The Informational Requirements of Management by Exception : A Positive Theory

The wide-spread routine practice of management by exception (MBE) is at odds with the normative finding that there is no economic demand for the computation of variances from pre-planned thresholds. To address this discrepancy, I propose an algorithm which captures salient features of MBE and may produce payoffs that are nearly identical to a normative (no-threshold) benchmark. Relative to normative theory, the study shows that informativeness is no longer a sufficient condition for inclusion in the exception report. Furthermore, an activity's materiality may be inversely related to its weight in triggering an investigation. Instead, the demand for information about an activity may depend on how it complements MBE practice (i.e., how does it distort the algorithm?). The frequent waivers of negative variances are explored; with the trigger-like bond covenants in lending and the external auditor's waivers of financial misrepresentations serving as illustrations