The Joint Effect of Justification and Ambiguity on Operating Decision Distortion

Abstract

We examine the interactive effect of justification and ambiguity on the tendency to distort operating decisions in an incentivized experiment. Managers decide whether to drop or keep a project on behalf of the owners. Although dropping the project always leads to higher payoffs for managers, keeping the project leads to higher payoffs to the owners for projects with good future outcomes. Dropping a project with good future prospects is akin to real earnings management (REM), such as cutting R&D to meet bonus targets. We find that justification increases REM when project outcomes are ambiguous but has no effect when the distribution of project outcomes is known. Ambiguity gives flexibility for managers to craft a plausible justification for dropping the project that appears accountable to the owners. The opportunity for impression management makes selfish actions more attractive to managers because it helps to promote a positive social image.