PUBLIC CAPITAL BUDGETING AND MANAGEMENT: THE CONCEPT AND ITS APPLICATION IN THREE IMPORTANT FEDERATIONS Natalia Ermasova Politics and Public Administration Unit Governors State University John L. Mikesell1 School of Public and Environmental Affairs Indiana University ABSTRACT This paper reviews the literature on national government capital budgeting approaches, identifies the standard features expected to be found in such processes, and compares how the procedures are applied in three large and significant federations, the German Federal Republic, the Russian Federation, and the United States. The study uses a comparative case study approach to uncover contrasts, similarities, and patterns of capital budgeting in these countries. This paper examines infrastructure status and gaps and how capital budgeting procedures identified here can help resolve problems. The main finding is that effectively managing and budgeting capital expenditures are among the most pressing challenges to contemporary governments and the effort requires comprehensive and systematic planning, centralized execution and project management, and infrastructure maintenance. Keywords: capital budgeting, capital management, capital infrastructure, capital resources, federal budgeting, state and local budgeting 1. INTRODUCTION Public infrastructure is critical for economic growth and development and for comfortable life. This infrastructure contributes directly to the production of desirable government outcomes (like facilities used in public education or hospitals), as well as serves as an input to production of goods and services by 1. Professor John Mikesell passed away on 12 September 2019. Dr. John L. Mikesell was Chancellor's Professor in School of Public and Environmental Affairs at Indiana University-Bloomington. His works on government finance and taxation had appeared in such journals as National Tax Journal, Public Budgeting and Finance, Public Administration Review, Public Choice. Professor Mikesell served as editor-in-chief of Public Budgeting & Finance for fifteen years. Professor Mikesell was resident advisor on USAID fiscal reform projects in Ukraine and Russia and served on World Bank fiscal restructuring programs in several countries of the former Soviet Union. Public Finance and Management Volume 19, Number 3, pp. 175-199 2019 ISSN 1523-9721 176 Ermasova private entities (like harbors and waterways). At its best, the capital budget process provides a means for evaluation, choice, management, renewal, and development of core public physical assets. When it functions properly, the process contributes to the common good. When it malfunctions, the public can be endangered by an infrastructure that does not meet the standards for delivery of safe, convenient, and efficient service to the public. Underinvestment in public assets has proven to be a problem in many nations, including the three federations examined in detail here. The problem is considerable in the United States (Chen, 2014, 2016, 2017; Chen and Bartle, 2017; Ermasova, 2013; Ermasova and Ebdon, 2019; Srithongrung, Ermasova, and Yusuf, 2019). Chen (2018) found that “declining quality and poor performance of public infrastructure system impose huge costs on US businesses and individuals and create bottlenecks that constrain economic development” (p.126). Germany faces similar issues. Due to decreasing capital investments, Germany fell from third on a list of countries with the best infrastructure in 2008 to seventh place in 2013 and tenth place in 2017 (German Council of Economic Experts, 2018; German Finance Ministry, 2014, 2015, 2018; Ermasova, 2019, Van der Putten, 2017). These problems are also particularly significant in the Russian Federation. In Russia current levels of investment funding are far below what is needed to properly maintain, improve, and expand public infrastructure to avoid economic costs and inefficiencies (Ermasova, 2019). WEF Global Competitiveness Report (2018) shows that the lack of capital investments over the last 20 years has dropped Russia to 35rd place globally in quality of overall infrastructure. Because there has been mounting disquiet about the status of public infrastructure in the United States, Germany and Russia, it is particularly appropriate to reassess their capital budgeting, asset acquisition and management systems so that these resources may serve their appropriate functions. Four sections follow. The first section examines the thoughts and theories about capital budgeting that have developed over roughly the past half century. In light of the significance of capital infrastructure, it is no surprise that there are many views on the topic, not all consistent with each other. The second section considers the practice of public capital budgeting by comparing capital budgeting across three important federations – the Federal Republic of Germany, the Russian Federation, and the United States – to provide a sense of how ideas are implemented in countries with apparent organizational similarities but with great differences in practice. The third section considers the problem of asset underinvestment and approaches that have been developed to attempt to remedy the problem. The final section identifies important gaps in academic and practical understanding of capital asset investment and management and how Public Capital Budgeting and Management 177 the capital budgeting process might be revised to improve the condition of society. The article provides a greater understanding of capital budgeting in different countries and identify avenues for fruitful future research. 2. LITERATURE REVIEW Capital budgeting, in common with budgeting overall, is partly political, partly economic, partly accounting, and partly administrative (Hyde, 2002, p.1). As a political process, capital budgeting allocates the scarce resources among different government departments, agencies, and investment projects. Because capital projects are place-specific, political debates can become particularly intense. As an economic and fiscal process, capital budgeting serves as the primary instrument for evaluating needs for capital improvement, analyzing the condition of infrastructure, and assuring that the program can be financed. As an accounting process, it tracks government spending on capital projects. The process itself is the part of the fiscal management system focused on capital assets.2 Finally, as a managerial and administrative process, capital budgeting establishes criteria by which public services are monitored, measured, and evaluated (Khan and Hildreth, 2002). Many scholars (Ammar, Duncombe, and Wright, 2001; Boex, MartinezVazquez, and McNab, 2000; Chen, 2017; Chen and Bartle, 2017; Bland, 2007; Beckett-Camarata, 2003; Ermasova, 2012, 2013; Ermasova and Ebdon, 2019; Halachmi and Sekwat, 1997; Kovner and Lusk, 2010; Mikesell, 2007; O'Toole and Stipak, 1988; Srithongrung, 2008, 2018; Srithongrung, Ermasova, and Yusuf, 2019) have explored whether strategic practices can be integrated into capital processes. Premchand (2006, p.29) agreed with the importance of the multi-year budget framework and highlighted the necessity of following changes in expenditure management: (1) preparation of a medium-term fiscal outlook; (2) preparation of medium term rolling expenditure budgets; (3) formulation of functional or program resource ceilings; (4) recognition of risks and associated measures; (5) formulation of priorities and strategies; (6) explicit recognition of performance links; (7) fundamental or periodic reviews; and (8) introduction of accrual budgeting and accounting. A large number of studies analyze how capital spending decisions have been made (e.g., Temple, 1994; Balsdon, Bruner, and Rueben, 2003; Chudhury, Clingermayer, and Dasse, 2003; Srithongrung, Ermasova, and Yusuf, 2019). Poterba (1995); Gordon, Kleiner, and Natarajan (1986), Srithongrung (2008), 2. The Office of Management and Budget (OMB, 2017a) defines federal capital assets as “land, structures, equipment, intellectual property (e.g., software), and information technology (including IT service contracts) used by the Federal Government and having an estimated useful life of two years or more.” 178 Ermasova Srithongrung, Ermasova, and Yusuf (2019) focused on the impacts of administrative institutions, including the use of a separate capital budget. Halachmi and Sekwat (1997) found that the use of separate capital budgets leads to strategic practices, including capital planning and infrastructure inspection, in local governments. In contradiction, Spackman (2001, p.34) pointed out that capital and current budgets should be considered together: “(1) budgeting and decision-making processes for capital and current spending must be considered together; (2) capital spending within the budget, once it is set, must be clearly identified separately; (3) investment proposals should be subject to processes for appraisal (of the capital and all the associated operating costs); (4) strong procedures should be in place for capital asset procurement and for project management, and for subsequent monitoring and management of capital assets.” Dorotinsky (2008) argued that “the well-designed public financial management system supports each aspect of the system, including capital spending. In summary, an effective capital budgeting process should form an integral component of a sound over-all budgeting system” (p.20). Many authors find that public capital management practices enhance the quality and quantity of public infrastructure systems (Ermasova, 2012, 2013, 2019; Kovner and Lusk, 2010; Orszag, 2008; Srithongrung and Kriz, 2012; Srithongrung, 2010, 2018; Srithongrung, Ermasova, and Yusuf, 2019). The government institutions play a crucial role in determining the scope of government capital spending. Questions such as "Is the fluctuation in spending considered optimal or an under-investment, relative to the public needs?" and "What should be an objective guide for public investment?" are of particular concern. However, some models focus on factors other than budget procedures in assessing public infrastructure choices. The alternatives include the bureaucracy model (Berry and Lowery, 1987, Courant, Gramlich, and Rubinfield, 1979; Niskanen (1971), the fiscal illusion model (Buchanan and Wagner, 1977; Dollery and Worthington, 1996; Rogers and Rogers, 1995), public policy literature (Gramlich, 1994) and political economy literature (Glazer, 1989, 1993; Crain and Oakley, 1995). According to the bureaucracy model, bureaucratic self-interest is the main cause of public sector expansion beyond the optimal level (Berry and Lowery, 1987). Niskanen (1971) suggests that bureaucrats are likely to expand the government budget and to control information in their relationships with legislators. According to fiscal illusion theory, government revenues are not completely transparent and the true costs of government may be consistently misconstrued by the citizenry of a given fiscal jurisdiction (Buchanan and Wagner,1977; Dollery and Worthington, 1996; Rogers and Rogers, 1995). Public Capital Budgeting and Management 179 Liu and Mikesell (2014) highlight that “politicians, as vote maximizers, tend to propose new government programs as much as possible to attract new voters, which makes government bigger” (p.348). The political economy literature on pork barrel politics suggested that capital projects are allocated to politically powerful legislators or based on election considerations, rather than on productivity criterion. Glazer (1989) wrote, “the rational voters will show a consistent bias in favor of building durable projects” (p.1207) and it depends on commitment effect and efficiency effect. Glazer (1993) suggested that a fundamental aspect of collective decision–making in choosing capital projects should be recognized. Glazer (1989) highlighted that durable project “forces government to provide some services that voters in the future may prefer it did not” (p.1212). Liu and Mikesell (2014) analyzed the impact of public officials’ corruption on state spending and found that “show that real per capita state construction expenditures tend to be larger in states with higher levels of corruption, and the impact is statistically significant. This finding is consistent with the view that corrupt public officials increase expenditures on construction, expecting bribes from construction companies” (p.353). Poterba (1995) considered state capital investment as a political process bounded by presence or absence of a formal capital budget process and by aggregate fiscal controls and found that “suggest that states with separate capital budgets spend more on public capital projects than comparable states with unified budgets” (p.165). The literature on the economic returns from infrastructure spending, for example, suggests that such public spending often has positive returns, but that both the average return and the range of returns among projects vary significantly and depend on a number of factors (Orszag, 2008). Research suggests that the returns to early public investments, such as expanding the interstate highway system, can be large but that the economic payoff depends on the amount of infrastructure that is already in place. Aschauer (1990) proved that public capital is productive at both state and national levels. First, Aschauer (1990) found that public capital was highly productive during the period 1949– 1985. Second, public capital appeared to be more productive than private capital at the margin. Finally, he traced the productivity slowdown in the United States during the 1970’s and 1980’s to the decrease in spending on public infrastructure. According to Aschauer (1990), the decline in public capital formation, and in particular the decline in what he terms “core” infrastructure (which consists of streets and highways, airports, electrical and gas facilities, mass transit, water systems and sewers) is an important reason behind the productivity slowdown experienced by the US economy since the early 1970s. Ford and Poret (1981) have applied Aschauer's framework to OECD countries with mixed results, the effect of infrastructure on total factor productivity being always significant in five cases (the USA, Germany, Canada, Belgium and Sweden), never significant in three cases (the UK, Norway and Australia), and sometimes significant 180 Ermasova in the last three cases (France, Japan and Finland). Further evidence has also been provided by Berndt and Hansson (1992) for Sweden, Lynde and Richmond (1992) for the USA and Otto and Voss (1992) for Australia. Farazmand and Neill (1996) argue that the theory of capital budgeting exists “at a crossroad in which the traditional quantification techniques have yet to be reconciled to the qualitative influences on the budgeting process” (p.429). Doss (1987) pointed out that “projections of future local government income are typically based on both market factors- health of the economy and political "climate" factors including state and federal spending decisions” (p.58). Many scholars found evidence of large private sector productivity gains from public infrastructure investments (Aschauer, 1990; Department of the Treasury and the Council of Economic Advisers, 2010; Dabla-Norris, et al., 2012; Moomaw, Mullen, and Williams, 2002; Munnell, 1990; Lobo and Rantisi, 1999). According to Doss (1987), an accurate determination of the economic wellbeing of a local government cannot be made unless information about the status of the infrastructure and the effectiveness of the capital maintenance system is included in the formula. Burchell and Listokin (1981) express another view: “if a city fails to maintain and replace its inherited capital facilities, it in effect liquidates capital assets by converting them to cash"(p.260). In their view, the cash savings take the form of lower levels of new capital investment and smaller outlays for upkeep and maintenance. Srithongrung (2008) pointed out that “capital management processes based on systematic and strategic practices should result in an effective infrastructure system that can attract private investment and new residents” (p.91). Many scholars found that asset maintenance is the weakest area in capital management at the state and local levels (Chen, 2014, 2016, 2017; Chen and Bartle, 2017; Ebdon, 2007; Ermasova, 2012, 2019; Marlowe, 2013). Ebdon (2007) suggests: “Capital assets need to be maintained in good working order to prevent excessive long-term costs and safety hazards. This requires good information systems and regular, comprehensive condition assessments to determine the status of assets, the cost of maintaining them in good condition, and the financing available to pay for the maintenance needs” (p.66). According to Marlowe (2013), it is common to defer funding for maintenance in difficult economic times because it is less visible than other priorities. 3. NATIONAL CAPITAL BUDGETING IN PRACTICE Governments do not implement the process of constructing and maintaining their public capital infrastructure in the same way, even when there are similarities in the basic logic of governments in the nation. The following section compares the public capital process for the German Federal Republic (GFR), the Russian Federation (RF), and the United States (US) to see how the practice Public Capital Budgeting and Management 181 matches the principles. These countries provide an ideal standard for comparison because each is constitutionally organized as a federation, because each governs an important country, and because the practices in each influences those in other countries, sometimes because of formal technical assistance programs (e.g., USAID or GIZ) and sometimes because of long-standing links that influence practice (e.g., the USSR). Importantly, the three countries are also substantially different in their structures and governance and that makes for particularly useful contrasts. Some of the differences between the countries are these. First, federal governments in the three countries are of dramatically different ages with the U.S. being almost 250 years old, the GFR being around three-quarters of a century old, and the RF being roughly 25 years old. That provides a considerable experience range for experimentation and adjustment as fiscal, economic, environmental, and political realities have changed. In some respects, the federal governments may be at differing points in their life cycles. Second, the three federal governments have considerably different governance structures. The US is characterized by a balance of power between executive and legislative branches with a separately elected head of government (the president); the GFR employs a parliamentary system in which the head of government is a member of the legislative branch and there is no clear distinction between heading the legislature and leading parliament; and the RF has two legislative bodies (the Federation Council and the Federal Assembly) with a prime minister but also has an elected president with considerable formal and informal powers in the legislative process. Third, each of the countries has multiple levels of government, with none serving only as a regional branch of a higher level. However, in the US, the states have considerable sovereignty and protected powers (possibly because the states created the federal government and were cautious about keeping important powers for themselves) but states do not directly have a role in federal legislation. In the RF, the federal government exercises considerably greater control over what subordinate governments are permitted to do and the subnational units have no authority over federal actions. There is regular concern about the “power vertical” and some concern with “horizontal federalism,” the relationship between regional governments, both concepts almost completely foreign to American observers. In the GFR, lander have considerable power to influence what the federal government is permitted to do. In terms of what tiers of government are expected to do, in the US, the national constitution does little in terms of assigning fiscal roles, options, and responsibilities to the tiers of government. There is greater attention to direct assignment in the fundamental national law of GFR and RF. 182 Ermasova Finally, subnational governments in each of these countries face somewhat different public service expectations and, crucially, different expectations about how their spending will be financed. In the US, the standard presumption is that spending by subnational governments will be primarily financed by subnational taxes and charges. In the GFR, subnational governments have financing responsibilities but there is also a substantial federal flow of general financial assistance provided these governments. In RF, the federal government exercises great control over fiscal resources that subnational units might employ, it administers any subnational taxes, and provides considerable fiscal assistance and control in subnational government programs. For the reasons outlined here, the choice of US, GFR, and RF for the comparison provides important insights into the workings of a process for capital budgeting and management. Several important features of the capital budgeting and management process differ between the three federations. Dual or Unitary Budgets The US and Germany federal governments employ a unitary budget. Capital investments do not have a separate framework and the budget makes no distinction between capital investments and operating expenses. Capital spending, social insurance outlays, and operating expenses are treated the same. US budget documents provide details on physical infrastructure expenditures, but there is no special consideration or budgetary path for this spending and normal appropriation rules apply. Russian Federation has dual budget. Until 2008, the budget formulation process in Russia was divided between appropriations for current expenditures (coordinated by the Ministry of Finance) and appropriations for capital expenditure (coordinated by the Ministry of Economic Development). The Russian government transferred the supervision of capital spending from the Ministry of Economic Development to the Ministry of Finance in 2008. The government asset investments are controlled by the Budget Code and approved through the annual budget process. Term of Appropriation The US federal government normally makes a series of annual appropriations for capital expenditures, although there are also sometimes multi-year, no year, or program appropriations. Germany federal government also makes a series of annual appropriations to cover capital expenditures. Russian Parliament is authorized to approve amendments to the budget that are submitted by any subject of legislative initiative based on Article 213 of the Budget Code. The appropriation framework allows some possibility for the government to change and reallocate the funding within the investment portfolio during budget execution. Public Capital Budgeting and Management 183 Role of Executive In the USA, there IS separation of powers between legislative and executive branches, so shared roles. The President of the United States is both the Head of State and Head of the Government. The president is head of the executive branch, which is independent of the legislature. Legislative power is vested in the bicameral Congress, which is composed of the Senate (the upper house) and the House of Representatives (the lower house). The judiciary consists of the Supreme Court and the lower federal courts, with their role to interpret the U.S. Constitution, federal laws, and regulations, and to resolve disputes between the executive and legislative branches. Germany is a federal parliamentary republic. The laws and key institutions are grounded upon a Basic Law (Grundgesetz). The Federal President is the Head of State, and the Federal Chancellor is the Head of the Government. The legislature of Germany are the bicameral German Parliament that consists of the Federal Legislature (the Bundestag), and the Federal Council (the Bundesrat). Each of the regions (Länder) has its own government, premier, and legislatures with significant powers and jurisdiction over many areas of governance. In Russia, the Head is the President, who is also the Supreme Commander in Chief, and holder of the highest office. The President determines the basic course of domestic and foreign policy. The Government of Russia is the highest organ of executive power, the members consisting of the Prime Minister (the Head Government), the deputy prime ministers, and the federal ministers and their ministries and departments (Ermasova and Ermasova, 2019). The legislature of Russia is the Federal Assembly of the Russian Federation, a bicameral Parliament, consisting of State Duma (the lower house), and Federation Council (the upper house). Subnational Governments The U.S. structure differs from many other countries in the relationships between the federal government and other levels. According to U.S. Census Bureau (2012), there are 90,106 state and local governments in the United States. This includes 50 states, 38,910 general purpose governments (cities and counties), 12,880 school districts, and 38,266 special districts (e.g., fire protection or water supply districts). For example, Illinois has 6,963 local governments with numerous jurisdictional boundaries and overlapping special districts. States are responsible for capital assets such as state highways, university facilities, parks, prisons, and office buildings. Local governments and special districts have a great deal of autonomy and responsibility for capital related to the services that they provide. Local governments are responsible for jails, courts, local streets and bridges, school buildings, police and fire facilities and equipment, local airports, public hospitals, local parks, libraries, parking garages, water and sewer systems. 184 Ermasova The German general government comprises federal, regional (the Länder), local governments, and social security funds. Germany consists of 16 states (Länder) that have a high level of autonomy. The Länder are responsible for regional roads, hospitals, museums, courts, police, culture, sports, education, and water management (Gamper, 2012, p.4). The federation and the Länder are autonomous on managing their budgets. Municipalities are responsible for the local registry, the administration of living and social subsidies, construction planning, waste management, spatial planning, children day care, libraries, museums, and retirement homes. The districts are responsible for cross-municipal tasks like transport systems, museums, nature reserves, district roads, waste management, hospitals, and primary schools (OECD, 2006, 2014, 2015a, 2015b, 2017, 2018). In Russia, governments are structured in three layers: federal, regional, and local. The Russian Federation has 85 subjects (regions) that include: 22 republics, 46 oblasts (provinces), 9 krays (territories), 4 autonomous okrugs (areas), 1 autonomous raion (county), and 3 federal cities (Moscow, Sevastopol, and St. Petersburg) (Ermasova, Ijose, and Ermasov, 2018). The Russian Federation has more than 24,000 local governments with dramatically different levels of economic strength and development (Ermasova and Ermasova, 2019; Ermasova and Mikesell, 2016; Zhuravskaia, 2000). For example, City of Moscow has 25 % of total gross regional product (GRP) and 8 % of population of the country. The Russia’s fiscal federalism is more centralized than in Germany and the USA. Public Spending In the USA, the major supported functions are national security (22 %), pensions (25%), health care (27%), welfare (9%), education (3%), transportation (2%) in 2018 (U.S. Department of the Treasury, 2018; US Government spending, 2018). The subnational governments are responsible for 76.5% of direct public expenditures (OECD National Accounts Statistic, 2016). In Germany, general government spending focuses on social protection (34%), defense (5%), healthcare (18%), transport (5%), and environment protection (2%). The subnational governments are responsible for 47 % of public expenditures (OECD National Accounts Statistic, 2016). In Russian Federation, the major supported functions are defense (17.2 %), protection (7.7%), social protection (20.8%), economic development (12.8 %), education (3.3%), health care (2.2%), and environment protection (0.4%) in 2017 (Federal State Statistics Service, 2018; Ministry of Finance Russian Federation, 2017, 2018a,b). Subnational governments are responsible for 58.4% of public expenditures (OECD National Accounts Statistic, 2016). Public Capital Budgeting and Management 185 Roles of Governments in Capital Expenditure In the USA, public capital expenditure is divided between federal (31%), state and local (69%) governments (Ermasova and Ebdon, 2019). State and local governments spend more on capital investment than does the federal government. The public capital spending on three levels of governments was $483.4 billion that includes $334.2 billion of state and local governments’ capital spending in 2014-2015 (U.S. Census Bureau, 2015, Office of Management and Budget, 2017a, 2017b). The direct federal spending for capital investment was $172.4 billion in 2017 that includes $134.0 billion for defense and $38.4 billion for nondefense. Federal budget provided $38.4 billion for investment grants to state and local governments (Office of Management and Budget, 2018). In Germany, public capital expenditure is divided between federal (31%), lander (29%), and local (30%) governments (German Finance Ministry, 2015; Statistisches Bundesamt, 2018; Trading Economics, 2018). The federal investment spending was around 2 % of the total federal budget in 2017 (Ermasova, 2019). Table 1. Total capital spending and economic performance data in Germany, the USA, and Russia Country 2015 Total public capital spending ($billion)* 2015 Population (million) ** Germany United States 80.34 1.1 Russia 483.4 13.7 21.2 44.3 2015 Total public capital spending per capita ($billion) 8 990.67 3 1,504 1 0.69 2015 GDP ($billion) *** 2015 Per Capita GDP 1990 Per Capita GDP**** 3 ,618 44,615 19,433 52,740 23,955 23,303 8,013 1 6,940 3 ,363 Source: Created by authors based on Srithongrung, Ermasova, and Yusuf (2019) * From Office of Management and Budget, USA (2017a, 2017b), Federal Ministry of Finance Germany (2018). Ministry of Finance of Russian Federation (2018b)_ ** For mid-year 2015; from Population Reference Bureau (2015) *** Financial data are in real USD based year 2011; from IMF (2018) ***** 1990 Per Capita GDP is in current USD; from The World Bank (2018) In Russian Federation, public capital expenditure is divided between federation (61.7%), regional governments (31.1%), and local (7.2%) governments (Finance of Russia, 2016). The federal government plays a major role in capital investments in Russia (Ermasova and Ermasova, 2019). According to OECD (2016a,b,c), the government provides around 65 % of infrastructure investments. According to Chakrabarti (2016), the share of the private sector, as a percentage of cumulative infrastructure investments in in the US was 29%; in 186 Ermasova Germany around 90%. Table 1 presents the public capital spending and economic performance data: the International Monetary Fund (IMF) income group, total population in 2015, total GDP in 2015, per capita GDP in 2015 and per capita GDP in 1990. Conditions of Public Infrastructure According to the Global Economic Forum (2017), USA was ranked ninth, Germany tenth, and Russia thirty fifth on a list of countries based on their infrastructure conditions (WEF Global Competitiveness Report, 2017). Table 2 demonstrates the ranking of federal countries based on conditions of their infrastructure in 2017. Table 2. The ranking of federal countries based on conditions of their infrastructure in 2017 Ranking Countries Score 81 Argentina 3.9 28 Australia 5.3 14 Austria 5.7 24 Belgium 5.4 16 Canada 5.7 115 Ethiopia 2.7 10 Germany 6.0 66 India 4.2 35 Russia 4.9 61 South Africa 4.3 12 Spain 5.9 6 Switzerland 6.3 5 United Arab Emirates 6.3 9 United States 6.0 117 Venezuela 2.6 Source: WEF Global Competitiveness Report. (2018). More information is available at http://reports.weforum.org/global-competitiveness-index-2017-2018/competitiveness-rankings/#series=GCI.A.02 There is evidence of specific gaps in American, German and Russian capital infrastructure (American Society of Civil Engineers, 2013, 2017; Chen, 2014, 2016, 2017; Chen and Bartle, 2017; Ermasova, 2012, 2013; Ermasova and Ermasova, 2019; Ermasova, 2019, Ermasova and Ebdon, 2019; Fratzscher, 2014,2015, 2018; Ganelin and Vasin, 2014; National Association of Manufacturers and Building America’s Future Educational Fund, 2013). Public Capital Budgeting and Management 187 Capital Planning and Forecasting The long-term plan should clearly describe an entity’s performance gap, the resources needed to bridge it, and a clear justification for new acquisitions proposed for funding with links of proposed investments to an organization’s long-term strategic goals. In the USA, a long-term capital investment plan covers from 5 to 6 years (Ermasova and Ebdon, 2019; OMB’s Capital Programming Guide and GAO’s Executive Guide, U.S. General Accounting Office, 1998). Presidential policy estimates for the nine years following the budget year enable an analysis of the long-term consequences of proposed long-term capital programs (Office of Management and Budget, 2016). Germany has fifteen-year and five-year investments plans that prepare the basis for the budgeting for specific investment projects. In the Russian Federation, the Ministry of Economic Development of the Russian Federation prepares the 15 years’ macroeconomic forecasts for the federal budget (Ermasova and Ermasova, 2019). The Ministry of Economic Development publishes two scenarios: (1) an optimistic, (2) pessimistic macroeconomic scenario (Ministry of Economic Development, 2013). These scenarios are based on the oil price, the exchange rate, and global economic developments. Public Investment Project Analysis In the USA, capital projects must be approved by the OMB based on benefitcost assessment, total life-cycle costs and benefits (OMB, 1992). Federal agencies and departments use a performance-based management system for estimation of cost, schedule, and performance goals for the investment throughout the acquisition process (Office of Management and Budget, 2016a, 2016b, Ermasova and Ebdon, 2019). In Germany, the analysis of a public investment project is also based on a cost-benefit analysis and includes the following components: reduced transportation costs, travel time, safety benefits, security, regional economic and social impact, job creation, and derived economic effects (OECD, 2014, p.55). There are following ranking principles: safety, reduced transportation costs, travel time, security, regional economic impact, job creation, social impact, and derived economic effects (Ermasova, 2019). In Russia, public capital investment projects are selected on the basis of economic and social impact for whole country not one region (Ermasova and Ermasova, 2019). The Government Commission selects investment projects based on national, regional, and interregional importance (Ermasova and Ermasova, 2019). The political level plays a key role in deciding which projects will be part of the portfolio appropriation in the USA, Germany, and Russia. In all three federations, the political support for a project can be more important than costbenefit estimates. Table 3 provides summary of capital budgeting and management in Germany, Russia, and the USA. 188 Ermasova Table 3. Summary of capital budgeting and management in Germany, the USA, and Russia Normative Recommendations Practices Germany Long-term Capital Planning Strategic National Development Policy; The Capital Plan- Joint Task for the Improvement of Rening gional Economic Structure; TwentyYear, Ten-Year, Five-year framework investment plans There are following infrastructure and network plans in Germany: Federal Transport Infrastructure Plan; Federal Regional Policy Plan; Trans-European Transport Networks; Energy Network; EU-Habitats Directive; 16 Länder-level plans, regional development plans and programs, regional project plans; Sector-specific plans such as energy plan or mining in North Rhine-Westphalia. Capital Im15 year CIP for transport infrastructure provement investments; 5 year CIP Program Capital Budgeting and Financial Management Systematic Investment projects are ranked accordPriority ing to cost-benefit analysis, the exRanking pected need for the project, and the assessed urgency in constructing the asset The USA Russia The OMB 1997 Capital Programming Guide A-11 to provide agencies a foundation for establishing a long-term capital investment plan that covers from 5 to 6 years to guide the implementation of organizational goals and objectives The Ministry of Economic Development issues long-term projections for the economy, 100 page document presenting medium-term macroeconomic assumptions, objectives of fiscal policy, projection of general government finances, breakdown of budget expenditure, and sources of financing 5 year CIP The short-term orientation of the yearly (operating) budget cycle influences Congress to systematically under-invest in public infrastructure in favor of the more politically popular consumption-based programs. Investment projects are ranked according to cost-benefit analysis, the expected need for the project, and the assessed urgency in constructing the asset Investment projects are ranked according to cost-benefit analysis, the expected need for the project, and the assessed urgency in constructing the asset Three-year budgeting framework. The government’s budget submission to parliament. Capital Budgeting Process Resource-allocation process from the outset, resulting in a distinctive form of “top-down budgeting” since 2010. The budgeting for capital projects are integrated into the ordinary budget process in Germany. The U.S. federal government does not have a separate capital budget. The budgeting for capital projects are integrated into the ordinary budget process in the USA. Debt Management Policy/Disclosure The German Schuldenbremse ("debt brake" ) as debt ceiling, Binding borrowing constraints Pay-as-you-use finance Annual borrowing is limited to 15 % of revenue net of federal grants for regions and 10 % for municipalities Deferred maintenance and repairs are measured using one of three methods: Condition assessment surveys; Life-cycle cost forecasts and Management analysis OMB use the asset priority index (API) and facility condition index (FCI) N/A Infrastructure maintenance Maintenance Planning through National Reform ProPlanning gram and Federal Transport Infrastructure Plans Maintenance Funding Funding through National Reform Program and Federal Transport Infrastructure Plans No mid-term, no long-term policy of maintenance funding Source: Created by authors based on Ermasova, 2019, Ermasova and Ermasova, 2019, Ermasova and Ebdon, 2019 Public Capital Budgeting and Management 189 4. RECOMMENDATIONS AND CONCLUSION Public infrastructure makes an important contribution to the economic and social life of a nation. National governments develop and manage their part of this system of capital assets through capital budget processes of varying degrees of formality, as the analysis of the three federations reported here show. The processes for capital investment planning are complicated and not well coordinated within the budget process in the USA and Russia. Separate planning of capital expenditure and related current expenditure for maintenance has led to negative consequences in both countries, such as uncompleted construction projects, prolongation of construction terms, and high exploitation costs of completed projects. Based on example of Germany’s national capital improvement plan (CIP) that requires the government to establish a 5-year rolling capital plan based on budget forecasts, this study suggest implementing strategic rolling capital plan at the national level in the USA. In the USA, the short-term orientation of the yearly (operating) budget cycle influences Congress to systematically under-invest in public infrastructure in favor of the more politically popular consumption-based programs (Congressional Budget Office, 2015; Ermasova and Ebdon, 2019; Frankel and Wachs, 2017). The USA could use Germany’s long-term capital budgeting and management approach. The German Federal Republic, the Russian Federation, and the United States have decline of public investments in last twenty years. To solve the problem of investment activity decline, the government’s stimulus programs were established in Germany. A special investment and redemption fund was created in Germany in 2009 which gave a particular boost to government investment. The USA and Russia could use this approach to improve public investment environment. Crumbling infrastructure appears to be an issue in these three federations, regardless of the state of their capital budgeting processes. Asset maintenance has been found to be the weakest area in capital management in all three countries. Germany, Russia and the USA had faced problems in maintenance funding as public investment slowed and the countries experienced infrastructure aging and backlog. For example, around one million jobs are expected to be lost due to the economic impacts of deteriorating transportation infrastructure in the USA by 2025 (American Society of Civil Engineers, 2017). Ebdon (2007) suggests that “capital assets need to be maintained in good working order to prevent excessive long-term costs and safety hazards. This requires good information systems and regular, comprehensive condition assessments to determine the status of assets, the cost of maintaining them in good condition, and the financing available to pay for the maintenance needs” (p.66). Maintenance planning should involve asset management and accounting for public capital assets based on historical records of investment, major repairs, and depreciation rates that would help guide capital resource allocation and project selection. According to 190 Ermasova Afonso (2014), if the government would use dedicated revenues to finance public facility depreciation, the government would be able to ensure annual appropriation for regular maintenance schedule. Maintenance funding could help to avoid accumulating public infrastructure backlogs because annual repairs would extend the useful life of a project. ACKNOWLEDGEMENT We would like to thank the anonymous referees for their thoughtful comments. REFERENCES Afonso, W.B. 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Overconfidence and Resistance to Abandoning Unprofitable Capital Budgeting Projects: The Effects of Autonomy, Internal Audit, and Accountability* JOHNNY JERMIAS, Simon Fraser University and Universitas Persada Indonesia YAI BILLY KIN HOI HU, Singapore University of Social Sciences Received on May 26, 2017; editorial decision completed on February 18, 2020 ABSTRACT The purpose of this study is to investigate the effects of managers’ autonomy in choosing a capital budgeting project has on their confidence in managing the project. Furthermore, this study examines the role that internal audit reports and accountability play in mitigating the impact of autonomy on managers’ resistance to abandoning unprofitable capital budgeting projects. Building on motivated reasoning theory, we hypothesize and find that managers who are given autonomy to choose their own projects are more confident that their projects will be successful than managers who are assigned the projects by their superiors. This study also shows that internal audit reports and accountability are effective mechanisms for reducing the influence of prior decisions on managers’ resistance to abandoning unprofitable projects. Keywords Accountability; Autonomy; Capital budgeting; Internal audit; Resistance to change EXCÈS DE CONFIANCE ET RÉTICENCE À ABANDONNER DES PROJETS D’INVESTISSEMENT NON RENTABLES : EFFETS DE L’AUTONOMIE, DES AUDITS INTERNES ET DE LA RESPONSABILISATION RÉSUMÉ Le but de cette étude est d’examiner les effets de l’autonomie des gestionnaires quant au choix des projets d’investissement sur leur confiance dans leur capacité à gérer ces projets. En outre, elle se penche sur le rôle des rapports d’audit interne et de la * Accepted by Pascale Lapointe-Antunes. The instrument and data used in this study are available upon request from the corresponding author. We are grateful for financial support from Nanyang Business School. We appreciate the valuable comments and suggestions of Jane Kennedy and Robert Libby on the early version of this paper. This paper has further benefitted from comments and suggestions from participants at a Simon Fraser University Research Seminar, the 2013 European Accounting Association Annual Congress, the 2013 Canadian Academic Accounting Association Annual Conference, and the 2013 American Accounting Association Annual Conference. AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) pages 49–71 © CAAA/ACPC doi:10.1111/1911-3838.12222 50 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES responsabilisation pour réduire l’impact de cette autonomie sur la réticence des gestionnaires à abandonner les projets d’investissement non rentables. En nous appuyant sur la théorie du raisonnement motivé, nous présumons et établissons que les gestionnaires qui disposent de l’autonomie nécessaire pour choisir leurs projets ont davantage confiance que ceux-ci connaîtront du succès que les gestionnaires à qui les projets sont attribués par leurs supérieurs hiérarchiques. L’étude montre également que les rapports d’audit interne et la responsabilisation constituent des mécanismes efficaces pour réduire l’influence des décisions antérieures sur la réticence des gestionnaires à abandonner des projets non rentables. Mots clés : évaluation des projets d’investissement; audit interne; autonomie; responsabilisation; résistance au changement 1. INTRODUCTION Capital budgeting decisions are used as a primary means for planning and controlling long-term projects that require a large amount of companies’ resources. Often managers have to compete for resources to fund projects because resources are limited and because a company usually receives more investment proposals than it can fund. Merchant and Van der Stede (2017) assert that managers invest a significant amount of time and effort in preparing capital budgeting proposals and often use their negotiation skills, political power, and track records to influence the outcome of their proposals. Once the proposals are approved, managers tend to be highly committed to the associated projects given that their reputation is often linked to the number of projects that they win funding for, and also how successfully they manage the implementation and operationalization of these projects. In addition, companies tend to evaluate the managers responsible for long-term projects by comparing expected and realized outcomes. Given the long-term nature of capital budgeting activities, managers must review ongoing projects regularly to determine whether they are achieving their intended purposes and if they should be modified, or even terminated. Unfortunately, managers are often not the unbiased evaluators that traditional economics rationality considers them to be. Research has shown that managers’ courses of action tend to be strongly influenced by their prior decisions. Using the theory of motivated reasoning (Kunda, 1990), studies have documented the importance of prior beliefs in explaining managers’ behavior. Some studies have shown that decisions based on managers’ prior beliefs were often suboptimal, such as an unwillingness to abandon unprofitable projects (Loh, Coytes, and Cheng, 2019; Cheng, Luckett, and Schulz, 2003; Ho and Vera-Munoz, 2001) and resistance to changing outdated costing systems (Jermias, 2001). Staw (1981) asserts that managers tend to justify ineffective past decisions by escalating their commitment to unprofitable projects. Although previous studies have been able to show the link between prior beliefs and subsequent behavior, scant research has investigated the mechanisms that mitigate suboptimal decisions resulting from biased decision-making processes, particularly within the context of capital budgeting. Existing literature proposes mitigating this phenomenon through the following techniques: providing counter explanations for the potential failure of managers’ plans (Kadous, Krische, and Sedor, 2006); having experts publicly provide a dissenting opinion that AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) OVERCONFIDENCE AND RESISTANCE TO ABANDONING UNPROFITABLE CAPITAL BUDGETING PROJECTS 51 disagrees with an official opinion (Kahneman, Lovallo, and Sibony, 2011); and requiring managers to demonstrate accountability and produce an assurance report (Libby, Salterio, and Webb, 2004). Our study extends the existing literature by incorporating an internal audit report to mitigate managers’ resistance to abandoning unprofitable capital budgeting projects. Kunda (1987) proposes that the influence of prior beliefs on subsequent decisions, such as managers’ decisions to continue working on an unprofitable project that they have chosen, is constrained by the ability to rationalize desired decisions. Petty and Cacioppo (1986) argue that people’s ability to rationalize their desired conclusions can only be exercised to the extent that reason permits. Further, individuals often accept undesirable decisions when confronted with convincing arguments that support the undesired decisions. Thus, having internal auditors verify the quality of data and provide strong arguments for managers to abandon undesirable projects can address their reluctance to doing so (Libby et al., 2004; Kennedy, 1995). Making managers accountable for their decisions will also increase their willingness to discontinue unprofitable projects (Jermias, 2006; Lerner and Tetlock, 1999). It is important to understand the effects of internal audit and accountability on the quality of decisions made within a capital budgeting context for three reasons. First, researchers have questioned whether assurance reports effectively enhance the quality of decisions (Reck, 2001; Maines et al., 2002). Second, the Institute of Internal Auditors (IIA) has recommended that internal auditors objectively assess evidence in order to provide opinions or conclusions regarding an entity, operation, function, process, or system (IIA, 2017a). Internal auditors should add value and improve companies’ operations by making credible recommendations and effectively communicating them to management (IIA, 2017b). With respect to capital budgeting, PricewaterhouseCoopers (2018) recommends that internal auditors should determine the elements to be reviewed and how to review them, document the specific scope of work to be performed and the associated audit steps for each element, communicate the rationale for timing based on the existing project schedule to the project management team, and document the lessons learned and actionable recommendations for continuous improvement on existing or future capital projects. This study provides useful insights into the positive capacity of the internal audit report to mitigate managers’ resistance to abandoning unprofitable capital budgeting project due to their prior commitment. As suggested by this study, the third reason why the effects of internal audit and accountability on the quality of capital budgeting decisions are important is that public accountability is a mechanism that motivates managers to be more objective in evaluating alternative courses of action. This is important because previous studies have reported mixed results regarding the effects of accountability on the quality of managers’ decisions. Some studies show that accountability improves judgment (Jermias, 2006; Tan, Ng, and Mak, 2002; Koonce, Anderson, and Marchant, 1995; Simonson and Staw, 1992). Other studies, however, report that accountability has a negative effect (Siegel-Jacobs and Yates, 1996) or no effect on the quality of judgments (Chang, Ho, and Liao, 1997; Kennedy, 1993; Cloyd, 1997). AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) 52 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES Specifically, our research investigates the effects of autonomy on managers’ confidence that their projects will be successful.1 Furthermore, we introduce and examine whether internal audit (Kennedy, 1995) and accountability (Lerner and Tetlock, 1999) mitigate the influence of prior decisions on managers’ willingness to abandon unprofitable capital budgeting projects. The study’s objective is to gain a deeper understanding of the role that autonomy plays with respect to managers’ confidence about executing their projects, and to gain insights into effective interventions that can reduce managers’ tendency to continue with unsuccessful past decisions. In doing so, the study can help managers to enhance firms’ value by ensuring that they use firms’ scarce resources effectively and efficiently. It also shows how having access to management accounting information can enable managers to make better decisions (Luft, 2016; Sprinkle, 2003). Gaining insights from motivated reasoning theory (Kunda, 1990) and research on escalation of commitment (Loh et al., 2019; Staw, 1981; Chow, Harrison, Lindquist, and Wu, 1997), we hypothesize that managers who have the autonomy to choose their own projects will be more confident that those projects will be successful than those who are assigned projects by their superiors. This is because managers who choose projects will exaggerate the potential benefits of those projects and downgrade their potential risks (Kunda, 1990). In addition, we predict that these managers will be more motivated to support their prior decisions by showing higher resistance to abandoning unprofitable projects than managers who are assigned projects. We further hypothesize that internal audit and accountability will mitigate the influence of managers’ prior decisions on their resistance to abandoning unprofitable capital budgeting projects. This is because internal audit reports enhance data quality, given that internal auditors provide independent and objective recommendations to add value to companies and improve their operations (IIA, 2017b). We also hypothesize that accountability will mitigate the effects of autonomy on managers’ unwillingness to abandon unprofitable capital budgeting projects because they need to judge projects accurately as part of their performance evaluation and are accountable to a legitimate audience (e.g., superiors). The results of this study are consistent with our hypotheses that (i) managers’ confidence in the success of their projects is higher when they have autonomy to choose their own projects than when their superiors assign the projects, and (ii) internal audit reports mitigate the influence of autonomy on managers’ resistance to abandoning unprofitable capital budgeting projects. With respect to accountability, the results suggest that holding managers accountable by requiring them to justify their decisions reduces their resistance to abandoning unprofitable projects. This study contributes to the literature on capital budgeting, autonomy, internal audits, and resistance to change. First, our study contributes to the debate in the accounting literature with regard to the extent of influence managers should be allowed in selecting and managing capital budgeting projects. While autonomy creates an 1 We obtained ethics clearance from the Office of Research Ethics at Simon Fraser University prior to conducting the experiment. AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) OVERCONFIDENCE AND RESISTANCE TO ABANDONING UNPROFITABLE CAPITAL BUDGETING PROJECTS 53 environment of confidence for managers, when projects turn out to be unprofitable due to unexpected factors it might cause managers to escalate their commitment to the projects and maintain it for an unnecessarily long time. Second, the study results suggest that internal audit reports are an effective mechanism to mitigate the effect of autonomy on managers’ resistance to abandoning unprofitable capital budgeting projects. This finding is important given that some researchers have questioned whether internal audit reports effectively enhance managers’ decisions. For example, Maines et al. (2002) assert that the effect of internal audit reports on the quality of manager’s decisions is largely unexplored. Third, the results are consistent with the proposition that accountability causes managers to exercise more efforts in justifying their decisions, which in turn mitigates their tendency to make biased decisions that favor prior commitment. Finally, the findings should also be of interest to practitioners because they suggest that providing managers with an internal audit report that verifies the data regarding project feasibility and makes managers accountable for their decisions reduces their tendency to continue working on unprofitable capital budgeting projects. Reducing managers’ resistance to abandoning unprofitable capital budgeting projects might save companies from unnecessary losses, enabling them to reallocate firms’ scarce resources to alternative, profitable projects. The remainder of the paper is organized as follows. In the second section, we discuss relevant background theory and related literature, and advance our hypotheses, after which we describe the participants and explain the experimental procedures and variable measurement. In section 4, we present the data analyses and study results. In the final section, we discuss the major findings, the limitations of the research, and its implications for future research and practice. 2. RELATED LITERATURE, RESEARCH FRAMEWORK, AND HYPOTHESES Kahneman and Tversky (1974) propose that people tend to rely on a limited number of heuristic principles to simplify the decision-making processes required to perform complex tasks. Heuristics are mental shortcuts that help people form judgments by focusing on limited aspects of a complex problem and ignoring other aspects that are perceived to be irrelevant. In a similar vein, Thaler (1980) suggests that although people are not fully rational when making complex decisions, their irrational behavior can be anticipated and controlled by streamlining the decision-making process. He further argues that people make complex decisions by focusing on separate components of those decisions rather than considering their broader context. Overconfidence in the Project’s Success Merchant and Van der Stede (2017) assert that one of the important issues in capital budgeting is the level of autonomy managers should be allowed in choosing and executing the projects. On one hand, autonomy in choosing their projects enhances managers’ commitment to work hard towards achieving the projects’ outcome and also increases information sharing between the managers and the top executives (Jermias and AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) 54 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES Yigit, 2013; Nouri and Parker, 1996). On the other hand, autonomy might induce managers to engage in undesirable behavior such as creating slack by setting lower targets when preparing the capital budgets which increases the probability of achieving the targets and rewards with less than optimum effort (De Baerdemaekera and Bruggemana, 2015; Van der Stede, 2000). Prior studies (Cheng et al., 2003; Ho and Vera-Munoz, 2001; Chow et al., 1997) have shown that managers tend to persistently pursue unprofitable projects and are reluctant to abandon them. Researchers argue that managers tend to escalate their commitment to failing projects due to the self-interested aim of protecting their reputation (Harrison and Harrell, 1993). Brockner and Rubin (1985) argue that this escalation of commitment occurs when decision makers invest further resources into continuing a course of action, despite information that the project is failing. When managers believe that a project was assigned to them, they will attribute a negative outcome to external sources. This attribution is made so that the negative consequence poses no threat to managers’ self-image as worthy. Because of it, managers are more willing to abandon unprofitable projects than profitable projects. However, if managers believe that they have chosen to manage a project, they will be committed to their choice and try to rationalize their decisions even when those decisions have negative consequences (Aronson, 1973). As a result, they will be reluctant to abandon an unprofitable project because in doing so they will acknowledge that they have made a bad decision, which is inconsistent with their cognition that they are effective and intelligent persons (Cooper and Fazio, 1984). We predict that managers who have the autonomy to choose their project will exaggerate the attractiveness of capital budgeting projects and downgrade the projects’ risks. As a result, they will be overconfident about the project’s success. In contrast, when managers do not have the autonomy to choose the project (i.e., the project is assigned by the CEO of the company), they are more objective in evaluating the project’s attractiveness as well as its associated risks. Hence, we predict that prior decisions will affect the judgment used in decision making. Specifically, the following hypothesis will be tested: HYPOTHESIS 1: Managers who freely choose a project to manage will show higher confidence in the success of the project than managers who are assigned a project to manage. Internal Audit and Managers’ Resistance to Abandoning Unprofitable Projects As discussed earlier, managers’ motivation to arrive at a particular decision is constrained by the quality of information available to them when they evaluate the feasibility of projects. Kennedy (1995) proposes that adequate data quality will mitigate managers’ tendency to make decisions that are biased by prior beliefs. Thus, managers will be more willing to abandon unprofitable capital budgeting projects if they are presented with data that provides them with a strong argument for doing so (Kennedy, 1995). One way to improve data quality is to provide internal audit reports about companies’ activities AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) OVERCONFIDENCE AND RESISTANCE TO ABANDONING UNPROFITABLE CAPITAL BUDGETING PROJECTS 55 (Libby et al., 2004). An internal audit report is a formal document that summarizes internal auditors’ work on an audit and reports their findings and recommendations (Institute of Internal Auditors North America, 2018). Burton, Emett, Simon, and Wood (2012) investigate whether managers are willing to change their initial decisions in response to the recommendations made by internal auditors. They find that managers are particularly likely to change their initial position when they are presented with preferenceinconsistent recommendations. In a similar vein, Fanning and Piercey (2014), find that managers change their decision following an internal auditor’s recommendation when the internal auditor is likeable and presents a thematically organized argument. We predict that when a project is judged to be unprofitable and managers are not provided with an internal audit report, those who have had autonomy to choose the project will show higher resistance to abandoning the unprofitable project than those to whom it has been assigned. On the other hand, when a project is judged to be unprofitable and managers are provided with the internal audit report, the former managers’ resistance to abandoning the unprofitable project will be reduced to a level similar to that of the latter. This leads to the following hypothesis: HYPOTHESIS 2: Internal audit reports will mitigate the impact of autonomy on resistance to abandoning the unprofitable project such that the difference in this resistance between managers who have autonomy and those who do not have autonomy will be negligible. Accountability and Managers’ Resistance to Abandoning Unprofitable Projects Lerner and Tetlock (1999) propose that for accountability to attenuate biased decision making, decision makers need to understand that they are required to make accurate judgments and be held accountable to a legitimate audience. Following Lerner and Tetlock (1999), we define accountability as the pressure for one to provide others with clear and legitimate reasons for the actions one takes. In our study, we manipulate accountability by asking managers to provide upper level management with reasons as to why they have decided to continue or terminate a project. We expect that when a project is judged to be unprofitable and managers have low accountability for its outcome, those who had the autonomy to choose the project will show a higher resistance to abandoning the unprofitable project than those who have been assigned the project. In contrast, when a project is judged to be unprofitable but managers have high accountability for its outcome, the former managers’ resistance to abandoning the unprofitable project will be reduced to a level similar to that of the latter. This is because managers who are highly accountable for their decisions tend to engage in a more objective evaluation of alternatives and pay greater attention to the cues they use (Lerner and Tetlock, 1999; Johnson and Kaplan, 1991). This leads to the following hypothesis: HYPOTHESIS 3: Accountability will mitigate the impact of autonomy on resistance to abandoning the unprofitable project such that the difference in this resistance AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) 56 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES between managers who have autonomy and those who do not have autonomy will be negligible. 3. EXPERIMENTAL METHOD Participants We recruited 112 MBA students to participate in the study. The ratio of sample size to independent variables is 37.33. Pedhazur (1997) suggests that the minimum sample sizeindependent variables ratio is 10, so 37.33 indicates that the model is stable and the results can be interpreted accordingly. We conducted two pilot studies to test the research instrument. The first study used eight students to examine the degree of understanding of the experimental materials. As a result, we made some minor modifications to the original instrument to improve its clarity and understandability. The second study used eight different students to obtain preliminary results related to the hypotheses developed in this study and to investigate any further changes necessary before conducting the actual experiment. The results of the second study indicate that students do not have any concerns about the experimental materials. Hence, we did not make any changes to the experimental materials after the second pilot study. All responses from the students who participated in these two pilot studies were excluded from the statistical analyses and none of these students participated in the actual experiment. The participants were volunteers. They were told that they were going to participate in a study about managerial judgment and decision making, and that they could discontinue the experiment at any time without penalty. They spent 30 minutes on average to complete the experiment (minimum 20 minutes, maximum 52 minutes) and were compensated $20 for their participation. Their average age was 29 years and their average working experience was 6 years. Seventy-five percent (83 participants) of the participants were male and 25 percent (27 participants) were female. Experimental Task and Procedure The experiment is a 2 (Autonomy, No Autonomy) × 2 (Internal Audit, No Internal Audit) × 2 (High Accountability, Low Accountability) between-subjects design. Participants were randomly assigned into one of the eight cells depicted in Table 2, panel A. Participants were asked to assume the role of a project manager for Advac Company. They were informed that project managers in this company gain the reputation of being highly talented when their projects are managed successfully and that the company uses the Internal Rate of Return (IRR) to evaluate the performance (i.e., success) of all of its projects. The experiment consisted of two stages. In the first stage, participants were informed that they were to manage a very promising project that has a useful life of seven years with an expected IRR of 26.71 percent. They were also informed that the company’s IRR range of other projects was 9–22 percent and that the average IRR of the manager’s previous projects was 15 percent. This information indicated that the project to be AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) OVERCONFIDENCE AND RESISTANCE TO ABANDONING UNPROFITABLE CAPITAL BUDGETING PROJECTS 57 managed would be very profitable. Participants in the Autonomy group were informed that they had decided to invest in the project after evaluating it in detail. In contrast, participants in the No Autonomy group were informed that the CEO of the company had assigned them the project. All participants were then asked to consider the information provided to them and indicate how strongly they believed that the project would be successful on a 10-point Likert-type scale in which 1 = “very weak” and 10 = “very strong.” In the second stage of the experiment, participants were provided with information about the actual performance of the project during the first four years of its useful life. They were informed that due to unanticipated and complex implementation problems, the level of annual net cash flow generated by the project was not as high as expected and had started to decline after year two. The experimental material indicated that when the cash flow first started to fall below the expected level in year three, the CEO of Advac had asked the manager about the project’s profitability. At that time, the manager was confident that the implementation problems could be resolved and convinced the CEO that the project could turn around in year four and achieve the expected level of cash flow. Participants subsequently learned that the manager had just been told that the net cash flow in year four was again below expectations and that the complex implementation problems might not be resolved. Participants were then presented with two options. Option one was to continue the project with a 25 percent chance that the implementation problems could be resolved, which would result in an overall IRR of 24 percent. However, there was a 75 percent chance that the implementation problems could not be overcome, in which case the overall IRR of the project would be 8 percent. Therefore, the new expected IRR of the project would be 12 percent. Option two was to terminate the project, in which case the equipment used for the project could be sold for $210,000 and the proceeds could be invested in an alternative project with a 25 percent chance of achieving an IRR of 17 percent and a 75 percent chance of achieving an IRR of 21 percent, resulting in an overall expected IRR of 20 percent. Participants in the internal audit group were presented with an internal audit report (shown in the Appendix) indicating that the company’s internal audit department had reviewed the project and assessed the reasonableness of the cash flow projection. All participants were then asked to rank their choice regarding whether to continue or to terminate the project on a 10-point Likert-type scale in which 1 = “definitely terminate the project” and 10 = “definitely continue the project.” Participants in the high accountability group were then asked to provide at least two specific reasons why they decided to continue or terminate the project and were informed that the reasons provided by them would be reviewed by the company’s board of directors or the project approval committee. Participants in the Low Accountability group were not asked to provide any reasons for their decision. Hence, accountability is a dummy variable (one for High Accountability group and zero for the Low Accountability group). Lastly, all participants were asked to complete a postexperimental questionnaire and provide demographic information. It should be noted that in real-life situations, managers who are assigned projects might not have the authority to terminate them if they are unprofitable. However, project AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) 58 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES managers should be able to voice their opinion about their objective assessments of projects, even though it is top level managers who will make the final decision to terminate unprofitable projects. 4. DATA ANALYSES AND RESULTS Manipulation Check The manipulation of the autonomy condition was assessed by participants’ responses to two statements. The first was “The decision to invest in the project was made by you” and the second was “The decision to invest in the project was made by the CEO of the company.” Participants responded to these questions by putting a check mark beside the question. The results show that the autonomy condition was successfully manipulated. All participants in the Autonomy group indicated that they made the decision to invest in the project. Similarly, all participants in the No Autonomy group indicated that the CEO of the company made the decision for them to invest in the project. The manipulation of the internal audit condition was assessed by participants’ responses to two statements. The first was “The internal audit department of Advac has provided the assurance report on the results and feasibility of the project.” The second was “There is no assurance report on the project feasibility included in the materials.” The results show that the internal audit manipulation was successful. All participants in the internal audit condition indicated that they received the assurance report from the internal audit department. Similarly, all participants in the nointernal audit report condition indicated that they did not receive the assurance report. The manipulation of the accountability condition was assessed by participants’ responses to two statements. The first was “You are required to provide specific reasons for why you choose to continue or terminate the project.” The second was “There is no requirement to provide specific reasons for why you continue or terminate the project.” The results show that the accountability manipulation was successful. All participants in the high accountability condition indicated that they were required to provide reasons for their choice. Similarly, all participants in the low accountability condition indicated that they were not required to provide reasons for their choice. Descriptive Statistics Panel A of Table 1 reports the descriptive statistics by the experimental conditions (Autonomy and No Autonomy) for the first stage of the experiment. As predicted, managers with autonomy were more confident that the project would be successful than those with no autonomy (Mauto = 7.75 [point B in Figure 1], and Mno-auto = 7.32 [point A in Figure 1]). Panel B of Table 1 shows the analysis of variance (ANOVA) result of the effect of autonomy on level of confidence. AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) OVERCONFIDENCE AND RESISTANCE TO ABANDONING UNPROFITABLE CAPITAL BUDGETING PROJECTS 59 We include gender and working experience as covariates in all the statistical analyses. The results indicate that both gender and working experience are not statistically significant. Hence, we excluded these two covariates from the results reported in this study. The overall model is statistically significant, F(3, 107) = 4.42, p < 0.01. The results show a significant autonomy main effect, F(1, 107) = 3.54, p < 0.05. Participants who had the autonomy to manage the project again showed significantly higher confidence that TABLE 1 First Stage: Test of Hypothesis 1—Confidence in the Project’s Success Panel A: Descriptive statistics Mean No Autonomy 7.32 Autonomy 7.75 Overall 7.53 Panel B: ANOVA results Source Sum of squares Autonomy 5.17 Error 162.06 SD 1.72 0.97 1.41 Minimum 3.00 6.00 3.00 Maximum 10.00 10.00 10.00 N 57 55 112 df 1 111 Mean squares 5.17 1.46 F-value 3.54 p-value 0.03* Notes: Panel A reports descriptive statistics by the experimental conditions Autonomy and No Autonomy: One (Autonomy) if managers choose to invest in the project, zero (No Autonomy) otherwise. Panel B reports ANOVA results of the effect of autonomy on the level of confidence, based on a 10-point scale where 1 = “very weak success” to 10 = “very strong success” in response to the question “How strongly do you believe that Project Proton will be successful?” *denotes significance level of 0.05, based on one-tailed test. FIGURE 1 Results of effects of autonomy on managers’ confidence. AP Vol. 19 No. 2 — PC vol. 19, n 2 (2020) 60 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES the project would succeed than those who were assigned the project by the company CEO. These results support Hypothesis 1. Results Table 2 reports the research design, descriptive statistics, and overall ANOVA for the second stage of the experiment. The overall model is statistically significant, F(9, 107) = 8.69, p < 0.01. The results indicate that only the Autonomy × Internal Audit and Autonomy × Accountability interactions are statistically significant at 0.10 level. We then separate the data into Internal Audit and Accountability subgroups to test Hypotheses 2 and 3. It is interesting to note that under the No Autonomy condition, the lowest resistance occurs in No Internal Audit and Low Accountability setting (2.75). This increases when Accountability is high (3.86), followed by when Internal Audit is present (4.08) and when Accountability is high and Internal Audit is present (4.14). These results suggest that under the No Autonomy condition, the presence of internal audit and accountability increase individuals’ resistance to abandoning unprofitable projects. We performed F-tests to compare the means of these four groups. The results indicate that the mean differences among these four groups...
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