Effects of Reputation and Ethics on Budgetary Plans

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The Effects of Reputation and Ethics on Budgetary Slack
This paper conducts an experimental study to test the effects on budgetary slack of two potential controls for opportunistic self-interest – reputation and ethics. In the experimental study the level of information asymmetry between the subordinate and the superior regarding productive capability is manipulated and the subordinate’s reputation and ethical concerns regarding budgetary slack are measured. The paper examines how information asymmetry affects reputation and ethical concerns. Prior experimental studies regarding the effects of risk aversion, information asymmetry, and pay scheme on budgetary slack have provided general support for agency predictions. However, the studies have also shown that subjects under slack-inducing pay schemes have created much less than the maximum amount of slack. This is inconsistent with opportunistic self-interest. By constraining their slack, subjects have significantly reduced the amount of money they earned for the same level of productive effort. Budgetary slack is defined as the amount by which subordinate understates his productive capability when proposing a budget against which his performance will be evaluated. According to a study by Kren and Liao (1998), when superiors use budgets to evaluate performance, subordinates have incentives to build slack into their budget to increase the likelihood of achieving the budget. Budgetary slack poses a problem for the firm to the extent that it inflates costs and reduces profits. Similar experimental studies in the past have yielded different results. Young (1985) found that risk aversion was an important determinant of budgetary slack, but his information asymmetry did not have a significant impact on it. Chow (1998) found an interactive effect between information asymmetry and pay scheme. Slack was lower under a truth-inducing pay scheme than under a slack-inducing pay scheme, but only in the presence of information asymmetry. Similarly, Waller (1988) found that switching from a slack-inducing to a truth-inducing pay scheme significantly reduced slack only for risk-neutral subordinates. In these studies, one notable fact was noted and that there was relatively limited budgetary slack found under slack-inducing pay schemes. Researchers have speculated that such behaviors reflect ethics-related influences such as personal integrity. This paper tests the effects of reputation and ethics on budgetary slack in an experimental setting that carefully controls social interactions and facilitates subject learning. Student subjects set budgets in a simple production setting and earned pay based on their performance relative to the budget. The pay scheme was slack-inducing and provided an economic incentive for subjects to set their budgets at zero. The results provide strong evidence that reputation and ethics reduce budgetary slack. While slack levels under a slack-inducing pay scheme are higher than in prior experimental studies, subjects still restrict the amount of slack in their budgets below the maximum, and thereby fail to maximize their pay. Budgetary slack is negatively associated with a measure of ethical responsibility from the pre-experiment personality questionnaire as well as reputation and ethical concerns expressed in the exit questionnaire. Subordinates express lower reputation concerns as information asymmetry regarding productive capability increases, thereby reducing the superiors ability to monitor the slack in their budget. Ethical concerns, however, are not diminished with increases in information asymmetry. These results suggest that reputation is a socially mediated control whereas ethics is an internally mediated control for opportunistic self-interest. In conclusion, this paper highlights an important concept and that is in an organization, providing an incentive in monetary form is not sufficient enough to motivate an employee and maximize his full...
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