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Table of Contents
Strategy Implementation and Target-Setting ..................................................................... 2
Arnold M.C. Artz M. 2015. Target difficulty, target flexibility, and firm performance:
Evidence from business units’ targets. Accounting, Organizations, and Society, 40 (1): 61-77:
................................................................................................................................................ 2
Kim Langfield-Smith (1997): Management Control Systems and Strategy: A Critical Review ....... 3
Sitkin, Miller: The stretch goal paradox: Harvard business review ............................................. 6
Performance measures and incentives .............................................................................. 7
Banker, Chang & Pizzini. The balanced scorecard: Judgmental effects of performance measures
linked to strategy: the accounting review ................................................................................. 7
Brüggen, Krishnan & Sedatole. Drivers and consequences of short-term production decisions:
evidence from the auto industry. ............................................................................................. 8
Quinn & Thakor. Creating a purpose driven organization: Harvard business review. .................. 9
Internal capital markets ................................................................................................. 10
Stein. Agency, information and corporate investment ............................................................ 10
Part A External capital markets ................................................................................................................... 10
Part B Investment inside firms .................................................................................................................... 13

Ethics, corporate social responsibility and sustainability ................................................. 19

Joshi & Li. What is corporate sustainability and how do firms practice it? A management
accounting research perspective ............................................................................................ 19
Strategy Implementation and Target-Setting

Arnold M.C. Artz M. 2015. Target difficulty, target flexibility, and firm performance:
Evidence from business units’ targets. Accounting, Organizations, and Society, 40 (1):
61-77:

Purpose:
examine how intra-year target flexibility is related to target difficulty and firm performance, thereby
comparing the context of control vs. decision-making.

Hypotheses:
H1  After controlling for target flexibility, target difficulty is positively associated with firm
performance. Weakly supported
RQ 1  target flexibility is a partial mediator between target difficulty and firm performance. True
H2  After controlling for target difficulty, target flexibility is negatively associated with firm
performance. Supported
H3  Target difficulty is positively associated with target flexibility. Supported
H4a  After controlling for target flexibility, the association between target difficulty and firm
performance is less strong if targets are predominantly used for decision-making.
H4b  After controlling for target difficulty, the negative association of target flexibility and firm
performance is less strong if targets are predominantly used for decision-making.

Limitations:
 only investigated for intra-year
 Survey based research has the risk of measurement errors

Implication:
 The results imply that the difficulty of a target may be not only a motivational device but also a
signal about potential adjustments of targets intra-year.
Kim Langfield-Smith (1997): Management Control Systems and Strategy: A Critical
Review

Purpose:
Review and critique research that examines the relationship between Management Controls and
Strategy.

Management Control Systems:

Definition: “the process by which managers ensure that resources are obtained and used effectively
and efficiently in the accomplishment of the organization’s objectives.”

Categories of control:
Anthony:
 Formal controls  written, tangible, rules/procedures
 Informal controls  unwritten, unconsciously designed, derived from company culture

Informal controls are getting more important within MCS and the effectiveness of formal controls
may be dependent on the nature of the informal controls that are also in place.
 MCS’s role in formation and implementation of strategy is becoming more important  need to
expand understanding to serve these areas.

Strategic framework
Strategy is approached in many ways, but the biggest problem is that strategy is often not considered
multidimensional  can negatively affect integrity of research findings/ design.

Defining strategy:
Strategy: a pattern of decisions about the organization’s future, which take on meaning when it is
implemented through the organization’s structure and processes.
Corporate strategies: concerned with decisions about the types of businesses to operate (structure
and finance the company).
Business strategies: relate to each business unit of the organization and focus on how individual
SBUs compete within their industries.
Operational strategies: address how the various functions of the organization contribute to the
particular business strategy and competitiveness of the organization.

Strategy formulation and implementation:

Strategy formulation: The managerial activity (often of a cognitive nature) involved in forming
strategies
Strategy implementation: Is concerned with translating the chosen strategy into actions. These
actions encompass allocating resources and designing suitable administrative systems, including
MCS.

Alternative research paradigms concerning the operationalization of strategy:

 Textual description  for case study research and theory building
 Partial measurement  consideration of variables such as market share
 Multivariate/Multidimensional measurement  large-scale analysis with multiple variables
  Typologies  comprehensive profiles of strategy types
Strategic variables

Organizational strategic typologies  Rate of change in products or markets

 Prospectors  looking for opportunities/ creating uncertainty and change
 Defenders  narrow product range/little development
 Analyzers  Combination of both
Strategic positioning  Competitive Advantage
 Differentiation  focusing on high quality/service and economies of scope
 Cost leadership focusing on lowest costs and economies of scale
 Focus strategyFocusing on niche
Categories Extent of product innovation
 Entrepreneurs pursue innovation
 Conservative reluctant to innovate
Strategic missions intended trade-off between market share and short-term earnings
 Buildincrease market share, regardless of short-term earnings
 Harvestmaximize short-term earnings
 Hold protect market share and aim for reasonable ROI
 Divest cease operations

Take-aways from contingency research:

Prospector (Entrepreneurs) Defender (Conservative)

Planning and Difficult to implement comprehensive planning
systems due to changing demands of environment.
control systems
More focused on problem finding than solving.
Focus Quick response & change  reliance on flexible
structures and processes.
Disadvantage: coordination= expensive and
difficult due to overlapping teams and shared
resources
Control Decentralized and result oriented.
systems
Operations Broadly defined jobs and lack of standard operating
procedures  encourage innovation
Porter Support differentiation strategy  also relies more
on coordination than formal controls
Miller & Require control systems that signal when
productivity and efficiency have fallen
Freisen
Very detailed, focused on reducing uncertainty
and problem solving  unable to assist in new
product development or spot opportunities.
Finance & production  so technological
efficiency important
Centralized and reliant on feedforward control
Highly specialized work roles & standard
operating procedures
Support cost leadership focus  highly
structured
Need control systems that signal need for
innovation through measures (e.g. reduction in
sales)

Control systems and the level of competition:

Ambivalent findings: Although it is found by kwandwalla that reliance on control systems grows
together with the level of competitiveness, practise shows that for example companies that face high
product competition are likely to follow prospector or differentiator strategies.  innovation does not
go together with formal controls.

Controls and discretionary decision making:

Descretionary decision making  making rational decisions without having formal guidelines
Limited findings (exploratory research) no noticeable difference between controls used in growth
businesses or maintain or selective growth strategy businesses.

Strategy and cost control:

No regard for non-financial controls while it was argued that normally cost controls suit
defenders, Simons found that prospectors place importance on standard controls, and more intensively
than defenders. He also argued that size matters in this case since mostly the large defender did not
value control systems. Explanation for his findings:
 In case that authority for development and innovation is delegated, control mitigates risk
taking behaviour.  balances innovative excess
 Prospectors rely on performance monitoring in case of task or environmental uncertainty to
stimulate organizational learning.
 Financial controls are needed to capture the wide scope of prospectors

Performance evaluation and reward systems

Defender, Cost leadership & Harvest  objective performance evaluations and reward systems,
great precision due to high level of certainty.
Prospector, differentiator & Build  difficult to measure performance of managers, mostly due to
the long-term nature of the strategies.

Resource sharing and control systems

High performing cost leaders  output controls combined with resource sharing
High performing differentiators  behaviour controls combined with resource sharing
output controls with low resource sharing
Conflict  should be the other way around, behaviour controls for cost leaders, output for
differentiators.
Explanation  agency theory explains this unclear and not convincing.

Operational control systems and strategy (manufacturing)

Economic conformance level model: demonstrates how the cost of producing your product drops
when a quality assurance program begins, only to swing back up as the cost of the quality assurance
program increases.
Zero defects model: every defect represents a hidden cost (design, production, labour, time) 
control may be achieved through continuous improvement of quality goals, the reduction in defective
units and frequent feedback on quality performance to employees.

Simon’s Levers of control

 Interactive controls  prospectors
 Diagnostic controls  defenders
 Belief system  core values, positive and inspirational forces
  Boundary system  control for critical performance variables, set constraints, ensure
compliance

Sitkin, Miller: The stretch goal paradox: Harvard business review

Stretch goals (Management moonshots)  seemingly unattainable goals

The paradox  companies that possess the capabilities and resources do not set stretch goals, while
companies that do not perform well and lack resources turn to these in desperation

Difference with normal goals

 Involves radical expectations
 Included brand new paths and approaches

Factors determining success

 Recent performance influences attitudes and behaviour
 Slack resources  tangible + intangibles (information, money, material)
Performance measures and incentives

Banker, Chang & Pizzini. The balanced scorecard: Judgmental effects of performance
measures linked to strategy: the accounting review

Purpose:
Examining the impact of explicit and detailed strategy information on the use of strategically linked
performance measures in conjunction with common and unique measures  in the balanced
scorecard.

Method:
Manipulated BSCs effect on manager performance through the understanding of strategic linkages

Hypotheses:
H1 In evaluating performance, managers who have detailed strategy information will place greater
(less) weight on strategically linked (non-linked) measures than those who do not have detailed
information
H2When managers have detailed strategy information, they will place more weight on strategically
linked measures than on non-linked measures in evaluating performance.
H3When managers have (do not have) detailed strategy information, they will place more (less)
weight on unique linked measures than they will on common nonlinked measured in evaluating
performance.

 al hypotheses confirmed

Limitations:
 Participants did not have any experience in retail or with BSC
 Participants did not face real life incentives
 Additional information was quite explicit.
Brüggen, Krishnan & Sedatole. Drivers and consequences of short-term production
decisions: evidence from the auto industry.

Purpose:
Examining the role of management accounting in relation to absorption cost accounting and
performance measurement systems, and the association between excess production and tangible and
intangible costs.

Method:
Interviews and statistical regression of one auto company.

Hypotheses/Links:
L1+2+3 performance measurement incentives combined with absorption costing (overhead costs
of overproduction go to production instead of period) causes overcapacity to lead to overproduction.
L4 excess production leads to increased customer rebates/incentives (discounting to sell
overproduced produce)
L5 excess production leads to increased advertisement costs (need to sell more)
L6 excess production leads to increased inventory costs (overstock)
L7 customer discounts decrease the brand image because it takes away the image of the product
being “premium”.
L8 advertising will increase brand image through brand awareness
L9 inventory will decrease brand image, which signals that the brand is not that wanted.

Problems:
 Managers are aware of the negative relationship between overproduction and intangible costs,
but often intangible costs are not easily measured
 Short-term focus

Limitations:
 Only examines costs of excess production, not benefits
 Does not examine other contributing factors that may encourage overproduction
 Only based on one industry, one company, one research  not generalizable
Quinn & Thakor. Creating a purpose driven organization: Harvard business review.

Purpose:
Guide organizations through 8 steps in creating a purpose-driven organization, which results in
increased engagement and commitment.

Steps
Step 1 Envision an inspired workforce
Envision a company to be able to step out of the regular principal-agent relationship and inspire
employees with a common purpose.

Step 2  Discover the purpose

Create a written statement of the mission and vision. Do not invent a purpose but discover the
purpose by talking to the people in the organization  understanding the basic assumptions and
needs of the workers. Work with this to generate a common purpose and use the feedback received
and provide feedback in how you use their contribution.

Step 3  Recognize the need for authenticity

Sharing the mission and vision, or the purpose, does not work if it is not meant, so it needs to show
authenticity in everything that happens in the company, and all decisions made show that same
direction. This starts with top management (tone at the top).

Step 4  turn the authentic message into a constant/standard message

The company culture needs to be formed in such a way that the purpose flows through everything and
everyone, at every level of the organizations  complete alignment. First and foremost, managers
need to lead by example (again, tone at the top). Clarify the purpose of all divisions and hold purpose
constant and consistent and do not show doubt of waiver. If employees recognize the authenticity at
the top, they will start believing in it as well and start adapting their attitude and behaviour.

Step5  stimulate individual learning

In order for organizations to grow you need to focus on learning and development of individuals, also
to boost engagement and to give them the feeling they can reach their potential. This also makes them
more willing to learn, grow and develop to attain goals, and they will start seeing their work as a tool
to develop. Less need for middle managers due to employee empowerment.

Step 6  turn middle managers into purpose driven leaders

Middle managers need to pass on the message and commitment of the organization’s purpose. And
serve as “role models” to set the tone and lead by example.

Step 7  Connect the people to the purpose

Link the daily activities and tasks to the purpose and communicate this with the employees in order to
give them a feeling of being valuable and contributing to the achievement of the company’s purpose.

Step 8  unleash the energizers in the company

You need certain people in the organization (mascot) to spread the purpose throughout the
organization and give energy to it. By doing so, the purpose and company culture will be livelier and
more dynamic. Also, they need to go out and share ideas and come back with new input, so the
organization experiences changes and new impulses to avoid being too complacent too quickly.
Internal capital markets

Stein. Agency, information and corporate investment

Part A External capital markets

2. Theoretical building blocks: investment at firm level

Models will be discussed that have implications for investment at firm level, so within the external
capital market regarding one firm.

2.1 Models of costly external finance

Purpose  explain how being resource constraint, and having to issue fund externally, will
lead to underinvestment. This is because issuing funds externally will include frictions.

Cost of equity finance

The problem with raising equity is linked to adverse selection  you issue equity when you
know the market overvalues your shares, so when the market value is superior to the
fundamental value (Tobin’s Q), the market will notice this and interpret this as bad news.
Bottom line  firms really in need of equity are unwilling or unable to raise equity because
of this adverse selection (e.g. when they have investment opportunities and lack resources).

Cost debt finance

When you have inability to access new equity it does not necessarily limit investment,
because there is still the option to touch the debt level, however, this will not be without
market friction  also leads to underinvestment. There are three types of frictions within
debt financing.
Adverse selection, moral hazard and credit rationing
Adverse selection  if you know you are likely to go default (not being able to reimburse
debt), you are more likely to increase your debt, especially because the bankers/investor will
not know what you know.
Moral hazard  If the manager increases his debt and knows he will perhaps not be able to
pay it back, this will increase his risk taking, mostly because it does not concern his own
money (bad intention).
Credit rationing  both adverse selection and moral hazard lead to the situation where
managers will not be able to borrow more money for the same interest rate (a limit on the
amount you can issue will be placed for each interest rate).
Debt overhang
When a firm has a big debt burden it limits further new investment
Ex ante  this concerns the situation where there is small to middle sized debt, so not debt
overhang yet, and this causes reluctance to issue more debt because of the fear to end up in
debt overhang  this leads to underinvestment by declining projects.
Ex post  there is a large debt overhang, and because you know you will not receive
additional investments because the profits of potential projects will go straight to the
existing debtors instead of serving as a return to the new investors, and the investors know
this as well.
Optimal contract
Optimal contract  an internal financial contract to tackle agency problems, where the
manager is held accountable for payment of the debt.
 In this situation, a contract is made with the investor with fixed payback terms, and the
manager is entrepreneurial in the sense that he serves as the only stockholder. The
agreement includes that as long as the manager adheres to the payback terms, nothing will
happen, but if not, the investor can hire an auditor to claim the remaining debt  costly
bankruptcy, in the sense that the lender keeps everything he finds.
Allocation of control right
The manager has control and values this control, so if he does not pay the debt, he gets
punished and loses this control  this creates extra leverage from the lender’s side, since
even hidden cash flows can result in payback.
Conclusion:
“Firms with bad intentions suffer less because they have less to lose”

2.2 The agency conflict between managers and outside stockholders

In previous situations the assumption was made that managers act in the interest of the stockholders.
However, this part emphasizes the situation where managers of publicly-traded firms pursue their own
private objectives, which may clash with the stockholders’ objectives.
Empire building
Suggests that managers like running big firms, but not necessarily profitable ones, and use all of their
resources to invest in available projects to expand  overinvestment.
Basic predictions  investment increases internal resources, and leverage (debt) leads to decreased
investment.
More developed ideas  managerial private benefits are also taken into account and are
proportionate to either the investment level or the return level  automatic conclusion that empire
building also leads to overinvestment is wrong, because often the investments are made with
increased debt, which ultimately leads to underinvestment, as also mentioned before.
Empire preservation, entrenchment and diversification  managers would like to keep their benefits
and do not want to risk going out of business, so this will decrease overinvestment and leads to the
preference of diversification, choosing projects that make the firm valuable and the application
specific human capital.
Reputational and career concerns
Suggests that actions affect reputations and ultimately their perceived value in the labor market
Short termism (myopic behaviour)
Underinvestment in hard to measure assets  Long-term shareholder value will be negatively
affected because of managers’ incentives to focus on short-term gains in order to boost their personal
reputation or stock price
Overinvestment  because of their motivation to impress the stock market
Implications  greater underinvestment in case of takeover value, or preparing to issue new equity,
this is especially the case for young venture capital firms that still need to build reputation.
Herding (blindly copying decision of previous managers)
This occurs because the market responds badly to managers that make their own decisions instead of
following the herd, even though the decisions could be better and based on good, reliable
information.
Other distortions induced by career concerns
Managers choose not to invest of safe projects because:
 It reveals information about the manager’s ability
 Market responds to this information and will adjust wages to the ability of the manager
 Active projects will not be killed to prevent being seen as a failure.
The quiet life (slow paced decision-making)
Overinvestment  in case an unprofitable project should be killed, but preference for the quiet life
leads to the project being active longer than needed.
Underinvestment  when projects with high profitability should by accepted, but preference for the
quiet life leads to postponing entering this project or line of business.
Overconfidence (too optimistic)
Benevolence  in this situation the manager still acts with the conviction of acting in the interest of
the shareholder, but in fact is too optimistic about the return of the investment and it destroys value
Reluctance to issue equity  stock prices in the external market will seem unfairly low, so they
choose to rely on internal resources to invest.
Problem  because managers are convinced that they are acting out of the interest of the
shareholder, it is difficult to resolve this problem e.g. with punishment.

2.3 Investment decisions when stock prices deviate from fundamentals

All theories mentioned so far share the common premise that financial markets are informationally
efficient. This part suggests that one might wish to view his market efficiency premise with some
skepticism, which comes with the question how noise in asset prices might influence the behaviour of
corporate investment and alter some of the conclusions offered before.
Managers’ rationality  managers are rational and have good judgement, and therefore will not be
easily influenced by noise in stock prices
Firms dependent on external equity  investment is more sensitive to non-fundamental variations in
stock prices, which shows that for them the stock market is a determinant for investment
 In case of low stock prices they are reluctant to invest (undervalue of own shares  smaller
loan)
 In case of high stock prices they are prone to invest (overvalue of own shares  bigger loan)
In case of M&A  being bought is more attractive when stock prices are high, while buying is more
attractive when stock prices are low.

3 Evidence on investment at the firm level

3.1 Financial slack and investment

What we know: firms with more cash and less debt invest more (financial slack)
Endogeneity problem (causality) exists in relation to the information about a firm’s investment
opportunities based on its cash position or debt level, for example:
 Firms tend to save cash when profitable, which leads to a high market value  can be
intepreted as underinvestment.
  Firms may take on debt precisely when they plan to cut investment, to make it hard to infer
causality from increases in debt and reduced investment  both situations cause the cash
level to increase.

4 Macroeconomic implications
So far, the perspective has been microeconomic  focused on the extent to which information or
agency problems can lead a single firm’s investment to deviate from its first best value.

4.1 The financial accelerator

Positive shock  shock in the market influences cost of internal resources  leads to better
profitability and retained earnings  increased investment and output  amplifies the economic
improvement effect and so on. This will work the exact other way around in case of a negative shock.

4.2 When banks face financial frictions

Capital crunch  prices of primary assets (e.g. real estate) in the bank’s surroundings crash, which
results in large loan losses and depleted equity capital. In case they cannot rebuild their equity
capital base it will reduce their lending capability and in turn weaken the economy.
Central bank  Banks find themselves in an adverse selection problem when the central bank cuts of
resources, so the banks cannot offer any insurance on deposit to replenish their reserves, and
therefore cannot offer loans anymore.  results in problems in the economy.

4.3 Cross country differences in financial development, investment and growth

The quality of auditing and disclosure and the degree of legal and regulatory systems to protect
investors influence the efficiency of corporate investment in a way that these systems decrease the
information asymmetry between managers and investors.

Part B Investment inside firms

5.1 Fundamental differences between internal and external capital markets.

External market  line of business seeks investment in the external capital market, e.g. bank, venture
capitalist or public debt or equity market
Internal market  line of business seeks investment in the internal capital market, in which case the
manager always approaches the CEO for funding.

Simplest case: a benevolent CEO overseeing just one division

Details  CEO acts on behalf of ultimate shareholders, only 1 division reporting to CEO.
Differences with external capital market:
Getting funds
 CEO serves as single centralized provider of funds, in contrast to group of investors in
external capital market.
 CEO might be expected to put more effort in monitoring  benefit of internal capital market
(higher quality of information).
 Ex ante incentives are weakened because of soft budget constraints  even poor peforming
projects are often not terminated.
CEO has total and unconditional rights
 CEO can unilaterally decide what to do with the division’s physical assets
  The CEO has greater monitoring incentives because he is in charge of making decision 
internal market brings higher quality of information to bear decisions
 CEO is on top of the manager in the chain of command  most likely discourages the manager
from taking advantage and try to manipulate results for example, at least more difficult than in
the case of bankers in the external market.
More interesting case: abenevolent CEO overseeing multiple divisions
Details  CEO oversees multiple divisions with each a separate manager
Reallocative authority  in contrast to bankers, the CEO own the assets and therefore has the right to
allocate them as he pleases.
Disadvantages reallocative authority
 Managers may attempt to receive larger shares of the capital budget
 Managers face uncertainty regarding the possibility to reinvest all of their earnings
Advantages reallocative authority
 Overall efficiency can be enhanced when manager try to convince the CEO of giving them more
resources using valid and legitimate ‘hard’ information.
The CEO is herself an agent
The assumption that the CEO will act benevolently towards the shareholders is unrealistic.
2 layers of agency
 Between CEO and the shareholders
 Between the division manager and the CEO

5.2 implication for the efficiency of capital allocation

Describes several mechanisms by which the allocation of investment funds in an internal capital
market can lead to either increases or reductions in efficiency.

The bright side of internal capital markets

 2 ways to create value by integrating multiple businesses under one roof:
The more money effect  more total external financing to be raised than could be raised by the
individual businesses independently.
 Integration of these divisions increases the debt capacity compared to individual firms
 Integrated firms only borrow a trivial amount more than their stand-alone counterpart
The smarter money effect  a given amount of funding is allocated across projects. This concept
relies on two premises:
 The CEO will become relatively well-informed about the prospects of the firm’s divisions
 The CEO uses high-quality information as the basis for reallocation across divisions.
 The information gain resulting from the smarter money effect enables the CEO to increase the
process of winner-picking, by using the information about the divisions and the competitive
environments to weight which projects will be most profitable, and thereby to rank these projects,
which will also be beneficial for the shareholders.
 even in the case the CEO is self-interested (e.g. empire-building preferences), the intrinsic
incentives for doing good intra-firm resource allocation are present (due to their desire for large
profitable firms).

The dark side of internal capital markets

 2 ways in which an internal capital market can reduce value
General tendency towards overinvestment  the belief that overinvestment is likely, and the more-
money effect is seen as a bad thing, because it allows for overinvestment to exist.
Disbelief of efficient allocation
 Division managers waste their time and to influence the CEO to give them more capital by
overstating prospects.
 Socialist outcomes  allocating to weaker divisions instead of efficient profitable divisions
 The capital budget is a tool that the CEO, acting as principal, uses in part to design a more
effective incentive scheme to control division-manager rent-seeking
 Managers of weak divisions spend more effort building up their outside options, which in turn
forces the CEO to compensate them more highly in order to retain them.

Pulling it together: when are internal capital markets most likely to add value?
Under what conditions is an internal capital market most (or least) likely to add value relative to an
external capital markets benchmark?
 An internal capital market should, all else equal, be more valuable in situations where the
external capital market is underdeveloped.
 The internal capital market is most likely to run into problems when the firm’s divisions have
sharply divergent investment prospects
 These problems may be exacerbated when divisional managers both:
o Have a strong incentive to maximize their own division’s capital allocation as opposed
to profits; and
o Are powerful relative to the CEO and so can threaten to disrupt the firm’s activities

5.3 How information and agency problems

Lower level (division) managers have better information about project prospects than their superiors,
but also have empire-building preferences, and hence cannot be relied on to truthfully report their
private information.  Capital budgeting procedures serve as a mechanism to elicit truthful revelation
of this private information, e.g. through adoption of payback-like criteria that effectively punish
distant cashflows more heavily than does the NPV.

6 Empirical work on internal capital allocation

6.1 the value consequences of diversification

What are the consequences of diversification for shareholder value?
Diversification discount.  comparing stock price of the integrated diversified firm with the
standalone values of the individual counterparts. The diversification discount is an undervalue based
on the fact that the value of a diversified firm is less than the sum of its part.
Value destruction of the discount
 The discount is tainted by endogeneity bias  often relatively weak firms are the ones that
choose to diversify
 The discount is partly driven by the fact that stocks of diversified firms have higher expected
returns than their pure-play counterparts. It may be because the cashflows of diversified firms
are inefficiently undervalued by the market.
Greater divergence in investment opportunities leads to less efficient internal capital allocation

There is no evidence of the positive or negative impact of diversification. Rather, the theory is pointing
to specific circumstances under which internal capital are more likely to destroy value.
6.2 Evidence on investment at the divisional and plant level
Is there an active internal capital market?
 The cashflows of one of a firm’s divisions affects the investment of its other division.
 If a single firm owns two divisions in apparently unrelated SIC codes, they may still be related
because of a common factor at the firm level.
 It seems very hard to argue with the simple statement that the internal capital market actively
reallocates funds across divisions
Is the internal capital market efficient?
On-average statement  diversified firms are characterized by the high degree of socialist cross-
subsidization, at least at the divisional level, and by having a low degree of investment sensitivity
(because of their relation with the other divisions).
The cross-section
2 key findings
 Socialist cross-subsidization is more pronounced when there is a greater diversity of investment
opportunities within the firm.
 Firms whose investment behaviour looks more socialistic suffer greater discounts.
CEO incentives
 Socialism is more pronounced in those diversified firms in which top management has a small
equity stake.
 There is more socialism when firms have large (and, he presumes, less effective) boards of
directors.
Division-manager incentives
 There is more socialist cross-subsidization when division managers’ compensation is less
closely linked to overall firm performance, either through stock ownership or options. 
Linked to agency theory
 A principal would want to offer more high-powered incentive compensation (based on overall
firm performance) to those division managers who have the greatest ability to rent-seek, or to
otherwise engage in distortionary influence activities designed to increase their share of the
capital budget.  Division managers’ compensation contracts are designed to reduce rent-
seeking incentives.
Spinoff-firms
Once a division is spun off from its parent, its investment becomes markedly more sensitive to industry
q.
The change in investment behaviour is most pronounced for those spinoffs to which the stock market
reacts favourably.
 Evidence that there is inefficient overinvestment in the weak divisions prior to spinoff
 In those particular cases where integration appears to be a bad idea, the problems are at least in part
attributable to socialist-type inefficiencies in the internal capital market
Relatedness
the subsequent investment decisions of the integrated firms are more responsive to division profitability
than those of the specialized firms that operate only discount businesses
 the positive, winner-picking function (ranking) of the internal capital market will work best if the
firm in question operates in related lines of business, because it’s easier to compare.
Conclusions: implications for the boundaries of the firm
 The process of allocating capital to investment projects is made difficult by the existence of
information asymmetries and agency conflicts.
 This problem arises both when capital is allocated across firms via external debt and equity
markets, and when capital is allocated within firms via the internal capital market.
 A CEO’s authority will make her more willing to invest in learning about any given business
that she oversees than would be say, a bank lender, or an atomistic shareholder. These should
be lines of business that can potentially be well-monitored and well-understood by a single
properly-motivated individual. this can in turn have beneficial incentive effects on the agents
further down in the hierarchy
 The more expert is the CEO – in terms of being able to assess the value implications of data
presented to her by her subordinates – the more likely it is that the subordinates’ attempts at
advocacy will take the form of useful information creation as opposed to wasteful and
uninformative lobbying.
 An ill-informed CEO allocates capital, the outcome can be strictly worse than one in which
capital is allocated by an equally ill-informed capital market. the capital market has the
advantage that even if it is no better informed, its impersonal and hence objective nature makes
it much less subject to such rent-seeking distortions.
Ethics, corporate social responsibility and sustainability

Joshi & Li. What is corporate sustainability and how do firms practice it? A
management accounting research perspective

Problem:
Firms, especially the large multinational corporations, are being challenged to behave in an
environmentally sustainable and socially responsive manner while maintaining and improving
shareholder value.
Information needed:
 Stakeholders: information on the environmental and social impacts of business operations as well
as on measures to benchmark corporate social and environmental performance
 Investors: disclosure of material environmental risks and related compliance costs and liabilities
 Firm managers: information to improve the triple bottom line performance and to make informed
trade-offs among often-conflicting financial, environmental, and social objectives
What is sustainability as it relates to business?
Dyllick and Hobert based on the Brundtland Commission:
 “meeting the needs of a corporation’s current direct and indirect stakeholders without
compromising its ability to meet the needs of future stakeholders as well”
Schaltegger, Burritt, and Petersen:
 Business approach that is designed to shape the environmental, social, and economic effects of a
company in such a way that, first, results in the sustainable development of the company and,
second, provides an important contribution toward the sustainable development of the economy
and society.
Debate:

In favour
Bowen, 1953
Obligations of businessmen to pursue policies,
decisions, and lines of action that are desirable in
terms of the objectives and values of society.
Davis, 1960
Good chance of bringing long-run gains = payback for
its socially responsible outlook
Benefits regarding costs, risks, assets, resources,
stakeholders, customers, market management.
 the controversy remains
Sceptical
Friedman, 1970
Corporations only have “artificial responsibilities” that
can be defined explicitly by law or regulations and the
only social responsibility of business is to maximize
shareholder wealth.
Disadvantages
 Additional constraints on production technology =
forces suboptimal choices
 CSR goals divert attention of managers and drain
resources from productivity-enhancing activities and
investments. (short-term view)
 Perceived as unproductive ceremonial institutional
practices
 Manager further personal agenda and reputation at
cost of investors
 Seen as corporate charity at the cost of shareholders
Corporate CSR investment decisions and relating accounting practice – 3 views:
Analyze CSR investments in the same way that they analyze other investments because it aims at
maximizing the owners’ benefits.
 Environmental, social and financial factors should be managed in the same way
 Managers should disclose aspects of environmental and social performance that are material to
investors
Company managers should make CSR investments that benefit society even at a sacrifice of company
profits
 Owners derive utility from economic as well as the environmental/social value created by the
business, and managers as agents of the owners attempt to maximize the utility of owners
 Managers are obligated to comprehensively measure and disclose environmental and social
performance along with financial information to the investors
 Firms can use the triple bottom line performance mix as a differentiation strategy to attract
investors
 Evidence = massive growth in sustainable, responsible, and impact investing
Stakeholder theory
 Double-way relationship between the firm and the stakeholders
 Businesses exist in a social setting and inevitably draw on critical resources = firms need the
legitimacy and “the license to operate” from a broader set of stakeholders
 Stakeholders make the companies accountable for the impact of their operations on the natural
and social capital and their long-term sustainability + expect managers to take their external
impact into account in decision-making

What is sustainability accounting?

To practice sustainability, companies need to implement an accounting system to generate and organize
information to enable external sustainability reporting, to facilitate management control, and to
influence internal decision-making.
A number of organizations are developing sustainability reporting standards for firms with the goal of
making external sustainability reports accurate, consistent, reliable, and comparable across time and
across firms.
 GRI, IIRC, SASB, etc.
Some organizations attempt to define and standardize the sustainability performance metrics (often
industry specific) for external reporting, businesses have to develop internal management and control
processes to achieve these performance metric targets
 ISO

To practice sustainability management, firms choose the sustainability performance targets that are
material to and consistent with the mission and core business strategy, and that are relevant to the
external stakeholders.

Sustainability management becomes an integral part of the overall business strategy:

Environmental costs of information influence key business decisions
 Product costing and pricing, product mix, risk management, tax planning, etc.
Creates opportunities
 New products, new markets, business model innovation, etc.
Translation of strategy into info needs, KPI, decision-making criteria necessitate tools like BSC,
strategy maps, eco-control or sustainability management control.
What is the value relevance of corporate sustainability performance?
Several studies suggest that disclosures of environmental liability information is informative to
investors and that corporations disclose environmental performance information strategically,
consistent with either voluntary disclosure theory or the legitimacy theory

Some also argue that corporate CSR activities simply add noise and volatility to capital markets.

How does the quality of conventional financial disclosures affect the use of sustainability
performance information?
 Voluntary disclosure, lack of generally accepted disclosure and certification standards
 Corporate disclosures of social, ethical, and environmental information do not seem to meet
investors’ needs
 To enhance the credibility in corporate sustainability reports, firms may voluntarily employ
independent third parties to certify their CSR or sustainability reports (like auditors)
 Article: Results indicate that firms committing higher audit fees are more likely to issue a
standalone CSR report, and this positive association is stronger when CSR reports are longer
and when firms have more CSRrelated concerns
 CSR reports issued by firms committing to higher financial reporting quality provide more
effective and credible signals to investors about firms’ future performance (higher standards).

What factors drive the adoption of sustainability accounting practices?

Institutional theorists
 Posit that external social institutions constrain firm behaviour by defining legal, moral, and
cultural boundaries, thus differentiating the legitimate from the illegitimate.
o Possible natures of restraints: regulative, normative, cultural-cognitive
 Also recognize that institutional expectations do not apply uniformly to all organizations, and
firms can respond differentially to these isomorphic pressures
Bhimani, Silvola, and Sivabalan (2016)
 Hypothesize that early CSR reporters are driven by competitive advantage through a
differentiation strategy
 Firms primarily involved in sustainability-related activities chose not to be early CSR reporters
as expected = their strategic focus on sustainability lessened the need to signal their
sustainability ethos through CSR reports (who shouts most, does least).
Herremans and Nazari (2016)
 They find that the rigor and characteristics of sustainability reporting depend on the managerial
motivations and attitudes within companies.
o When managers are primarily motivated by mandatory requirements to develop
stakeholder relationship and sustainability reporting, the control systems are not well
developed
o Managers believe that there is value in preparing individual sustainability reports, they
engage in organic learning and benchmarking with industry peers to design
sustainability reporting systems that use both formal and informal control mechanisms.
How do firms integrate sustainability management control systems with traditional management
control systems?
Ditillo and Lisi (2016)
Underlying premises
 For firms to implement a sustainability strategy successfully, their SCSs must be fully
integrated with other MCSs so that organizational decision making is based on the broadest
possible set of financial, ecological, and social data
 The sustainability orientation of managers represents the condition that motivates
organizational actors to fully integrate SCSs with traditional MCSs
Results
 The nature of companies’ sustainability orientation affects the degree and mode of the
integration between SCSs and traditional MCSs
o 2 proactively oriented companies deeply integrated their SCSs with their conventional
MCSs across a variety of control mechanisms
 The evidence also supports the view that other factors also facilitate the integration process,
including organizational arrangement, stakeholder engagement,

How does the designing of sustainability management control systems contribute to corporate
performance?
 The resource-based view (RBV)(fixed mindset) of firms argues that not every company can
benefit from a ‘‘ green’’ strategy; rather, only firms with unique resources and management
capability can realize the financial benefits from eco-efficiency improvements. These resources
and capabilities cannot be easily imitated or transferred.
 Joumeault (2016)  “growth mindset”
o Hypothesizes that the combination of sustainability management practices (eco-control
package) helps the development of environmental capabilities, which, in turn,
contribute to an organization’s environmental and economic performance.
o Results:
 The eco-control package fosters capabilities in eco-learning, continuous
environmental innovation, stakeholder integration, and shared environmental
vision = contribute directly to the firm’s environmental performance and
indirectly to economic performance
 Different eco-control practices support different environmental capabilities.
 Simultaneous use of several eco-control practices may be necessary to support
development of comprehensive environmental capabilities

Is sustainability accounting sustainable? Conclusion and future directions

No conclusion