Indjejikian & Matejka (2012)

THE ACCOUNTING REVIEW American Accounting Association
Vol. 87, No. 1 DOI: 10.2308/accr-10168

2012
pp. 261290
Accounting Decentralization
and Performance Evaluation
of Business Unit Managers
Raf J. Indjejikian
University of Michigan
Michal Matejka
Arizona State University
ABSTRACT: We use survey data to examine firms propensity to rely on financial
measures in evaluating local business unit managers. We find that firms rely less on
financial measures (and more on nonfinancial measures or subjective evaluations) in
determining local managers bonuses when those managers have greater influence over
the design of internal accounting systems. At the same time, we find no significant
association between the choice of performance measures and local managers authority
to make operating decisions. Instead, we find that local authority to make operating
decisions is positively associated with local managers influence over accounting
systems. Taken together, our findings suggest that the design of internal accounting
systems is an important dimension of overall organizational design. Our findings also
cast doubt on the maintained assumption in prior work that major organizational design
choices are complementary.
Keywords: performance measurement; private information; internal accounting sys-
tems; business unit controllers.
Data Availability: Data used in this study cannot be made public due to condentiality
agreements with participating rms.
I. INTRODUCTION
Q
uestions regarding rms performance-evaluation practices and the incentives these
practices provide have been of interest to academics as well as practitioners for several
decades. Following Holmstrom (1979), the standard agency insight holds that rms place
more weight on performance measures that are more precise and/or more sensitive indicators of
We acknowledge helpful comments of two anonymous reviewers as well as Harry Evans, Steve Kachelmeier, Susan
Kulp, Jason Schloetzer, and workshop participants at The Pennsylvania State University, University of North Carolina,
and University of Oregon.
Editors note: Accepted by John Harry Evans III.
Submitted: December 2009
Accepted: July 2011
Published Online: August 2011
261
managerial performance. In this spirit, there is evidence that growth opportunities, business
strategy, and earnings volatility affect the extent to which rms rely on nancial or
accounting-based performance measures to evaluate their managers (e.g., Ittner et al. 1997). There
is also recent evidence that performance-evaluation practices are related to the knowledge and
commensurate decision rights of local business unit (BU) managers (e.g., Baiman et al. 1995;
Abernethy et al. 2004; Hwang et al. 2009). Prior literature, however, rarely highlights how
performance-evaluation practices relate to characteristics of internal accounting systems, even
though internal accounting reports often represent the underlying source of performance-evaluation
information.
We contribute to this literature by examining how rms reliance on nancial measures relative
to nonnancial measures in determining BU managers bonuses depends on the delegation of two
distinct categories of decision rights. We refer to the rst category of decision rights as operational
decentralization, by which we mean BU authority to make marketing, production, and related
operating decisions. Much of prior literature focuses on this category of decision rights and argues
that operational decentralization allows BU managers who are knowledgeable about their local
business environment to make better decisions than managers at corporate headquarters (e.g.,
Christie et al. 2003). We refer to the second category of decision rights as accounting
decentralization by which we mean the extent to which local BU managers have authority to design
internal accounting systems or make accounting choices that affect the reported nancial results of
their local operations. This category of decision rights has received much less research attention,
although there is some evidence that rms try to alleviate the information asymmetry between BU
managers and corporate headquarters by centralizing the design of local accounting systems (e.g.,
Simon et al. 1954; Siegel and Sorensen 1999).
Given the paucity of prior studies on accounting decentralization, we begin by presenting
eld evidence about the nature of accounting decentralization. We nd that some rms exercise
centralized control by standardizing their internal reporting systems and enforcing a common
set of accounting practices among their BUs. In contrast, other rms allow BU managers to set
their own accrual policies such as valuing and depreciating divisional assets as well as allow
them to engage in a variety of BU-specic cost allocation and transfer pricing practices. Our
interviews with both corporate and BU managers also consistently suggest that accounting
decentralization increases the availability of locally relevant information and improves BU
decision making.
The idea that BU managers make better decisions when they rely on decentralized accounting
systems aptly coincides with the fundamental rationale for why rms delegate operating decisions
to local managers. Indeed, if decentralized accounting systems imply that BU managers have more
locally relevant information, and more local information implies that rms delegate more operating
decisions to BU managers, then we expect operations to be more decentralized in settings in which
accounting systems are also more decentralized. Thus, our rst hypothesis is that accounting
decentralization and operational decentralization are complements in organizational design.
The preceding discussion suggests that the benets of both operational and accounting
decentralization can be attributed to local private information. Of course, private information also
entails agency costs related to suboptimal decision-making or strategic misrepresentation of
information relevant for performance evaluation. Firms anticipate such agency costs when
designing their incentive compensation and measuring performance of local managers. Hence, our
next two hypotheses address the links between accounting and operational decentralization and
rms performance measurement choices.
We begin with a simple agency model (described in Section III and Appendix A) that
features how different types of local private information affect rms performance measurement
262 Indjejikian and Matejka
The Accounting Review
January 2012
practices.
1
We assume that a local manager has private information about drivers of rm value as
well as private information about the non-value components of reported performance measures.
Whereas the rst type of information helps the manager make value-added decisions, the latter
type of information helps the manager embellish his/her performance measure(s). We nd that the
emphasis on a performance measure decreases in the precision of a managers information signal
if the signal is relatively more informative about the non-value components of reported
performance than about the drivers of rm value.
In the context of our model, we characterize accounting decentralization as a setting in which
BU managers have access to different types of private information, i.e., information about drivers of
rm value as well as information about the non-value components of reported performance
measures (e.g., Jablonsky and Keating 1998; Indjejikian and Matejka 2006). That said, the
distinguishing feature of accounting decentralization is that managers with authority to make
accounting choices are uniquely more informed about the non-value components of accounting-
based measures. Thus, if BU-specic cost allocation, transfer pricing, or asset-valuation choices
improve BU managers understanding of their accounting-based reported performance more than
anything else, then we expect rms to deemphasize nancial measures in favor of nonnancial
measures such as market share or customer satisfaction that do not directly depend on such
discretionary accounting choices. Hence, our second hypothesis is that accounting decentralization
and the relative emphasis on nancial performance measures in BU managers bonus plans are
substitutes.
Next, we characterize operational decentralization as a proxy for private information about the
drivers of rm value, because the quality of local private information is a key reason why rms
delegate marketing and production decisions (e.g., Jensen and Meckling 1992). If authority to make
operating decisions implies that local managers have private information primarily about the drivers
of rm value, then we expect rms to emphasize performance measures that better reect such
decision-oriented local information. This is also consistent with Raith (2008), who shows that
private information about drivers of rm value is associated with greater emphasis on output-based
measures (as opposed to input-based measures). Assuming that output measures are mostly
nancial in nature, our third hypothesis is that operational decentralization and the emphasis on
nancial performance measures are complements.
Our three hypotheses represent predictions about pairwise associations among accounting
decentralization, operational decentralization, and the emphasis on nancial performance measures.
As Milgrom and Roberts (1995) point out, however, various organizational practices are often
adopted in clusters. Thus, it is important to also consider overall complementarityi.e., whether all
bivariate relations among the organizational design choices are complementary. In our context, we
do not expect overall complementarity to prevail because the second hypothesis predicts that two of
the choices are substitutes.
Our empirical tests are based on data obtained from a survey of 242 BU managers and
controllers of 121 BUs. Consistent with our rst hypothesis, we nd that accounting and
operational decentralization are positively associated. We also nd support for our second
hypothesis, which predicts that accounting decentralization and the emphasis on nancial
performance measures are substitutesi.e., when BU managers have considerable authority to
make internal accounting choices, their bonus plans are less sensitive to nancial measures of BU
performance. This nding contributes to prior literature by suggesting that performance-evaluation
practices depend on characteristics of internal accounting systems.
1
Although it is well established that local private information can improve decision making as well as exacerbate
agency costs (Christensen 1981; Milgrom and Roberts 1992), prior theoretical work rarely examines how private
information affects rms choices of performance measures.
Accounting Decentralization and Performance Evaluation of Business Unit Managers 263
January 2012
In contrast, we nd little support for our third hypothesisi.e., we nd no discernable
association between operational decentralization and the emphasis on nancial performance
measures, which is consistent with similar ndings in the literature (e.g., Bouwens and van Lent
2007; Widener et al. 2008). We attribute this nding to a lack of complementarity among the three
organizational design choices. In particular, our results imply that any positive association between
operational decentralization and the emphasis on nancial performance measures is offset by the
indirect negative effect due to the positive link between accounting and operational
decentralization.
2
Thus, while most prior empirical studies implicitly or explicitly assume that all
organizational design choices are complementary, our ndings suggest that complementarity
among a broad set of organizational design choices is unlikely to prevail.
Section II reviews prior literature and briey summarizes our eld evidence. Section III
presents our theoretical framework and develops our hypotheses. Section IV describes our data and
empirical methods. Section V presents the empirical results and Section VI concludes.
II. PRIOR LITERATURE AND FIELD EVIDENCE
How rms make organizational design choices has been studied in a variety of disciplines,
including accounting, nance, management, and economics. Milgrom and Roberts (1990, 1995)
suggest that because rms commonly adopt various organizational practices in clusters, studying
any practice (or a pair of practices) in isolation disregards important interactions among different
organizational practices. The reason is that direct effects of an exogenous force on an organizational
design choice are accompanied by indirect effects that might in principle be as large as the direct
effects and opposite in sign (Milgrom and Roberts 1990, 514). Under assumptions of
complementarity among a variety of organizational design choices, it is possible to show that
the indirect effects reinforce the direct effects and rms optimally adopt practices in clusters. In a
similar vein, Rivkin and Siggelkow (2003, 290) argue that organizational design choices can
interact as complements or as substitutes and that failures to appreciate the systemic nature of
organizational design commonly lead to suboptimal decisions.
In contrast to the notion of complementarity among various organizational practices, most prior
empirical studies examine only one rm choice, such as the extent of operational decentralization or
the weight on nancial performance measures in incentive plans. Thus, these studies implicitly
assume that the complement or substitute relations among key organizational design choices are
secondary in the sense that any hypothesized direct effects of exogenous environmental factors
always dominate potential indirect effects. We briey review this literature below.
Operational Decentralization
BU managers often have superior information about critical success factors in their local
markets. When such local information is too costly to transfer, rms delegate various marketing,
operating, and investment decisions to local managers (Melumad and Reichelstein 1987; Jensen
and Meckling 1992; Milgrom and Roberts 1992). A number of empirical studies provide support
for the theory that operational decentralization is associated with local private information. For
example, Bouwens and van Lent (2007) and Abernethy et al. (2004) nd that operational
2
Milgrom and Roberts (1990) show that lack of complementarity implies that all pairwise associations among
organizational design choices are attenuated by indirect effects. Given that our hypotheses predict signs but not
the relative magnitude of bivariate relations among the three organizational design choices, we cannot predict ex
ante which of our tests are low-powered and which tests suffer relatively little from the presence of indirect
effects. Nevertheless, our results in support of the second hypothesis suggest that the indirect effect due to the
positive relation between accounting and operational decentralization is not sufcient to offset the negative
association between accounting decentralization and the emphasis on nancial performance measures.
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decentralization is positively associated with information asymmetry between BU managers and
their superiors regarding local activities and technical expertise. Other studies nd that operational
decentralization is greater in settings characterized by high growth or high emphasis on innovation,
in industries generating relatively more specialized knowledge, or for large or complex rms
(Baiman et al. 1995; Nagar 2002; Christie et al. 2003; Graham et al. 2009).
Recent literature also suggests that operational decentralization and incentive strength are
complementary organizational design choices. In particular, there is evidence that greater
operational decentralization is typically associated with stronger incentives (Nagar 2002; Foss
and Laursen 2005; OConnor et al. 2006; Widener et al. 2008; Ortega 2009).
Choice of Performance Measures
Following Holmstrom (1979), a number of empirical studies have shown that rms place more
weight on performance measures that are more informative (less noisy or more sensitive) indicators
of managerial performance. For instance, Ittner et al. (1997) nd that the use of nonnancial
performance measures increases with noise in nancial performance measures and the extent to
which rms follow an innovation- or quality-oriented strategy. Several other studies suggest that
rms emphasis on nancial performance measures can be explained by volatility of earnings,
growth, within-rm interdependencies, and past performance (e.g., Bushman et al. 1996; Keating
1998; Moers 2006; Matejka et al. 2009). Evans et al. (2010) examine physician compensation
contracts and nd that nonnancial measures are used more frequently when the measures are more
informative.
There are also a few studies that examine how performance measurement choices (e.g.,
nancial versus nonnancial, input versus output, BU-level versus higher-level measures) depend
on various proxies for local knowledge and private information of managers and employees.
Hwang et al. (2009) nd that local specic knowledge, as measured by complexity of production
technology, is associated with a shift away from input-based rewards in favor of output-based
rewards. Abernethy et al. (2004) nd some evidence that operational decentralization is associated
with the use of BU summary measures, such as income or ROI, as opposed to disaggregated
nancial measures or nonnancial measures. OConnor et al. (2006) show that operational
decentralization is associated with objective performance measures in the context of Chinas state-
owned enterprises. In contrast, Widener et al. (2008) and Bouwens and van Lent (2007) nd no
signicant association between operational decentralization and the emphasis on nancial
performance measures, while Moers (2006) nds that the sign of the association can be positive
or negative depending on properties of nancial performance measures.
Prior Literature
Early studies on accounting decentralization show that some rms grant BU managers broad
discretion to design their own internal accounting systems according to their local needs, while
other rms centralize the design of internal accounting systems (Simon et al. 1954; Jablonsky and
Keating 1998; Siegel and Sorensen 1999). More recently, Indjejikian and Matejka (2006) nd that
BU managers who have considerable authority to design local internal accounting systems enjoy
informational rents in form of greater slack in budgetary targets, and at the same time are more
satised with how such accounting systems support their decision making. This evidence suggests
that authority to design local internal accounting systems is associated with local private
information and its attendant costs and benets.
Building on prior literature, we characterize internal accounting systems as centralized in
settings where BU nancial reports are largely standardized and where corporate accounting rules
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extend well beyond GAAP in the form of detailed formal or informal guidance in areas such as
asset valuation, cost allocation, or transfer pricing. In contrast, we characterize internal accounting
systems as decentralized in settings where BU managers have to comply with external GAAP but
otherwise have wide discretion to design their accounting systems according to their local needs.
To better illustrate the costs and benets of accounting decentralization, we present a brief
summary of relevant eld evidence collected as a part of this study (see Appendix B for more
detail). Briey, the eld evidence yields two key observations. First, rms balance the benets of
centralized and standardized accounting systems that facilitate corporate control against the costs of
burdening local BUs with additional reporting requirements that (1) are of minimal local relevance
and (2) constrain the amount of information available for local decision making. Second, the extent
to which internal accounting systems are decentralized appears to be directly or indirectly related to
operational decentralization.
Field Evidence
Our interviews suggest that accounting centralization enables standardization of internal
reporting and facilitates corporate control. In the words of a BU controller, If you talk about
inventory and [the headquarters] say inventory is too high and here they say: No, it is not too high
. . . If there are different denitions of inventory, then it is going to be difcult. At the same time,
accounting centralization also reduces the usefulness of internal reports for local decision making.
For example, a corporate controller acknowledged the downside of a centralized system as follows:
[O]ur accounting system prescribes FIFO for valuation of inventory. That is troubling, certainly
for [BUs in bulk chemical business], because the raw material prices uctuate so badly. If you work
with FIFO, you do not get the actual margins. Thus, [BUs in bulk chemical business] prefer to work
with LIFO, but that is not our system. A business group controller in another company made a
similar remark: We have a rather complicated system at [the company] . . . based upon full costing
. . . It is a rather good system if you are a production company, when you have a lot of people. It is
not such a good system if you are a trading company. Direct costing would be much more helpful,
easier to steer your company.
Our interviews also highlight the presence of a trade-off between generating information for
standardization and corporate control and generating information for local decision making. One
BU controller described the trade-off as follows: This is a big discussion within [the company] at
this momentstandardization versus individual needs. As usual, it is a pendulum . . .
Standardization is hard to nd in [the company] at this moment. Everybody has their own SAP
systems, implemented in their own way; everybody does it in a different way. The pendulum
swings the other way now. The truth must be somewhere in between. But at the moment the
pressure is on standardization, standardization ... worldwide standardization in accounting so that
we speak a common languageif we benchmark costs per ton or something else per ton across our
plantsso that we speak about the same costs.
Our eld evidence further suggests that the extent to which internal accounting systems are
decentralized is positively associated with the extent to which operating decisions are decentralized.
For instance, in circumstances where higher-level management is closely involved in local BU
operations, the demand for standardized reporting appears to be greater. A BU controller with prior
experience in auto manufacturing, where the local BUs were centrally run sales ofces in different
countries, commented as follows: I used to work for [a BU] where . . . the marketing and
controlling departments did not have a chance to work for the local [BU]. We were completely
dependent on a large amount of very detailed questions that came from the headquarters and we had
to answer those. This contrasts with the view of a BU controller in a large conglomerate (where
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local BUs were largely independent operating companies): I think that I am more useful for the
operating company than for the holding company. The holding company must receive several key
gures from me that are reliable and that are good. However, most of the information relates to
managing the company.
Finally, our eld evidence suggests the presence of an indirect link between accounting and
operational decentralization (see Appendix B). In particular, we nd that high-growth prospects and
lack of synergies among BUscommon determinants of operational decentralization (e.g., Nagar
2002; Bouwens and van Lent 2007)are also associated with accounting decentralization. We also
nd that individual characteristics and attributes of controllers and managers at the BU and/or
business group level can affect the extent to which accounting systems are decentralized.
III. THEORY AND HYPOTHESES
Considering accounting decentralization and operational decentralization as two distinct
categories of decision rights raises an important question: Should BU managers with more
operational autonomy have more or less authority to make internal accounting choices? That is,
should managers entrusted with marketing and production decisions have more or less control over
the accounting systems and performance reports on which they are evaluated? One response to this
question emphasizes the importance of co-locating information and decision rights (Jensen and
Meckling 1992; Aghion and Tirole 1997). Given that local private information is the rationale for
operational decentralization in the rst place (Baiman et al. 1995; Christie et al. 2003), this
perspective implies that BU managers with greater autonomy to make operating decisions should
also have more autonomy to design local accounting systems and generate reports that improve
their operating decisions. An alternative perspective emphasizes the agency costs or control costs
commonly associated with decentralized operations (Christensen 1981; Baiman and Evans 1983;
Baiman and Sivaramakrishnan 1991). If such agency costs are high, then BU managers with greater
autonomy to make operating decisions should have less autonomy to design local accounting
systems to facilitate corporate control and alleviate the information asymmetry between corporate
and BU management.
In light of these conicting views about the relation between accounting and operational
decentralization, we rely on our eld evidence to discern which of the two alternative theoretical
perspectives is more descriptive in our context. As discussed earlier, in circumstances where
higher-level management is closely involved in local BU operations, we nd that demand for
centralized and standardized internal accounting systems is greater. This suggests that the rst
perspectivei.e., the importance of co-locating information and decision rightsis primary, which
motivates our rst hypothesis concerning the relation between accounting and operational
decentralization.
H1: Accounting decentralization and operational decentralization are complements.
Our next two hypotheses link accounting and operational decentralization to rms choice of
performance measures. Because the unobservable theoretical construct that underlies both
accounting and operational decentralization is the presence of local private information, we draw
on agency-theoretic arguments that focus on private information as the major determinant of the
choice of performance measures in incentive contracts. In particular, Appendix A presents a formal
agency model that demonstrates how different types of local private information (e.g., those
underlying accounting and operational decentralization) affect the choice of performance measures
differently.
The key feature of our model is that the agent is privately informed not only about the rm
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production function, but also about the performance report on which s/he is evaluated.
3
The notion
that agents have private information and discretion regarding how their performance is reported has
been addressed in accounting research in various ways (e.g., Demski et al. 1984; Verrecchia 1986;
Natarajan 2004; Indjejikian and Matejka 2009). In this respect, our model is most similar to the
predecision private information models of Baker (1992), Bushman et al. (2000), and Baker and
Jorgensen (2003). Briey, these models suggest that the optimal contract is a function of the extent
to which an agents private predecision signal informs an agent about his/her upcoming decisions
(i.e., decision-oriented) versus his/her upcoming performance evaluation (i.e., evaluation-oriented).
If private information is more decision-oriented, then rms offer stronger incentives. Conversely, if
private information is more evaluation-oriented, then rms offer weaker incentives.
Our model extends the above intuition to settings with two or more performance measures and
multi-dimensional private information. Specically, we characterize the incentive weight on a
performance measure (relative to another measure) as a function of the amount (precision) and type
(decision-oriented versus evaluation-oriented) of local private information. We show that the
relative emphasis on a performance measure increases in the precision of a private signal with high
decision orientationi.e., a signal that is relatively more informative about rm value than about
reported performance. Conversely, the relative emphasis on a performance measure decreases when
the manager obtains additional private information that is evaluation-orientedi.e., primarily
informative about how to embellish the performance measure rather than how to increase rm
value.
To empirically operationalize our model, we describe accounting decentralization and
operational decentralization in relation to the two types of local private information (i.e.,
evaluation-oriented and decision-oriented) contemplated by our model (see Motivation of
Hypotheses in Appendix A). In particular, we characterize an increase in accounting
decentralization as providing BU managers with more evaluation-oriented information relative to
decision-oriented information. For example, greater discretion to make asset valuation or cost
allocation choices improves BU managers understanding of the drivers of their upcoming reported
nancial performance more than such discretion improves their understanding of how to run their
operations or their understanding of other measures used to evaluate their performance.
4
Hence, we
predict the following:
H2: Accounting decentralization and the relative emphasis on nancial performance measures
(as opposed to nonnancial measures) in BU managers bonus plans are substitutes.
Next, we characterize an increase in operational decentralization as a setting where BU
managers have more decision-oriented information. This is consistent with much of the prior
literature, which suggests that BU managers who have greater authority to make operating decisions
also have better knowledge of the business environment (e.g., Jensen and Meckling 1992). Our
model shows that rms will optimally increase the emphasis on nancial performance measures in
order to motivate BU managers to use such private information. This insight is similar to Raith
(2008), who nds that rms optimally emphasize output-based measures that are sensitive to
managers decision-oriented private information at the expense of input-based measures that are
insensitive to such information.
3
Following Courty and Marschke (2003), we can also extend our model to feature an agent explicitly manipulating
his/her performance report.
4
Although BU managers can also anticipate their upcoming performance on nonnancial dimensions (e.g., their
BUs customer satisfaction scores), how well they understand their nonnancial performance is unlikely to be
aided by their cost allocation or asset-valuation choices.
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H3: Operational decentralization and the relative emphasis on nancial performance measures
(as opposed to nonnancial measures) in BU managers bonus plans are complements.
Taken together, our three hypotheses imply an incentive design conict. Although accounting
decentralization is positively associated with operational decentralization (H1), the former calls for
less emphasis on nancial performance measures (H2), while the latter calls for more emphasis
(H3). This incentive conict arises because the three organizational design choices are not expected
to be complementary in the sense implied by Milgrom and Roberts (1990).
5
It follows that, in the
absence of complementarity, all pairwise associations implied by our hypotheses will be attenuated
by indirect effects, and empirical tests may lack statistical power to detect signicant relations.
IV. METHODS
Data
Our data are drawn from a database consisting of survey responses of managers and controllers
of 178 BUs of seven multinational rms with headquarters in The Netherlands. Indjejikian and
Matejka (2006) describe these rms as well as the survey administration procedures in more detail.
After excluding 48 BUs with only one respondent and 9 BUs due to missing data, we obtain a
sample of 121 BUs, ranging from 9 to 24 BUs per rm, where survey responses are available from
both the manager and the controller.
In each of the participating rms, we interviewed ve to ten controllers at different
organizational levels (48 interviews in total) and studied internal documents such as accounting
manuals, organizational charts, etc. Importantly, discussions with corporate executives revealed that
BU managers in these rms generally do not receive stock options or other equity-based
compensation, so that their incentive compensation consists mostly of annual bonuses. We rely on
this feature when we construct our proxy for the incentive weight on the nancial performance
measures described below.
Variable Measurement
Choice of Performance Measures
We measure the emphasis on nancial performance measures (FIN) using an instrument
similar to those in prior literature (Gupta and Govindarajan 1986; Abernethy et al. 2004; Bouwens
and van Lent 2007). As described in Appendix C, the instrument asks BU managers to state the
percentage of their bonus that depends on (1) BU nancial performance, (2) nancial performance
of several BUs or the whole rm, (3) nonnancial performance measures, and (4) subjective
evaluations. FIN is the weight on BU nancial performance measures divided by the sum of the
weights on BU nancial and nonnancial performance measures plus the weight on subjective
evaluations. In a similar way we calculate NONFIN, as the weight on nonnancial performance
measures, and SUBJECTIVE, as the percentage of bonus that is determined subjectively (without ex
ante targets). By denition, FIN NONFIN SUBJECTIVE 100. We use NONFIN and
SUBJECTIVE when discussing robustness of our results.
6
5
For complementarity to prevail, all three pairwise associations have to be positive (or two pairwise associations
have to be negative and one positive, which after rescaling is equivalent to three positive pairwise associations).
For a detailed discussion of the necessary conditions for complementarity among multiple organizational design
choices, see Arora and Gambardella (1990).
6
We exclude measures relating to performance of several BUs or the whole rm from the calculation of FIN as it
is not clear to what extent BU managers are knowledgeable about the drivers of performance in other BUs. We
discuss an alternative way of incorporating higher-level performance measures into our analysis in Section V.
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To assess the external validity of FIN, we correlate it with the extent to which respondents
agree with the following statement, using a seven-point Likert scale where higher scores indicate
disagreement: When evaluating performance of our business unit, higher-level managers rely
heavily on accounting information. As expected, FIN correlates positively with agreement of both
BU managers (p 0.06) and BU controllers (p 0.04).
Indjejikian and Matejka (2006) measure the extent to which BU controllers operate
autonomously from corporate headquarters using a formative model with six dimensions, three
of which pertain directly to the extent to which BUs have authority to design local accounting
systems.
7
For purposes of this study, we calculate accounting decentralization (ACCDEC) as an
equally weighted average of these three dimensions after standardization.
To test the external validity of ACCDEC, we correlate it with a measure of budgetary slack
employed by Indjejikian and Matejka (2006). Our theory suggests that BU-specic accounting
systems increase BU managers information advantage regarding what drives their nancial
performance measures. BU managers can exploit this advantage when negotiating budgetary
targets. Thus, we predict and nd a positive association between ACCDEC and budgetary slack (r
0.22, p 0.03). We also note that this correlation is not affected by the common method bias
because ACCDEC is solely based on responses of BU controllers, while the budgetary slack
measure is based on responses of BU managers.
Our measure of operational decentralization (OPERDEC) is similar to an instrument
commonly used in the accounting and management literature (Inkson et al. 1970; Ghoshal and
Nohria 1989; Abernethy et al. 2004). Using seven-point Likert scales, BU managers describe four
dimensions of delegation of decision rightsmarketing (four items), nancial (ve items),
operational (ve items), and purchasing (two items) decisions. OPERDEC is an average of
managers reverse-coded responses to these 16 items. We nd evidence of inter-rater reliability
based on a conrmatory factor analysis model using nine of the 16 items answered by both the BU
manager and the BU controller (Anderson 1985, 1987).
8
7
A formative model assumes an underlying construct is formed or induced by indicators that describe its inherent
constitutive facets (Bollen and Lennox 1991; Diamantopoulos and Winklhofer 2001). In contrast, a reective
model assumes an underlying construct is reected or manifested by a series of indicators. A key difference is
that, in formative models, indicators need not covary, rendering traditional reliability evaluation tools based on
internal consistency (e.g., Cronbachs alpha) meaningless, illogical, and inappropriate (Bisbe et al. 2007, 803).
Throughout this paper we use both formative and reective models for our constructs. ACCDEC is a
multidimensional construct with three formative dimensions, each of which is manifested by several reective
indicators.
8
As in the case of ACCDEC, OPERDEC is a multidimensional construct with formative dimensions. Given that
traditional tests of reliability are not appropriate (see footnote 7), we test for inter-rater reliability as follows. First,
we group nine of the 16 items that are answered by both informants into the four dimensions of decentralization
(marketing, nancial, operational, and purchasing decisions), because it reduces the number of estimated
parameters and deviations from normality (Hoyle 1995, 70). Specically, each dimension is calculated as an
equally weighted average of corresponding items after normalization, assuming that there is an underlying
continuous variable having a standard normal distribution (Jo reskog and So rbom 1988). Second, we test a model
with six latent variables: the four dimensions of decentralization and two factors capturing informant specic
variance. We constrain item loadings to be equal for both informants. Fit of the model is satisfactory: v
2
18.4, df
10, p 0.05, RMSEA 0.08, GFI 0.96, NNFI 0.92, n 121.
January 2012
Control Variables
We follow prior literature discussed in Section II when identifying relevant control variables.
Most of these control variables below have been validated and used in prior studies. We provide
limited additional information about the reliability and validity of these variables.
Environmental uncertainty (ENVIRON). We use a proxy for noise in BU nancial
performance measures akin to a measure of environmental uncertainty employed by Gul and Chia
(1994). In particular, we ask both BU managers and BU controllers to indicate the predictability of
BUs business environment with regard to competitors actions, market demands, production
technology, product attributes/design, purchasing of supplies, and government regulation.
ENVIRON is an equally weighted average of responses on all 12 items.
The inter-rater reliability of ENVIRON is weak. Correlations between BU managers and BU
controllers responses on the same items range between 0.10 and 0.16 but are not signicant at
conventional levels (p0.14, p0.14, p0.21, p0.12, p0.30, p0.30 following the order of
items in Appendix C). Although this suggests that individual items are noisy, averaging all 12 items
of two different respondents likely alleviates the measurement error problem.
BU growth (GROWTH). We adopt an instrument similar to the one suggested by Gupta and
Govindarajan (1984). We ask respondents about the percentage of total sales for which the strategy
is to increase sales and market share, be willing to accept low returns on investment in the short-to-
medium term, if necessary. To reduce deviations from normality, we calculate the square root of
this percentage.
Interdependencies (INTERDEP). We calculate INTERDEP as the square root of an equally
weighted average of seven items reecting business sharing with other BUs in the same rm in the
following areas: customers, sales force, advertising, plant facilities, advertising, R&D, internal
transfers, and purchasing (Davis et al. 1992).
Past performance (PASTPRF). We measure BU performance relative to budget in the last
year preceding the survey. Respondents indicate BU performance on a seven-point scale ranging
from far below the budget to far above the budget.
Size (SIZE). We calculate SIZE as the natural logarithm of the number of employees in a BU
and include it in our regressions to control for other confounding effects.
V. RESULTS
Descriptive Evidence
Table 1 provides descriptive evidence for our sample. We note that annual bonuses are an
important incentive component for our sample BU managers; bonuses comprise 10 to 65 percent of
BU managers total compensation with an average of 31 percent.
9
The relative incentive weight on
nancial performance measures is 67 percent on average and varies considerably, ranging from 0 to
100 percent for our sample BUs. Most other variables exhibit substantial variation as well. For
example, the median BU has 350 employees, with a minimum of 34 and a maximum of 39,000.
Growth products account for 26 percent of BU sales on average, ranging from 0 to 100 percent. The
scores on our measure of BU interdependencies range from the theoretical minimum of 1 almost to
the theoretical maximum of 7 (based on our scale). Finally, both the mean and median BU
performance is about 4.0, which is labeled on our scale as performance about the same as the
budget.
9
We ask BU managers about the percentage of their total compensation that is paid as a variable bonus (BONUS).
January 2012
The last column of Table 1 measures the importance of rm-level effects in our BU data. The
interclass correlation coefcient, which reects correlation between two randomly drawn BUs
within the same rm, is small (less than 0.2) or not signicantly greater than zero for most of our
variables. The only exception is FIN with a relatively high interclass correlation of 0.45. We
acknowledge that the large rm-level variation in the emphasis on nancial performance measures
may limit the power of some of our tests.
10
Table 2 shows bivariate correlations and Table 3 presents a multivariate examination of the
determinants of the key organizational design choices. Specically, in Table 3 we regress
accounting decentralization, operational decentralization, and the emphasis on nancial
performance measures on the control variables, as follows:
DESIGN
ij
b
0j
b
1
ENVIRON
ij
b
2
GROWTH
ij
b
3
INTERDEP
ij
b
4
PASTPRF
ij
b
5
SIZE
ij
e
ij
; 1
where DESIGN stands for ACCDEC, OPERDEC, or FIN, respectively; the subscript i denotes BU-
TABLE 1
Descriptive Statistics
n Mean Std. Dev. Min. Median Max. q
BONUS 113 30.78 11.14 10.00 30.00 65.00 0.14
FIN 121 67.32 28.03 0.00 66.67 100.00 0.45
ACCDEC 121 4.96 1.22 1.00 5.00 7.00 0.19
OPERDEC 121 4.78 0.76 2.44 4.81 6.25 0.15
ENVIRON 121 3.27 0.61 1.00 3.25 5.00
GROWTH 121 25.94 24.25 0.00 20.00 100.00
INTERDEP 121 2.88 1.03 1.00 2.86 6.14
PASTPRF 118 4.19 1.95 1.00 4.00 7.00
SIZE 121 1,059 3,641 34.00 350 39,000 0.19
Reported statistics for the data are before transformations. For ACCDEC this means that descriptive statistics pertain to
the average of the seven underlying items (see Appendix C) rather than to the (less informative) average of standardized
scores actually used in Tables 24. Three missing values for GROWTH are replaced using the mean of BUs in the same
business group. There are eight missing values in BONUS (not replaced).
q is the interclass correlation coefcient that estimates the proportion of variance accounted for by rm-level effects. It is
equal to the correlation between variable scores of two randomly drawn BUs within the same rm (Snijders and Bosker
1999). q is not reported when the null hypothesis of no rm-level effect cannot be rejected.
Variable Denitions:
BONUS BU managers bonus as a percentage of total compensation;
FIN relative incentive weight on nancial performance measures;
ACCDEC accounting decentralization (BU authority to design local accounting systems);
OPERDEC operational decentralization;
ENVIRON perceived environmental uncertainty;
GROWTH BU growth opportunities (sales of growth products as a percentage of total sales);
INTERDEP interdependencies;
PASTPRF prior years performance relative to budget; and
SIZE number of employees.
10
The large interclass correlation for FIN arises in part because one of our rms sets bonus weights on nancial
performance measures at 100 percent for all its BUs in our sample. Excluding this rm and all its BUs from our
sample does not qualitatively affect our results.
January 2012
level observations, and the subscript j 1,. . .,7 denotes rms. To account for clustering of BUs
within rms, we include rm-specic intercepts and allow for rm-specic error terms by means of
the weighted least squares (WLS) estimation technique.
11
We also estimate standard errors robust
to data clustering.
12
Below, we selectively highlight some of the results from Tables 2 and 3.
Table 2 shows that BU managers in larger BUs receive greater bonuses on average, and these
bonuses tend to be based relatively more on nancial performance measures. Both Table 2 and 3
further suggest that BUs operating in uncertain environments tend to have more centralized
operations, consistent with our interview-based evidence suggesting that corporate executives are
more involved with BU operations when the potential for negative surprises is greater. High
environmental uncertainty is also associated with limited BU authority to design accounting
systems. To the extent that uncertain operating environments encourage the recording of
discretionary accruals, such as provisions for future losses, bad debt write-offs, etc., rms may nd
it necessary to limit BU discretion over such accounting choices. Finally, Table 3 shows that,
controlling for rm xed effects, the emphasis on nancial performance measures is relatively high
in BUs that performed poorly in the past.
TABLE 2
Pearson Correlations
BONUS FIN ACCDEC OPERDEC ENVIRON GROWTH INTERDEP PASTPRF
FIN 0.32**
ACCDEC 0.04 0.29**
OPERDEC 0.15 0.14 0.33**
ENVIRON 0.05 0.13 0.23* 0.26**
GROWTH 0.06 0.05 0.13 0.05 0.04
INTERDEP 0.07 0.13 0.12 0.05 0.06 0.15
PASTPRF 0.01 0.07 0.02 0.01 0.11 0.22* 0.06
SIZE 0.26** 0.21* 0.04 0.00 0.01 0.08 0.10 0.05
*, ** Denotes signicance at the 0.05 and 0.01 levels (two-tailed), respectively.
Variable Denitions:
ACCDEC accounting decentralization;
SIZE log of the number of employees.
11
WLS, also referred to as feasible generalized least squares (Greene 2000), is an iterative procedure that obtains
consistent estimates of rm-specic error variances and uses them in a subsequent step as weights to calculate
coefcient estimates. Alternatively, we also consider corner solution models that take into account that FIN
cannot exceed the value of 100. In particular, we estimate a Tobit model and also a less restrictive Cragg double-
hurdle model and obtain qualitatively similar results (Cragg 1971; Wooldridge 2002).
12
Clustered standard error estimates have to be interpreted with caution given the small number of clusters in our
sample. Our inferences in all our tests remain qualitatively unchanged when we use standard errors without
clustering.
January 2012
Test of Hypotheses
We follow prior literature and test our hypotheses about complementarities in organizational
design by estimating conditional correlations among the three organizational design variables
(Arora and Gambardella 1990; Arora 1996; Athey and Stern 1998). Table 4 implements conditional
correlation tests using the error terms from regressions estimated in Table 3, which holds the effect
of control variables constant. To account for clustering of BUs within rms, the correlations and
standard errors in Table 4 are estimated by means of nonparametric block bootstrapping (Cameron
and Trivedi 2005).
Consistent with H1, Table 4 reports a signicant positive association (p 0.04) between
OPERDEC and ACCDEC. We stress that OPERDEC is based on BU managers responses, while
ACCDEC is based on BU controllers responseshence, this positive correlation is not an artifact
of the common method bias. Rather, it suggests that the decision-making benets of operational
decentralization are best harnessed when BUs also have the authority to design their accounting
systems.
Consistent with H2, Table 4 reports a signicantly negative association (p 0.04) between
accounting decentralization and the relative incentive weight on nancial performance measures.
The theory motivating H2 attributes this nding to the effect of increasing BU managers private
information about the drivers of nancial performance measures. Greater BU authority to design
TABLE 3
Weighted Least Squares Model of the Relative Incentive Weight
on Financial Performance Measures
Variables ACCDEC OPERDEC FIN
ENVIRON 0.76*** 0.27*** 1.73*
(0.001) (0.008) (0.058)
GROWTH 0.06 0.02 0.51
(0.498) (0.352) (0.168)
INTERDEP 0.88** 0.13 0.54
(0.016) (0.658) (0.857)
PASTPRF 0.04 0.03 1.28**
(0.704) (0.315) (0.012)
SIZE 0.16 0.01 0.18
(0.264) (0.949) (0.812)
Adjusted R
2
0.14 0.14 0.38
Adjusted R
2
(excl. xed effects) 0.04 0.04 0.03
n 120 120 118
*, **, *** Denotes signicance at the 0.10, 0.05, and 0.01 levels, respectively. Two-tailed p-values are reported in
parentheses (based on standard errors robust to clustering of data).
Variable Denitions:
January 2012
local accounting systems makes it easier for BU managers to generate favorable BU performance,
as measured by their accounting system. Consequently, greater accounting decentralization reduces
the contracting value of nancial performance measures relative to nonnancial or qualitative
performance measures that do not directly depend on accounting choices.
Finally, Table 4 suggests that operational decentralization (OPERDEC) is not signicantly
related to the relative incentive weight on nancial performance measures (p 0.97). This result
provides little support for suggestions in the prior literature that the aggregate nature of nancial
performance measures makes them relatively more useful for contracting in decentralized
environments (Prendergast 2002; Moers 2006; Raith 2008). However, given that operational
decentralization goes hand-in-hand with accounting decentralization, our tests may simply lack
power to detect both the negative effect of ACCDEC on FIN as well as the positive effect of
OPERDEC on FIN.
We also test H1H3 using the usual regression approach, but with more structure regarding
how rms make organizational design choices. In particular, we assume that operational
decentralization is the most fundamental choice among the decision variables considered in this
study and is determined only by exogenous characteristics of a BUs environment. That is, we
assume that operational decentralization is predetermined at the time a rm considers the extent of
accounting decentralization. Furthermore, we assume that both operational and accounting
decentralization are predetermined at the time a rm considers the importance of various
performance measures. Using these assumptions, Table 5 estimates WLS models of accounting
decentralization and the emphasis on nancial performance measures.
Overall, the results in Table 5 closely parallel those in Tables 3 and 4. As before, we nd a
signicantly positive association between ACCDEC and OPERDEC (p 0.06), as well as a
negative association between ACCDEC and FIN (p 0.02). We also fail to nd support for H3,
which predicts a positive association between FIN and OPERDEC. In addition, the last column of
Table 5 shows that the relative incentive weight on nancial performance measures is lower when
TABLE 4
Conditional Correlations among Organizational Design Choices
Predicted Sign ACCDEC Predicted Sign OPERDEC FIN
ACCDEC 1.00
(0.000)
120
OPERDEC H1: 0.18** 1.00
(0.042) (0.000)
120 120
FIN H2: 0.19** H3: 0.00 1.00
(0.043) (0.969) (0.000)
118 118 118
** Denotes signicance at the 0.05 level.
Tabulated is the Pearson correlation of error terms from regressions in Table 3. Correlations and corresponding two-
tailed p-values (in parentheses) are estimated using a nonparametric block bootstrap reecting clustering of BUs within
rms.
Variable Denitions:
OPERDEC operational decentralization; and
FIN relative incentive weight on nancial performance measures.
January 2012
BU managers describe their business environment as more uncertain (p , 0.01). To the extent that
uncertain environments imply greater volatility of nancial performance measures and lower
informativeness relative to nonnancial performance measures, this result is consistent with
standard agency predictions (e.g., Keating 1998). Moreover, we nd that the relative weight on
nancial performance measures is high when BU performance relative to prior years budget is poor
(p 0.02). This nding is consistent with prior literature suggesting that poor performance makes
nancial performance measures relatively more congruent with the goal of rm survival and
nancial protability (Ittner et al. 1997; Ittner and Larcker 2002; Matejka et al. 2009). Finally, we
nd that BU growth, another potential proxy for informativeness of nancial performance, is not
related to the relative incentive weight on nancial performance measures.
In summary, the evidence in Tables 4 and 5 is inconsistent with overall complementarity
among the three organizational design choices. We nd that accounting and operational
decentralization are complements, while accounting decentralization and the emphasis on nancial
performance measures are substitutes. These two ndings combined imply that the positive
association between FIN and OPERDEC predicted by H3 is attenuated by an indirect negative
TABLE 5
Weighted Least Squares Model of Accounting Decentralization and the Relative Incentive
Weight on Financial Performance Measures
Variables Predicted Sign ACCDEC Predicted Sign FIN
ACCDEC H2: 1.74**
(0.021)
OPERDEC H1: 0.52* H3: 0.17
(0.055) (0.911)
ENVIRON 0.59** 3.25***
(0.036) (0.000)
GROWTH 0.08 0.29
(0.408) (0.582)
INTERDEP 0.75** 0.60
(0.038) (0.861)
PASTPRF 0.02 1.12**
(0.868) (0.017)
SIZE 0.15 0.04
(0.235) (0.968)
Adjusted R
2
0.16 0.39
Adjusted R
2
(excl. xed effects) 0.11 0.07
n 120 118
*, **, *** Denotes signicance at the 0.10, 0.05, and 0.01 levels, respectively.
Two-tailed p-values are reported in parentheses (based on standard errors robust to clustering of data).
Variable Denitions:
January 2012
effect through ACCDEC (Milgrom and Roberts 1990). Thus, lack of complementarity at least partly
accounts for the weak bivariate association between operational decentralization and the emphasis
on nancial performance measures. In conclusion, although accounting and operational
decentralization are complements, they likely have different implications for the emphasis on
nancial performance measures.
Robustness Checks and Additional Evidence
To assess the robustness of our main results, we consider several alternative ways to measure
rms choices of performance measures. In particular, we reestimate the empirical model in (1)
using as the dependent variable: (i ) the relative incentive weight on nonnancial performance
measures (NONFIN), (ii ) the percentage of bonus determined subjectively (SUBJECTIVE), and
(iii ) a modied version of FIN incorporating higher-level performance measures.
13
As discussed
below, our results largely corroborate earlier ndings in Table 5.
Consistent with the motivation behind H2, the results in Table 6 suggest that accounting
decentralization is positively associated both with the relative incentive weight on nonnancial
performance measures (p , 0.01) and with the percentage of bonus determined subjectively (p ,
0.01). Regarding H3, we nd that operational decentralization is not associated with the relative
importance of nonnancial targets (p 0.94), but is negatively related to subjectivity (p 0.07).
One explanation is that subjectivity is more effective than explicit nonnancial targets when
motivating effort in centralized environments.
In untabulated analyses, we also reestimate (1) after adding the percentage of bonus depending
on higher-level nancial performance measures to the denominator of FIN. This specication
assumes that group- or rm-level performance measures are more like nonnancial performance
measures, in the sense that BU authority to design local accounting systems provides BU managers
little knowledge about the drivers of higher-level nancial measures. Consistent with Table 5, we
nd a signicant negative association with accounting decentralization (p 0.01) using this
alternative specication.
Next, we present additional evidence regarding the relation between overall incentive strength
(BONUS) and the other three organizational design variables. As before, we rst estimate
conditional correlations as in Table 4 (untabulated). We nd strong conditional correlation between
incentive strength and operational decentralization (p , 0.01) and somewhat weaker associations
between incentive strength and accounting decentralization (p 0.11) and incentive strength and
the emphasis on nancial performance measures (p 0.11).
Second, in Table 7, we also estimate WLS models of incentive strength as measured by
BONUS, similar to those in Table 5. Column (1) shows that neither accounting nor operational
decentralization are signicant at conventional levels when included as regressors jointly. In
contrast, Columns (2) and (3) show that operational decentralization (p 0.05), as well as
accounting decentralization (p 0.05), are signicant when regressed separately. We further nd
that BONUS is associated with size and interdependencies. While prior research suggests that
13
For a large number of our sample observations, NONFIN and SUBJECTIVE equal zero, which calls for
estimation models, allowing for corner solution outcomes. The results in Table 6 are estimated using the Cragg
double-hurdle model, which simultaneously estimates the probability of non-zero incentive weights and the
expected incentive weights conditional on including nonnancial performance measures (allowing for subjective
evaluations) in bonus plans (Cragg 1971; Smith and Brame 2003). Given that our theoretical framework pertains
to the magnitude of incentive weights rather than to institutional forces allowing or precluding the use of
nonnancial measures (subjectivity) in bonus plans, Table 6 presents only parameters describing the
(conditional) expected incentive weights. The results should be interpreted with caution given the difculty of
estimating such limited dependent variable models with relatively small samples.
January 2012
interdependencies affect the choice of performance measures rather than incentive strength (e.g.,
Bouwens and van Lent 2007), it is plausible that interdependencies proxy for the high marginal
product of BU managers effort in our sample and thus are associated with greater incentive
strength.
VI. SUMMARY AND CONCLUSIONS
We study the use of nancial and nonnancial measures in business unit (BU) managers
bonus plans and how the design of internal accounting systems affects the choice of performance
measures. We nd that managers in some BUs have considerable discretion over internal
accounting choices, while internal accounting choices in other BUs are largely centralized. We
examine how this variation in accounting decentralization relates to operational decentralization and
the emphasis on nancial performance measures in BU managers bonus plans.
Our ndings contribute to a stream of prior research examining how private information affects
rms organizational design choices. First, we nd that accounting decentralization is negatively
TABLE 6
Models of the Relative Incentive Weight on Nonnancial Performance Measures and the
Percentage of Annual Bonus Determined Subjectively
Variables NONFIN SUBJECTIVE
ACCDEC 4.01*** 3.10***
(0.008) (0.000)
OPERDEC 0.32 6.52*
(0.937) (0.073)
ENVIRON 2.07 4.80**
(0.616) (0.012)
GROWTH 0.91 1.01
(0.558) (0.598)
INTERDEP 2.38 13.58
(0.365) (0.622)
PASTPRF 0.74 0.78
(0.647) (0.746)
SIZE 3.88 2.40
(0.385) (0.830)
r 22.37 17.66
n 118 118
*, **, *** Denotes signicance at the 0.10, 0.05, and 0.01 levels, respectively.
Two-tailed p-values are reported in parentheses (based on standard errors robust to clustering of data). Estimated using
the Cragg double-hurdle model. For brevity, rst hurdle results and rm-specic intercepts are not reported.
Variable Denitions:
NONFIN relative incentive weight on nonnancial performance measures;
SUBJECTIVE percentage of bonus that is determined subjectively (without ex ante targets);
January 2012
associated with the emphasis on nancial performance measuresi.e., when BU managers have
considerable authority to make internal accounting choices, their bonus plans are less sensitive to
nancial measures of BU performance and more sensitive to nonnancial measures or subjective
evaluations. Second, we nd that accounting decentralization is positively associated with
operational decentralization. Finally, we nd no signicant association between operational
decentralization and the emphasis on nancial performance measures, although there is some
evidence that managers of decentralized BUs are less likely to be evaluated subjectively.
Taken together, our ndings are inconsistent with complementarity among accounting
decentralization, operational decentralization, and the emphasis on nancial performance measures.
For instance, our ndings imply that the hypothesized positive association between operational
decentralization and the emphasis on nancial performance measures is attenuated by an indirect
negative effect due to the positive link between accounting and operational decentralization. To our
knowledge this is the rst study to provide empirical evidence suggesting that complementarity
among several organizational design choices does not hold. In contrast, most prior empirical studies
narrowly focus on only one or two variables that are part of a broader set of organizational design
TABLE 7
Weighted Least Squares Model of Overall Incentive Strength
Variables (1)
BONUS
(2) (3)
ACCDEC 0.77 1.08**
(0.196) (0.046)
OPERDEC 3.06 3.56**
(0.122) (0.047)
ENVIRON 1.58 0.92 1.03
(0.299) (0.501) (0.432)
GROWTH 0.33 0.39 0.33
(0.238) (0.117) (0.231)
INTERDEP 5.76** 4.08* 5.65**
(0.045) (0.096) (0.043)
PASTPRF 0.19 0.34 0.26
(0.739) (0.512) (0.662)
SIZE 1.15 1.34* 1.20
(0.122) (0.060) (0.125)
Adjusted R
2
0.17 0.12 0.15
Adjusted R
2
(excl. xed effects) 0.04 0.02 0.04
n 112 112 112
*, ** Denotes signicance at the 0.10, and 0.05 levels, respectively.
Two-tailed p-values are reported in parentheses (based on standard errors robust to clustering of data).
Variable Denitions:
January 2012
choices and disregard potentially important indirect effects arising due to complementary or
substitute relations among organizational design choices. At a minimum, our results call for the
exercise of greater caution for researchers who seek to understand rms myriad organizational
design practices.
Finally, we acknowledge a number of caveats to our study. First, we use a nonrandom sample
of BUs owned by seven multinational rms headquartered in The Netherlands. Second, our main
organizational design variables are complex constructs that can only be measured with error. Third,
due to space limitations on our survey questionnaire, we have only a limited set of control variables.
Thus, to the extent that our set of control variables is not exhaustive or measured with error, our
results may be subject to correlated omitted variable problems. Despite these limitations, we believe
our data and analyses are uniquely suited to inform future research on incentives, decentralization,
and other key organizational design choices.
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January 2012
APPENDIX A
THEORETICAL MODEL
In this appendix, we show how Hypotheses 2 and 3 can be motivated by agency models similar
to the predecision private information models of Baker (1992), Bushman et al. (2000), and Baker
and Jorgensen (2003). We begin with a somewhat general model that allows for multiple
performance measures and multidimensional private information. We then solve for special cases
that motivate our hypotheses.
General Model
We consider a business unit (BU) whose contribution to the rm (or principal) is represented
by Vve, where e is a BU-specic task and v is uncertain BU productivity with v ;Nl; r
2
v
. The
rm delegates the task e to a BU manager or agent, who is (weakly) risk-averse with negative
exponential utility with risk-aversion parameter r 0, and who can perform the task at a cost equal
to
1
2
e
2
. We assume e is one-dimensional although we can easily consider multi-dimensional tasks

as well.
We assume that neither the task, e, nor the outcome, V, is directly observable and contractible.
Instead, we assume the rm pays the BU manager compensation, W, via a linear contract using a set
of performance measures p as Wa b
0
p where a is the xed component of compensation, b is a
vector of incentive coefcients, and p (p
1
, p
2
,. . .)
0
is a vector of performance measures. Let p
ee, where the vector e (e
1
, e
2
,. . .)
0
captures the tasks uncertain marginal impact on the set of
performance measures.
14
The elements of e are joint-normally distributed with mean vector l
p
and
variance-covariance matrix R
pp
. Note that since V is not contractible, v is not an element of e;
however, v may be (imperfectly) correlated with e.
A central feature of our model is that a BU manager is more informed about his/her working
environment than anyone else in the rm. We assume that, after accepting employment but prior to
performing task e, the BU manager privately observes a vector of information signals y whose
elements are informative about what drives the BUs contribution to rm value V as well as what
drives his/her performance measures p. In particular, we assume that y is normally distributed with
mean vector l
y
, variance-covariance matrix R
yy
, covariance between y and v given by the vector R
vy
(c
v1
,c
v2
,. . .)
0
6 0, and covariance between y and e given by R
py
6 0.
15
A nonzero c
vy
implies that
the BU manager has private decision-facilitating information in the sense implied by Baiman and
Demski (1980), whereas a nonzero R
py
implies that the BU manager has private information about
what drives his/her reported performance.
Finally, we note that because the BU manager does not observe y prior to accepting
employment, his/her decision to accept the contract must reect the expectation that s/he will
observe y prior to performing task e. That is, his/her participation constraint need only hold on
average, rather than for each possible observation of y. In contrast, the BU managers incentive
compatibility constraint must be met for each observation of y because s/he performs e after s/he
observes y.
Given the assumptions above, we can characterize the rms choice of an optimal linear
contract as follows:
14
We can also characterize p ee gg where g represents a gaming or a window-dressing activity and the
( potentially random) g
i
s represent the marginal impact of gaming activities on the performance measures. This
characterization of p is qualitatively similar to our model (see also Courty and Marschke 2003).
15
In what follows, and without loss of generality in our single task setting, we rescale the elements of y as well as e
so that the elements of both l
y
and l
p
are equal to l.
January 2012
Proposition 1: The optimal linear compensation contract is characterized by a vector of
coefcients b that solve the following:
]p
]b
EEejyv EEejye
0
b rXb 0; 1
where:
X b
0
EEejyvVarejy
b
0
R
py
R
1
yy
R
0
py
b
1 rb
0
R
pp
b
!
EEejye
0
1 rb
0
Varejyb
1 rb
0
R
pp
b
R
py
R
1
yy
R
0
py
bb
0
1 rb
0
R
pp
b
!
ll
0
: 2
Proof of Proposition 1
After observing y, the manager chooses effort e to maximize his/her certainty equivalent:
MAX
e
Ea b
0
pjy e
2
=2
r
2
Vara b
0
pjy: = 3
The solution to (3) is given by:
e
y
b
0
Eejy
1 rb
0
Varejyb
; 4
where:
Eejy l R
py
R
1
yy
R
0
py
and Varejy R
pp
R
py
R
1
yy
R
0
py
:
The second order condition equals 1 rb
0
Varejyb ,0:
Because at the time of signing the contract, neither the rm nor the manager has any
information about the state of the world, we have:
E expra b
0
p e
2
=2

expr

U; 5
where

U is the managers certainty equivalent opportunity wage. Without loss of generality, we
assume

U 0. Since p ee and e is given by (4), the left-hand side of (5) can be restated as:
E exp r a
b
0
Eejye
0
b
1 rb
0
Varejyb

1
2
b
0
EejyEejy
0
b
1 rb
0
Varejyb
2
( ) ! " #
: 6
Because y and e are joint normally distributed, the expectation in (6) can be computed directly so
that (5) can be restated as:
a
1
2
b
0
ll
0
b
1 rb
0
R
pp
b

1
2r
ln
1 rb
0
R
pp
b
1 rb
0
Varejyb

0: 7
For the rm, the optimal linear contract solves the following maximization problem:
MAX
b
Eve
y Ea b
0
p; 8
where e*(y) is given by (4) and a is given by (7). Substituting for e*(y) and a, the rms objective
function can be restated as the following unconstrained maximization problem:
January 2012
MAX
b
b
0
EEejyv EEejye
0
b f g
1 rb
0
Varejyb
1
2
b
0
ll
0
b
1 rb
0
R
pp
b

1
2r
ln
1 rb
0
R
pp
b
1 rb
0
Varejyb

: 9
The rst-order condition of this maximization problem, given by expression (1), is a higher-
order polynomial in b with at least one positive solution. To establish that the solution to (1) is a
unique maximum in the positive domain, the second-order condition requires that the Hessian
matrix
]
2
p
]bb
0 be negative semidenite for all b . 0. We have:
]
2
p
]bb
0
EEejye
0
rZ; 10
where both E[E(ej y)e
0
] and Z are positive semidenite matrices (details on Z are available from the
authors). Hence, it follows that the Hessian in (10) is negative semidenite in the positive domain
and thus b . 0 that solves (1) is a unique maximum. n
Special Cases
While expression (1) provides a general characterization of the optimal linear contract, in what
follows we present a series of specic illustrations assuming that the manager is risk-neutral,
observes two information signals, and is evaluated based on two performance measures. Although
these illustrations are with some loss of generality, they facilitate a comparison of our results with
the prior literature and help motivate our empirical predictions.
To describe the managers information signals, let y (y
1
,y
2
)
0
, R
vy
(c
v1
,c
v2
)
0
, and assume that
R
1
yy

s
1
0
0 s
2

. For expositional ease, we label the performance measures p
n
ne for
nonnancial and p
f
f
e for nancial, so that we can represent R

0
py
as
r
n1
r
n2
r
f 1
r
f 2

. To assess
the usefulness of a representative signal y
i
, i 1,2, on its own, we assume the other signal is
uninformative and derive from Proposition 1 that the incentive coefcients are b
n

c
vi
r
fi
r
ni
r
fi
and
b
f

c
vi
r
ni
r
fi
r
ni
. These coefcients reect a trade-off between the decision benets of signal y
i
(through
the term c
vi
) and the costs of observing such information in the event that y
i
is informative about the
performance measures (through the terms r
ni
and r
). This trade-off suggests the following

denition, which applies even when both signals y
i
, (i 1,2) are informative.
Denition: The decision-orientation of signal y
i
with respect to performance measure p
j
is:
d
p
j
y
i

c
vi
r
\ ji
r
ji
r
\ ji
i 1; 2 j f ; n; 11
where c
vi
is the covariance between BU productivity v and information signal y
i
,
(i 1,2), r
jt
is the covariance between the sensitivity of performance measure j
( j f,n) and information signal y
i
and r
( \ j)i
signies the covariance between the
sensitivity of the other performance measure (i.e., not j) and information signal y
i
.
Note that the decision-orientation of a signal y
i
with respect to performance measure p
j
is
increasing in the extent to which the signal is informative about rm value v and decreasing in the
extent to which the signal is informative about measure p
j
, both adjusted for the extent to which the
signal is informative about the other performance measure.
The denition in (11) will prove useful in assessing how the quality of predecision information
affects incentive coefcients. In particular, to provide a basis for our empirical hypotheses below,
we analyze how an increase in s
i
, the precision of signal y
i
, affects the relative incentive weight on
the nancial performance measure p
f
. We have:
January 2012
Observation: The relative weight on p
f
increases with information precision s
i
if, and only if,
the decision-orientation of signal y
i
(with respect to p
f
) exceeds the decision-
orientation of the other signal (with respect to p
f
), i.e.:
sign of
d
b
f
b
n

ds
i
d
p
f
y
i
d
p
f
y
k

c
vi
r
ni
r
fi
r
ni

c
vk
r
nk
r
fk
r
nk

i; k 1; 2; i 6 k: 12
Thus, an increase in the precision of an information signal increases (decreases)
the relative emphasis on a performance measure if the signal is relatively more
(less) decision-oriented than the alternative signal(s).
The intuition underlying this observation also extends to a setting where one of the
performance measures is insensitive to predecision information. For example, let p
n
le and
p
f
f
e, so that R
0
py

0 0
r
f 1
r
f 2

. This example is in the spirit of Raith (2008), who considers
a similar principal-agent setting in which an agent is evaluated based on two performance measures.
The rst is an input measure that is informative about managerial effort but is insensitive to
predecision information, p
n
. The second is an output measure that reects both managerial effort
and predecision information, p
f
. It follows that the right-hand side of (12) simplies to
c
vi
r
fi
c
vk
r
fk
;
which is positive (negative) if the decision-orientation of signal y
i
with respect to performance
measure p
f
is greater (less) than the decision-orientation of signal y
k
. Finally, we note that the
general intuition underlying our observation in (12) extends directly to settings where y is multi-
dimensional.
Motivation of Hypotheses
As discussed in the introduction, the theoretical construct that underlies both accounting and
operational decentralization is the presence of local private information. To motivate H2, we
characterize accounting decentralization as the precision of a predecision information signal or a
set of signals with low decision-orientation in the sense described above. That is, we view
accounting decentralization as an information signal i with precision s
i
with lower decision-
orientation c
vi
/r
than other sources of information that have decision-orientation c

vk
/r
fk
. In
particular, because greater authority to make accounting decisions conveys knowledge about the
drivers of reported nancial (or output-based) performance measures unobtainable from other
sources, we expect r
to be typically much larger than r

fk
. Hence, even though accounting
decentralization also enhances decision-making (i.e., c
vi
is nonzero), we predict that greater
accounting decentralization will be associated with a lower weight on nancial or output-based
performance measures.
To motivate H3, we characterize operational decentralization as the precision of a predecision
information signal or a set of signals with higher decision-orientation than other sources of
information in the sense described above. This is because delegation of operating decision rights
invariably implies superior knowledge and information about the rms key success factors. Hence,
following our observation above, we predict that greater operational decentralization, correspond-
ing to an increase in the precision of a signal with high decision-orientation, will be associated with
a higher weight on nancial or output-based performance measures.
January 2012
APPENDIX B
FIELD EVIDENCE
Prior to conducting our survey, we collected extensive eld evidence from each of the
participating rms through interviews with controllers and internal audit or consolidation managers
at corporate (23 interviews), business group (11), and business unit (BU) (14) level. Maas and
Matejka (2009) also draw from this eld evidence and describe the data-collection process in more
detail.
The reporting structure of all seven rms participating in our surveys was very similar. Each
rm had a corporate reporting manual that required BUs to supply basic accounting data for
consolidation and external reporting purposes. Typically, the corporate manual went only slightly
beyond GAAP rules in terms of data requirements and the detail of denitions. However, all seven
rms were organized into business groups and that structure sometimes called for a signicant
amount of additional reporting from BUs.
We present selected quotes from survey participants that shed more light on how rms
determine the extent of accounting decentralization and why such accounting decentralization may
vary across BUs within the same rm or even within the same business group. One business group
controller highlighted the importance of growth as a factor in explaining why local accounting
systems are decentralized: We do not issue rules for indirect costs. We leave it up to the local
management at the moment. It is because of our history. We are quite young and concentrate on
growth more than standardization . . . We do not want to stress these problems now.
Another business group controller emphasized the lack of synergies among BUs as a factor
contributing to greater accounting decentralization: We have got several specialized BUs, all of
which have their own business drivers and performance indicators. It is quite difcult to
consolidate. That is why we have said: Let everybody simply report in their own way, the way they
think is most valuable to them, and if they think they have enough information, then it must be the
case that a higher level also has enough information. Given that growth and lack of synergies are
also often associated with greater operational decentralization (Nagar 2002; Bouwens and van Lent
2007), these remarks suggest that accounting decentralization and operational decentralization often
coincide.
Several interviewees also highlighted that individual characteristics of controllers and
managers affected the translation of formal reporting requirements into practice. For instance, a
BU controller commented on the difference in accounting decentralization between his/her current
and former employer: There were manuals in [prior employer] too, but they just were not as
important as they are within [current employer]. Here they are really emphasized and often referred
to, then they become an important document . . . I think that it is the inuence of the business group
controller. Similarly, a corporate controller noted: You can arrange things formally very well but
still personalities of the BU manager and controller are very important . . . With the same formal
rules, even within the same company, you can have gigantic differences.
In summary, accounting decentralization likely varies within rms due to BU and business
group differences in growth, synergies, operational decentralization, and individual characteristics
of controllers and managers involved. The differences in accounting decentralization most
commonly mentioned in our eld interviews refer to the extent of standardization regarding the
denitions and reporting of indirect costs, inventory valuation, performance indicators, and
nancial ratios. We draw on these insights when constructing the survey measure of accounting
decentralization as described in Appendix C.
January 2012
APPENDIX C
QUESTIONNAIRE ITEMS
Incentives
How is your bonus determined? Please indicate the percentage of the total bonus that is decided in a
subjective manner or by using some explicit formula as described below.
Bonus is determined:
_____% by using nancial performance formula based on performance of your business unit.
_____% by using nancial performance formula based on performance of several BUs or the whole rm.
_____% by using some explicit nonnancial formula.
_____% subjectively (without any explicit formula).
_____% __________________________________.
100 %
Variable bonus is about ________% of the total compensation.
How is authority divided between your business unit and higher levels when a decision to change
the following accounting techniques and reporting procedures is made?
Allocation of manufacturing overhead
Allocation of marketing costs
Transfer prices for transactions within your BU
Expensing versus capitalizing costs (e.g., provisions, writing-off receivables)
Inventory valuation
Budgeting process within your business unit
Short-range nancial planning

Scale:
1 Decision is taken at our business unit without consulting higher levels.
7 Decision is taken at higher levels without consulting our business unit.
The items have been reverse-coded.
How is authority divided between your business unit and some higher level for each of the
following classes of decisions?
The price of the output
The extent and type of market to be aimed for
To determine a new product or service
Level of advertising expenditures
To make a major capital investment
To decrease working capital
Management of nancial risk
To spend unbudgeted money on capital items
To take long-term loans
The hiring and ring of managerial personnel
Salaries of managerial staff

January 2012
Training methods to be used
To create a new job
To create a new department
Which suppliers are to be used
Buying procedures
Scale:
1 Decision is taken at our business unit without consulting higher levels.
7 Decision is taken at higher levels without consulting our business unit.
The items have been reverse-coded.
Noise in BU Financial Performance Measures
How predictable are the following factors in the environment of your business unit?
Competitors actions
Market demands
Production technology
Product attributes/design
Purchasing of supplies
Government regulation
Scale:
1 Highly predictable.
7 Highly unpredictable.
BU Growth Opportunities
Given below are descriptions of several alternative strategies. Depending upon the context, each of
these descriptions may represent the strategy for all or only a fraction or none of a companys
products/services. Please indicate below what percentage of your current total sales is accounted for
by products/services represented by each of these strategy descriptions. Your answers should total
100%.
Increase sales and market share, be willing to accept low returns on investment in the
short-to-medium term, if necessary
_____%
Maintain market share and obtain reasonable return on investment _____%
Maximize protability and cash-ow in the short-to-medium term, be willing to sacrice
market share, if necessary
_____%
None of the above (please specify) _____%
Total 100 %
Interdependencies
To what extent does your business unit share business with other companies in the rm?
Customers
Sales force
Plant and equipment facilities
Advertising and promotional efforts
Research and development efforts
Internal product transfers
Raw material purchases

January 2012
Scale:
1 Sharing of business in this area occurs very rarely.
7 Sharing of business in this area occurs almost always.
Past Performance
What was the performance of your business unit in the last three years relative to your budget?
Scale:
1 Far below the budget.
4 About the same as the budget.
7 Far above the budget.
January 2012
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THE ACCOUNTING REVIEW American Accounting Association

Vol. 87, No. 1 DOI: 10.2308/accr-10168

. We assume e is one-dimensional although we can easily consider multi-dimensional tasks

e for nancial, so that we can represent R

). This trade-off suggests the following

than other sources of information that have decision-orientation c

to be typically much larger than r

Allocation of manufacturing overhead

Allocation of marketing costs

Transfer prices for transactions within your BU

Expensing versus capitalizing costs (e.g., provisions, writing-off receivables)

Budgeting process within your business unit

Short-range nancial planning

The price of the output

The extent and type of market to be aimed for

To determine a new product or service

Level of advertising expenditures

To make a major capital investment

To decrease working capital

Management of nancial risk

To spend unbudgeted money on capital items

To take long-term loans

The hiring and ring of managerial personnel

Salaries of managerial staff

Training methods to be used

To create a new job

To create a new department

Which suppliers are to be used

Plant and equipment facilities

Advertising and promotional efforts

Research and development efforts

Internal product transfers

Raw material purchases

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