Executives’ ‘Off-the-Job’ Behavior, Corporate Culture, and Financial Reporting Risk

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday February 11, 2014 at 9:15 am
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Editor’s Note: The following post comes to us from Robert Davidson of the Accounting Area at Georgetown University, Aiyesha Dey of the Department of Accounting at the University of Minnesota, and Abbie Smith, Professor of Accounting at the University of Chicago.

In our paper, Executives’ ‘Off-the-Job’ Behavior, Corporate Culture, and Financial Reporting Risk, forthcoming in the Journal of Financial Economics, we examine how and why two aspects of top executives’ behavior outside the workplace, as measured by their legal infractions and ownership of luxury goods, are related to the likelihood of future misstated financial statements, including fraud and unintentional material reporting errors. We investigate two potential channels through which executives’ outside behavior is linked to the probability of future misstatements: (1) the executive’s propensity to misreport (hereafter “propensity channel”); and (2) changes in corporate culture (hereafter “culture channel”).

Motivated by the criminology literature, we interpret an executive’s prior legal infractions, including driving under the influence of alcohol, other drug-related charges, domestic violence, reckless behavior, disturbing the peace, and traffic violations, as symptoms of a relatively high disregard for laws and lack of self-control. We predict and find a direct, positive relation between CEOs’ and CFOs’ prior records and their propensity to perpetrate fraud (propensity channel), as reflected in the executive being named for fraudulent corporate reporting in a Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement Release (AAER). We find no relation between CEOs’ prior legal infractions and other insiders being named in an AAER, unintentional reporting errors, or other symptoms of a relatively weak control environment (culture channel).

We interpret an executive’s ownership of luxury goods, including expensive cars, boats, and houses, as a symptom of relatively low “frugality.” Motivated by the psychology and managerial accounting literatures, we predict that CEOs who refrain from acquiring luxury goods (hereafter “frugal CEOs”) are likely to run a “tight ship” relative to unfrugal CEOs (culture channel). Consistent with the culture channel, we find that the probabilities of both fraudulent reporting by other insiders and erroneous reporting are higher in firms run by an unfrugal (vs. frugal) CEO, and these differences become more pronounced over the CEO’s tenure. Further, we find some evidence that the increasing probability of fraud over the tenure of unfrugal CEOs is associated with the appointment of an unfrugal CFO, as well as an increase in more “traditional” fraud risk factors, i.e., an increase in executives’ equity-based incentives and weakened board monitoring. In contrast to executives with records, we find no evidence that unfrugal executives have a higher propensity to perpetrate fraud.

The interpretation of our results is subject to several caveats. First, due to the high cost of the background checks used for data on legal records and asset ownership, our fraud and error samples are small, and have a high proportion of fraud and error firms relative to the underlying population of firms. Second, our fraud and error samples include only firms whose misreporting is detected and enforced, raising the possibility that our results are confounded by factors associated with the SEC’s detection and enforcement procedures. And third, endogenous sorting of executives to firms may bias our results. Our results are robust to a variety of identification strategies for addressing the latter two issues, mitigating these concerns.

Subject to these caveats, our paper makes three main contributions. First, we provide new evidence on the risk of materially misstated financial statements. Second, we introduce novel measures of executive “type” based on prior legal infractions and luxury asset ownership. We document evidence that these measures of executives’ “off-the-job” behavior capture meaningful differences in managerial style in a financial reporting context, raising the possibility that these measures are useful in exploring other aspects of corporate behavior and performance. And third, we provide the first evidence of which we are aware of how changes in corporate culture over the tenure of CEOs differ in an intuitive and intriguing way by CEO type.

The full paper is available for download here.

 

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