Honesty in Managerial Reporting

1. Honesty in Managerial Reporting John H. Evans III, R. Lynn Hannan, Ranjani Krishnan, and Donald V. Moser Presented by Irana Scott

2. Objectives of Study • Reassess the empirical importance of preferences for honesty • Baiman and Lewis’ (1989) • Preferences for honesty are too small to be important • Results in this paper • More honesty than predicted by agency theory

3. Objectives of Study • Provide evidence regarding the strengths/weaknesses of existing models • Revelation principle • Firms get honest reporting if they pay enough for it • Agency Models • Purely wealth maximizing • Types Models • Purely Honest • Results from this study • These theories cannot predict findings of this study • The firm did not pay anything for the honesty in these experiments

4. Objectives of Study • Investigate factors that affect the extent of honest reporting • Brickley et al. (1997) • Trade off model • Level of honesty will decline as the payoff to lying increases • Results of this study • Little evidence is found of a trade-off • Reporting may depend on how the contract divides the surplus

5. Objectives of Study • Provide evidence concerning how the extent of honesty affects firm profit • Agency theory • Contract with a production function yields more profit than a contract with only a reporting feature • There is no value to adding a reporting feature to a contract that already incorporates the production feature • Results of this study • Agreement that there is more profit with a production function, but the difference is smaller • Profit increases when the contract employees both features

6. Experiments • Three experiments • 28 MBA students assume the role of division manager • The manager reports cost to headquarters in the form of a budget request • The manager may obtain excess resources by lying (overstating cost) • Lies are not detected

7. Experiment 1 • Trust contract • The manager receives a base salary • The more the manager lies, the more he earns • Reduction of firm profit • Cash payments were based on one period selected randomly • They find a significant positive association between reports and actual costs • Subjects have a preference for honesty

8. Experiment 2 • High payoff trust contract • Identical to experiment 1 except the maximum that can be gained is increased from $66.67 to $333.33 • Number of subjects reduced to 11 • Subjects did not lie significantly more

9. Experiment 3 • Modified trust contract • Add a production hurdle to experiments 1 and 2 • For cost reports greater than 5, the manager receives on his salary • They found a significant positive relation between reported costs and actual costs • Preferences for honesty affected the reports of subjects, even though they were less honest in this scenario • Subjects lie more to achieve a more favorable distribution of the total surplus

10. Baiman and Lewis (1989) • They tested • Communication and non-communication based contracts • Dishonesty under increasing monetary rewards • Threshold effect • Little misrepresentation at the lowest level of monetary reward, but above that level, most subjects were willing to lie • Reward was relatively small with a range of $6.375 to $10.00

11. Differences in the Studies • Baiman and Lewis (1989) • “Encouraged” subjects to use an expected value approach • 58.3% of subjects lied • 41.7% did not lie, which is close to Evans et al. (2001)