A Positive Theory of Accounting-Based Management by Exception

Abstract

ABSTRACT Under the widespread planning-and-control paradigm, organizations schedule their budgeting early in the period (planning) when the organization has more time to carefully reflect on the processes to be later controlled. I refer to a budgeting process that conveys thresholds to managers as management by exception (MBE), and model MBE as a limited communication device, which alleviates the manager's burden of retrieving the details from the planning phase while preserving enough information to maintain effective control. Accordingly, I identify a threshold-based MBE algorithm, which is shown to approximate the performance of a full-communication policy, suggesting that simple static threshold-based communication can be effective. The equivalence between a full-disclosure policy and perfectly flexible budgets helps to explain the popularity of static budgets in light of these findings. The results also challenge the accounting concept of materiality by suggesting that less important activities may actually have tighter thresholds. JEL Classifications: D21; M41.