Impaired Judgment: The Effects of Asset Impairment Reversibility and Cognitive Dissonance on Future Investment

Abstract

This paper examines how the reversibility of the accounting effect of asset impairments affects managers' investment decisions. We conduct two experiments in which participants act as CEO of a multi-division electronics company that suffers a large asset impairment at one of the divisions. Drawing on prior psychology research involving cognitive dissonance and decision reversibility, we predict and find that managers who are responsible for the decision to record the asset impairment invest more in the impaired division when the accounting effect of the impairment is reversible than when it is irreversible. This is consistent with the idea that reversible accounting effects encourage behavioral attempts to alter the cash flow outcome, while irreversible accounting effects encourage belief revision to rationalize the cash flow outcome. Also in line with cognitive dissonance theory, we show that managers who are not responsible for the decision to impair the asset, or managers who are given the opportunity to deny responsibility for the asset impairment, do not differ in their investment in the impaired division, regardless of impairment reversibility.

Individual risk tolerance and herding behaviors in financial forecasts

“…In line with other recent top journal contributions studying psychology-related mechanisms relevant to the behavior of accounting and finance professionals (e.g., Chang et al, 2016;Emett & Nelson, 2017;Kumar, 2010;Rennekamp et al, 2015), we test and find support for our two hypotheses via an experimental setting using 289 business graduate students. Although the participants are not professional financial analysts, they do possess important analyst characteristics, such as knowledge of financial accounts and the limitations pertaining to earnings predictability.…”

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“…Therefore, participants recruited through MTurk are an appropriate proxy of retail investors, once appropriate screening procedures are implemented. Notable studies in accounting that have used MTurk participants include Koonce et al [22], Rennekamp [4], and Rennekamp et al [23].…”

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