Paying People to Lie- The Truth

about the Budgeting Process

European Financial Management, Vol. 9, No. 3, 2003, 379406

MICHAEL C. JENSEN, THE MONITOR GROUP AND HARVARD BUSINESS SCHOOL

June 1, 1998
Submitted by: Saurabh Singh, Shubham Goyal
 Paying People to Lie- The Truth about the
Budgeting Process
European Financial Management, Vol. 9, No. 3, 2003, 379406

CORPORATE BUDGETING DISTORTS INCENTIVES, MOTIVATING

PEOPLE TO ACT IN WAYS THAT RUN COUNTER TO THE BEST
INTERESTS OF THEIR COMPANIES.

Typical pay for performance management system

In a traditional pay-for performance incentive system, a managers total cash compensation (salary plus
bonus) is constant until a minimum performance hurdle is reached commonly 80% of a budgeted target[1].
This create strong incentives to game the system. As long as the manager believes she can make the
minimum hurdle, she will naturally try her best to increase performance by legitimate means or, if push
comes to shove, by illegitimate ones.
Paying People to Lie- The Truth about the Budgeting Process | 6/1/1998

If, on the other hand, the manager concludes that she cant make the minimum hurdle, her incentives flip
180 degrees. Now her goal is to move earnings from the present to the future. After all, her compensation
doesnt change whether she misses the target by a little or a lot; she still gets her full salary

Gaming the Realization of Targets

The author argues that when confronted with a standard budget / reward system, managers have incentives
to play two types of games that he argues destroy firm value:

The Realization of Targets

The Setting of Targets
If a budget is already met, I will shift the realization of revenues to next year, and possibly front-end costs
If it appears that I may come up short, I may encourage shifting the realization of revenues.

1
CUTTING THE BUDGET-BONUS LINK
In his paper the author hints at but does not directly confront the notion of the typical performance management
systems. In light of that and taking reference of other research papers[2] we propose the following steps that must be
followed through in a typical performance system. A linear system of rewards that would eliminate the kink from the
pay for performance management systems in the need of the hour.

Linear bonuses. Make bonuses for a given level of performance the same whether the budget target
is below or above the actual performance
Clear performance measures. Establish a single, clearly defined measure of overall business
successe.g., economic value added. Conflicting goals such as increase market share and profits
might tempt managers to aim for one goal at the expense of the other; e.g., boost market share by
cutting prices, thereby reducing profits
Longer-term bonuses. Set bonuses for a number of years out based on longer term projections for
growth and profitability. This avoids too much focus on the previous years performance
Compensation limits. Set upper and lower bonus limits outside the range of likely outcomes, to
minimize gaming; e.g., raise bonus caps well above traditional levels.

Paying People to Lie- The Truth about the Budgeting Process | 6/1/1998

2
 Works Cited
1. Adizes, I. Corporate Lifecycles (Englewood Cliffs, NY: Prentice Hall, 1989, p. 9091).
2. Collingwood, H., The earnings game: everyone plays, nobody wins, Harvard Business Review,2001, pp.
6574.
3. DeGeorge, F., Patel, J. and Zeckhauser, R., Earnings management to exceed thresholds,Journal of
Business, Vol. 72, no. 1, 1999.
4. Healy, P. M., The effect of bonus schemes on accounting decisions, Journal of Accounting and Economics,
Vol. 7, 1985, pp. 85107.
Paying People to Lie- The Truth about the Budgeting Process | 6/1/1998