Steven T. Schwartz

A Laboratory Investigation of Verification and Reputation Formation in a Repeated Joint Investment Setting

Two managers invest funds in either a division-specific or common project. Managers are privately informed of their own division-specific return ratio and issue forecasts to their partner. Experimental parameter values are chosen such that: (1) investment in the division-specific project constitutes a strictly dominated strategy and (2) socially efficient investment requires truthful forecasts and dictates that (only) the manager with the lower rate of return invest in the common project. This creates a role for ex post verification, the main manipulation in the experiment. In addition, random and continuous pairing of subjects are used. With randomly pairing settings, verification significantly increases honest forecasting and efficiency. With continuous pairings, verification improves coordination of investment strategies, but has only a muted effect on efficiency. Even without verification, continuous pairings increases efficiency. These results indicate that verification and repeated pairings act as substitutes in improving forecast quality and efficiency. Key words: Experimental economics; Verification; Reputation; Cooperation

Reputation Without Repeated Interaction: A Role for Public Disclosures

This paper conductsan experiment to investigate the economic effect of public disclosureswithin a multi-move adaptation of the Prisoners Dilemma game.The game, which has multiple equilibria, is characterized by:(1) a stochastic endpoint, (2) random, repeated pairings withanonymous partners, and (3) public disclosures concerning thecurrent partners previous strategies. In the experiment, cooperationis improved by the disclosures. In addition, subjects cooperatemore frequently when encountering a player who has tended tocooperate in the past, and less frequently when encounteringa player who has tended to defect in the past. Delayed disclosureleads to levels of cooperation only slightly less than thoseobtained with timely disclosure.

A Note on Bundling Budgets to Achieve Management Control

By its very nature, management control research can be complex and difficult to understand, and hence challenging to introduce into the classroom. Nevertheless, it is important for accounting instruction to retain a connection between teaching and research. This note provides guidance on how recent findings in the theory of management control can be introduced into the classroom. The general approach is to present findings in the academic literature using a combination of numerical examples and classroom experiments. We use this two-pronged approach to illustrate that the bundling of budget proposals mitigates management they in a setting where control issues arise because subordinates are privately informed and self-interested. In our experience this approach stimulates student interest and increases the likelihood of successful implementation in undergraduate and graduate classes.

The Behavioral Implications of Aggregation and Delay on Budget Approval Decisions

An experiment with three treatments is used to evaluate the social efficiency of budgeting protocols induced by other-regarding preferences. In disaggregated superiors receive three individual proposals in iterated fashion, and must decide whether to accept each project without knowledge of the forthcoming proposals by the subordinate. In aggregated three projects are bundled together, and subordinates submit an aggregate proposal that is intended to cover the cost of all the projects combined. Superiors can accept all of the projects to which the proposal pertains, or none of them. In delayed subordinates submit individual proposals as in disaggregated, but superiors delay making a decision on any of them until they receive all three proposals. The results indicate that superiors are slightly more demanding in aggregated than in the other two treatments, and subordinates submit lower proposals for high-cost projects. However, superiors are not so demanding that the social benefit of aggregation is completely undone: the likelihood of project acceptance under aggregated is significantly greater than under disaggregated and delayed, especially for the highest cost projects. It therefore appears that the aggregation of budget requests into a single proposal to cover all costs is somewhat efficacious in increasing project acceptance. Interestingly, only when the superior is forced to consider an aggregated budget is social welfare improved. In this sense, aggregation may be thought of as a substitute for a commitment to view only the total budget proposed, and not its components. More generally our results provide a rationale for restricting the level of information in the evaluation of subordinates when superiors cannot commit to how they will use the information.

The Effect of Endogenous Contract Selection on Budgetary Slack: An Experimental Examination of Trust, Distrust, and Trustworthiness

This study examines the effect of endogenous contract selection on budgetary slack using two slack-inducing contracts found in the literature: a trust contract where the superior must accept any feasible budget submitted by the subordinate and a discretion contract where the superior can accept or reject the budget. We find that both contracts generate less budgetary slack when they are endogenously selected by the superior than when they are randomly assigned by the experimenter. Exit questionnaire responses support our expectation that selecting a trust contract signals trust and expectations of trustworthiness whereas selecting a discretion contract signals distrust and an increased willingness to reject unreasonable budgets. We find the greatest level of efficiency with the endogenously selected discretion contract, which is not significantly different in efficiency than the optimal hurdle contract under traditional agency assumptions. Thus, our results suggest that endogenous contract selection improves efficiency whether it signals trust or distrust and signaling distrust may be optimal for the firm in some contracting settings.

Accounting, Finance and Adverse Selection: Illustrations and Applications

Accounting is often viewed from a legalistic rather than economic perspective. Finance, on the other hand, is deeply rooted in economic theory, but at its heart is built on assumptions of frictionless markets. Neither perspective fully incorporates the rich economic environment in which we find the practice of accounting and finance; a market setting rife with information inefficiencies. We illustrate and review one such inefficiency, adverse selection. Adverse selection results when market participants have different levels of information about an attribute of payoff relevance. In such cases, less informed parties transact in a market where the profile of assets for sale or employees for hire is worse than the population as a whole. In general, adverse selection causes a loss of social welfare and, in extreme cases, may cause the breakdown of an entire market. Each illustration is based on one of the seminal papers written by the Nobel Laureates of 2001, recognized for their work on adverse selection. We then trace the insights into the accounting and finance literatures. We consider both disciplines jointly, because accounting information is often useful in mitigating the market inefficiencies studied in finance.

Unobservable Commitment and Management Control: An Experiment

We conduct an experiment designed to investigate unobservable commitment in a management control setting with a privately informed subordinate. The experimental setting follows closely that found in Evans, Hannan, Krishan and Moser [2001] and Rankin, Schwartz and Young [2003]. In one treatment the superior makes an unobservable, but binding commitment regarding her future behavior. In the other treatment the superior reacts to the subordinate’s actions without having made a prior commitment. In both treatments the superior sends a non-binding announcement regarding her intended response. Arguments are presented for how an unobservable commitment might affect the superior’s resolve to punish undesirable behavior by the subordinate. We find that unobservable commitment weakens the superiors’ willingness to inflict costly punishment on the subordinate and, in turn, subordinates eventually learn to be more aggressive. One possible implication is in some circumstances it may be better for superiors to let their emotions have “free rein” if their goal is to convince subordinates of their willingness to retaliate against them for their unfair behavior.

A teaching note on the controllability “Principle” and performance measurement

Purpose - The purpose of this note is to expose accounting students and others to recent findings in management control, specifically to the relationship between the informativeness of a performance measure and its usefulness in performance evaluation. Design/methodology/approach - Numerical examples illuminate key ideas and are easy to follow and replicate by students. Findings - Seemingly in contradiction to the controllability principle, performance measures that are informative about actions taken by employees are not necessarily useful for performance evaluation. This occurs when the performance being measured is related to an intermediate task, such as prepping items prior to final assembly. If prepping is an important factor in the quality of not only the intermediate good but also the finished good, and the quality of the finished good can be reasonably measured, it may not be useful to measure the prepping performance. This result holds even if obtaining the intermediate measure is costless and the intermediate measure provides unique information on the effort given to the intermediate task. Originality/value - Opportunities to measure employees’ intermediate outputs are ubiquitous; therefore, judicious decisions should be made regarding the use of limited monitoring resources. This note contains intuitive, easy-to-follow illustrations (based on recent findings) that will help students and others identify situations where such evaluations are more and less useful.

Bank Runs and the Accounting for Illiquid Assets in Financial Institutions

Abstract Financial services are an increasingly important sector in modern economies, yet many accounting and auditing texts focus on manufacturing and retailing. This teaching note describes the role of financial institutions in transforming long-term, difficult-to-sell assets into short-term bank accounts. This is referred to as liquidity transformation. The social benefits and risks of liquidity transformation are described. The social benefit occurs due to the increased liquidity provided by the bank to depositors. The risk comes in the form of a bank run, wherein difficult-to-sell assets cannot be redeemed in time to cover the rapid and unexpected withdrawals of depositors. The financial statements of a financial institution are presented and the issue of valuation is discussed. Finally, practical relevance for accounting students is enhanced by including discussions of historical precedents and of implications for financial reporting and auditing.

A Note on the Properties of Aggregate Evaluation of Budget Proposals

Agency research on capital budgeting has demonstrated that a principal can reduce information rents by contracting on several investment projects in aggregate rather than on each investment project individually. We investigate the robustness of this result in a model that facilitates comparative statics. We find that the relative advantage of aggregation over individual evaluation is maximized for intermediate levels of expected profitability and intermediate levels of the variability of profitability. We also explore the effects of correlated project outcomes. We find that if aggregation is beneficial, its benefit is decreasing in the correlation between the projects’ profitability. Applications of our results are discussed.