Here is something that everyone – academics, managers, employees, owners—would like to know more about: How do organizations shape a new managerial role? What are the consequences of different approaches? This matters because organizations keep changing their roles. At the top, there is an amazing proliferation of CXO titles: Chief (fill in the blank) Officer. Do you know how many meanings the abbreviation CCO can have? I know of five. Below that level, the movement toward more partial organizations and greater coordination across organizations has led to many important roles that involve managing people and processes outside the organization, and doing so in different ways depending on the relation.
A recent paper in Administrative Science Quarterly by Sukhbir Sandhu and Carol Kulik looks at this issue using data on how 21 organizations developed the new role of sustainability manager. Sustainability management means making the organization friendly toward its natural and social environment, and it is described very differently by different people. Skeptics call it “building an emotional bank account with the community,” while idealists say, “We realized that to be sustainable, we had to be part of a sustainable society.” Organizations have a mixture of skeptics, idealists, and care-nots, and in this environment the sustainability manager position has been created and shaped in ways that work with the rest of the organization.
You might imagine that this would be an improvised process. It was, but somehow the improvisation followed three distinct patterns, each with its own set of consequences: prospecting, orchestrating, and championing. Prospecting organizations asked a manager to scout for sustainability initiatives done elsewhere and introduce them to other managers, who made decisions on initiatives based on potential reputational and legitimacy benefits. Orchestrating organizations had formalized corporate sustainability plans and used the managers to internally market and implement those plans, based largely on a business case of cost / benefit. Championing organizations had a mixture of planned and opportunistic sustainability efforts, the manager was integrated with the top management team, and sustainability initiatives were embedded in functions.
So what were the consequences of these patterns? Often that problems accumulated to the point that the organization transitioned to another pattern. Such transitions followed a sequence. Prospecting was a natural starting point for organizations with no prior sustainability manager, but in this pattern the manager had little discretion and had difficulty convincing top management to act. In some organizations, this missing communication and continued pressure to do more led to orchestrating. Orchestrating involved ambitious planning and many initiatives, but there was often poor follow-up by the organization because the sustainability manager did not have sufficient authority over other organizational units. This lack of implementation sometimes led to championing: the stage at which sustainability tasks became integrated with other organizational tasks and the sustainability manager had both the authority and opportunity to promote new initiatives. What Sandhu and Kulik found was that sustainability managers had the greatest success when top management bought into the necessity of the role and set parameters for it but the managers could determine how to do their work within those parameters.
The results of shaping a new role from both the top and bottom are good for sustainability, but the implications are a problem if organizations incorporate many new roles in the same way. Combining bottom-up and top-down initiatives for each new role means top management teams may need to grow, as they need to make more-complex and more-frequent decisions. No one said that management was easy, but the complexity of a modern organization has made it harder than ever.
Sandhu, S., and C. T. Kulik
2018 "Shaping and Being Shaped: How Organizational Structure and Managerial Discretion Co-evolve in New Managerial Roles." Administrative Science Quarterly, forthcoming.
Are you one of the people who sneers at the resurgence of the vinyl record these days, when CDs are obsolete and we carry our music on phones? If you own or aspire to a Rolex, or any Swiss mechanical watch, you should probably shut up. Vinyl records and mechanical watches are examples of the same phenomenon. Sometimes technologies that appear to have been surpassed by other technologies are reborn, not just as niche products but as resurgent and successful new product categories. How does that happen?
A new paper in Administrative Science Quarterly by Ryan Raffaelli answers this question using the Swiss mechanical watch industry as an example. The Swiss watch industry nearly collapsed when quartz watches appeared, because soon quartz watches were more accurate than mechanical watches at any price level—and much, much cheaper than mechanical watches that came close. In the early days of this transition to quartz technology, the most successful Swiss effort was the all-quartz Swatch brand. But now, the industry has somehow turned the clock back, and Swiss mechanical watches (not Swatch watches) are by far the highest-revenue segment. This looks like an interesting process to understand.
The process has multiple stages, but they share one feature: The rebirth of a technology is a social construction that takes significant effort by organizations using the technology, and the effort has to be carefully directed to succeed. It starts with a redefinition and celebration of the old technology. Swiss firms started promoting their age and associated artistry, the artisanal and complex movements, and the traditional connection of watches to wealth and nobility. In short, they reminded themselves and the world that watches showed time, but more importantly they showed something about the owner.
The next step is to build communities. A community that is easy to overlook but very important is that of the watch makers committed to mechanical movements. They started interacting more intensely and excluding quartz makers, including Swiss quartz makers. A shared sense of purpose and interchange of ideas helped them think about products and market position. As a sign of just how far they have come, there is a fairly clear hierarchy of brands, and (unlike many other industries) in each hierarchical level the makers are satisfied with their position and do not try to move up or encroach on the market segment below them.
A more obvious community is the enthusiast customers. The first segment of them was easy to find – old-watch auction participants and club members—and highly useful for understanding the best ways to appeal to potential customers with the mechanical watch technology. With this knowledge, the firms carefully crafted their marketing to celebrate the newly defined technology and its products while appealing to the emotions that they had identified in the enthusiast customer segment. The marketing is very effective. I currently do not use a watch (my phone does the job), but I have seen enough marketing to know that Rolex is in the lower layer of the elite pyramid, and the watch brands above it is when pricing starts to get exclusive and they keep their auction value. If Rolex is a like a black Prada Killer bag, Patek Phillipe would be a Hermes Birkin.
Technologies are often thought of as scientific and – dare we say – mechanical things. But products using technologies are social constructions, and that is why organizations are able to reshape the understanding of a technology to engineer a surge of age.
Raffaelli, R. 2018 "Technology Reemergence: Creating New Value for Old Technologies in Swiss Mechanical Watchmaking, 1970-2008." Administrative Science Quarterly, forthcoming.
Here is a situation that occurs regularly and would be scary if it weren’t so professionally managed. The U.S. Federal Reserve, which is responsible for setting the federal funding rate, issues a statement that discusses the state of the economy, sets target interest rates, and gives the reasons for these. The reason this should be scary is that this interest is directly linked to a massive amount of debt and indirectly linked to even more debt because it influences interest rates of loans taken by firms in the U.S. and made by lenders worldwide. Any loan has two sides, lender and borrower, so unexpected adjustments up and down will lead to losses for one side.
As you may imagine, the Fed crafts its statements carefully. There are data and analysis behind the discussion of the economy, there are reasons for the economic forecast and interest rate target, and there is often a discussion of how the premises of these reasons follow our taken-for-granted understanding of the economy. Everything is perfectly calibrated for a world of fully rational actors. But how about the world we live in, where it is hard to find anyone who is fully rational? That is the question answered by a recently published paper in Administrative Science Quarterly by Derek Harmon, and the answer is not encouraging. Maybe we should be scared after all.
His idea is the following: people are comfortable with data, reasons, and premises. What they are not comfortable with is talk about premises that are so accepted that they are taken for granted. If this sounds strange, consider the following: Usually we persuade by bringing up points that our counterparts are not aware of and should consider in order to reach our conclusion. That’s what data and reasons do. But taken-for-granted premises don’t work that way – we are all supposed to know them, so why talk about them? In a rational world, saying something that everyone knows makes no difference. In a world of bounded rationality it does make a difference, because saying something everyone is supposed to know, and does know, makes others question whether it is true after all. Saying what was obvious makes it debatable.
That’s deeply disturbing to financial markets because they have prices that are built on expectations about the future, and the expectations are fundamentally theoretical. As long as everyone believes in the same theory, their expectations are the same and everything goes well. If they don’t, there is confusion and fear. And that’s exactly what Harmon found. The VIX index of uncertainty goes up the more premises are stated rather than just assumed to be true. It gets even worse if there is already fear in the markets. The only situation in which stating premises is safe is when the Fed statement is overall optimistic about the future.
So what to do? The obvious recommendation is for the Fed to understand the fear created by stating the obvious and to stop doing so. At a deeper level, this is a reminder that financial markets are special because everything that matters happens in the future. No one is Doctor Strange, so the future cannot be visited, and instead everyone needs some agreement on what this future will look like. When the agreement breaks down, the result is usually bad, as we saw during the 2007/2008 financial crisis.
Harmon, D. J. 2018. When the Fed Speaks: Arguments, Emotions, and the Microfoundations of Institutions. Administrative Science Quarterly, forthcoming.
Let’s start with the good news. The photovoltaic (PV) generation of electricity has become more and more economical thanks to rapid improvements in technology, making fossil fuels and their effects on global warming a shrinking threat to our future. Many saw this coming because PV is a semiconductor technology, and as any computer user knows, semiconductor technology improves quickly. And there is more good news. What drives much of the actual installation of PV power generation is families and firms, who gain much more from their power plants if they can sell the electricity to the network when they are not using it. If my house uses no electricity when I’m at work, the electricity it generates during that time can be sold to the utility company and power my workplace. This has been made easier too, through government intervention, establishing rules to force utilities to buy power from PV plants, often at high prices.
I have hinted that there is bad news too, but I should right away say that the news is not very bad. Quite simply, the suspicion that governments don’t make such rules to save the planet is quite right, and evidence is found in a paper in Administrative Science Quarterly by Panikos Georgallis, Glen Dowell, and Rodolphe Durand. The key to showing this is to look for differences in which governments were among the earliest to make rules forcing utilities to buy PV power. If there are no systematic differences, then maybe the world’s worry about global warming was the only mechanism at play. If there are differences depending on a country’s exposure to rising ocean levels, then a more local worry about global warming would be at work. If there are differences depending on the state of the national PV component industry and its adversaries—other forms of power generation—then we know that the support of PV has an economic component.
You have likely guessed already that nations support solar power to grow their local PV industry. The simple indicator of this is that a stronger PV industry means more government support, but there are also other indicators. The support is stronger if the firms participating in the PV industry are dedicated to this form of power generation only, instead of being diversified but traditional power producers.
The effect of an adversary is particularly interesting. If there is a strong traditional power industry, it may not consider the emerging industry a threat. But if it does, a battle for government attention and assistance ensues. In this case, the PV industry benefits from increased coherence, which means not having traditional power firms among its ranks. And when the emerging PV industry is coherent, it actually gets more government support if it faces a strong rival sector.
So we know that governments see solar power as more important for saving the world if they have a coherent local industry begging for help and if it faces strong opposition from the incumbent energy industry. That’s not the most virtuous motive we can imagine, but it has been good enough for the PV industry to develop fast and to gain strong footholds in many developed economies and some developing economies. Selfish action can also help the planet.
Georgallis, Panayiotis, Glen Dowell, and Rodolphe Durand. 2018. "Shine on Me: Industry Coherence and Policy Support for Emerging Industries." Administrative Science Quarterly forthcoming.
Socially responsible investment is a big buzzword these days, with many new investment funds adding social responsibility as a goal to supplement the usual goal of earning financial returns. Major investment entities such as some European state pension funds now require social responsibility in all their investments. The combination of social and financial goals has long been problematic because various “sin stocks” of firms that manufacture unhealthy products (cigarettes, alcohol, guns) earn high returns, and many other public companies manufacture harmless products but have other socially irresponsible practices. Sweatshops and dangerous factories are often profitable and never responsible.
Investing in a socially responsible fund often means earning lower returns than would be possible with another investment, and managing a socially responsible fund means spending more time checking firms and ending up with lower returns than would be possible. In some ways it is surprising that these funds are so popular, and one wonders what drives them forward. In a new article in Administrative Science Quarterly, Shipeng Yan, Fabrizio Ferraro, and Juan (John) Almandoz looked at exactly this question and paid particular attention to three potential players: financial professionals, priests, and unions.
On the financial side, we have investment fund managers and all others involved in fin
ancial transactions, who are typically seen as pursuing returns only, preferably with no responsibility constraints. The religious side includes many Christian churches that have been strong advocates of responsibility in society generally, including investments. The union side involves those advocating for workers and for consumer safety, including through their investment choices. Among these three, who has the most influence on socially responsible investments?
The answer is that the financing side matters most, but not in the way we might think. Socially responsible investment is not ideal for finance professionals, but it does not happen at all if they are not well established in society. Their expertise and resources are required for socially responsible investment funds to be established and to be successful. The caveat is that if a society is tipped too heavily toward financial concerns, socially responsible funds will have a hard time attracting investors.
What about the influence of religion and unions? Many of the early promoters of socially responsible investment were churches, and many early funds had a religious affiliation, but that does not give religion a strong role in socially responsible investment today – in fact, Yan, Ferraro, and Almandoz found no effect at all. The role of unions is more important, as higher union membership translates into more fund management companies engaging in socially responsible investment. Labor and capital are united, at least in this domain.
People are motivated to invest for many reasons, and figuring out how and when the financial sector responds to those motivations seems key to keeping it on its best behavior.
Yan, Shipeng, Fabrizio Ferraro, and Juan Almandoz. 2018. "The Rise of Socially Responsible Investment Funds: The Paradoxical Role of the Financial Logic." Administrative Science Quarterly, forthcoming.
Sometimes social science is born from observing simple puzzles. Consider this one: In China, many attractive temples charge admission fees that are obviously higher than is needed for maintenance and the feeding of monks, but other temples do not. What is going on? The fees are for the local government, which sees a famous temple as a way to get revenue without taxing the local people. But what is convenient for the local government is a moral outrage for the monks and many locals, who will sometimes successfully mobilize against the fees. The interesting question is why they can defeat the fee-collecting government officials sometimes but not always.
In a recent article in Administrative Science Quarterly, Lori Qingyuan Yue, Jue Wang, and Botao Yang look at this question to find out how popular movements based on moral and religious principles contend with pressures from the government and market forces. The battle is unequal because the government has the power of formal authority and markets have the persuasive power of money. The popular movement has none of these, only moral outrage. The contention is particularly unequal in an authoritarian state, where outrage does not translate into power through elections, and illegal forms of protest can be dealt with harshly.
The answer to this question, like many questions about society, lies in how organizations work. The government organization is one side of the story, and there the main issue is that it has many layers – local and central parts of the state. The central state cannot govern locales effectively and prefers to stay away, but it also wants economic development and social peace. Knowing this, the local government officials can ratchet up fees when their areas are economically backward, but they need to reduce them when the protests are loud enough to catch the attention of the central state.
The other side of the story is the organization of protests. Here, the religious leaders did the obvious thing – founded an organization with the specific goal of reducing fees. But protesters don’t just make their own organizations, they also use existing ones. Here, the press was used, though in an authoritarian state the companies that hire journalists and publish newspapers or TV programs are not the most useful. They are too accountable to the state to be able to do much. Instead, the effective organizations are the providers of social media, because they allow the protestors to make themselves heard both by other potential protestors and by the state, which monitors social media protests to understand social unrest and censor its expression.
So a battle may look like a contest between a union of markets and local governments on the one side and the moral outrage of individuals on the other, but that is not its true nature. There are organizations on both sides, and this is true for any conflict that each side really wants to win.
As I suggested in the title, the conflict between markets and morality is an old one. Two gospels mention Jesus driving merchants out of the temple and overturning their tables. It is a good story, but it is no longer how conflicts are won. People don’t get results; organizations do.
Yue, L. Q.,Wang, J., & Yang, B. 2018. Contesting Commercialization: Political Influence, Responsive Authoritarianism, and Cultural Resistance. Administrative Science Quarterly, forthcoming
I know that business schools don’t educate priests, so calling them seminaries is provocative. The provocation is based on facts, and these facts deserve attention. Like any other form of education, business schools teach strongly held beliefs on how the world works and why some actions are better than others. By the way, what I just said is not equally true for all kinds of education. For example, science places more emphasis on how the world works, while engineering places more emphasis on what actions are best. Business schools are even more engineering than engineering departments, because students taking MBA degrees are very interested in knowing what to do to become successful, and they prefer short explanations of why the sources of success are connected with how the world works.
This is important because the actions taken by those few MBAs who become CEOs of major corporations are very consequential, so business schools are also very consequential. What we teach is practiced by firms, both when it is right and when it is wrong. A recent paper in Administrative Science Quarterly by Jiwook Jung and Taekjin Shin looks at how business schools were behind the largest change in firm structure in recent history: the breaking up of diversified corporations into smaller specialist firms.
This change is literally a textbook case of what firms should do. According to finance theory of capital markets, investors are better off diversifying by buying many specialist firms than a single diversified firm. According to the economic theory of managers, firms are more valuable when they are so specialized that it is easy to reward and punish CEOs based on how well they do. The combination of these two theories moved into business schools in the 1970s and has stayed there ever since. Jung and Shin discovered an easy way to measure its effect: In the exact same time period, firms led by CEOs with MBAs from before the 1970s kept diversifying, and firms led by CEOs with MBAs from the 1970s onward were de-diversifying. The CEOs were practicing what their business schools preached.
Does this sound like a good effect of education, or is there anything scary about it? We like people to choose the right actions based on knowledge of how the world works. Business schools have a special responsibility because some of the people we educate become very important for the society and economy. So this seems like a good outcome: for anyone who believes what business schools teach, it was great that businesses became less diversified.
Here is the scary part. Any form of science is wrong or incomplete sometimes, especially if it is a young science like the branches of knowledge that business schools teach. Remember when all the finance professors thought the economy was healthy, just before the financial crisis? It gets even worse when our graduates learn what actions are best but prefer short explanations of how the world works. Remember when all investment advisors loved web businesses, just before the dot-com bust? If we teach too confidently, trouble will follow.
De-diversification sounds like a safe case, because there is pretty good evidence that diversified firms are worth a little less than de-diversified ones. But we should keep in mind that even this case isn’t entirely clear. The de-diversification took place during a time period when changes in competition law enforcement meant that buying competitors and increasing prices became easier and a better use of money than diversifying. Also, for firms heavily engaged in product development, some diversification can be a significant advantage, as another recent ASQ paper has shown. Even the best of our knowledge can be changed as we continue to learn. That’s how science works, and that’s why teaching should be done with some modesty.
PS: For those who wonder about the picture of this blog: Martin Luther was a professor and a priest.
Jung, Jiwook, and Taekjin Shin. 2018. "Learning Not to Diversify: The Transformation of Graduate Business Education and the Decline of Diversifying Acquisitions." Administrative Science Quarterly, forthcoming.
One of the most studied and least understood aspects of life is how people decide to trust each other. Trust is not much on our minds in daily life, but that is because trust is not needed for most of what we do. When shopping, we know that a credit card payment probably won’t lead to fraud later on and that the change we get when paying with bills is not fake currency. In traffic, trusting others is more important, but we generally trust that other drivers know the rules of the road, except perhaps if we’re on a bike.
In some areas of life, trust is very important, including on the job. Even in occupations that are mostly safe, every now and then there may be dangerous situations in which trust in others is important. Trust matters because danger triggers a fight-or-flee dilemma: you can try to solve the problem, at some risk to yourself, or you can escape and let the problem get worse. When solving a dangerous problem calls for teamwork, it is important that everyone makes the same decision.
This type of trust is the inspiration behind a recent paper in Administrative Science Quarterly by Michael Pratt, Douglas Lepisto, and Erik Dane. They looked at firefighters, whose occupation calls for risky teamwork. They have to trust that others will “have their back” in fighting a fire when the situation gets dangerous, so that each can rely on the other. Firefighting is especially interesting because firefighters don’t actually spend much time fighting fires. The increased fire safety of buildings and the need to have enough firefighters on the payroll in case of large fires means that they spend most of their time waiting for calls or handling emergencies that have nothing to do with firefighting. Helping cats down from trees is mostly a myth, but vehicle accidents, gas leaks, and emergency medical assistance are facts of life – firefighters can often get to a scene before the ambulance.
The problem with having safe buildings is that firefighters have little direct evidence from fighting fires together of whom they can trust – when they’re called to the scene of a fire, they may not have ever seen each other fight fires. That means they have to operate on trust derived from indirect evidence. I started by saying that trust is well studied and little understood. One thing we do know is that when people try to decide whom to trust, they look for signs of trustworthiness. When this happens in occupations, the signs may not make sense to outsiders, but they are very real for the people involved. The firefighters in this research tried to understand where their colleagues were coming from, both in their backgrounds and in their attitudes toward the everyday chores at the firehouse. Based on small or large signs they picked up in their early interactions with a newcomer, they would put the newcomer into a small set of categories. And here is where the interesting part lies, because the categories did not inspire the same amount of trust.
The firefighter who has a college education? That one is the “book-smart” type and is not a commonsense type whom you can trust to think quickly and do the right thing in a dangerous situation. The firefighter who buys his own scanner and goes to fires even when he’s off duty? That would be a “spark,” who has the right motivation but is too excitable and thus is only warily trusted. Less trusted is the “paycheck” firefighter, who is there for only one reason and likely won’t take risks to help a fellow firefighter out of a burning building. So who is trusted most? For firefighters it is the “worker” type, who they see as always reliable and careful – someone who combines the professionalism of a (good) plumber with the discipline of a soldier, who checks the equipment, cleans up, or does whatever else needs to be done when there are no calls. So the answer to the question of who do you trust is that if you are a firefighter, you probably don’t fully trust the colleague who is just book smart, the one excited by fires, or the one who’s there for the paycheck.
If you are not a firefighter, the answer to the question is different. You don’t know who to trust, and you can’t tell who is of what type. That’s part of how organizations work, because they contain occupations and jobs that have internal codes understood by few others, including management. That’s one reason why managers should be careful not to judge quickly when they see behaviors they don’t understand. Look inside the thinking of the people responsible, and things make more sense.
Pratt, Michael G., Douglas A. Lepisto, and Erik Dane. "The Hidden Side of Trust: Supporting and Sustaining Leaps of Faith among Firefighters." Administrative Science Quarterly, forthcoming.
#mefirst: Female Executives Are Superior to Male Executives in Societies that Discriminate against Women
Here is an unusual business idea. Suppose you are a business in a society that discriminates against a group of people, such as women. Why not hire and promote members of that group—not because you can pay them less, but because their talent, dedication, and way of thinking make them different than others in ways that can be beneficial to your organization? Is this done anywhere, and does it increase organizational performance?
In a recent paper in Administrative Science Quarterly, Jordan Siegel, Lynn Pyun, and B. Y. Cheonlooked at firms that promote women into upper mid-level and senior managerial positions in South Korea. At those levels, there are few women in a typical Korean firm because of a significant social bias against women having roles of responsibility outside the family. Using the best data and methods available to us for analyzing firms’ profitability, they could precisely measure the effect of having female executives. Add 10 percent women at the top level, and you will get a 1-percent increase in returns on assets. In case you wonder, a 1-percent increase in profitability is a lot of money, and it is easy to add 10 percent female executives because most Korean firms don’t have any.
What is going on here? Obviously, the increased profits aren’t explained by what female executives are paid compared with male counterparts. Executive payment (at least in Korea) adds up to only a tiny fraction of the profitability we are seeing here. Siegel, Pyun, and Cheon asked observers who know how businesses operate, and they got some interesting answers. The most important is that women think differently, and think more independently, than men. The different way of thinking is typical of people who have different roles in society, and it is the reason we often want decision-making groups to be diverse. More kinds of people mean more ideas, and diversity is kind of low when the average executive team has 2.5 percent women.
Independent thinking may seem like a somewhat radical explanation, but it makes sense in this study for both a general reason and a more specific one. In general, people who are discriminated against need to think on their feet because doing well in the workplace is not something that happens based on who they are: it depends on what they do, and in particular what they do differently. The promoted female executives did well because they were special. Also, there was a specific reason that independent thinking led to greater success in this study: young men in Korea have to serve in the military, where independent thinking is strongly discouraged and following orders is encouraged. Female executives have a creative advantage over male executives in this context.
So if firms in such societies can gain so much advantage by promoting women, why don’t they all do it? There are many reasons for not breaking with a norm of discrimination, starting with ignorance. Firms don’t know that female executives are superior (which is why this research was needed), and they may not even recognize that there are few women among their executives. After all, being male is normal for an executive.
Still, some firms in this study did hire and promote female executives, and many of them were foreign. Does this mean that discrimination is absent in the homelands of these foreign firms? No. Most of the foreign firms were multinationals with hardly any women in their home country among their top executives. Discrimination against women may have been weaker in their home country than in Korea, but just as importantly, they had discovered the benefits of promoting women in Korea. Discrimination in society seems to be easier to overcome if it is costly—not a highly virtuous conclusion, but one with some hope at least.
It was fun for me to read this research. I had the idea of doing a research project like this a long time ago when I worked in Japan. I was too busy with other projects to do it and did not check whether there were data available that would have made it possible. Now it has been done, and the results confirm what I expected.
Jordan, Siegel, Pyun Lynn, and B. Y. Cheon. 2018. "Multinational Firms, Labor Market Discrimination, and the Capture of Outsider’s Advantage by Exploiting the Social Divide." Administrative Science Quarterly, forthcoming.
The relationship between an auditor and the audited firm has always been interesting. Auditors are supposed to check the firm’s financial accounts and approve them, which lets others such as investors and the state know that the firm is not misrepresenting any information. They have some other duties as well, but you could say that auditors save the investors from seeing artificially high profits and the taxman from seeing artificially low profits. So who hires the auditor, the investors or the state? The firm does. That’s why it gets interesting, because it means that the auditor is implicitly hired to keep the firm within the rules for investors and the state while serving the interests of its management.
In a recent paper in Administrative Science Quarterly, Aharon Mohliver looks at an even more interesting part of this relationship by doing research on the role that auditors played in first condoning, then spreading, and finally extinguishing a questionable practice firms began to use when changes in the tax code affected their ability to pay managers above a $1 million cap without subjecting them to significant tax liabilities. At first the practice was questionable but not illegal, and auditors in some local offices helped their client firms start using it. The findings tell a very informative story of how auditors pay close attention to the interests of the managers who hire them, and also to the fine line between legal and illegal.
The questionable practice is called stock-option backdating. Stock options are often given to managers because they let managers earn higher income if the value of the firm increases, and to make them fair they are often given (for free, of course) at the exact value of the firm on the day they are given. In MBA-speak, those options have upside potential, no downside potential, and are incentive compatible. In plainer words, they reward managers for effective management but don’t punish failure. Firms report the costs of stock options as compensation expenses.
What I just explained is a regular stock option, without backdating. A backdated stock option looks just the same, but in reality it has been assigned an earlier formal date than when it was given, and that formal date somehow turns out to be a day just before the firm had a big increase in value. Through what seems like a very lucky dating of the option, the managers getting the backdated stock option earn significant sums of money not taxed as regular income. Backdated stocks are a trick for compensating managers at the expense of investors. They are a form of fraud, and though they were unethical from the start, initially there were no laws or rules against backdating so they were not yet illegal. (There were no rules because no one making rules had thought of backdating stock options.)
So the auditors stepped in. They spread knowledge of backdating from one client to the next, especially if clients were part of their local and dense communication networks. They were also sensitive to lawmakers, however, so this spreading of backdating was strongest when the uncertainty about the legality of backdating was greatest. When it became more certain that backdating would be made illegal, the auditors stopped spreading the backdating trick, and when it actually became illegal they stopped its use in the firms that had already started using backdating. So, auditors follow written law very well, are neutral to law that will soon happen, and are willing to help management profit from legally questionable conduct. Nice to know if you happen to be a manager, investor, or lawmaker. If you are an auditor you probably know it already.
Mohliver, A. How Misconduct Spreads: Auditors’ Role in the Diffusion of Stock-option Backdating. Administrative Science Quarterly, forthcoming.
This blog is devoted to discussions of how events in the news illustrate organizational research and can be explained by organizational theory. It is only updated when I have time to spare.