Management Control Using Nonbinding Budgetary Announcements

Abstract

We use an experiment to investigate the efficacy of a nonbinding budgetary announcement made by an owner in order to mitigate a management control problem induced by asymmetric information. The owner's announcement indicates how much funding she will provide for each possible cost report by the manager regarding an investment opportunity. The manager has private knowledge of the cost, incentive to overstate it, and the ability to do so undetected by the owner. The experiment consists of three treatments: (1) the owner fully commits to honor her announcement regarding how she will use the manager's cost report, (2) the owner makes no announcement at all, and (3) the owner makes a nonbinding announcement regarding how she will use the manager's cost report. The first two treatments establish empirical benchmarks to gauge the effectiveness of the nonbinding announcement. There are three main results. First, owners in the nonbinding announcement treatment significantly outperform those in the no-announcement treatment throughout the experiment. Second, owners appear to use the nonbinding announcement as a bluff in an attempt to convince managers that they will reject a profitable project more often than they intend. This strategy appears to be particularly effective for the owners in the first half of the experiment. Third, the difference in owner welfare between the nonbinding announcement and binding announcement treatments is much less than the prediction made from standard game-theoretic assumptions. The third result suggests that, to the extent that commitment is costly, an optimal control system might not employ commitment.

The Effects of Perceived Fairness and Communication on Honesty and Collusion in a Multi-Agent Setting

“…Fehr, Fishchbacher and Gacher (2002) show that in the presence of punishment opportunities, the strong reciprocators can force the selfish-type players to cooperate. In accounting, Rankin et al (2003) show that the subordinates in their experiment anticipate the superiors' preference for honesty and their ability to reject projects. As a result, they only overstate costs by an average of 58%.…”

“…Rankin, Schwartz and Young (2003) investigate whether non-binding budgetary announcement made by principals can reduce agents' consumption of slack in a participatory budgeting setting. They find that principals use nonbinding announcement as a bluff in an attempt to convince agents that they will reject a profitable project more often than they intend.…”

Can Agent Cheap Talk Mitigate Agency Problems in the Presence of a Noisy Performance Measure? An Experimental Test in a Single- and Multi-Period Setting

“…This prediction, however, is contradicted by robust experimental findings in both accounting and economics that cheap talk is ''sticky'' to both the recipients and senders of the unenforceable signal (Farrell 1987(Farrell , 1993Kachelmeier et al 1994;Rankin et al 2003;Brandts and Cooper 2007). In related experimental research in management accounting, participants have been found to be motivated by social norms for honesty, which is reflected in the fact that participants frequently provide ''truthful'' budgets in participative budgeting settings where the economic incentive is to build significant slack into their budgets (Evans et al 2001;Stevens 2002;Hannan et al 2006;Rankin et al 2008;Hobson et al 2011).…”

“…Traditional economic theory considers this communication cheap talk because the promised effort cannot be enforced and the principal is therefore expected to ignore it (Farrell 1987(Farrell , 1993. Prior experimental studies in management accounting have demonstrated that cheap talk on the part of the principal can result in superior outcomes in a budgeting setting (Kachelmeier et al 1994;Rankin et al 2003). Cheap talk on the part of the agent, however, has received little attention in the literature.…”

“…Thus, our study contributes to the management accounting literature by demonstrating the effectiveness of the promise-keeping norm in a principal-agent setting and the ability of cheap talk on the part of the agent to activate this social norm. While researchers in economics have begun to examine benefits from cheap talk emanating from the agent (Brandts and Cooper 2007), researchers in management accounting have only examined benefits from cheap talk emanating from the principal (Kachelmeier et al 1994;Rankin et al 2003).…”