The Unintended Consequences of Corporate Innovation

According to a recent survey of over 1,500 chief executive officers, creativity is the single most important leadership skill needed for enterprises to navigate today’s complex global business environment.[1] This is not surprising; innovative company culture has many benefits. However, research in psychology and organizational behavior suggests that a strongly innovation-focused culture could have unintended negative consequences. For example, past studies have found that innovative thought can lead to more dishonesty and risk-taking.[2],[3]

These downsides of creative culture could develop in many parts of the company. However, the greatest opportunity for self-interested behavior may exist when employees are responsible for operations and also play a role in the financial reporting process. In the post Sarbanes-Oxley era, companies are more likely to manage earnings through the strategic timing of investing, financing, and operating decisions than through traditional manipulation of accounting accruals.[4] These techniques, known as real earnings management (REM) strategies, present an interesting dilemma for investors, auditors, and accounting regulators, as they do not involve misstatement of accounting records, are hard to discern from valid operational decisions, and are not indicative of management bias. But while REM does not result  in misstated financial statements, engaging in REM often involves trading off long-term benefits to the company in the pursuit of short-term rewards and, in many cases, REM strategies reduce firm value.[5]

In addition, when bonuses are aligned with overall company performance, these strategies provide an incentive for earnings management to occur outside of the traditional accounting and financial reporting functions and instead within the rank and file of company operations. To explore how the willingness to engage in self-serving REM behavior is affected by innovation-focused corporate culture, I conducted an experiment with 139 current and past managers who had experience making spending decisions in an organization. In this experiment, participants completed tasks designed to immerse them in a more or less innovation focused culture and then were asked to make a spending authorization decision that would require them to forego or delay at least some portion of a personal bonus in order to reduce risk to the company and its customers. This provided an opportunity to engage in real earnings management to hit a bonus target. The spending decision was specifically designed to capture the trade-offs that decision makers face when deciding whether to focus on short-term gains at the expense of increased long-term risk and, especially, when that decision involves their own financial well-being.

In the study, I found being immersed in a more innovation-focused culture increased the appeal of self-interested behavior and led to higher levels of real earnings management to achieve bonus targets. Once this relationship was shown, I tested two interventions patterned after established research in psychology that I designed specifically to reduce the self-interested behaviors that came as a consequence of innovation-focused culture. I found that both of these interventions reduced the frequency and appeal of self-interested real earnings management behavior in the scenario.

Overall, the results of my experiment provided a couple of key takeaways. First, company leaders looking to increase innovation in their firms should be aware that, while there are advantages to cultivating innovation, there could be potential disadvantages as well. Even though a company’s culture may not appear harmful, if elements of the culture increase the appeal of risk-taking behavior, this fact ought to be considered. Second, additional analyses suggest that participants in my experiment, who were facing a moral dilemma with respect to this particular earnings management choice, identified what they should do and how this was at odds with what they wanted to do, but chose to engage in the self-serving earnings management behavior regardless. These findings tell us that employees may recognize internal moral conflict, yet still be able to rationalize behavior they know that they should not do. This implies that interventions that only serve to highlight behavior that should not be engaged in may not be as effective as hoped.

And finally, I am clearly not suggesting that companies forego innovation. Instead, we should better understand how innovation focus affects the decisions that managers make across the organization. This study, combined with work in psychology, is a first step towards understanding these unintended consequences. By learning more about the psychological processes involved in, and implications of, creative mindsets we can work to cultivate innovative corporate cultures while still being apprised of what could go wrong.

ENDNOTES

[1] IBM. 2010. Capitalizing on Complexity: Insights from the Global Chief Executive Officer Study: IBM Global Business Services.

[2] Gino, F., and D. Ariely. 2012. The dark side of creativity: original thinkers can be more dishonest. Journal of Personality and Social Psychology 102 (3): 445. http://dx.doi.org/10.1037/a0026406.

[3] O’Reilly, C. A., J. Chatman, and D. F. Caldwell. 1991. People and organizational culture: A profile comparison approach to assessing person-organization fit. Academy of Management Journal 34 (3): 487-516. http://dx.doi.org/10.2307/256404.

[4] Cohen, D. A., A. Dey, and T. Z. Lys. 2008. Real and accrual-based earnings management in the pre-and post-Sarbanes-Oxley periods. The Accounting Review 83 (3): 757-787. http://dx.doi.org/10.2308/accr.2008.83.3.757.

[5] Rowchowdury, S. 2006. Earnings management through real activities manipulation. Journal of Accounting and Economics 42 (3): 335-370. http://dx.doi.org/10.1016/j.jacceco.2006.01.002.

This post comes to us from Professor Ryan Guggenmos  of the Samuel Curtis Johnson Graduate School of Management at Cornell University. It is based on his paper, “The Effects of Creative Culture on Real Earnings Management,” available here.