Steven Huddart & Hong QU

1. Rotten apples and sterling examples: Moral reasoning and peer influences on honesty in budget reporting MEAFA January16, 2014 Steven Huddart & Hong QU

2. Why do accountants care about norms and honesty? • Accounting, at its foundation, concerns the reporting of private information. • The analysis of private information communication in the traditional agency theory framework is based on the assumption of pure self-interest maximization. • BUT, the reporting behavior of other may affect one’s own reporting behavior.

3. Importance • Art Wyatt argued in an AAA plenary address that Arthur Andersen was brought low by bad corporate culture. • Sorting employees according to moral characteristics and promoting good norms within organizations may be underused ways to improve performance

4. Guides to behavior • Traditional economic models incorporate • contractual incentives • legal incentives • reputation considerations • Individuals also have innate preferences to conform to the behavior of their peers. • injunctive norms of behavior • empirical norms of behavior

5. Norms for all kinds of acts: Empirical evidence • Desirable action: Kim, Morse, and Zingales (2006): • Academics’ research productivity is influenced by the cultural norm of the department that houses them. • Undesirable action: Fisman and Miguel (2006): • Differing propensities of Nigerian and Norwegian diplomats posted to New York City to accumulate unpaid parking tickets • Social norms related to corruption are significant and persistent because diplomats behave like others in their home countries. • Undesirable action: Chen and Sandino (2011) • Retail theft and collusive retail theft by employees is lower when pay is higher. • higher wages have the direct effect of curbing employee theft and also promote an ethical environment among coworkers

6. Norms for all kinds of acts: Experimental evidence • moral development affects decisions • Arnold and Ponemon (1991): internal auditors with high moral development are more likely than those with low moral development to suggest whistle blowing • social norms influence decisions • Ponemon (1992a): peer pressure increases the likelihood that audit staffers will under-report the time spent on an audit task. • Lord and DeZoort (2001): peer pressure increases the likelihood that auditors sign off on financial statements that are materially misstated. • Ponemon (1992b): public accounting firms select and promote individuals who demonstrate a low but homogenous stage of moral development.

7. Kohlberg’s (1969) Theory of Moral Reasoning • Pre-conventional: responds to individual rewards and penalties • Conventional: desire to respect group norms of behavior • Post-conventional: motivated by personal principles and values

8. Formalizing Kohlberg:Fischer & Huddart (2008) • Risk-neutral agent maximizes pay net of personally cost of actions • wi + bi r(ai ) – f(ai – Nai ) • where f(x) is the cost of the act Nai is psychic cost to i due to norm for action a

9. Structure Norm of behavior, Nai = (1 –li)Pi– liS, where Pi represents the personal standard of agent i, i.e., the injunctive norm S is the endogenous average behavior of the peer group, i.e., the empirical norm li  [0,1) represents extent to which agent is conventional

10. Features • Action, ai, influences performance measure used for contracting. • Action is beneficial to the principal. • Action choice is influenced by a personal norm of behavior, Pi, and a social norm of behavior, S. • The weight on the social norm, li, measures the extent to which the agent is conventional. • Social norm of behavior is endogenous—it depends upon how agents behave within the organization.

11. Motivation • Theory of moral reasoning (Kohlberg, 1969) • Pre-conventional: responds to individual rewards and penalties • Conventional: desire to respect group norms of behavior • Post-conventional: motivated by personal principles and values • A model with endogenous social norms (Fischer and Huddart 2008) • Behavioral assumptions • Economic self-interest • AND • a personal standard for behavior • a desire to conform to the average behavior of a peer group

12. Contributions • Probe the validity of assumptions about individual preferences that underlie such models as Fischer & Huddart (2008). • Examine how individual traits such as moral types explains heterogeneous reporting behavior and susceptibility to social influences. • Extend ethics research in accounting by linking moral types to practical reporting outcomes.

13. Budget Reporting Experiment • Experimental setup • Participants play the role of managers • Observe private cost C perfectly • Submit budget report R to headquarters • Maximum cost is 6 and minimum cost is 4. • Economic Incentive (in Lira) • Fixed salary+budget slack:1000+1000*(Report-Cost) • Prior experimental evidence(Evans et al. 2001) • Reports are partially honest • Reporting Honesty=1.00- (Report-Cost)/(6-Cost) • Average honesty is 0.45.

14. Budget Experiment with Peers subject to social pressure • Peer group • Half the subjects are managers of Division A • Observe own cost and submit budget reports • Treatment group • Half the subjects are managers of Division B • Stage 1: observe own division’s cost and submit a report (uninformed report) • Stage 2: observe Division A’s cost and report, submit a second report (informed report) subject to social influence

15. Experimental procedure Peer 1: see own cost and report (Peer Honesty) Manager: see own cost and report (Uninformed Honesty) Period 1 Within-Period Change Manager: see peer 1’s cost & report, and report (Informed Honesty) Between-Period Change Peer 2: see own cost report (Peer Honesty) Manager: see own cost and report (Uninformed Honesty) Period 2 Manager: see peer 2’s cost & report, and report (Informed Honesty)

16. Subjects choices: early

17. Subject choices: Late

18. Average Changes in Honesty Conditional on Peer Behavior Peer More Honest (Peer Honesty - Uninformed Honesty > 0.1) Peer Less Honest (Peer Honesty - Uninformed Honesty < -0.1)

19. Personal standards: Reporting honesty without social information Average honesty of uninformed reports in period 1, by Kohlbergian type

20. Between-period change in honesty by moral types Averages computed from responses in periods 1–4, by Kohlbergian type.

21. Within-period change in honesty by moral types Averages computed from responses in periods 1–4, by Kohlbergian type.

22. Findings • Reporting honesty in the absence of social information about peers varies by Kohlbergian type, but not monotonically in p-score. • Reductions in honesty in response to “bad apples” is strong and pervasive. Strongest among pre-conventional types. • Improvements in honesty in response to “shining examples” is significant, but only among conventional types. • Norms and pay together shape outcomes

23. T3a–Evolution of honesty (within)

24. T3b–Evolution of honesty (between)

25. REVISION • Neo-Kohlbergian approach • Simplify the analysis

26. Kohlberg’s (1969) Theory of Moral Reasoning • Pre-conventional: responds to individual rewards and penalties • Conventional: desire to respect group norms of behavior • Post-conventional: motivated by personal principles and values

27. Neo-Kohlbergian Theory: degrees of three type of behavior • Self interest • Maintaining norms • Principled reasoning

28. Neo-Kohlbergian Classification from DIT2

29. Absent social information, what makes people honest, social norms or moral reasoning?

30. Changes in Response to Peers:Norms or Principles?

31. Changes in Response to Peers:Norms or Principles? (late)

32. Extensions • What is most salient in forming norms? • the most recent example • the most extreme behavior • the most consistent behavior • How does an empirical norm evolve? • option backdating • earnings management

33. Heinz Dilemma • Heinz's wife was near death, and her only hope was a drug that had been discovered by a pharmacist who was selling it for an exorbitant price. The drug cost $20,000 to make, and the pharmacist was selling it for $200,000. Heinz could only raise $50,000 and insurance wouldn't make up the difference. He offered what he had to the pharmacist, and when his offer was rejected, Heinz said he would pay the rest later. Still the pharmacist refused. In desperation, Heinz considered stealing the drug. • Would it be wrong for him to do that? Should Heinz have broken into the store to steal the drug for his wife? Why or why not?[

34. Summary of DIT2 responses

35. T2: Summary Statistics on Honesty Measure