I reflect on attempts to revise the theory behind corporate governance and management control in light of evolving organizational and market realities. First, I discuss the resistance to early attempts by prominent neoclassical economists to revise the theory of the firm. Second, I discuss the outcome of that resistance—an economic theory that is largely unable to describe common governance systems and management controls found in practice as well as new systems and controls aimed at increasing the environmental and social responsibility of the firm. Finally, I describe recent efforts to revise the theory by relaxing the assumption of narrow self-interest, incorporating insights from stakeholder theory, and incorporating important individual and social factors left out of the theory. I conclude by discussing how these revisions provide a roadmap to further revisions in the theory to improve its usefulness to researchers, practitioners, and policymakers.

The search for a moral foundation for capitalism has a long history that continues to unfold, yet many are unaware of this search or its implications for the future of capitalism. The recent pandemic has uncovered cracks in the foundation of capitalism and raised doubts regarding its ability to meet the broader needs of society. In Search of a Moral Foundation for Capitalism explains the continuing demand for a moral foundation from the perspective of business leaders, business educators, and policymakers, and tells the story of the search for that moral foundation through its leading characters. By presenting the life stories and writings of these leading characters – from Adam Smith to Amartya Sen – this book reveals the rich moral critique provided by these great thinkers and explains how that rich critique was lost through the influence of the Chicago School and its emphasis on self-interest.

Recent research and public debates suggest that the economic theory of the firm is incomplete and in need of revision. For example, the theory fails to address fundamental issues of value creation and how that value creation is reflected in the financial statements and market price of the firm. Further, it has led to endless public debates regarding the purpose of the corporation, shareholder capitalism versus stakeholder capitalism, and whether corporations need to sacrifice their profit-making obligation to investors to serve the wider needs of society and the environment. We argue that these debates are due to the lack of a holistic, comprehensive theory of the firm. This paper addresses this weakness of current theory by describing the pragmatic theory of the firm (PTF) and showing how it can be extended by incorporating social norms. We begin by summarizing the potential benefits from a theory of the firm and the development of the economic theory of the firm in finance and accounting. This summary highlights the resistance of neoclassical economists to useful extensions of their economic theory and how that resistance reduced its usefulness. Next, we explain how the PTF provides important intuition by modeling the firm as a value-creating system and making explicit the connection between the firm's life-cycle financial performance and its market valuation. Importantly, the theory positions maximizing shareholder value not as the firm's purpose, but as the result of a firm successfully achieving its value-creating purpose. The rest of the paper describes how incorporating social norms increases the ability of the theory to explain value creation (and destruction) in the firm given the new economy. We conclude that social norms are not only essential for the effective management of the firm, they are also needed to achieve the value-creating purpose of the firm to the benefit of capitalist society.

I discuss the rediscovery of The Theory of Moral Sentiments by neoclassical economists and the implications for Behavioral Finance and Economics. First, I discuss Michael Jensen’s changing views of behavioral assumptions after the severe market collapse of 2007-08, which has opened wide the door for innovations in the theory of the firm. Second, I discuss the Chicago School’s mischaracterization of Adam Smith and his writings that led to the traditional theory of the firm. Third, I discuss the rediscovery of The Theory of Moral Sentiments by neoclassical economists and use their own statements to explain Smith’s moral theory and its importance to his economic theory. I conclude by discussing the implications for behavioral finance and economics and providing a roadmap for incorporating Smith’s moral theory into future behavioral research.

We argue that recent participative budgeting experiments designed to extend agency theory reveal the effects of responsibility, transparency, and accountability. We define these three theoretical constructs and present two experiments designed to isolate their main and interactive effects. In Experiment 1, we show that subordinates who score high in responsibility report more honestly in the absence of transparency and accountability as captured by an information system and face-to-face budget reporting. We also show that transparency and accountability increase reporting honesty independently and interactively. In Experiment 2, we maintain face-to-face budget reporting and show that the responsibility effect we document can be crowded out by the superior’s choice to implement the information system. While all subordinates perceive the superior’s choice as a signal of distrust, only high responsibility subordinates report less honestly as a result. We examine alternative theoretical frameworks that could be integrated with agency theory to explain our results.

This study examines the effect of endogenous control choice on budgetary slack. The superior chooses between two alternatives: no control, wherein the superior commits to accept any budget, and a discretionary rejection authority control, wherein the superior decides ex post whether to accept or reject budgets. For both alternatives, we find that slack is lower when the superior chooses an alternative than when it is assigned exogenously. Our theory and results suggest that a superior's choice of whether to introduce controls signals a superior's expectations and intentions. The superior's choice of no control signals trust and an intention to foster a norm of trustworthiness. The superior's choice of rejection authority signals an above-average willingness to use rejections to enforce norms. Our results suggest that the value of participative budgeting may be increased if superiors can communicate to subordinates the expectations and intentions behind the design of the control system.

Growing calls for expanded disclosure on managerial stewardship raise important questions about how finer (i.e., disaggregated) reporting, when paired with discretion over classification, will influence managerial behavior. To study this question, we develop an investment game in which, if the investor chooses to invest, the manager privately observes production costs, chooses their personal pay, and provides a cost report in one of three reporting regimes: aggregated, disaggregated without discretion, or disaggregated with discretion. In Experiment 1, as predicted, managers report lower personal pay under both disaggregated regimes than what they consume under the aggregated regime. Yet, when disaggregated reports allow for discretion, managers misclassify personal pay as production costs to such an extent that their actual consumption is no different than in the aggregated condition. In Experiment 2, we allow managers to choose either an aggregated report or a disaggregated report with discretion. We find that, rather than remaining silent, the vast majority of managers still prefer the opportunity to report on their pay explicitly so that they can use their reporting discretion to appear trustworthy, despite not actually being so. In summary, our evidence suggests a strong weight of preferences for appearing trustworthy in the managers' utility function, a much lower weight for actually being trustworthy, and little evidence that preferences for being honest are strong enough for discretionary disaggregated reporting to curb agency costs. In other words, whether disaggregation can reduce agency costs will depend on managers' reporting discretion. Our findings have important implications for control system designers, financial and sustainability accounting standard setters, and regulators.

ABSTRACTGrowing calls for expanded disclosure on managerial stewardship raise important questions about how finer (i.e., disaggregated) reporting, when paired with discretion over classification, will influence managerial behavior. To study this question, we develop an investment game in which, if the investor chooses to invest, the manager privately observes production costs, chooses their personal pay, and provides a cost report in one of three reporting regimes: aggregated, disaggregated without discretion, or disaggregated with discretion. In Experiment 1, as predicted, managers report lower personal pay under both disaggregated regimes than what they consume under the aggregated regime. Yet, when disaggregated reports allow for discretion, managers misclassify personal pay as production costs to such an extent that their actual consumption is no different than in the aggregated condition. In Experiment 2, we allow managers to choose either an aggregated report or a disaggregated report with discretion. We find that, rather than remaining silent, the vast majority of managers still prefer the opportunity to report on their pay explicitly so that they can use their reporting discretion to appear trustworthy, despite not actually being so. In summary, our evidence suggests a strong weight of preferences for appearing trustworthy in the managers' utility function, a much lower weight for actually being trustworthy, and little evidence that preferences for being honest are strong enough for discretionary disaggregated reporting to curb agency costs. In other words, whether disaggregation can reduce agency costs will depend on managers' reporting discretion. Our findings have important implications for control system designers, financial and sustainability accounting standard setters, and regulators.

Researchers in accounting have recently provided evidence of a striking increase in the usefulness of earnings announcements based on stock market price and volume reactions (Beaver et al., 2018; Barron et al., 2018). Price reactions, however, are unable to capture investor disagreement and volume reactions capture both the resolution of prior disagreement and newfound disagreement generated by earnings announcements. Thus, it remains to be determined if earnings announcements have become increasingly useful in leveling the informational playing field, a key public policy objective of financial reporting. To address this possibility, we examine changes in disagreement around annual earnings announcements over the last forty years using analyst forecast measures found in the literature. First, we show that forecast dispersion is reduced around earnings announcements and this reduction has increased over time. Next, we use a forecast measure of informedness from Barron et al. (1998) to show that analysts as a group are more informed by earnings announcements in recent time periods. Finally, we use Barron et al.’s forecast measure of consensus to show that the ability of earnings announcements to make analysts more commonly informed has increased over time.

Researchers have documented a behavioral benefit of an information system in that reducing information asymmetry regarding the level of honesty in the budget increases reporting honesty (Hannan, Rankin, & Towry, 2006; Abdel-Rahim & Stevens, 2018). We extend this literature by examining whether the superior’s choice to implement an information system diminishes this behavioral benefit. Consistent with prior results, we observe an increase in reporting honesty when the information system is randomly assigned. When the information system is chosen by the superior, however, we find that this behavioral benefit is significantly reduced. This reduction is attributable to the behavior of subordinates who score high in social norm sensitivity as measured by the Responsibility scale of the JPI-R (Jackson 1994). Exit questionnaire responses reveal that while both high and low norm sensitivity subordinates viewed the superior’s choice of an information system as a signal of distrust, only high norm sensitivity subordinates felt less obligated to report honestly as a result. A path analysis provides further evidence that the superior’s implementation choice reduced reporting honesty in high norm sensitivity subordinates by reducing their obligation for reporting honestly in the budget. This study documents a crowding-out effect for information systems and provides evidence regarding the underlying factors behind that effect.

Researchers in accounting and economics have established that financial controls can diminish intrinsic motivation in the subordinate when they are intentionally imposed by the superior. We study the ability of a non-financial control to generate a similar crowding out effect on honest reporting in a participative budgeting setting. Because it has been shown to increase honest reporting, we use the superior’s choice of an information system that reduces information asymmetry regarding the level of honesty in the budget. Consistent with prior results, we observe a strong positive effect on honest reporting when the information system is randomly assigned. When the information system is chosen by the superior, however, this positive effect is significantly reduced. We find that this reduction is attributable to the behavior of subordinates who measure high in norm sensitivity and thereby have intrinsic motivation for honest reporting. Further analysis suggests that both high and low norm sensitivity subordinates viewed the superior’s choice of an information system as a signal of distrust, but only high norm sensitivity subordinates felt resentful and less obligated to report honestly as a result. The beliefs and behavior of superiors are also affected by their own social norm sensitivity. Our findings demonstrate that imposing a non-financial control can crowd out intrinsic motivation by signaling distrust to subordinates with high norm sensitivity. This study extends the crowding out effect found with financial controls to non-financial controls and provides evidence regarding the underlying theory behind this effect.