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| Behavior, Measurement, and Neutrality AUGUST 2005 - Among the most difficult general problems of financial accounting continues to be the question of how measurement influences behavior. Whenever humans know that their performance is being measured and their well-being depends on performing well, they have ample incentive to actively manage both the measured activity and the measurement itself. A goal of most measurement systems is vigilance in safeguarding the faithfulness of the measurements in representing actual activity.Measurement Management Some years ago, a large public company engaged me to study problems and recommend solutions associated with its warehouse management system. The system collected extensive measurements on warehouse stocks and flows, many of which would be extremely useful for management purposes. About three years earlier, an innovation had changed the nature of the program. A performance-evaluation component was added to rank the company’s several hundred warehouses by their relative standings on the measurements and to compensate warehouse managers based on this ranking. The company engaged me because it was convinced that warehouse managers were spending too much time finding ways to manage the measurements and not enough time focusing on effective and efficient warehouse management. For a number of legitimate reasons, including design problems and fairness perceptions, many of the warehouse managers under this system had concluded by the end of its second annual cycle that they had to actively manage the measurements to reflect the perceptions of their performance rather than passively report actual activity. Most of those unconvinced of the design and equity issues had also begun to manage the measurements, in self-defense. The problem came to the company’s attention because a few managers had quit rather than participate in this gamesmanship; not surprisingly, those managers were also always at the bottom of the rankings. Financial Accounting Measurements Financial accounting standards have similar potential to refocus managements from actual activity to measurement management. Such potential is especially great when entire classes of managements are compensated according to how they measure up. Even though our current approach to financial accounting standards treats public companies, private companies, and not-for-profit organizations alike, the specific nature of the risks associated with measurement management, and the incentives for it, differ across these groups—although its incidence might not. All managements experience performance pressure, but the stakes, context, incentives, disincentives, and repercussions can differ widely. Managers Manage What Is Measured Managers pay close attention to how their performance is measured, in both substance and form. For example, when financial accounting was primarily a matter of revenue recognition and expense matching, managers focused on activities that would produce good results in such a measurement program. Opening new markets, creating new products, selling more products, producing and distributing more efficiently, and administrating more effectively are all substantive activities that such a focus would help motivate. On the other hand, managers might also manipulate the accounting through improper revenue recognition and expense matching; the literature on income smoothing contains many examples of such behavior. When financial accounting is primarily a matter of asset-and-liability recognition, however, management’s attention becomes focused on the substance and form of items on the balance sheet. In such an environment, there are increased incentives to find ways either to trade balance-sheet items directly or to create financial instruments tied to balance-sheet items that can be traded or revalued. The efforts to manipulate the accounting in such a balance sheet–oriented measurement system focus on transaction structuring, favorable valuations, and alternative business structures that remove trading losses, downward revaluations, and liabilities from the balance sheet. Neutrality A long-held tenet of financial accounting standards setting has been that standards should not be made in order to achieve some economic or behavioral goal apart from appropriate accounting. On the whole, FASB standards setting since its inception in 1973 has been remarkably neutral in maintaining the focus on good accounting rather than attempting to achieve some social or behavioral goal. Because the nature and content of financial accounting standards and how they are put into practice have enormous impact on aggregate wealth and risk and their distributions in our society, the issues surrounding the behavioral impacts of measurement will likely continue to increase. Whereas in the past such issues have almost always been dealt with in the world of accounting practice, it will likely be necessary for standards setters to pay closer attention to the potential effects of standards on managerial behavior in a variety of entities.
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