Company Diversification, False Accounting, and Incentives
One reason why managers and why owners would like to diversify across products and countries is to take advantage of profit opportunities. Another reason is to complicate accounting so as to be able to fool other people. Let’s think about the implications. They may help explain the idea of “core competency”.
Suppose a manager’s effort E is unobservable to the shareholders, so he is paid based on the company’s profit, Y, which is a function of E plus noise. One reason to diversify across countries– say, to invest in China— is to reduce the noise, so the manager doesn’t need to be paid as much. That is a trivial reason, though, because his pay is such a small part of costs of the firm.
A better reason is that investment in China is profitable in itself. Suppose the true profit of investment in China is X, distributed normally with mean zero. The manager knows the value of X, and so do shareholders.
The incentive pay will cause the manager to make the right decision, even if the shareholders do not instruct him.
But suppose that there is another reason to invest in China: the possibility of confusing the accounting. In addition to the true profit, the investment allows the manager to add, if he wishes, a false profit of F to the firm’s total profit. F is also normally distributed with mean zero, but distributed independently of X. For simplicity, the manager learns F and the decision of whether to invest in China before he picks his Effort E.
Now, the shareholders will not want to allow investment in China if X>0 but X is small. The reason is that it would allow the manager to maybe slack off if F>0.
As a result, firms will require a higher hurdle rate for Chinese investments than for domestic ones. Also, firms that invest in China will do worse at home, because the manager can slack off more.