The Effect of Contract Framing on Budgetary Slack and Performance

• In Event: Firm Performance
  In Paper Session: Managerial Accounting

Abstract

We examine the effect of contract framing on subordinates’ propensity to create budgetary slack and its impact on subsequent performance. The contract is designed in economically equivalent penalty and bonus forms with multi-dimensional incentives: a reporting bonus (penalty) associated with reporting budgeted production accurately and a production bonus (penalty) associated with meeting (not meeting) a budget target. By design, this contract creates a direct link between the budgeting component and the effort (performance) component in a multi-dimensional environment. In such a setting, the effects of contract framing may lead to different behavioral responses than previously examined or predicted. We find that under bonus-framed contracts individuals create budgetary slack by underreporting their productive capabilities (i.e., the traditional and widely studied slack concept). Consistent with prospect theory, we find evidence that subordinates working under penalty-framed contracts over-report their capabilities by creating optimistic slack. This reporting of optimistic slack is an interesting finding. The results suggest that under penalty-framed contracts subordinates are more likely to over-report their capabilities, whereas subordinates under bonus-framed contracts are more likely to under-report their capabilities. The findings demonstrate that penalty contracts impact how individuals report their capabilities. We find that subordinates subsequent performance after reporting does not differ when they work under bonus-framed and penalty-framed contracts. This finding is inconsistent with prior research. This study provides a possible explanation for why penalty-framed contracts are not common in practice.

Authors

• Maia J Farkas, California State University, Fullerton

• Lee Michael Kersting, Northern Kentucky University

• Uday S Murthy, University of South Florida