Rotten Apples and Sterling Examples: Moral Reasoning and Peer Influences on Honesty in Managerial Reporting

Abstract

We develop a general representation of a norm-dependent utility function that imposes a disutility for actions that deviate from the norm. The disutility depends on the distance of the action from the norm, the individual’s norm sensitivity, and distinguishes between acts that are inferior (or superior) to the norm represented by separate components of the utility function. To infer whether one, both, or neither components are present, we investigate the moderating role of norm sensitivity in explaining peer influences in a laboratory experiment. In a budget reporting experiment, managers become less honest after seeing a less honest peer (the rotten apple effect) and more honest after seeing a more honest peer (the sterling example effect). We measure the sensitivity to social norms by the Maintaining Norms Schema score generated from the responses to the DIT-2 moral reasoning questionnaire. We find that (i) the sterling example effect is significantly increasing in an individual’s sensitivity to social norms and (ii) the rotten apple effect does not vary significantly with an individual’s sensitivity to social norms. Our evidence supports inclusion of a disutility component for actions that are inferior to the norm in representations of personal preferences.

Keywords: Financial incentives, Non-financial incentives, Compensation, Earnings management, honesty, dishonesty, peer effects, social norms, social preference

JEL Classification: C72, D03, J44, M41, M55