Media Releases

How smart managers make dumb decisions and why shareholders encourage them: Rotman paper

November 14, 2011

TORONTO, ON – From Enron in the Unit­ed States to Satyam in India, there are plen­ty of exam­ples of cor­po­rate man­agers lying about their com­pa­nies’ earn­ings and ulti­mate­ly hurt­ing them­selves and the busi­ness­es they work for.

Why do they do it?

A lim­it­ed capac­i­ty to see the whole pic­ture – known as “bound­ed ratio­nal­i­ty” — com­bined with a faulty eth­i­cal com­pass are two big rea­sons, shows a new study from the Uni­ver­si­ty of Toronto’s Rot­man School of Man­age­ment. The study also finds that share­hold­ers are just as guilty of the same weak­ness­es and that insid­er trad­ing is linked to earn­ings manip­u­la­tion.

“For a long time we’ve asked our­selves, ‘How come smart, ratio­nal peo­ple car­ry out short-term schemes that in the long-term undoubt­ed­ly are going to sink them?’” says author Ramy Elitzur, who holds the Edward J. Ker­naghan Pro­fes­sor­ship in Finan­cial Analy­sis and is an asso­ciate pro­fes­sor of account­ing.

“The answer is — we’re not ratio­nal. We’re ratio­nal only in a lim­it­ed sense.”

The study bases its find­ings on a mod­el of the man­ag­er-own­er rela­tion­ship over time. The mod­el is also note­wor­thy for com­bin­ing prin­ci­ples of game the­o­ry – used to pre­dict strate­gic behav­iour — with the idea of bound­ed ratio­nal­i­ty – that our deci­sions are always made with­in the lim­its of avail­able time, infor­ma­tion, and the human capac­i­ty to ana­lyze it.

“It tells us, for exam­ple, that if we would like to have man­agers who engage less in earn­ings manip­u­la­tion and in insid­er trad­ing, we should look for man­agers who are more eth­i­cal and suf­fer less from bound­ed ratio­nal­i­ty,” says Prof. Elitzur.

That’s not a triv­ial find­ing, he says, because the mod­el also shows that choos­ing less eth­i­cal man­agers may be in the best inter­ests of cur­rent share­hold­ers, but not future ones. Unless cur­rent share­hold­ers also suf­fer a penal­ty for such a choice, they will encour­age uneth­i­cal and dam­ag­ing behav­iour. Some pro­vi­sions in the U.S. Senate’s Finan­cial Reg­u­la­tion Over­haul bill from 2010 help to guard against these ten­den­cies, the study says.

The case of Enron is well-known. The scan­dal at Satyam Com­put­er Ser­vices was dubbed “India’s Enron,” and broke in 2009. Pri­or to his res­ig­na­tion, Satyam’s chair­man Rama­lin­ga Raju admit­ted to years of sys­tem­at­ic infla­tion of earn­ings and assets, begin­ning with small manip­u­la­tions of account state­ments that even­tu­al­ly got out of con­trol.

Prof. Elitzur says that it took a decade to devel­op his mod­el and get it pub­lished part­ly because of ini­tial resis­tance to his find­ings.

“Many accoun­tants believed that mar­kets are effi­cient and as such, a lot of the issues of earn­ings man­age­ment would be cor­rect­ed by the mar­kets,” he says. “But this belief has changed over time, and we under­stand bet­ter now that earn­ings manip­u­la­tion occurs and does indeed affect mar­kets.”

For the lat­est think­ing on busi­ness, man­age­ment and eco­nom­ics from the Rot­man School of Man­age­ment, vis­it www.rotman.utoronto.ca/NewThinking.

The Rot­man School of Man­age­ment at the Uni­ver­si­ty of Toron­to is redesign­ing busi­ness edu­ca­tion for the 21st cen­tu­ry with a cur­ricu­lum based on Inte­gra­tive Think­ing. Locat­ed in the world’s most diverse city, the Rot­man School fos­ters a new way to think that enables the design of cre­ative busi­ness solu­tions.  The School is cur­rent­ly rais­ing $200 mil­lion to ensure Cana­da has the world-class busi­ness school it deserves. For more infor­ma­tion, vis­it www.rotman.utoronto.ca.

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For more infor­ma­tion, please con­tact:

Ken McGuf­fin
Man­ag­er, Media Rela­tions
Rot­man School of Man­age­ment
Uni­ver­si­ty of Toron­to
416–946-3818
mcguffin@rotman.utoronto.ca
Fol­low Rot­man on Twit­ter @rotmanschool