Friday, March 16, 2018

Do Auditors Prevent Fraud by Firms? It Depends

The relationship between an auditor and the audited firm has always been interesting. Auditors are supposed to check the firm’s financial accounts and approve them, which lets others such as investors and the state know that the firm is not misrepresenting any information. They have some other duties as well, but you could say that auditors save the investors from seeing artificially high profits and the taxman from seeing artificially low profits. So who hires the auditor, the investors or the state? The firm does. That’s why it gets interesting, because it means that the auditor is implicitly hired to keep the firm within the rules for investors and the state while serving the interests of its management.

In a recent paper in Administrative Science Quarterly, Aharon Mohliver looks at an even more interesting part of this relationship by doing research on the role that auditors played in first condoning, then spreading, and finally extinguishing a questionable practice firms began to use when changes in the tax code affected their ability to pay managers above a $1 million cap without subjecting them to significant tax liabilities. At first the practice was questionable but not illegal, and auditors in some local offices helped their client firms start using it. The findings tell a very informative story of how auditors pay close attention to the interests of the managers who hire them, and also to the fine line between legal and illegal.

The questionable practice is called stock-option backdating. Stock options are often given to managers because they let managers earn higher income if the value of the firm increases, and to make them fair they are often given (for free, of course) at the exact value of the firm on the day they are given. In MBA-speak, those options have upside potential, no downside potential, and are incentive compatible. In plainer words, they reward managers for effective management but don’t punish failure. Firms report the costs of stock options as compensation expenses.

What I just explained is a regular stock option, without backdating. A backdated stock option looks just the same, but in reality it has been assigned an earlier formal date than when it was given, and that formal date somehow turns out to be a day just before the firm had a big increase in value. Through what seems like a very lucky dating of the option, the managers getting the backdated stock option earn significant sums of money not taxed as regular income. Backdated stocks are a trick for compensating managers at the expense of investors. They are a form of fraud, and though they were unethical from the start, initially there were no laws or rules against backdating so they were not yet illegal. (There were no rules because no one making rules had thought of backdating stock options.)

So the auditors stepped in. They spread knowledge of backdating from one client to the next, especially if clients were part of their local and dense communication networks. They were also sensitive to lawmakers, however, so this spreading of backdating was strongest when the uncertainty about the legality of backdating was greatest. When it became more certain that backdating would be made illegal, the auditors stopped spreading the backdating trick, and when it actually became illegal they stopped its use in the firms that had already started using backdating. So, auditors follow written law very well, are neutral to law that will soon happen, and are willing to help management profit from legally questionable conduct. Nice to know if you happen to be a manager, investor, or lawmaker. If you are an auditor you probably know it already.

Mohliver, A. How Misconduct Spreads: Auditors’ Role in the Diffusion of Stock-option Backdating. Administrative Science Quarterly, forthcoming.

Thursday, March 8, 2018

Follow the Money: How Endorsements Influence Entry

Applications are part of life. Some are minor, like applying for a library card; some are consequential, like applying for a job. Often the consequential ones involve selection of a few from many, like applications for work or study admission. We usually think that they should be decided based on merit. Partly this is because we care about fairness, and partly it is because the selection matters for the workplace and the school too, not just for the applicant. Selecting the best should give the best results.

So what exactly is the purpose of having others endorse your application? Maybe you have never done that, but it is common for applicants to have others contact individuals who could sway the decision. Is it a way of cheating, by bypassing the evaluation of merit? Is it a way to get attention so the merit gets considered more carefully? Or is it simply useless? The question is important because so many crucial decisions happen through application processes in which some but not all applicants are endorsed. A recent paper in Administrative Science Quarterly by Emilio J. Castilla and Ben A. Rissing has looked closely at what happens, using applications to an MBA program as their data. The results are interesting.

The dim view of endorsements as saying nothing (good) about quality is at least partly true. The endorsed applicants were sometimes (not always) rated as stronger “on paper” as seen through CVs but often were scored lower than the non-endorsed applicants in interviews. Yet in the end, endorsed applicants were more likely to be selected for program admission – twice as likely, in fact. Clearly, getting endorsed is a good idea for those who are almost good enough to make it based on merit. This is not because their applications are examined more carefully. There was no evidence that the same qualification was discovered more easily when the applicant was endorsed. Instead, the endorsed applicant was more likely to be selected even if his or her qualifications were good but not the best.

Maybe there is something about the endorsed applicants that test scores and interview responses can’t discover? Well, Castilla and Rissing also looked at what happened later. Among those who got admitted, the endorsed applicants were no more likely to receive awards. Or get higher grades. Or get higher salary or signing bonuses in their first jobs. Or have higher salary growth. Essentially they were the same as non-endorsed applicants in their performance after being admitted, both at school and after school.

But there were two differences. One seems minor but is interesting. Endorsed applicants were more likely to lead a student club while in the program. Maybe endorsement is a sign of good citizenship? The other is not minor at all. Endorsed applicants gave larger donations to the school five years after graduation. So in a way, it is better to select endorsed applicants, but it is in a follow-the-money way. They repay the favor of being selected, while those who were selected purely on merit have less reason to pay back – or maybe they have less (family) money.

Castilla, Emilio J., and Ben A. Rissing. 2018. "Best in Class: The Returns on Application Endorsements in Higher Education." Administrative Science Quarterly, forthcoming.

Wednesday, February 28, 2018

Schools Unite, Churches Divide: When Communities Organize to Help

Two of the most powerful organizing efforts following recent shootings are #neveragain following the Marjory Stoneman Douglas High School massacre and #BlackLivesMatter following the shooting of Michael Brown by a police officer. They have something in common that you may not have noticed: they were triggered in homogeneous communities. Parkland, Florida, where the massacre took place, is overwhelmingly white and well-off. Michael Brown was shot in a majority-black neighborhood in Ferguson, Missouri.  Each community came together to mourn the death of their own and to prevent repeats of the same tragedy. Each effort has been very effective, at least in getting media coverage.

I mention these examples because communities don’t always organize effectively, and we have seen in past research that more-homogeneous communities can more easily organize both for self-support and for supporting others. In a recent article in Administrative Science Quarterly, Wesley Longhofer, Giacomo Negro, and Peter W. Roberts test this effect again, and they also look at whether local organizations can unite or divide communities that would not be naturally united. They find that schools unite and churches divide, and the reason is interesting.

We have to start with why diverse communities have difficulty organizing to help. The problem is that when communities have a mix of people with different color, wealth, religion, and other characteristics, people start believing that those who seem different may have different values and ideas of what is good and bad. More and more, people associate with those who are most like themselves, including in community organizations. And as they interact with those who are most like themselves, they continue to strengthen the beliefs that they are different from the rest. The result is a community that is separated in its people, and also in the community organizations that people belong to, like churches, clubs, and associations of many kinds.

Suppose there is a common cause that just about everyone agrees to support. In this research, the common cause was collection of money for UNICEF (the Trick-or-Treat campaign done every year). Many people are in favor of UNICEF, especially if they have children. But it is still the case that homogenous communities organize better and help more because they are more united to begin with. The exception is that campaigns organized by public schools overcome the negative effect of diversity, and even reverse it to make diverse communities more helpful. Public schools are special because they are mandated and (in the USA) are organized to maintain diversity of students, so they span diverse groups of people and help them understand each other. That way, public schools unite diverse communities.
For the same reason, campaigns organized by churches and clubs had less effect in diverse communities. Both are voluntary organizations, so they are exactly the type of place where people interact with those most similar to themselves. Community organizations that reflect the divisions of the community, like churches and clubs, divide efforts to organize help; those that span the divisions of the community, like public schools, unite efforts to organize help. In times with many and deep divisions in communities, it is worth asking what organizations exist that can span different groups and help the community help itself and others.

Tuesday, February 20, 2018

When Networks Merge: The Other Benefit of Firm Acquisitions

Here are two facts we have known for a long time. One is that a firm acquiring another firm combines their assets, and that can give synergies if they have something that works better together than apart. That something can be any kind of asset, by the way, including knowledge or intellectual property. The other is that firms establish and change interfirm networks through forming and dissolving alliances with other firms, and they use alliances to gain synergies too. So far everything sounds conventional and straightforward.

But these two facts don’t tell the whole story. A firm acquiring another firm also combines their networks, and that can create synergies when the combined network is better than the original ones. In fact, it can change a network much more radically than just forming and dissolving alliances one by one. This third fact is the start of an article in Administrative Science Quarterly by Exequiel Hernandez and J. Myles Shaver, but the article does not end there. It also checks whether firms are deliberately choosing acquisition targets based on these network synergies.

The question is important. It speaks to how smart firms are in maneuvering and modifying interfirm networks, which is useful to know, especially because people are not particularly smart in modifying interpersonal networks. But firms are not people, and acquisitions are not normal firm actions – they are analyzed carefully, and networks could be one of the factors taken into account. They could even be more important for acquisitions than some of the assets that researchers have long obsessed over. After all, alliances are observable in advance, like physical assets are, but they are unique and therefore more strategic. The other unique and strategic assets in play are often people with knowledge, but they are known to sometimes leave a firm after it has been acquired, so it is pretty risky to acquire to get people. Alliances usually stay. 

Network synergies are especially potent if they make the combined firm a better broker of knowledge because they connect to firms that are not themselves connected and do not have other shared connections (that’s called gaining structural holes). Brokers of knowledge can help create novelty and can reap more of its benefits. Synergies are also potent if they make the combined firm more central in the overall network, giving it higher status. Pretty much any combination of firm networks will improve brokerage and status, however, so it is not enough to see that this happens after an acquisition. What we need to know in order to look for deliberate choice of network synergy is whether the increase from the firm network that got acquired was better than the increase would have been for other firms that could have been acquired. Strategy is about choices, so a choice has to be compared with what was not chosen. 

This is where Hernandez and Shaver make a fully convincing case for network synergies as an important factor in acquisitions. They studied biotech, where networks are very important, and so are assets like people and intellectual capital. Their analysis is impressive and leaves no doubt that the opportunity to combine networks and gain network synergies was an important factor in the choice of acquisition targets. That means we now have a new way of looking at acquisitions, and we are better able to tell what firms may get acquired, and what they were acquired for. 

Hernandez, E., & Shaver, J. M. Network Synergy. Administrative Science Quarterly, forthcoming.

Wednesday, February 7, 2018

From Tigger to Eeyore: How Gig Economy Workers Cultivate Work Identities

When some people hear the term “gig economy,” they think of temps working for agencies, but that misses 90 percent of the picture. The gig economy consists of people who act as independent workers, contract firm workers, on-call workers, and temporary help agency workers. Fully half are independent workers, and with the gig economy growing fast and now encompassing one-sixth of the U.S. workforce, independent workers have become important in society. But what is it like to be an independent worker in a world of organizations and employees?

An article in Administrative Science Quarterly by Gianpiero Petriglieri, Susan Ashford, and Amy Wrzesniewski finds that the answer is… complicated. The reasons give an interesting look at both the world of employees and the world of independent workers. Studying the world of organizational employees, scholars and observers of society have long been interested in how people’s identities become shaped by their affiliation with an organization, and how some organizations strengthen this and make use of it. The classic book “The Organization Man” by William Whyte was part of a greater conversation on how people’s identities and actions may become too connected to the safety of being in an organization as part of a collective.

If the idea of collectives as capturing and constraining people captured employees’ reality, for independent workers, contracting and independent work should mean freedom and the ability to express one’s individuality. And that should be a good thing. The problem is that Whyte may have been right when he suggested that people like collectives and fear the freedom of individualism. The independent workers interviewed by Petriglieri, Ashford, and Wrzesniewski expressed an unmoored existence with wildly fluctuating emotions – like the Tigger and Eeyore fluctuations that one of them mentioned. They also experienced uncertainty about their personal identity, economic position, and the recognition of their work. All of this because independent workers don’t have an organization as a holding environment that defines their identity, determines their economy, and recognizes their work.

So what do the independent workers do? The key finding is not that they have found one clear solution, but instead that they seize on all sorts of ways to secure their work identities. They make routines for anchoring themselves, not necessarily because the routines help the work. They connect to places where they do the work, almost as a ritual of establishing the place as a context that helps define their individuality. They connect to people who can provide interpretations of what they do and affirmations of who they are. They find ways of connecting their work to higher goals for society, so they can define a purpose of life. Some of their actions are hard to understand for people who work for organizations. I don’t know how a writer can revere the public library as a workspace, but maybe that’s because I don’t know enough about writing. I did software development much earlier in my life, though, and it is a mystery to me that an independent software engineer can describe his home office as a “fighter pilot cockpit” – to me, part of the beauty of software engineering is that it is completely portable, so places are unimportant.

When actions are hard for outsiders to understand, have seemingly precarious links to outcomes, and are highly varied across person, time, and place, they display all the signs of having a function. In this case, the function is to hold on to and cultivate an identity in the absence of a collective, and to manage the emotions that come with independence. We may find that the new economy has many more unmoored people holding onto their identities in ways we’ve not seen before.

Petriglieri, G., Ashford, S. J., & Wrzesniewski, A. 2018. Agony and Ecstasy in the Gig Economy: Cultivating Holding Environments for Precarious and Personalized Work Identities. Administrative Science Quarterly, forthcoming.

Sunday, January 28, 2018

Improving Social Science: What Can Journals and Editors Do?

We all know that correct science is needed for much of what we do. So many parts of our modern world—things we buy, use, or interact with in various ways—are based on science and work as they should only when the science is correct. Social science does not build things, but it teaches us how society works and how it can be improved. This gives value to social science, including to organization and management theory. One could even argue that organization theory has special motivations to be a correct science, because so many parts of our modern world—things we buy, use, or interact with in various ways—are made and operated by organizations and work as they should only when the science of managing is correct.

In an editorial essay in Administrative Science Quarterly,William Starbuck argues that we need to improve social science. The argument has multiple parts, and I will discuss just one here. It is a simple issue with a lot of complications: Research is done by people. People have all sorts of thoughts, feelings, actions, and reactions, which are often different from the cold and objective look at evidence that science calls for.

People want safe jobs, success, and recognition. They often feel under pressure to do well, both from what they want and from rules such as the promotion system we have, which is strongly driven by publications. This drives some of them to deviate from the true reporting of findings, which could involve selective modeling to strengthen findings, holding back findings that go against expectations, making up theory for unexpected findings, or even editing or falsifying data. A very important problem is that many researchers who are selective, hold back, or make up theory believe that they are better than those who edit or falsify. But they are not. Any one of the actions I just mentioned is a misleading departure from scientific standards. We understand why some people do it, but we need them to stop.

People assess scientific results, but they also think about the people doing the science, and that colors their assessment because people have stronger feelings about people than they have about scientific findings. Much of social science is aware of this effect and tries to shield authors through double blind review, to hide their identity from those who assess them. The fields that don’t do this end up rewarding the already famous over and over again. But double blind is not enough. People are good readers and can make all sorts of guesses about who the writer is, or at least what kind of person the writer is. The guesses are
usually accurate, but the assessments that follow the guesses are biased and disadvantage those who have low status. We understand why some assessments are shaped by status, but we need it to stop.

When people make the science, with bias, and people assess the science, with bias, how can we improve it? Starbuck has a wide range of suggestions that can help improve our procedures. At ASQ we are thinking carefully about these problems, and we have wondered whether part of the problem is that the evidence is not presented with enough appeal and transparency. We have changed our invitation to contributors to encourage more display of data before showing models and to encourage using graphical approaches that show the reader exactly how much is explained by the theory and how much is not yet explained. I have also written a blog post on this issue. People will still be people. The solution has to involve better procedures, including those that allow the data we work with to become more prominent.

Thursday, January 11, 2018

Between Guardrails: How Organizations Handle Mission Contradictions

Digital Divide Data (DDD) is a commercial enterprise doing data-entry work for profit. It is also a social enterprise that trains Cambodians to obtain better jobs than the ones they do for DDD. Is that a contradiction? Maybe it is not fully contradictory but instead just a tension—one that many social enterprises handle because they need to sustain themselves commercially, not just do good work. We have long known that the dual purpose of social enterprise is seen as a contradiction internally and can lead to various problems and coping strategies, but we have not known much about the long-term effects.

Now we know more, thanks to an article in Administrative Science Quarterly by Wendy Smith and Marya Besharov. They followed DDD for more than ten years, seeing it as a great example of the effects of how such contradictions are dealt with over a long time. It is a great example both because DDD has coped with them well, while many other organizations break apart or fail, and because it has faced a particularly difficult tension between its commercial and social work, as the commercial work has slim margins and some of the social activities can undermine it seriously.

What do we learn from DDD? As you might expect, the answer to such contradictions has more than one part, but here I want to describe just one: guardrails. Establishing guardrails is a way to set up the organization that follows some old organization theory almost to the book, although the DDD founders may not have been aware of it. In a hybrid organization like DDD, whose commercial and social activities are both important, one of the many possible solutions is to make sure that the organization holds strong advocates of each one and is not set up to let one type of activity dominate. That setup results in a battle for dominance between these advocates and between the coalitions they can muster for support whenever a critical problem arises.

That sounds like a noisy and costly way to organize, and it is. But its key feature is that the battles arise whenever one coalition sees the organization as going too far in one direction and neglecting the other, and the battles help to pull it back to the center. As long as the organization can balance its activities, it is peaceful. That’s why competing advocates and coalitions function as guardrails – they keep the organization from going off track and favoring one mission over the other.

The reason this is important is that hiring advocates for contradictory positions without giving priority to one looks like a way to generate problems for the organization. There is not one overriding mission, there is not a clear organizational identity, it is not possible to predict when conflicts will start, and it is hard to predict how they will end. But all these frightful sources of noise help stabilize the organization and resolve the tension between its contradictory goals and activities.