Reference Points and Budget Requests: Can Controls Destroy Honesty in Managerial Reporting?

Abstract:     
This paper experimentally examines the level of honesty in capital budget requests under different levels of profit that the firm earns from a divisional manager’s production. In all conditions, participants, acting as division managers, are given the same contract in which a self-interested person would always fully misrepresent costs at the expense of the firm. Results show that many participants produce partially honest reports. Yet, firm profitability is an important reference point in this decision: misrepresentations are in particular much lower when the firm’s profit is on the edge (i.e. close to zero), than when the firm would always earn a profit or loss from the participant’s production. Surprisingly, results further show that the use of a control system with the intention to constrain misrepresentations (holding constant economic incentives to misrepresent cost) may sometimes backfire. In settings were misrepresentations are lower without any form of control, that is when firm profitability is on the edge, the evidence suggests higher misrepresentations as a result of such controls. These findings offer practical implications for the decision control function within firms. Situational contexts can sometimes activate more truthful reporting and costly controls may not always form a solution to reduce rent extraction by employees.

Number of Pages in PDF File: 35

Keywords: Capital budgeting, social concerns, honesty, and management controls

JEL Classification: C91, D82, M41

working papers series