Featured Research

from universities, journals, and other organizations

How smart managers make dumb decisions and why shareholders encourage them

Date:
November 14, 2011
Source:
University of Toronto, Rotman School of Management
Summary:
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.

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.

Related Articles


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."


Story Source:

The above story is based on materials provided by University of Toronto, Rotman School of Management. Note: Materials may be edited for content and length.


Cite This Page:

University of Toronto, Rotman School of Management. "How smart managers make dumb decisions and why shareholders encourage them." ScienceDaily. ScienceDaily, 14 November 2011. <www.sciencedaily.com/releases/2011/11/111114142043.htm>.
University of Toronto, Rotman School of Management. (2011, November 14). How smart managers make dumb decisions and why shareholders encourage them. ScienceDaily. Retrieved November 22, 2014 from www.sciencedaily.com/releases/2011/11/111114142043.htm
University of Toronto, Rotman School of Management. "How smart managers make dumb decisions and why shareholders encourage them." ScienceDaily. www.sciencedaily.com/releases/2011/11/111114142043.htm (accessed November 22, 2014).

Share This


More From ScienceDaily



More Science & Society News

Saturday, November 22, 2014

Featured Research

from universities, journals, and other organizations


Featured Videos

from AP, Reuters, AFP, and other news services

WFP: Ebola Risks Heightened Among Women Throughout Africa

WFP: Ebola Risks Heightened Among Women Throughout Africa

AFP (Nov. 21, 2014) Having children has always been a frightening prospect in Sierra Leone, the world's most dangerous place to give birth, but Ebola has presented an alarming new threat for expectant mothers. Duration: 00:37 Video provided by AFP
Powered by NewsLook.com
Toyota's Hydrogen Fuel-Cell Green Car Soon Available in the US

Toyota's Hydrogen Fuel-Cell Green Car Soon Available in the US

AFP (Nov. 21, 2014) Toyota presented its hydrogen fuel-cell compact car called "Mirai" to US consumers at the Los Angeles auto show. The car should go on sale in 2015 for around $60.000. It combines stored hydrogen with oxygen to generate its own power. Duration: 01:18 Video provided by AFP
Powered by NewsLook.com
Ebola: Life Without School in Guinea

Ebola: Life Without School in Guinea

AFP (Nov. 21, 2014) Following the closure of schools and universities in Guinea because of the Ebola virus, students look for temporary work or gather in makeshift classrooms to catch up on their syllabus. Duration: 02:14 Video provided by AFP
Powered by NewsLook.com
NSA Director: China Can Damage US Power Grid

NSA Director: China Can Damage US Power Grid

AP (Nov. 20, 2014) China and "one or two" other countries are capable of mounting cyberattacks that would shut down the electric grid and other critical systems in parts of the United States, according to Adm. Michael Rogers, director of the National Security Agency and hea Video provided by AP
Powered by NewsLook.com

Search ScienceDaily

Number of stories in archives: 140,361

Find with keyword(s):
Enter a keyword or phrase to search ScienceDaily for related topics and research stories.

Save/Print:
Share:

Breaking News:

Strange & Offbeat Stories


Science & Society

Business & Industry

Education & Learning

In Other News

... from NewsDaily.com

Science News

Health News

Environment News

Technology News



Save/Print:
Share:

Free Subscriptions


Get the latest science news with ScienceDaily's free email newsletters, updated daily and weekly. Or view hourly updated newsfeeds in your RSS reader:

Get Social & Mobile


Keep up to date with the latest news from ScienceDaily via social networks and mobile apps:

Have Feedback?


Tell us what you think of ScienceDaily -- we welcome both positive and negative comments. Have any problems using the site? Questions?
Mobile: iPhone Android Web
Follow: Facebook Twitter Google+
Subscribe: RSS Feeds Email Newsletters
Latest Headlines Health & Medicine Mind & Brain Space & Time Matter & Energy Computers & Math Plants & Animals Earth & Climate Fossils & Ruins