9.

Management Control-Related Ethical Issues,

Contingency Theory, MNC

Outline
1. Theory of Ethics
2. Analyzing Ethical Issues
3. Reasons for unethical behavior
4. Examples of Control-Related Ethical Issues
5. Contingency Theory of MCS
6. Strategy and MCS Design
7. MNC: Translation, Transaction and Economic Effects
8. International Transfer Pricing

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 Management Control – Ethical Issues
Why should a business manager behave ethically?

Reciprocity Concern for

quality of our
lives

Do unto others as you

would have them do unto By behaving ethically, we
you will make our life, work
place, class, a better
place

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More reasons why should a business manager behave
ethically?
•Macro perspective: unethical behavior (e.g., bribery)
distorts market system and leads to inefficient allocation
of resources
•Micro perspective: ethical behavior is needed for
cooperative behavior
•Need to develop trust, commitment, and effort
•Lower contracting cost (cost of dishonesty): “The
market for lemons”
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 Ethics
n Ethical principles can provide a useful guide for defining
how employers and employees should behave.
n Both employers and employees should consider the impact
of their actions on a variety of stakeholders:
§ Shareholders, bondholders, creditors
§ Board of directors, management, employees
§ Competitors, customers, suppliers
§ Government, communities
§ Society-at-large

n Ethical issues ¹ legal issues.

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 Ethics and earnings management
Type of accounting Accounting Choices Real cash flow choices
practices
Within GAAP
Conservative accounting - Overly aggressive recognition of - Delaying sales
provisions or reserve - Accelerating R&D or advertising
- Overvaluation of acquired in-process expenditures
R&D in purchase acquisition
- Overstatement of restructuring
charges and asset write-offs
Neutral Accounting Earnings that result from a neutral
operation of the process

Aggressive accounting - Understatement of the provision for - Postponing R&D or advertising

bad debts expenditures
- Drawing down provisions or reserves in - Accelerating sales
an overly aggressive manner

Violates GAAP
Fraudulent Accounting - Recording sales before they are
realized
- Recording fictitious sales
- Backdating sales invoices
- Overstating inventory by recording
fictitious inventory

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 Ethical Theories
n Deontological theory:
– actions are judged morally right based
upon how well they conform to some set
of duties
– In order to make the correct moral choices,
we simply have to understand what our
moral duties are and what correct rules
exist which regulate those duties.
– When we follow our duty, we are behaving
morally; when we fail to follow our duty, we
are behaving immorally.

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Example of Deontological Theory: Board
of directors’ Duties

n Duty of care
– Duty to make/delegate decisions in an informed way.
n Duty of loyalty
– Duty to advance corporate over personal interests.
n Duty of good faith
– Duty to be faithful and devoted to the interests of the
corporation and its shareholders.
n Duty not to “waste”
– Duty to avoid deliberate destruction of shareholder value.

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 Ethical Theories
n Consequentialist Theory:
– Actions are judged morally right based
upon their consequences
– In order to make the correct moral
choices, we have to have some
understanding of what will result from our
choices.
– When we make choices which result in the
correct consequences, then we are acting
morally; when we make choices which
result in the incorrect consequences, then
we are acting immorally.
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Example of Consequentialist
Theories
–Budgetary slack: Some slack is created
to fund longer-term projects
– Appointment of a CEO’s friend on BOD à
provide better access to source of
funding

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 Ethical Theories
n Virtue-based Theory:
– People make moral decisions based upon
which actions would make one a good
person.
– It doesn’t judge actions as right or wrong
but rather the character of the person
doing the actions.
– “What sort of person should I be?” (The
first two systems focus on the question
“What should I do?”)

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 Ethical Theories
n Virtue-based Theory:
– Acquiring and putting into practice the right
relevant “virtue”
– Courage (bravery)
– Moderation (self-mastery)
– Justice (fairness)
– Prudence (good judgment)
– Thus, virtue-based ethical theories place much
less emphasis on which rules people should
follow and instead focus on helping people
develop good character traits, such as kindness
and generosity.

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 Ethical Theories
n Justice Theory:
– These concepts require that actions taken
reflect comparative treatment of
individuals and groups affected by the
action.
– Procedural justice: focus on the process
– Outcome justice: focus on the results

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 Ethical Theories
n Rights theory
– Individuals have certain entitlements that
should be respected, such as freedom of
speech and conscience, free consent, and
the right to privacy and due process.
– Therefore, human beings possess these
rights and the duty to respect them
regardless of any utilitarian benefits that the
exercise of the rights and duties may
provide for others.

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 Ethical Theories
n Utilitarian Theory.
– The theory looks beyond self-interest to
impartially consider the interests of all
persons affected by an action.
– In other words, utilitarian theory focuses
on the consequences of an action on
individuals affected by an action.

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 Ethical Theories
n Utilitarian Theory.
– Utilitarians recognize that trade-offs exist
in decision-making.
– A utilitarian is concerned with balancing
social harms with social benefits such that
making a decision maximizes net benefits
and minimizes overall harms for all
stakeholders.

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 Ethical Theories
n Example of utilitarian theory:
– Economic theory: principle of least efforts
§ To generate maximum gains with least amount of resources
– Cost benefit analyses
§ Invest in project only when the benefits outweigh the cost

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 Codes of conduct
n Corporate codes of business conduct & operating
principles often make ethical behavior explicit as part
of a personnel/cultural control mechanism
n They often include virtues, such as:
§ Integrity
§ Loyalty
§ Objectivity
§ Confidentiality
§ Competence
n Tone at the top
n Many important ethical issues are not black or white
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 Reasons for unethical behaviour
• Budget too difficult • Ineffective internal
• Need to generate profit control
in the short term • Too much trust
• Need to perform • No segregation of
beyond the bogey point duties
• Job security • Complex tasks with less
supervisions

• I’m underpaid, the company owes me

• Everyone else is doing it
• Top management’s judgment is subjective
• I did it for good reasons
• I did not benefit personally
• I lost income due to unfair compensation system
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 Analyzing Ethical Issues

n Good ethical behavior needs to be

guided by more than just opinions,
virtues, intuition, rules or character
traits.
n There are many decisions models
available, most (all?) of which can be
condensed down to the following six
steps (AAA)
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 Analyzing Ethical Issues

1. Clarify the facts: what is known or

what needs to be known, in order to
define the problem(s)?
– The facts should identify the 4Ws+H —
who, what, where, when and how.

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 Analyzing Ethical Issues
2. Define the ethical issue: what is it
about the situation that causes an
ethical issue to be raised?
– The assessment should be posed in the
context of one or more of the ethical
models.
§ Have any stakeholders been harmed or put at
risk?
§ Are there conflicts over rights?
§ Is someone being treated unfairly?
§ Is someone acting without integrity?
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 Analyzing Ethical Issues
3. What are the alternatives: what are the
options available to resolve the issue?
4. Compare values and alternatives: is
there a clear decision, or is there
ambiguity and uncertainty with respect
to the circumstances?
5. Assess the consequences: what are the
short- and/or long-run, positive and/or
negative consequences for the
alternatives?
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Analyzing Ethical Issues

6. Make a decision: balance the

consequences against the
primary ethical principles or
values in order to select the
alternatives that is most
appropriate.

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Contingency/situational factors
n There are no universally best control systems
that apply to every situation in all organizations.

n Contingency factors
- Organizational factors
- Technological factors
- Strategic factors

MCS variables Outcome variables

- Type and tightness of controls used -Dysfunctional side-effects
- Design of the budgeting system -Control costs
- Performance measures emphasized -Performance
- Objectivity of performance evaluations
- Design of reward systems

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 Strategy typologies
n Corporate diversification strategy
§ Refers to what businesses the firm should invest
in and how these businesses should be
coordinated
§ Defines where to compete
§ Single business – related/unrelated diversified

n Business unit competitive strategy

§ Determines how to compete in each of the
businesses
§ Low cost – differentiation
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Corporate diversification strategy
Single
High

Business
Firms Ø One line of business
Degree of Relatedness

Ø Operational synergies
Related based on a common set
Diversifiers of core competencies

Ø Connection between
businesses is purely
Unrelated financial (holdings)
Diversifiers

low Number of Businesses High

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 Implications for MCS design
Single/Related Unrelated
Business Diversified

Control of SBU-manager
Budgets

Low high
over budget formulation

Importance attached to Low high

meeting the budget

financial and
Bonus criteria primarily financial criteria
Incentives

nonfinancial criteria
primarily subjective
Bonus determination primarily formula-based
or discretionary

Bonus basis SBU and corporate primarily SBU-performance

performance

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Business unit competitive strategy
Cost leadership Differentiation
• economies of scale • brand loyalty
• tight cost control • superior customer
service
• standard products
• product features
• cost minimization
• product design
• standardized tasks and
production processes • technology

… different business unit strategies require different MCS ...

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 Implications on MCS design

BUDGETING Low Cost … Differentiation

Control of SBU-manager
over budget formulation relatively low relatively high

Budget revisions relatively difficult relatively easy

during the year
Tolerance towards
budget deviations relatively low relatively high

Importance attached to relatively high relatively low

meeting the budget

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Implications on MCS design (Continued)

Low Cost … Differentiation

INCENTIVES primarily more emphasis on

Bonus criteria financial criteria nonfinancial criteria

Bonus determination primarily more subjective

formula-based or discretionary

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n MNC: creates additional difficulties:
– The economic, legal, political, social, and
cultural environments differ across contries
– Government control of certain products
– Availability of resources (RM, skilled labor,
infrastructures)
– Different currencies: inflation, exchange
rate fluctuations

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n Performance measurement in multinational
companies: cash flows are denominated in
several currencies and the exchange rates
are different at different times.
n Problems with changes in exchange rates:
a. Translation effect:
I/S and B/S of MNCs should be translated
into single currency to consolidate their
accounts.

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Example:
Budget Actual
Can$ US$ Can US$
Revenue 100 70 100 65
Profit 10 7 10.5 6.8

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b. Economic effect:
• The impact of exchange rate
fluctuations on the present value of a
firm’s future cash flows.
• The risk can affect the relative
competitiveness of the firm.

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 Example:
Northern Nippon (Jpn)
Telcom (Can)
Jan 1 (Can $1=Y130) $80 $ 80
(Y 10,400)
Dec 31 (Can $1=Y140) $80 $74.29
(Y10,400)

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• Cost structures of the two companies have
not changed
• Customer demand has not change
• The Nippon has become more
“competitive”
• Incorporate foreign exchange movement in
preparing master budget (e.g., budgeted
sales, budgeted cash flow, budgeted I/S)

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c. Transaction effect:
Exchange rate effects that the company has in
its cross-border transactions when such
transactions are entered into today, but
payments to settle the transactions are made
at some future time.

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n Management considerations in designing
performance measurement for MNC:
• Subsidiary managers should not be held
responsible for translation effects (compare
budgets and actual results using the same
metric)
• Transaction effects are best handled
through centralized coordination of the
MNC’s overall hedging needs (cheaper and
simpler and prevents the subsidiary
managers from becoming a foreign
exchange speculator)
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• The subsidiary managers should be held
responsible for the dependence effects of
exchange rates resulting from economic
effects (e.g.., use contingent budget
system which would revise the budget
standard to reflect the exchange rate
fluctuations).
• Evaluation of subsidiaries as a basis for a
decision to locate operations in a country
or to relocate operations from a country
should reflect the consequences of
translation, transaction, and economic
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•Multinational Transfer Pricing*: consider other factors such as taxation,
government regulations, tariffs, foreign exchange controls, funds
accumulations and joint ventures.
•Taxation: shift profits to low-tax countries can reduce total worldwide
income taxes
•Government regulations: determine how transfer prices should be
calculated (In Canada, Information Circular 87-2 provides guideline to
calculate transfer prices for multinational corporations)
•Comparable uncontrolled price
•Resale price
•Cost-plus
*Horngren et al, 2019, Cost Accounting: A managerial emphasis, Chapter 21, pp. 874-876

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1. Comparable uncontrolled price

Parent Company $150 Subsidiary

(Canada) (Mexico)
+/-
Adjustments

$150

Independent
Customers

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2. Resale price

200/unit
Parent Company Subsidiary
(Canada) (Mexico)
+/- adjustments

200/unit

Independent
Customers

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3. Cost plus

Parent Company Full cost Subsidiary

(Canada) (Mexico)
Adjustments

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•Tariffs: often charged as a percentage of import value of a
product. Thus, the lower the price, the lower will be the tariffs.
•Foreign exchange control: some countries limit the amount of
foreign exchange available to import certain commodities
(lower prices mean more quantities).
•Fund accumulation: companies may wish to accumulate their
funds in one country rather than in another. Use transfer prices
to shift fund into or out of a particular country
•Joint ventures: transfer prices may affect profit sharing of the
joint ventures regarding transfer of products from parent
company.

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Example (MN transfer pricing)
Simon Corp. has production facilities in two countries: Vietnam and Canada. All
products from the facility in Vietnam are transferred to Canada. Relevant information about the
company’s operations for 2021 is as follows:
Vietnam Canada
Cost incurred on transferred products
(Third-party cost) $2,000,000 $6,000,000
Sales revenues $8,000,000 $24,000,000
Tax rates 15% 40%
Import duty 2%
Other information:
Similar goods imported by other companies in Canada would have cost an equivalent
of $4,000,000 (However Simon Corp. argues that because it uses special approach to
manufacture its own goods, the appropriate transfer price is $8,000,000)
What is the impact of the company’s transfer pricing policy on its overall tax
liability?

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