The effect of information asymmetry on negotiated budgets: an empirical investigation

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Abstract

This study examines three issues: (1) the effect of information asymmetry on the budget negotiation process, (2) the effect of information asymmetry on budgetary slack when budgets are set through a negotiation process, and (3) whether subordinates consider superiors imposing a budget following a failed negotiation as being low in procedural justice, which in turn causes low subordinate performance. The results suggest that smaller differences in initial negotiation positions do not indicate a higher likelihood of agreement when initial differences are due to differential information symmetry. Further, information asymmetry affects the relationship between negotiation agreement and budgetary slack. Last, inconsistent with a pure economic perspective, having superiors impose a budget after a failed negotiation causes justice or fairness considerations to demotivate subordinates.

Introduction

Budgets are important tools for planning and motivating subordinate performance. Because subordinates often are better informed than superiors about their capabilities and the environmental factors affecting performance, having subordinates truthfully report their private information may have planning benefits for the company (Baiman and Evans, 1983, Chow et al., 1988, Dye, 1983). However, if subordinates are evaluated on their performance relative to the budget, they have incentives to misrepresent their private information, resulting in budgetary slack (Christensen, 1982, Magee, 1980, Schiff and Lewin, 1970).

This study addresses three issues related to budgeting. The first is the effect of information asymmetry on the budget negotiation process. Although accounting research has examined the effect of information asymmetry in budgeting contexts, (see, e.g. Chow et al., 1988, Young, 1985), these studies had subordinates unilaterally set their own budgets. In practice, budgets typically are set through participative budgeting. This participative budgeting commonly takes the form of a negotiation process where superiors have a major influence, if not outright control, over the final budget (Anthony and Govindarajan, 2001, Umapathy, 1987). Given that budgets—and thus budgetary slack—typically are a result of a negotiation process, it is important to understand how information asymmetry affects that process.

The second issue is the effect of information asymmetry on the level of budgetary slack when budgets are set through a negotiation process. Slack is an economic consequence of the budget-setting process, and the economic consequences of budgets set through a negotiation process differ from the consequences of budgets set unilaterally (Fisher, Frederickson, & Peffer, 2000). The specific issue we examine in this study is whether Fisher et al.’s finding that budgets contain less slack when the negotiation process ends in agreement holds across different levels of information asymmetry. Such knowledge will add to our understanding of how contextual factors affect the relation between information asymmetry and slack (Chow et al., 1988).

The final purpose of this study is to test Fisher et al.’s (2000) conjecture about subordinates’ perceptions of superiors imposing a budget following a failed negotiation. Fisher et al. suggest that subordinates view such situations as being low in procedural justice, which in turn causes low subordinate performance. With the exception of Lindquist (1995), we are not aware of any studies that consider the role of procedural justice or fairness in the budget-setting process on subordinate performance.

The hypotheses were tested in a laboratory experiment where subjects assumed the role of either superiors or subordinates and then negotiated a production budget for the subordinates. Subordinates made the initial budget proposal in the negotiation, and superiors had the authority to set the budget in the event of a negotiation impasse. In one condition superiors knew subordinates’ performance capabilities (information symmetry) and in the other condition superiors did not (information asymmetry).

The results indicate that information asymmetry affects both the negotiation process and the level of budgetary slack. With respect to the negotiation process, information asymmetry affected the difference between superiors’ and subordinates’ initial negotiation positions and the degree to which superiors relied on subordinates’ offers and counteroffers. However, contrary to our expectations, negotiations were not more likely to end in agreement under information symmetry. These results suggest that prior findings that a smaller difference in initial negotiation positions indicates a higher likelihood of agreement (Fisher et al., 2000) does not extend to situations where differences in initial negotiation positions are due to differences in information asymmetry. With respect to budgetary slack, information asymmetry affected the relationship between negotiation agreement and slack. Budgets contained more slack when negotiations ended in agreement under information asymmetry, but there was no difference in slack across negotiations that did and did not end in agreement under information symmetry.

Finally, the results are consistent with justice or fairness considerations in the budget-setting process being important determinants of subordinate performance. Subordinates in dyads that failed to reach agreement (1) perceived less power in determining their budgets, less satisfaction with the budget-setting process, less satisfaction with the budget, and less commitment to the budget and (2) performed at a lower level. More importantly, these results also hold for only those subordinates whose budgets were below their performance capabilities, indicating that it is superiors imposing a budget following a failed negotiation—as opposed to budget achievability—driving the results.

The remainder of the paper is organized as follows. The hypotheses are developed in the next section. In Section 3, the experimental method is described. The results are reported in Section 4. The concluding section discusses the implications of the findings, the study’s limitations, and directions for future research.

Section snippets

Incentives and setting

Assume there are superior and subordinate dyads where subordinates provide a productive input (e.g. effort) to production. Consistent with Fisher et al. (2000), the superiors and subordinates are compensated according to the following contracts.Psubordinate=FifXB=F+AX−Bif X>BPsuperior=RDX−FifXB=RDX−F+AX−Bif X>Bwhere P=compensation; F=subordinate fixed compensation; A=subordinate compensation per unit of production over budget; X=actual production; B=budget; D=profitability, exclusive of

Subjects and design

The subjects were 104 undergraduate students enrolled in intermediate accounting. Subjects were randomly assigned to either an information asymmetry or symmetry condition. The entire experiment, except for the negotiation process, was completed on computer.

Procedure

The experimental procedure closely parallels Fisher et al.’s (2000) procedure and consisted of the following steps:

  • 1.

    The computer lab was partitioned into two halves using a solid room partition. When subjects arrived, they were assigned

Results

Tests indicate no significant difference across cells for any of the following variables for either subordinates or superiors: performance capability, age, GPA, and length of work experience. In addition, there is no significant difference between subordinate performance in the third training session and their performance estimate for the work session, suggesting that subordinates believed they had mastered the task by the end of the third training session. Tests of the hypotheses are reported

Discussion and conclusion

This paper studies participative budgeting by examining the process by which budgets in practice are typically set: negotiation (Anthony and Govindarajan, 2001, Umapathy, 1987). This paper examined three issues associated with budget negotiations. The first issue was the effect of information asymmetry, which is an important contextual factor in participative decision making (Baiman, 1990, Locke and Schweiger, 1979), on the budget negotiation process. Subordinates made significantly lower

Acknowledgements

This paper has benefited from the comments of Jamie Pratt, Jerry Salamon, John Waterhouse, participants of the 1998 American Accounting Association National Meeting, the 2000 American Accounting Association Management Accounting Section Meeting, two anonymous reviewers, and workshop participants at INSEAD, Nanyang Technological University, University of Kentucky, University of Oklahoma, and University of Waterloo. Indiana University School of Business provided financial support.

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