Motivating Truthful Subordinate Reporting: An

Motivating Truthful Subordinate Reporting: An Experimental Investigation in a Two-Subordinate Context* CHEE W. CHOW San Diego State University MARK K. HIRST Australian Graduate Schooi ef Management MICHAEL D. SHIELDS The

AbstracL This experimental study tests the predicted effects of three performancecontingent pay sdiemes on subordinate misrepresentations: profit shariqg, a single-subordinate tnith-indudng scheme, and the Groves scheme. A contribution not found in prior experimental research is the introduction of the distinction between direct and indirect misrepresentations. The results show that, as predicted, the three schemes have different abilities to deter the two types of misrepresentations. The fewest direct and indirect misrepresentations occur under the Groves scheme and the most under the linear profit-sharing scheme. There is no significant difference between the singte-subonliiiate truth-indudng scheme and the Groves scheme in the incidence of direct misrepresentations, but indirect misrepresentations are significantly morefrequentunder the former. Risumi. La prfisente 6tude expdrimentale vise ft tester ceataincs hypothtaes relatives aux r&ultats de l'application de trois stnictuies salariales lites au rendement sur les dddarations trompeuses des subordonntfs : la participation lin£aire aux b£n£fices, une structure salariale individuelle favoriaant la frandiise et la structure Groves. Cette £tude se d£marque des etudes expirimentales ant£rieures en ce qu'elle introduit une distinction entre I'infonnation trompeuse directe et indirecte. Les r£sultats r£vfclent que, conform£ment aux hypotheses, les trois structures salariales pr£sentent des capadt^s diffdrentes de d£courager les deux formes de declarations trompeuses. La structure Groves est celle qui occasionne le plus petit nombre de declarations trompeuses directes et indirectes, tandis que la partic^Mtion lin£aire aux b6idfices est celle qui en occasiorme le plus. II n'existe pas de difference significative entre la structure salaiiale individuelle favcnisant la franchise et la structure Groves en ce qui a traitftI'occurrence des declarations trompeuses directes. mais les declarations trompeuses indirectes sont beaucoup plus frequentes dans le cas de la structure salariale individuelle.

*

An earlier venion of this paper was presented at the 1993 Contemporary Aooounting Research Confeience. The authors acknowledge the helpftil suggestions of two anonymous reviewers. Bill Waller. Mark Young, participants «>f the oonferenoe. and seminar participants at Arizona State University. University of Illinois. University of Oregon. Penn State Umversity. and University of Southern California.

Comemporary Accounting Research Vol. 10 No. 2 (Spring 1994) pp 699-720 "CAAA

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Contemporary Accounting Research

A major c^hallenge in organizations is ensuring that resources are allocated to their most profitable tises. Subordinate managers usually have better information than do their superiors about their expected performance or opportunity sets. Tnithfiil upward reporting of this infonnation can improve the effectiveness of the finn's overall resouree allocation (Baiman and Evans 1983; Dye 1983; Penno 1984). However, superiors can face a trade-off between motivating tnithftil upward communication and higher subordinate performance. Managerial pay is frequently based on performance relative to a standard (Mmk and Giardina 1985, and Fox and Peck 1986), and analytical research has shown that this an^angement can motivate higher perfonnance (Demski and Feltham 1978 and Christensen 1982). However, standard-based pay can motivate subordinates to understate their performance expectations to increase the probability of obtaining a lower standard (Hopwcxxl 1976 and Kaplan anc] Atkinson 1989). This problem is compounded when subordinates' reports regarding their expected perfonnance are used to allcxate firm resources among them. In this case, they may have additional incentives to misrepresent, but not necessarily to understate, their expectations. The current study experimentally tests two incentive schemes that have been proposed by analytical research for inducing truth-telling by subordinates. In so doing, it introduces to the experimental literature a distinction between two types of suborclinate misrepresentations: direct and indirect. A direct misrepresentation relates to the level of resource allcKation to a subordinate, which is profit maximizing for him or her but not nec:essarily for the firm. An indirect misrepresentation, on the other hand, relates to alternate levels of resource allocations to the subordinate. Alternate incentive schemes are not equally effective at deterring these two types of misrepresentations. Hence, distinguishing between them provic]es more powerful tests of the incentive schemes' truth-inducing effec:ts. The rentiaincler of this paper is organized as follows. The next section reviews the extant analytical and empirical literatures as the basis for developing six predictions. Then the experimental method is described. Next, the results are presented and discussed. The final sec:tion provides a summary and discussion. Uterature review and hypothesis development Experimental studies by Chow, Cooper, and Waller (1988), Waller (1988), and Chow, Cooper and Haddad (1991) have reported thiat the following pay scheme, which was developed by analytical research (Ijiri, Kinard, and Putney 1968; Weitzman 1976; Miller and Thornton 1978; and Bonin and Fukuda 1987), recluces a subordinate's misrepresentation of his or her performance expectations:

(

y (1)

Motivating Tmthful Subordinate Reputing

701

where B is the subordinate's pay, y^ is the subordinate's actual performance as measured, y^ is the partidpatively set performance standard, and a, b, and c are reward or penalty parameters set by the superior such that 0 < a < b < c. However, when there is more than one subordinate and subordinates' reports are used both to set their performance standards and to allocate resources among them, this single-subordinate "tmth-indudng" scheme (hereafter SSTI) no longer can ensure tmthful subordinate reporting (Loeb and Magat 1978). The Groves scheme has been proposed as a solution to the multisubordinate problem (Groves 1973,1976; Green and Laffont 1977; Groves and Loeb 1979, and Harris, Kriebel, and Raviv 1982). Under the Groves scheme (hereafter G), the pay for a subordinate manager is an increasing function of his or her performance measure:

)-Ai

(2)

where G,- is manager Ps performance measure, ^ ( ^ j ) is i's actual performance (e.g., profit) given the actual level of resources (Kf) allocated to him or her by his or her superior, S Pfif^p is tiie sum of the other managers' communicated (to the superior) forecasted profits for the levels of resources actually allocated to them, and A^ is a constant preset by the superior (e.g., a required retum on investment). Asstiming a one-perioid setting, absence of collusion and risk-neutral managers whose utility functions have pay as the only argument, analytical research has shown that the dominant strategy for eadi expected utility-maximizing manager under G is to report tmthfully, regardless of whether the others do so. This result has been shown fo hold when effort preference is added as a second argument in the managers' utility functions (Conn 1982 and Cohen and Loeb 1984). Waller and Bishop (1990) have experimentally tested the tmth-inducing effects of G versus (1) a unit profit scheme (UP), which paid a fixed amount per unit of reported realized profit, and (2) a unit profit plus penalty scheme (UPP), which reduced pay to 0 if realized profits fell short of the subordinate's communicated expected profit. Subordinates' misrepresentations under G were found fo be significantly lower than under UP, but significantly higher than under UPP. Waller and Bishop (1990, 826-827) speculate that the latter result may have been due to either or both of two factors in their experiment. First, under UPP, optimal behavior unambiguously was tmthfiil communication, whereas under G, optimal behavior was either tmthful communication assuming noncoUusion or overstatement assuming collusion. Second, the greater difficulty of understanding G may have impeded the partidpants' development of an optimal communication strategy in their experimental setting. A limitation of Waller and Bishop's (1990) study is that their experimental task was biased against G. The analytical research that developed

702


G was based on the general case of nonconstant retums to scale, in which each subordinate reports a vector of profits for altemate resource allocation levels. In such a setting, misrepresentations by suboidinates can be direct and/or indirect. The former entails misrepresenting the expected profitability of the subordinate's profit-maximizing resotirce allocation level; the latter involves misrepresenting the expected profitability of altemate allocation levels. As will be demonstrated later, G is more effective than the other two pay schemes tested by Waller and Bishop at deterring both types of misrepresentations. In Waller and Bishop's experimental task, the partidpants were precltided from indirect misrepresentations because they cotild report only a single profit parameter (which Waller and Bishop labeled the "p-ratio"). Since state uncertainty was absent in the experiment, it was impossible for misrepresentations of the p-ratio to avoid detection and UPP's laige penalty. Thus, Waller and Bishop were correct in identifying tmthful reporting as the tinambiguous dominant strategy under UPP. Even ignoring the extremeness of UFP (real-world managers are unlikely to detect all misrepresentations with certainty), if Waller and Bishop's partidpants had reported a vector of p-ratios for altemate resource allocation levels, then they could have misrepresented the expected profitability of their nonprofit-maximizing resource allocation levels while reporting tmthfully for their profit-maximizing allocation levels. To the extent that such (indirect) misrepresentations prcxluced the partidpants' desired allocation outcomes, they would have eluded detection (and the penalty of UPP) because the outcomes of nonselected alternatives generally are not observable. Suc^ indirect misrepresentations, even if undetected, still would have been penalized by C. Another limitation of Waller and Bishop's study is that their UPP penalized only profit shortfalls. As will be shown below, subordinates' misrepresentations can indude both over- and understatements. Even if Waller and Bishop's experimental task had permitted the reporting of profit vectors instead of a single index, UPP still would not have deterred the latter type of misrepresentation. Hie cuirent study eniqiirically tests the incentive effects of G, SSH, and a linear profit-siiaring scteme (hereafter, LPS), which, like Waller and Bishop's UP, pays the subordinate a constant proportion of actual profits. SSTI is induded because the analytical proposition that it Uxes its tnith-indudng property in a multisubordinate context has not yet been empirically testecL I J S is induded because it is r^mrted to be axnmon in practice (Mruk and Giardina 1985, Fox and Ptok 1986, and Kaplan and Atkinson 1989), and it is often used in analytical studies as the baseline against which other pay schen^es are compared. Hence, LPS supplies a benchmark for the other two scdiemes tested. Having such a bendunark is desirable because mostfirms'incentivesystems are seldom as complicated as those proposed by analyticalresearch(Baker, Jensen, and Murphy 1988, and Arrow 1985). As such, indusion of LPS enabies an assessnKnt of the maiginal benefits of the analytically derived schemes.

Motivating TmttafulSuboidinaieRBpoiting

703

Because the current study was designed independently of, and conducted contemporaneotisly with the one by Waller and Bishop (1990), UPP was not included in the original experiment. The empirical tests were not expanded to include it because, as is shown in the following example, SSTI and UPP have the same directional effects on subordinates' expected pay from direct versus indirect misrepresentations. Hence, SSTI can proxy for UPP. Performance-based pay schemes' effects on the incentives far direct and indirect misrepresentations A numerical example is presented below to show the distinction between direct and indirect misrepresentations, as well as how subordinates' incentives for each type of misrepresentation differ under alternate pay schemes. The example assumes a setting in which a central manager (CM) has two subordinate divisional managers (DMj, DM:). The CM is to allocate a fixed pool of capital resources ($4iD0) between the two DMs and will base this decision entirely on the latter's reports of their respective divisions' opportunity sets (a vector offorecastedprofits for alternate levels of resource allocations to the divisions). As operationalized in this example, the values of the applicable reward/penalty parameters yield equal pay across the pay schemes assuming truthful commtmications.^ LPS pays each DM 10 percent of his or her division's acttial profit. Under SSTI (equation 1), the pay for each DM is based on his or her own division's actual profit compared to his or her performance standard; the latter is the expected profit that he or she had reported to the CM for the level of resources subsequently allocated to him or her. SSTI's parameter values are a = 0.02, b = 0.1, and c = 0.4. Under G, each DM is paid an amount equal to 25 percent of his or her performance measure (equation 2). Thus, for DMj, Aj would be the CM's expected profit (based entirely on DMi's report) from allocating 0 resources to DMj and allocating to DM: the amount of resources that maximizes his or her division's expected profit. Finally, UPP is operationalized within the context of equation 1 by setting a = 6 = 0.1 if y^ > y^, and 6 = c - 0 i f y ^ < 3 ^ . (That is, each DM gets 10 percent of his or herreportedrealizedprofit when it exceeds or equals his or her conununicated expected profit, and 0 otherwise.) Case A: Truthful communications The two coltmms of Table 1 for case A show the resource allocation outcomes tmder truthful communication by both DMs. The CM would allocate $200 to each DM to maximize total expected profit ($50 + $50 = $100). This allocation mix would pay both DMs $5 unider allfourincentive schemes. Pay under LPS would be 10 percent of each DM's actual $50 profit. Under SSTI, each DM would exactly realize his or her standard performance ($50foran allocation of $200) and would be paid $5 [(0.10 * $50)

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TABLE 1 Communicated profit vectors

Resource level $ 0

100 200 300 400

Case A: Truthful communications

DM, $0 15 50* 80 60

DM, $0 15 50* 80 60

CaseB: Direct misrepresentation DM, DMj

CaseCI Indirect misrepresentation DMj DMj

$0

SO

15 50 86* 60

$0 15* 50 80 60

14 44 80* 60

$0" 15* 50 80 60

* Actual allocation based on communicated vectors. Communication misrepresentations are in bold.

+ 0.40 * ($50 - $S0)]. Under G, each DM's peiformance measure would be $20 ($50 + $50 - $80), and pay would be $5 (0.25 * $20). FinaUy, pay under UPP also would be $5 [(0.10 * $50) + 0.10 * ($50 - $50)]). Case B: Direct misrepresentations The two columns of Table 1 for case B show the reported profit vectors under truthful reporting by DM:, but an overstatement by DMj ($86 for the $300 resource level at which bis or her divisional profit is maximized). Based on both DMs' submitted forecasts, the CM would allocate $300 to DMj and $100 to DMj. The CM's expected firmwide profit from this allocation would be $101 ($86 from DMj and $15 from DM:), as compared to $100 from allocating $200 to each DM. The CM's expectation, however, would not be realized. The actual total firmwide profit (based on the DMs' true profit vectors) would be only $95 ($80 from DMj and $15 from DM:). Since LPS focuses only on realized outcomes, it would not penalize DMj for the $6 profit shortfall ($80 actual versus $86 reported). As a result, DMj's pay would be $8 (0.10 * $80), or $3 more than if he or she had reported truthf^y. In contrast, SSTl would impose a penalty on DMj for his or her $6 profit shortfall. However, even with this penalty, DMj still would receive more than the $5 that he or she would have been paid under truthful communication: $6.20 = (0.1 * $86) + 0.4 * ($80 - $86), when $80 and $86 are the reported realized and communicated expected profits, respectively. This situation would be reversed under G. Even with the $300 allocation and its higher profit, DMj's performance measure still would be reduced from $20 to $15 ($80 + $15 - $80), and his or her pay would drop from $5 to $3.75 (0.25 * $15). Finally, UPP also would penalize DMj for his or her profit shortfaU and reduce his or her pay from $5 to $0 [(0 * $80) + 0 * ($80 - $86)].

Motivating TrutiifulSuhoidinate Reporting

705

Case C: Indirect misrepresentations The two ccdiimns of Table 1 for case C show the reported profit vectois under truthful reporting by DM|. But instead at overstatiug the expected profit for a $300 allocation to his or her division, DMj understates the expected profits from other allocation levels. In this case, DMj's tindeistated expected pniGts for the $100 and $200 allocation levels woukl achieve the same result as a direct misrepresentation relating to his or her profit-maximiziug resource allocation levd. The CM still would identify a $300 allocation to DMj (and a $100 allocation to DMj) as being the most profitable mix ($95 = $80 + $15). A notable contrast between cases B and C is that in case C, DMj's indirect misrepresentation would not produce a profit shortfidl for him or her, because he or she would exactiy attain the reported expected profit ($80) for the $300 allocation level. As a result, compared to the tmthful reporting case, DMj's pay would increase from $5 to $8 under LPS, SSTI and UPP: LPS: (0.1 * $80); SSTI: (0.1 * $80) + (0.4 * ($80 - $80)); UPP: (0.1 * $80) + 0.1 * [$80 - $80]). However, G would penalize DMj's indirect misrepresentation. His or her performance measure would be reduced to $15 ($80 + $15 - $80), and pay to $3.75 (0.25 * $15). Thtis, the preceding example has shown that a subordinate can tise positive and/or negative misrepresentations to shift the superior's allocation in the direction of his or her profit-maximizing level. Ftirther, such misrepresentations can be direct and/or indirect. Distinguishing between these types of misrepresentations has important implications for the stq>erion To the extent tiiat the subordinate successfully tises indirect misrepresentations to obtain his or her desired allcxation level, the superior is less likely to detect (and thus counteract) such misrepresentations than direct misrepresentations because the outcomes of nonadopted altematives tend not to be observable. The example also has shown that an«>ng the four pay schemes analyzed, LPS neither deters nor provicles differential incentives for direct and indirect misrepresentations. While SSTI also does not elinunate the incentives for either type of misrepresentation, it does redtice the relative incentives for direct misrepresentations. The UPP tested by Waller and Bishop was similar to S S l l in that it (strongly) deterred direcrt, but not indirect, misrepresentations. (Recall that the former was the only type possible in their experiment.) Finally, G was shown to deter both direct and indired misrepresentations.^ The preceding results also hold for DM:. Even though DM: had reported tmthfully in cases B and C, in both cases his or her pay would have been reduced by DMj's misrepresentations. It can be demonstrated that if DM: had engaged in compensatory direcrt and/or indirect misrepresentations, then his or her pay would have been affected by the four schemes in the same way as that for DMj. For example, tmder G, both direct and indirect misrepresentations by D ^ to cotmter DMj's misrepresentations would prcxluce a lower pay for him or her than if he or she had

706


adhered to a policy of truthful commtmication.^ As such, under G, the dominant strategy for each DM would be tmth-telling regardless of the other's communication tmthfulness. Hypotheses Based on the prior analytical research and the analysis in the preceding section, our overall hypothesis is that the type of pay scheme affects subordinates' propensity to engage in misrepresentatiotis. Specifically, we predict that G would have the lowest inddence of both direct and indirect misrepresentations. A breakdown of SSTI's tmth-indudng property in a multisubordinate setting is predicted, such that the incidence of both direct and indirect misrepresentations under it is predicted to exceed that under G. However, the inddence of direct misrepresentations is predicted to be lower under SSTI than under LPS because the former does impose a penalty for realized profit shortfalls. Finally, the freqtiendes of inidirect misrepresentations are predicted not to differ between SSTI and LPS because neither penalizes such misrepresentations. These six directional predictions are summarized in Table 2. Method Participtmts The participants were 44 full-time students in their final year of an undergraduate accounting course at the University of New South Wales in Atistralia. Partidpation was voluntary, and the partidpants were told that they would receive cash payment based on their performance in the task. Task description The experimental task involved resource allocation in a two-division firm. The participants were assigned the role of a divisional manager. They communicated fo the firm's general manager (a research assistant) a foreTABLE 2 Predictions: Relative frequency of misrepresentations (1)

( ) /

=557/,

(5) LPS, >G, (6)SSTI,>G, LFS SSTI G D /

= = = = =

Linear profit sharirig Single-subordinate truth inducing Groves Direct misrepresentation Indirect misrepresentation

Motivating Tiuthful Subordinate Repotting

707

casted profit vector for each pericxl in the experiment. The profit vector was for six alternate levels of capital allcxation to the partidpant's division, ranging from $100,000 to $60OfiO0 in $100,000 increments (an allocation of 0 dollars always yielded a profit of 0 dollars). There were nine communication-resource allocation pericxls. Since the hypothesized effects were based on single-period analytical models, the nine pericxls were kept independent. The partidpants were told that the accurate profit forecasts were not related across pericxls, and that only they had acxess to their own divisions' accurate forecasts. In the empirical tests, pericxl 9 was dropped to control for any end-of-game effects while the first three pericxls were prcwided for learning.^ In every pericxl, each partidpant was given perfect forecasts of his or her own (but not the other) division's profits for the six capital allocation levels. Table 3 presents the tme profit vectors for each divisional manager position for the nine pericxls. To reduc» the potential of the partidpants' fixating on particular allegation mixes (e.g., 50-50), the vectors vary the allegation level at which each division's profit is maximized. They also vaiy the partidpants' potential gains or losses from misrepresentations by changing the profit differences across allcxation levels.^ Acting independently, the partidpants could dboosc to communicate either accurate or inaccurate profit vectors to the general manager. The partidpants were told that the general manager would use the communicated vectors to allcxsite a fixed amotmt of capital ($600,000) between the two divisions and that he or she would always chcx»e the allcxation mix that maximized the two divisions' combined expected profit. The general manager's allocation dedsion in each period was communicated to the partidpants so that the latter could determine their pay. Neither partidpant was told the other's ac:tual divisional profit. Experimental design The experiment was a 3 x 2 x 5 x 6 factorial design. There were two between-subjects variables: pay scdieme (three levels) and divisional manager (two levels).^ Hie remaining two variables, test pericxls (five levels) and resource allcxation vector (six levels), were within subject. The sanq)le size for each between-subjects cell was either 12 or 16 (i.e., six en* eight pairs).'' All three pay schemes paid the participants at the rate of one Australian dollar in cash for each 5,(X)0 experimental dollars eamed. The pay sc:hemes' parameter values were cxinstant across pericxls and the same as those used in the numerical example presented earlier. These values were intended to equalize both managers' expected pay, with tmthful communication, at $10,(XX) under eac:h pay scheme in every test pericxl.^ Procedure A separate room was used for each pay scheme treatment. The entire experiment tcx>k about three hours and contained three steps.

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