefits occurring at different points in time.”165 So most of the decisions we make are intertemporal choices. Former scholars in this discipline looked at this phenomena from the perspective of the discounted utility model, which supposes that we discount the future with a single unitary rate of time preference. However, more recent research has proven that the discounting rates are falling and hyperbolic. That means that an individual would tend to choose a reward immediately rather than a higher reward later, depending on the timeline and the value of the reward. Today, hyperbolic time discounting is still at the center of many research studies in neuroeconomics, psychology and management accounting, including aspects like the role of emotions and intra-individual variability, which makes the matter even more complex and interesting.166

163

Cf. Hannan et al. (2005), p.151. Cf. Church et al. (2008), p.153. 165 Loewenstein et al. (2003), p.2. 166 Cf. Loewenstein et al. (2003), pp.1-3. 164

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Examining the issue of intertemporal choice in a management accounting context, it is important to understand how managers make consequential decisions weighing the costs against the benefits of their final decision in a risky and uncertain environment. They might need to decide whether to make a long-term investment that benefits the company in the long-run or to make a less profitable investment that generates immediate financial returns. Choosing the latter short-term option could have considerable negative consequences for the long-term competitive position of the organization.167 However, managers typically act in their own interests and not in the best interests of the company and would thus choose the short-term investment, evaluating the value of the delayed reward. In the literature, such a short-term managerial behavior is called ‘managerial myopia’. Managers are often under the pressure to achieve the yearly budgetary targets, which might explain their short-term preferences. In addition, this pressure can even lead to performance data manipulation and budgetary slack.168 This is the reason why the positive view on traditional accounting measures as a guiding tool to optimal decisions has been distorted. Lambert, for instance, claimed that they would “motivate dysfunctional behaviour by causing managers to pay attention to the ‘wrong’ things.”169 Nevertheless, strong evidence from theory has shown that accounting measures usually motivate managers to make value-maximizing decisions about investments. Abernethy, Bouwens and van Lent explain in their study that the intertemporal action choices of managers can be affected by different types of performance measures. Hence, in order to make decisions that benefit the organization in the long-run, it is crucial for an organization to properly incentivize their managers. However, Abernethy, Bouwens and Van Lent claim that combining the wrong accounting measures and focusing on financial data can lead to a myopic behaviour. But they conclude that the design and selection of the right tools, including financial and non-financial information, can direct the managers’ attention to long-term preferences, which correlate with the organizations’ goals. In this regard, they support findings from van Rinsum and Hartmann and underline that especially non-financial measures and return measures, such as return on investment and residual income, counteract managerial myopia.170

167

Cf. van Rinsum and Hartmann (2011), p.3. Cf. van Rinsum and Hartmann (2011), pp.3-4. 169 Lambert (2001), p.201, as cited in Abernethy et al. (2013), p.947. 170 Cf. Abernethy et al. (2013), pp.947-949. 168

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These research studies provide great insights into the intertemporal choice problematic in management accounting in the form of short-term managerial behavior. Van Rinsum and Hartmann offer several solutions to solve the issue of managerial myopia, which often leads to performance data manipulation and budgetary slack, with non-financial measures and subjectivity being key components.171 However, this line of investigation still needs to be extended and could be improved through neuroeconomics as it also deals with intertemporal choices. In this section, myopic behavior has especially been explained by the environmental pressure to which managers are exposed in organizations. But managerial myopia can also be caused by the phenomena of hyperbolic discounting of future rewards, as explained above, especially when uncertainty about the realization of future payoffs exists. By now, hyperbolic discounting has hardly been considered in management accounting research. Neuroeconomics could play a decisive role in understanding why humans are subject to hyperbolic discounting and future findings may be a great help to management accounting research. Understanding the nature of intertemporal decisions may contribute for instance to the development of new management accounting performance measures and new compensation practices.

3.3.3 Motivation, Fairness and Other Social Aspects Management accounting as well as neuroeconomic research attach great importance to topics like motivation and fairness, which are all highly related to social decision making. Research on motivation is valuable for organizations and management accounting since it might offer new insights about the behavior of individuals. Knowing why an employee acts like he does and understanding how his behavior is triggered by intrinsic forces such as motives and needs is crucial in designing incentive schemes and evaluating their effectiveness. The better motivation is understood, the better outcome will be generated from management accounting techniques. Management accountants can only provide a positive contribution to the decision-making process of managers and the organization if the main factors and situations that motivate individuals’ actions are identified correctly.172 As cited earlier, five main theories of motivation can be found in the literature with expectancy theory being one example that is often used in accounting. It tries to

171 172

Cf. van Rinsum and Hartmann (2011), p.1. Cf. Riahi-Belkaoui (2002), p.22.

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explain the whole process of human behavior assuming that “people can objectively estimate value and probabilities of future outcomes.”173 But empirical evidence has demonstrated that our estimation of probabilities is subjective and based on the attractiveness of the reward, contradicting this hypotheses and slowing down research in this direction. Additionally, the measures used in this line of investigation have been criticized as being mainly self-reported. This is why alternative approaches such as neuroeconomic methods may play an important role in future research on motivation, offering new insights about reward processes in the brain and providing new experimental methods. In this regard, neuroeconomic scholars have already examined the role of money as a reinforcer in several studies. By now, the results are not significant enough to draw conclusions about the role of financial incentives on individuals in organizations but the potential is huge.174

Some researchers on motivation put the effect of fairness at the center of their discussion. Considering fairness is important for management accounting practices since organizational research has shown that justice perception, i.e. the fairness perception of outcomes, procedures and interpersonal treatment, affect significantly attitudes and behaviors of individuals within an organization. A negative perception of fairness involves systematically a decreasing performance due to unconscious affective and behavioral responses.175 Several studies have demonstrated that this factor is crucial in stimulating motivation, commitment and job performance. Thus, Hartmann and Slapnicar conducted a study examining how the design and use of performance evaluation systems affect justice perception. Although they could identify some characteristics such as the diversity of performance measures used or the formality of the evaluation process that have an effect on the perceived fairness, they found out that the effect depends on the level of task uncertainty and on the manager’s tolerance for ambiguity. They concluded that it is still too complex to fully understand the correlation.176 Nevertheless, this topic plays an important role in management accounting and should be further examined.

173

Slapnicar et al. (2012), p.13. Cf. Slapnicar et al. (2012), pp.15-17. 175 Cf. Ambrose (2002), pp.804-805. 176 Cf. Hartmann and Slapnicar (2012), pp.28-29. 174

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Social factors like fairness and motivation, as well as trust and effort that have not been further investigated here, are also key themes of neuroeconomics. Thus, management accounting could take evidence from this discipline into account, but results on the neural basis of social factors are still inconsistent. Nevertheless, Slapnicar et al. persist on the idea that combining neuroscientific techniques with management accounting tasks in order to create new experimental designs would improve our knowledge about the role of social factors such as motivation and fairness in a management accounting environment.177

177

Cf. Slapnicar et al. (2012), pp.17-18.

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4 Neuroaccounting The purpose of the thesis is to investigate the potential benefits of merging management accounting research with neuroscience into a new interdisciplinary field. Therefore, this section synthesizes the chapters on neuroeconomics and management accounting by presenting the emergence of a new sub-field that is likely to be called “neuroaccounting”178. After having presented how the idea of creating a field of neuroaccounting emerged, chapter four presents how neuroeconomics and management accounting might benefit from each other. A merging of the fields might contribute to a more accurate understanding of the decision-making process, implicate specific design improvements of incentive schemes and lead to positive outcomes for management accountants. Overall, it would improve managerial decision making. Finally, this section discusses some limitations and challenges that early neuroaccountants might encounter.

4.1 The Emergence of Neuroaccounting The aim of neuroeconomics is to understand how humans make economic decisions by looking at how their brain works. Although management accounting seem to have nothing in common with this new discipline, according to the typical definition of accounting, which rather highlights the function of providing financial information, the previous chapters have shown that there are essential similarities. This correlation can be found in the behavioral nature of management accounting and its curiosity for human behavior as individuals, in a group or in an organization.179 Usually, management accounting scholars are interested in examining the impact of financial and non-financial information on individuals in organizations. The way employee process information and make decisions differs depending on their personality traits, and on incentive systems and control mechanisms used by organizations.180 In order to understand this interplay management accountant researchers needed to collaborate with behavioral economists and psychologists. Hence, a group of behavioral accounting researchers emerged and started to integrate observations from these behavioral disciplines about human behavior into their models to

178

Birnberg and Ganguly (2012), p.1. Cf. Birnberg and Ganguly (2012), pp.7-8. 180 Cf. Slapnicar et al. (2012), p.2. 179

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better understand information processing and decision making in a management accounting context.181 Being the fruit of behavioral economics and psychology, introducing neuroeconomics seems to be a logical advancement of the field of behavioral management accounting. In accordance with some conceptual papers regarding this matter, merging both fields might give rise to a new sub-discipline – neuroaccounting.

Furthermore, neuroscientific methods and knowledge of neural processes have already provided useful insights to economics and other business areas like marketing, finance and information systems.182 Thus, it is plausible to expect neuroscience methods playing an increasingly important role in behavioral management accounting research. Such a neuroaccounting research study may basically be conducted in two ways. First, by adapting evidence from neuroscience or neuroeconomic research to a potential issue in management accounting. Second, current findings in management accounting research could be supported and further analyzed by neuroscientific methods.183 In the beginnings of neuroaccounting research, the experimental setup needs to be organized by the accountant, i.e. determination of the research question and design of the experimental task if best valuable results for the field of management accounting want to be obtained. Thereafter, it is the neuroscientist who conducts the study after having verified that the task designed suits the neuroscientific technique being employed.184

Birnberg and Ganguly believe that the use of neuroscientific methods in accounting will impact the cognitive, affective and inter-personal domain. That means that a successful application of neuroscience on management accounting will help to understand how individuals process information and stimuli, how they make use of control and respond to positive and negative experiences, and how they interact with each other in organizations.185 Gaining a wider knowledge of these behavioral domains will enable behavioral accounting researchers to extend, redefine or create new management accounting theories and models. Moreover, management accountants strive to grasp when and why individuals make some decisions rationally and other emotionally. In this regard, neuroeconomics

181

Cf. Riahi-Belkaoui (2002), p.xi. Cf. Slapnicar et al. (2012), p.2. 183 Cf. Birnberg and Ganguly (2012), p.8. 184 Cf. Birnberg and Ganguly (2012), p.8. 185 Cf. Birnberg and Ganguly (2012), p.8. 182

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already gives great insights that should be taken into account by management accountants. An example is that there is a complex interplay between affect and cognition with emotions playing a central role in rational decision making.186 A better understanding of cognition and affect in decision making will have significant implications for management accounting research. The design and use of management accounting tools such as incentive schemes is crucial for the success of many organizations. However, the extent to which they can effectively influence behavior is still a matter of debate. Therefore a deeper knowledge of behavior under risk and uncertainty, intertemporal choice, motivation, fairness and other behavioral outcomes, that are all central themes in neuroeconomics as well as in management accounting research, would certainly advance management accounting theory and help for instance to improve the design of incentive systems.187

Considering the number of academic papers that have been published in this new field of neuroaccounting, one might argue that management accounting scholars do not have a great interest in exploring this new discipline of neuroaccounting. Until the publication of ‘Is neuroaccounting waiting in the wings? An essay’ by Birnberg and Ganguly in 2012, only one conceptual paper, by Dickhaut et al., relating accounting principles with the human brain system had been published, and until today there is still no published empirical paper on neuroaccounting. However, neuroaccounting has been introduced for the first time at the 35th annual congress of the European Accounting Association in May 2012 and it was seen as one of the most pressing and innovative areas of research. Professor Benedetto de Martino presented the research study conducted by Associate Professor Sergeja Slapnicar, Professor Frank Hartmann, Doctor Stephan Kramer and Doctor Conrado Bosman, in which they offer a first insight into this new emerging discipline.188 In the same year, Professor Peter Leibfried and Angela Pernsteiner from University of St. Gallen started a neuroaccounting project in cooperation with KPMG Switzerland investigating “the reciprocal interaction of accounting subjects and accounting systems in the context of the complex international financial reporting standards (IFRS).”189 Furthermore, a research team from Rotterdam School of Management, Erasmus University, led

186

Cf. Slapnicar et al. (2012), pp.1-2. Cf. Slapnicar et al. (2012), p.1. 188 Cf. European Accounting Association (2012). 189 Leibfried and Pernsteiner (2012). 187

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by Professor Frank Hartmann, are also working since 2013 on a project entitled ‘Incentives, Accountability and Decision Making: A Neuroscientific Investigation’ that has been funded by CIMA.190 However, the results of these studies have not been published yet.

Although the number of research studies on neuroaccounting is restrained, the interest among management accounting scholars is growing. In general, we can say that the emergence of neuroeconomics has opened new doors for several business related fields as it provides new scientific insights on human behavior. Economic reasoning has always been at the center of discussions in economic disciplines and is also a core issue in management accounting. Individuals respond to diverse stimuli such as rewards, gains, losses and actions of others in different ways, depending on how their brain processes the information.191 Through the introduction of neuroscientific methods, theories and findings about human behavior from behavioral economics and psychology gained new support. Moreover, neuroscience also provides a basis for new approaches to behavioral issues that are important in management accounting contexts. By building this bridge between rational behavior and affect, neuroscience could offer a completely new perspective on management accounting. Accordingly, theoretical progress lies at the heart of a convergence between neuroscience and management accounting.192 A more accurate understanding of economic reasoning should provide better insights into the decision-making process of managers, which is decisive for an organization’s success. Consequently, theoretical progress might lead to practical developments in management accounting in the near future. Finally, it will certainly affect the role of the management accountant and enable the emergence of new designed incentive schemes such as management control systems and performance evaluation systems, which will further improve managerial decision making.

190

Cf. Rotterdam School of Management (2013). Cf. Birnberg and Ganguly (2012), p.9. 192 Cf. Slapnicar et al. (2012), pp.12-13. 191

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4.2 Potential Contribution of Neuroeconomics to Management Accounting Management accounting and neuroeconomics scholars are both interested in similar areas of research, such as decision making under risk and uncertainty, intertemporal choice, and social decision making including motivation. In order to facilitate the comprehension of their analogy, Figure 11 integrates main factors from neuroeconomics into the managerial environment described in chapter 3.2.1. Figure 11: Integration of neuroeconomic factors to the environment of managers

(Source: Own representation)

We can see several parallels. For instance, it is obvious that, in addition to organizational control structures, the responsibilities of the management accountant, which are to report financial and non-financial information to the manager and design motivational incentive schemes, represent to some extent a cognitive or rational system. On the other hand, managerial behavior, being affected by cognitive biases and a complex environment, could

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be seen as an affective or emotional system. Such a division relates highly to neuroeconomic theory and the dual-process view. Furthermore, Figure 11 shows that the common areas of research correlate with the environment of managers and thus might offer meaningful insights about the decision-making process of managers. Investigating these analogies might help to further improve managerial decision making and thus organizational effectiveness.

The following sections presents potential contribution of neuroeconomics to management accounting that might help to improve managerial decision making. First of all, integrating neuroeconomic evidence would advance our theoretical understanding of the decision-making process, by throwing light on the existence of cognitive biases and explaining why individuals constantly make suboptimal, irrational decisions. The subsequent part demonstrates how the design of management accounting tools such as incentive systems might be improved, once decision making is better understood. The final contribution presented in this thesis is the positive influence new scientific evidence might have on practicing and researching management accountants.

4.2.1 Understanding the Decision-Making Process Until today, the decision-making process remains a matter of debate in several disciplines since there is no uniform model. As the aim of neuroeconomics is to build a unify theory of decision making, combining evidence from psychology, behavioral economics, and neurosciences, meaningful insights can be expected to emerge from this discipline regarding the decision-making process. For management accounting, a better understanding of the process would lead to an improvement of managerial decision making.

With economic models being criticized by behavioral researchers as they do not integrate behavioral variables, some scholars have tried to design non-rational decision-making models considering the issue. However, in comparison to rational models, they do not offer a very comprehensible framework.193 In this regard, CIMA modeled a conceptual framework of the decision-making process of managers, which is presented in chapter 3.2.2. Due to environmental and task uncertainty as well as time and social pressure, this

193

Cf. Kreitner and Kinicki (2013), p.330.

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rational decision-making model explains the importance for management accountants to assist their manager at every stage of the process. For instance, they can help by framing the issue, collecting and providing financial as well as non-financial information, communicating and interpreting financial and operating information, or by monitoring and controlling the outcomes.194 Such a support is vital for the quality of the manager’s decisions since managers often need to act fast and efficiently, thereby using heuristics, which might raise cognitive biases, leading to systematic errors.195 In order to reduce these cognitive biases, a concept of evidence-based decision making has been proposed. But since evidence in a managerial context is often weak and the size, form and age of organizations differ significantly, it rather offers a point of reference to improve managerial decision making and do not substitute the rational decision-making model.196 Hence, it remains the management accountant’s challenge to design optimal incentive schemes and information systems, in order to reduce the risk of managers being subject to biases. However, in order to design these systems in an optimal way, managerial behavior and the nature of cognitive biases need to be better understood. Here, neuroeconomic evidence and neuroscientific methods might contribute to meaningful insights.

The decision-making process viewed from the perspective of neuroeconomics differs from the managerial decision-making process suggested by CIMA since neuroeconomics focuses on the neural basis of the process by investigating what happens in the brain of an individual while she makes a decision. Here, the most important stage of the decisionmaking process is the valuation stage. It takes place after the initial phase of representing the decision problem and identifying feasible courses of action, and is essential to the subsequent stage of action selection.197 Being the core of the process, it is important to understand the neural basis of value. When faced with a decision problem, several cognitive and affective processes take place in the brain of the decision-maker in order to assign a certain value to the different alternatives. The measurement of value has always been a matter of debate. Today, neurobiologists explain that the subjective value of an object is highly related to reward and punishment in the human brain.198 According to Beugré, seeking for reward and trying to avoid punishment is a common human behavior, which 194

Cf. Chartered Institute of Management Accountants (2008b), p.14. Cf. Tversky and Kahneman (1974), p. 1124. 196 Cf. Pfeffer and Sutton (2006), p.3. 197 Cf. Rangel et al. (2008), pp.545-546. 198 Cf. Peters and Büchel (2010), p.137. 195

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also occurs in the workplace, and evidence about their neural bases is given. He further notes that the ventral striatum, the DLPFC, the OFC, the NAc and the amygdala are involved in the reward process.199 Since the brain processing of reward is highly related to the subjective value we attribute to alternatives in a decision context, and since the valuation stage is seen as the core of the decision-making process, considering evidence from neuroeconomics about the neural basis of rewards seems to be decisive to understand more accurately how managers act. Rewards can be defined as “objects or events that (…) represent positive outcomes of economic decisions, and may engage positive emotions.”200 The brain’s reward circuitry, including dopaminergic neurons, can be activated by different kind of stimuli such as monetary but also non-monetary incentives like fairness and cooperation. Rewards that are expected, unexpected or higher than expected affect our brain and thus our decision making differently, and especially stimulate the NAc, which is the seat of dopamine receptors.201 Several neuroeconomic studies offer a starting point for further neuroaccounting research concerning rewards. Camerer, Loewenstein and Prelec, for instance, demonstrate that spending effort to earn money leads to a higher activation of the ventral striatum than just receiving money without effort. Further investigation in this line of research may provide meaningful evidence for optimizing the design of performance-based incentive contracts.

In addition, Camerer et al. explain that many individuals become workaholics because earning money may be directly rewarding and losing money, in the contrary, painful. This is related to the phenomena of loss aversion and similarly leads to a pain of paying. 202 This might further explain why managers sometimes decide not to invest, although it would be efficient. Dickhaut et al. found out that the NAc is activated when people experience pleasure or anticipate pleasure, and that the simple thought about gains already increases activation in the OFC.203 In accordance with Dickhaut et al., Beugré suggests that promising a reward like a bonus or a promotion in exchange for good performance is

199

Cf. Beugré (2010), pp.292-294. Schultz (2009), p.323. 201 Cf. Beugré (2010), pp.294-295. 202 Cf. Camerer et al. (2004), pp.564-565. 203 Cf. Dickhaut et al. (2003), as cited in Beugré (2010), p.294. 200

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a great motivation as the expectation of the reward will probably activate the NAc. However, he warns that seeing an opportunity for large rewards induces a phasic increase in the firing rate of the dopamine neurons and may incite individuals to underestimate potential risks.204 Further research in this direction may throw light on cognitive biases such as overconfidence, which is common for managers. Finally, Tabibnia and Lieberman demonstrated in their study on fairness and cooperation that fair offers and cooperative partners led to increased activity in several reward regions.205 Such neuroeconomic evidence about non-monetary incentives should be taken into account by management accounting scholars since it may further explain why managers take certain decisions.

So far, many studies have been conducted in neuroeconomics on the neural basis of decision making, including valuation and reward processes, but being a young field, there is still a lack of evidence regarding the whole decision-making process. Hence, we are still far away from a uniform theory of decision making promised by neuroeconomics. Accordingly, adopting findings to management accounting still requires caution. However, this line of research is following the right path and should bear fruit soon. Up to now, it seems like neuroscience can enhance the understanding of the decision-making process by investigating its neural basis. First significant findings such as the involvement of emotions in rational decision making should create awareness among management accounting scholars and be considered in corresponding research. A unified theory of decision making will certainly offer management accountants a greater understanding of the decision-making process of managers and also throw light on the occurrence of cognitive biases. This would enable management accountants to optimize the design of management accounting tools and thus better guide managers in their decision making.

4.2.2 Design Implications for Incentive Schemes Management accountants need to support managers during their decision making since they act in a very complex environment. To do so, they use a wide range of management

204 205

Cf. Beugré (2010), p.295. Cf. Tabibnia and Lieberman (2007), p.90.

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accounting tools. However, reward systems like incentive schemes are especially important as they motivate a desired behavior.206 Neuroaccounting research on specific topics such as framing effects, intertemporal choice, motivation, and fairness, can contribute to new designs of incentive schemes that are more adapted to managerial decision making and thus improve the managers’ decisions. This line of research might, for example, explain why some incentives motivate managers and others do not.

When managers are faced with a decision problem, one of the key steps of the decisionmaking process is to frame the issue.207 The better the issue is framed, the better managers will be able to value the alternative choices. From the perspective of prospect theory, framing means that the way the issue is presented to the manager affects her decisionmaking process, so that she might take different decisions depending on the frame. Since humans are mostly subject to the phenomena of loss aversion, a different framing might change the risk preferences of the decision maker unconsciously.208 For instance, if someone is asked to choose between a sure thing and a gamble while the outcome is framed as a gain, he would rather choose the sure thing, however, he would prefer the gamble in a loss frame.209 Today, there is neurological evidence about this effect. According to Slapnicar et al., neuroeconomic studies have shown that “humans have difficulties in objectively determining the magnitude of risk (…) [since] their perception of risk is [often] associated with feelings of fear.”210 As described in chapter 2.1.2, fMRI studies have demonstrated that feelings of fear and thus the framing effect is induced by the amygdala, which represents a central part of our emotional system. This demonstrates that framing effects can influence significantly human decision making and guide behavior.211 Therefore, if a management accountant understands framing effects and takes this knowledge into account while designing incentive schemes, the management accountant could influence the manager’s behavior, so that she acts in accordance with the organization’s interests.

206

Cf. Chartered Institute of Management Accountants (2009), p.24. Cf. Chartered Institute of Management Accountants (2008b), p.12. 208 Cf. Fox and Poldrack (2009), pp.149-151. 209 Cf. Birnberg and Ganguly (2012), p.24. 210 Slapnicar et al. (2012), p.13. 211 Cf. Roiser et al. (2009), p.5985. 207

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Another important aspect in the design of reward systems is the phenomena of intertemporal preferences. Interestingly, if someone has to choose between receiving 10€ immediately or 11€ the next day, he prefers to get 10€. However, if the same person is asked to make a decision between receiving 10€ in a year or 11€ in a year and day, he chooses to get 11€.212 Neuroeconomic scholars have investigated the neural basis of such a hyperbolic time discounting in several studies. They finally discovered that our preferences in the short-run are mostly guided by limbic and paralimbic cortical structures that are rich in dopaminergic innervation and thus highly affected by emotions. On the other side, our preferences in the long-run are rather connected to fronto-parietal regions, which support higher cognitive functions.213 Findings in this line of investigation might help management accountants to better understand managerial behavior in intertemporal settings. Managers often opt for short-term rewards or investments, although the long-run option has a higher value. Such a behavior is called managerial myopia in the management literature and is mostly explained by budgetary targets that put managers under pressure.214 In this regard, management accounting studies propose that the design and selection of the right tools, including financial and non-financial information, can direct the managers’ attention to long-term preferences.215 Adapting neuroeconomic findings about hyperbolic time discounting to this managerial problematic should, for instance, give rise to new approaches to explain managerial myopia and provide a solid basis for the design of incentive schemes.

Furthermore, research on motivation and fairness is also of high value for the design of reward systems since their aim is to motivate managers to act in a way that corresponds with the organizations’ interests.216 Researchers in neuroeconomics conducted several studies investigating how rewards trigger motivation by observing brain activity in rewarding contexts. They found out that the physical state of an individual influences significantly the perceived incentive value of a reward and that motivation is highly related with dopamine transmissions.217 Moreover, other scholars integrated social aspects like fairness into their research tasks in order to understand the behavior of individuals in

212

Cf. Häring and Storbeck (2007), p.11. Cf. Loewenstein et al. (2008), pp.660-661. 214 Cf. van Rinsum and Hartmann (2011), p.3-4. 215 Cf. Abernethy et al. (2013), pp.947-949. 216 Cf. Chartered Institute of Management Accountants (2009), p.24. 217 Cf. Slapnicar et al. (2012), pp.15-17. 213

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situations evoking social preferences and figure out which brain structures are stimulated when fairness or unfairness is perceived. The studies demonstrate that when we judge a situation involving social aspects, the prefrontal cortex, which represents the deliberative system, seem to regulate emotional impulses sent from other parts of the brain, such as the anterior insula, which is associated with negative emotional reactions such as anxiety or disgust.218 These results are meaningful, since organizational studies have shown that attitudes and behaviors of individuals within organizations are significantly affected by their perceived fairness of outcomes, procedures and interpersonal treatment.219 Although management accountants have started to investigate this line of research, many questions remain open. Furthermore, management accounting studies on motivation often rely on wrong assumptions. For instance, while the expectancy theory assumes that future outcomes can be objectively valued and estimated by individuals, neuroeconomic evidence shows that our estimations are subjective and based on the attractiveness of rewards.220 In this regard, management accountants would do well to introduce neuroeconomic methods in their experimental tasks, so that more significant results can be obtained.

Neuroaccounting scholars may have a great impact on the design of reward systems like incentive schemes if they manage to provide new insights on framing effects, intertemporal preferences, motivation and fairness perception. Contracting, which includes all these research areas, is for instance a highly debated matter in management accounting and could be optimized by neuroaccounting research. So far, there is evidence from neuroeconomics that could be adopted to management accounting studies to either support current findings or even provide new evidence relevant to reward systems, but as there is no official neuroaccounting discipline until now, research effort in this line of investigation is still at its minimum. However, the potential is huge and neuroaccounting scholars could, for example, investigate brain activity stimulated by different types of rewards, such as financial against non-financial rewards, or a claw-back of bonus against a loss of reputation.221 Successful research in this direction will certainly have major implications for future incentive schemes.

218

Cf. Loewenstein et al. (2008), p.661. Cf. Ambrose (2002), pp.804-805. 220 Cf. Slapnicar et al. (2012), p.13. 221 Cf. Slapnicar et al. (2012), p.17. 219

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4.2.3 Implications for Management Accountants The previous chapters have shown that the emergence of neuroaccounting might improve the understanding of the decision-making process and contribute to better designed reward systems. However, Hartmann claims, “it may be worth improving not only the management accounting system but also the management accountant.”222 Indeed, as we could see from the challenging developments that occurred in the role of the management accountant, an improvement of the system as well as the person makes sense if they want to remain competitive and relevant in their organizations. The corporate world expects a reshaping of the professional identity of management accountants, so that they become more valuable business partners, being more pro-active, approachable and people-oriented, while maintaining their professional expertise.223

In order to adapt management accountants to their new role, specific trainings regarding their non-accounting qualities and engagement in decision-making processes should be offered. According to Fox, changing and learning new skills and technologies is not impossible due to the neuroplasticity of our brain, i.e. its ability to adapt. However, trainings should be conducted in small groups and with technology.224 Nevertheless, according to Hartmann, the current requirements of the job of management accountants seem to be impossibly demanding since not only the nurture but even the nature of management accountants should be adapted, and current teaching and training methods would not fulfil these needs until now. For that reason, introducing neuroscientific methods to management accounting would be necessary.225 In this concern, Rangel, Camerer and Montague also expect neuroeconomics to contribute to a greater understanding of how to train individuals to become better decision makers, particularly when they are subject to extensive pressure and confronted with high risks.226 This might have implications for both the management accountant and the manager. First of all, being sensitive to one of the key findings from neuroeconomics, i.e. emotions play a major role in human behaviour, management accountants but also managers might develop a theory of mind, which is defined as “a person’s ability to understand other people’s motor intentions and actions, goals,

222

Hartmann (2014), p.13. Cf. Kim et al. (2012), pp.4-8. 224 Cf. Fox (2008), as cited in Beugré (2010), p.300. 225 Cf. Hartmann (2014), p.13. 226 Cf. Rangel et al. (2008), p.555. 223

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beliefs and thoughts.”227 Consequently, they might learn to predict actions and reactions of others more exactly.228 This demonstrates that neuroeconomic research does not only underline the importance of social skills in decision making but also gives support to the new challenging role of management accountants as business partner.

Furthermore, a better trained management accountant could provide more valuable support to his manager. Being involved in the decision-making process of the manager, he could adopt neuroeconomic evidence to better assess the managers final decision. For instance, if the management accountant knows that the manager is under time-pressure, having to meet a looming deadline, he might rather advise him to delay the final decision or to seek further inputs, since neuroeconomic evidence has proven that time-pressure activates emotional brain parts, thereby conducting to an irrational decision.229

Moreover, the emergence of neuroaccounting would also have a positive impact on management accounting researchers and not only on practitioners. Being able to better predict human behavior, neuroaccountants would certainly design more appropriate reward systems as suggested in the previous chapter. In addition to this, their increasing understanding of managerial behavior might lead them to develop new theories and strategies to predict the behavior of managers and guide their decisions towards the organizations’ interests.230 For instance, Hartmann started a study aiming to “reveal the extent to which the social skills of controllers are hardwired in the brain and the extent to which they can be manipulated – and how.”231 Hence, neuroaccounting research does not need to focus particularly on managerial behavior but could also provide insights about management accountants, so that their role can be better defined in future.

Concluding, we can say that merging neuroeconomics with management accounting research will certainly improve the skills of practicing management accountants and offer researchers new insights to valid extant findings as well as to conduct future research. Existing findings already support the importance of the new role of management account-

227

Singer (2009), as cited in Beugré (2010), p.300. Cf. Beugré (2010), p.300. 229 Cf. Beugré (2010), p.290. 230 Cf. Beugré (2010), p.298. 231 Hartmann (2014), p.13. 228

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ants and could be used, for instance, to improve training methods in this regard. Consequently, it is very likely that the emergence of neuroaccounting will improve the quality of incentive systems and thus of managerial decision making.

4.3 Limitations and Challenges in Neuroaccounting Neuroscience found its way into several behavioral disciplines and starts to cross the mind of behavioral accounting scholars. Some topics that are relevant to management accounting have already been investigated in neuroeconomics, thus offering a good starting point for management accountants. Nevertheless, although the emergence of neuroaccounting and the opportunities it offers to management accountants sounds exciting, there is still a long way to go as even neuroeconomics is only at its infancy.

Accordingly, neuroaccounting faces some limitations and needs to master several challenges. One of the major initial limitations is the cost/benefit ratio.232 Current management accountants normally do not have the required know-how about the anatomy of the brain and might not be interested in being trained in this direction. However, management accountants need to be aware of the potential data that can be collected by neuroscientists and identify theoretical variables in management accounting that might match. Thus, a basic knowledge about neuroscientific methods is necessary to design an optimal experimental research task. Hence, the introduction of neuroscientific methods in management accounting implicates significant intellectual startup costs. In addition to this, the access to neuroscientific tools is limited and the technology involved is expensive, so that external funding is crucial to conduct a neuroaccounting study.233 Therefore, an important challenge for neuroaccountants is to gain the interest of neuroscientists in studying accounting-related decision making and consequently to collaborate with them in order to guarantee the access to sufficient resources and facilities.

There should be at least one neuroscientist in a neuroaccounting team, who is skilled at performing and interpreting fMRIs or other neuro-imaging procedures.234 This leads us

232

Cf. Birnberg and Ganguly (2012), p.7. Cf. Birnberg and Ganguly (2012), p.7. 234 Cf. Birnberg and Ganguly (2012), pp.7-8. 233

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to another aspect that should be considered with caution in the early stages of neuroaccounting – the interpretation of results. Although neuroscientific methods have already been applied in economics and the number of publications is exponentially growing, the interpretation of neuroscientific observations remains delicate since neuroeconomics itself is still at its very beginning. The capability of scientists to analyze the activity of specific brain regions while performing a task does not permit to make simple deductions. Neurons of individuals react to stimuli such as rewards and risks, which enables an observation of brain areas involved in the specific action. However, pretending there is any reward or risk area in the brain would be a too trivial reasoning.235 By misinterpreting results from neuroscientific studies, we run the danger to build social theories on inaccurate foundations. Further, existing neuroeconomic studies often generate results that are contradictory, so that only limited evidence is applicable to management accounting research. Although such evidence might be a useful source for future research, results from neuroeconomic studies should not be simply adopted by management accountants but investigated with care. Only a strong collaboration between management accounting scholars and neuroscientists can improve the understanding and interpretation of brain activity and thus lead to significant theoretical progress based on solid foundations.236

So far, these limitations and challenges that management accountants encounter are slowing down the development of neuroaccounting. However, this new field of research has a great potential to advance management accounting theory and should be considered explicitly. Progress in neuroaccounting will help both management accountants and managers to become more effective and efficient in their organizations by providing new insights on managerial behavior. Understanding the neurological basis of behavioral outcomes such as motivation, fairness perception, trust, effort, intertemporal preferences and risky behavior will deepen our knowledge about the interplay of incentive systems, formalized control structures and accounting information on managerial behavior and thus improve the quality of decisions taken by managers.237 Furthermore, managers are often subject to cognitive biases since they are permanently under pressure acting in a complex and changing environment. Evidence from neuroeconomics can provide decisive insights to better understand those biases and the decision-making process of managers, which

235

Cf. Slapnicar et al. (2012), p.19. Cf. Slapnicar et al. (2012), pp.18-19. 237 Cf. Slapnicar et al. (2012), p.18. 236

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would subsequently further improve managerial decision making.238 Nevertheless, first of all the initial intellectual and financial costs need to be covered, for instance through external funding, and efficient interdisciplinary research teams need to be built. Hence, researchers will be able to start revisiting existing theories and old questions using neuroscientific tools with the hope of developing new theories over time.

238

Cf. Slapnicar et al. (2012), p.12.

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5 Conclusion This thesis explored the potential benefits of unifying the recently emerged research field of neuroeconomics and the established management accounting discipline. As both fields have great fundamental similarities with understanding human decision making and behavior being at the core of their research ambitions, the emergence of neuroaccounting seems to be a logical development of the field. The following presents a summary of the thesis and offers future research opportunities.

5.1 Summary of the Thesis The purpose of this thesis is to create awareness among current and future scholars for neuroaccounting by explaining its theoretical background and predicting probable implications for management accounting researchers and practitioners. The multidisciplinary field of neuroeconomics emerged a decade ago as a result of the effort to build a unify theory of decision making.239 This thesis argues that integrating such a theory into the field of management accounting and using neuroscientific methods will certainly advance management accounting research regarding issues related to decision making that could not be explained scientifically until now, such as cognitive biases and the decision-making process itself. A better understanding of these concerns will have important implications for the design of incentive schemes since new evidence could be applied to management accounting tools.240 Moreover, neuroeconomic evidence supports the crucial role of management accountants in organizations, being guardians of rationality and becoming business partners. Further investigation in this direction might provide meaningful insights for management accountants to adapt to their role more appropriately. Overall, this thesis concludes that the emergence of neuroaccounting will contribute to an improvement of managerial decision making by reducing the effect of the principal-agent problem and thus increase organizational effectiveness.

Nevertheless, this thesis also includes several limitations of neuroaccounting, especially because neuroeconomics is also still at its infancy. Rather high intellectual and financial startup costs as well as the complexity of conducting and interpreting a neuroaccounting

239 240

Cf. Rustichini (2005), pp.203-204. Cf. Slapnicar et al. (2012), pp.12-13.

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study confront early neuroaccountants with serious challenges that need to be overcome quickly if this new discipline intends to become popular soon.241 Since evidence from neuroeconomics cannot be transferred without doubts to neuroaccounting, there is only little to rely on for external investors. However, if enough interest can be aroused by increasing the efforts in raising awareness, external funding is possible. For instance, CIMA242 as well as KPMG243 have funded current neuroaccounting projects recently, showing that the awareness about the potential of neuroaccounting research is already growing. If relevant evidence results from these research projects, and investments in neuroaccounting research are therefore seen as reasonable, the academic and professional interest might increase exponentially like it happened in neuroeconomics. Furthermore, neuroscientific techniques that are scientifically viable today will, like most technologies, become cheaper in the near future, and new techniques will certainly appear, offering better temporal and spatial resolutions. Therefore, management accounting researchers should follow this path of research and start to collaborate with neuroscientists in order to design best possible experimental tasks that will make a positive contribution to both disciplines.244

5.2 Future Research Opportunities Being unexplored, the field of neuroaccounting offers plenty of opportunities for future studies. Neuroaccountants could rely on extant management accounting research and contribute to a more accurate understanding of managerial decision making in collaboration with neuroscientists. According to Slapnicar et al. the role of money as a reinforcer has already been investigated in several studies but the results are still ambiguous, so that it is not possible, so far, to draw conclusions about the role of financial incentives on individuals in organizations.245 Therefore, neuroaccountants could follow this path of research and examine, for instance, brain activities of managers when they are confronted with bonus and penalty based incentive plans, in order to figure out the motivational effect

241

Cf. Birnberg and Ganguly (2012), pp.7-8. Cf. Leibfried and Pernsteiner (2012). 243 Cf. Rotterdam School of Management (2013). 244 Cf. Birnberg and Ganguly (2012), p.1. 245 Cf. Slapnicar et al. (2012), pp.15-17. 242

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of financial incentives. This line of investigation could further be extended with neuroaccounting research on the motivational effect of non-financial stimuli.

Moreover, neuroaccountants could follow the current study of Hartmann on the neurological basis of the social skills of management accountants.246 In this regard, Vieider has demonstrated that the bias of loss aversion is reduced by accountability since it induces a higher cognitive effort, “which triggers a rational check on emotional reactions at the base of loss aversion.”247 According to this finding, management accountants seem to act more rationally due to their profession. Managers, in the contrary, are typically seen as rather emotional.248 Since both actors seem to represent the two brain systems suggested by neuroeconomic scholars, i.e. the cognitive and affective system, it would be interesting to investigate to what extent the neural correlates of their brain processes differ. By designing a specific experimental task relying on neuroeconomic evidence and a management accounting issue of interest, and directly analyzing the brain activity of managers and management accountants, neuroaccountants could enrich both management accounting and neuroeconomic research. This would for example explain whether future neuroaccountants can simply adopt neuroeconomic evidence about the decision-making process to both actors equally or if management accountants and managers need to be treated differently in this regard. At the same time, it might either confirm or challenge extant neuroeconomic research. Concluding, the results of the thesis, in combination with future research opportunities, can contribute to raising awareness among current and future management accounting scholars about the new innovative research field of neuroaccounting.

246

Cf. Hartmann (2014), p.13. Vieider (2009), p.96. 248 Cf. Hirsch (2008), p.41. 247

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Appendix: Abstract (English)

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Appendix: Abstract (English) This thesis investigates the potential benefits of merging management accounting with neuroeconomics into a new field of research. Neuroeconomics, which already combines behavioral economics, psychology and neurosciences, emerged with the aim to build a well-founded and unified theory on human behavior, thereby replacing the rather unrealistic concept of humans as homo economicus. The application of neuroscientific methods has already allowed researchers to describe and explain states as well as processes that happen in the human brain before, during, and after making economic decisions. For instance, they found out that affective processes overweigh cognitive processes during economic decision making and that emotions are crucial for rational behavior. In recent years, marketing and finance scholars have started to transfer successfully neuroeconomic evidence to their respective business fields. Therefore, the question arises, whether neuroeconomic evidence could also be relevant for management accounting since behavior also plays an essential role in management accounting. Accordingly, this thesis aims to present important aspects of neuroeconomic and management accounting research, and to clarify the potential contribution of merging both disciplines. The design of incentive systems and the role of the management accountant are at the center of the discussion, however, the current state-of-the-art of the field is also discussed critically. The thesis explains that applying neuroscientific methods on management accounting would enrich our knowledge about managerial behavior. Additionally, this would have positive implications for the design of incentive systems and support the role of management accountants as “business partners”. Overall, evidence from this new field of research would reduce the information asymmetry within organizations and thus have positive effects on the organizational effectiveness. The main purpose of the thesis is to raise awareness among management accountants about neuroeconomics. The thesis concludes by pointing out that many challenges need to be overcome in this new emerging research field of “neuroaccounting”, but with the potential to gain new insights being huge, neurosciences are very likely to induce theoretical progress in behavioral management accounting.