The Effect of Risk Management Systems on Honesty in Managerial Reporting: An Experimental Examination

• In Event: Risk-Taking and Risk Management

Abstract

An extension of the agency model of capital budgeting under private information shows that an owner’s investment in a risk management system (RMS) exacerbates the owner’s moral hazard problem as it increases the expected slack available for managerial expropriation. This study experimentally examines the effects of an RMS on honesty in managerial reporting and the incremental effect of the owner’s willingness to invest in an RMS. Applying insights from a model of social norm activation and behavioral economics, I predict that an RMS will increase managerial honesty in reporting by increasing common expectations for truthful reporting. Furthermore, I predict that the owners’ willingness to invest will activate a trustworthiness social norm for managers that will strengthen the positive effect of an RMS. Consistent with my theory, I find that an RMS has a positive effect on managerial honesty in reporting, and this positive effect is greater when the RMS is the result of an owner’s investment choice. An analysis of exit questionnaire responses confirms that the owners’ investment in an RMS signaled trust and increased the managers’ trustworthiness. The results suggest that an RMS can play a corporate governance role despite the potential increase in moral hazard, and the salience of the owner’s investment choice reinforces this role.

Author

• Heba Yousef M. Abdel-Rahim, Georgia State University