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Abstract

Exploring the behavior of CEOs and chief financial officers (CFOs), the authors find that the behavior of those who lack frugality in their personal lives contributes to a lax control environment at their firms, which can create an ideal environment for fraud and other questionable behavior. In addition, CEOs and CFOs with legal issues are more likely to engage in fraudulent behavior at their firms.

What’s Inside?

The proclivity of CEOs and chief financial officers (CFOs) for pecuniary excess and legal infractions in their personal lives may carry implications for corporate governance. The authors demonstrate that those with a legal record are more likely to engage in fraudulent conduct. Although there is no clear link between an executive’s lack of frugality and fraud, the behavior of executives who are not personally frugal may contribute to a lax control environment that could, in turn, engender questionable or illicit activities.

How Is This Research Useful to Practitioners?

The authors investigate two possible channels through which high-level executives’ outside behavior (i.e., problems with the law and imprudent, excessive personal spending) may lead to financial misstatements as a result of undisciplined reporting practices or outright deceit. The first is the propensity channel, which is the likelihood that the executive will misreport financial information, and the second is the cultural channel, which reveals to what extent such outside behavior influences firm culture and thus contributes to a breakdown of proper defenses against fraudulent practices.

Executives’ legal infractions may include such items as drunk driving, drug use, violence, and traffic violations. Such conduct is symptomatic of a disregard for law and poor self-control. The authors predict and identify a positive correlation between such conduct and CEOs’ and CFOs’ implication in fraudulent financial reporting, but this link does not extend to other insiders.

Excessive spending on such luxury items as high-end automobiles and homes is indicative of a lack of frugality. By “frugality,” the authors mean controlled and prudent spending rather than being miserly. They predict that frugal CEOs and CFOs manage their firms like a well-oiled machine. Firms with financially extravagant CEOs, by contrast, are more likely to engage in erroneous and fraudulent financial reporting, a symptom that worsens over time. Ancillary features of such a collapse could be the appointment of a spendthrift CFO, an increase in top management’s equity-based incentives, and a weakening of board oversight. Yet there is no direct evidence that spendthrift executives are more likely to commit fraud.

The authors acknowledge their study’s limitations, including a small sample and reliance on fraud and errors that have been both detected and enforced. Endogeneity in the sorting of executives to firms may skew results as well. These shortcomings notwithstanding, the authors contribute to the literature by providing new evidence on material financial misstatements, a new perspective on executive types that furthers the research on company behavior and performance, and finally, new research on how CEO personality type influences corporate culture over time.

Students and observers of organizational behavior and management, as well as behavioral psychologists, should find the authors’ study engaging and informative, its limitations notwithstanding.

How Did the Authors Conduct This Research?

The literature on behavioral psychology, auditing and earnings management, and criminology informs the basis for the authors’ inquiry. Their testable predictions are that CEOs with a legal record or who own luxury items are more likely to make future material financial misstatements. Those with a criminal record are more likely to have a propensity for fraud. Additionally, a corporate culture conducive to financial misstatements, intentional or otherwise, is more likely under the management of a personally profligate CEO.

The authors consider a sample of fraud firms from SEC Accounting and Auditing Enforcement Releases over a 20-year time period; cases that are redundant or not relevant directly to fraud are removed from the sample. They merge the remaining sample with data from CRSP, Compustat, and ExecuComp (which start in 1992) to arrive at 109 firms that initiated fraud between 1992 and 2004.

For a control group, each fraud firm is paired with a nonfraud firm from the same industry group with a similar estimated fraud probability, controlling for CEO age, firm size, growth prospects, leverage, and volatility. The sample of material reporting errors comes from the sample of restatements attributable to errors from the Audit Analytics database combined with results from an authoritative error sample that draws on the Government Accountability Office database. Data on executives’ legal infractions and luxury item ownership come from federal, state, and county databases to which licensed private investigators have access. Board-monitoring measures, which look for social connections between senior management and board directorship, come from several sources.

The authors apply regression models to this set of firms to test the aforementioned predictions, including the degree to which fraud and the probability of financial reporting errors vary with CEO type, how the probability of fraud and the CEO being implicated vary over his or her tenure, the likelihood of other insiders being named in frauds as a function of CEO type, and whether and how CEO type is linked to changes in firm governance and control environment. The authors subject these exercises to numerous robustness tests. For the most part, their analysis confirms the positive correlation between executives’ outside legal infractions and their propensity for fraud and misreporting. Additionally, CEOs’ pecuniary excess correlates positively with a more lax environment that is ideal for inaccurate reporting.

Abstractor’s Viewpoint

Character is hard to hide, but flaws may not always be transparent. A CEO’s behavior away from the office may affect firm culture. The authors focus on how executives’ inappropriate behavior and uncontrolled personal spending can set a bad precedent at their firms. Although it contains certain shortcomings, the investigation sheds critical light on managerial conduct. A possible avenue for further research would be applying the authors’ methodology to corporate culture in other developed and developing countries to ascertain what outcomes might transpire and the degree to which the translation of questionable conduct in other corporate cultures could influence markets.

About the Author(s)

Marc L. Ross CFA

Marc L. Ross, CFA, is a senior compliance consultant at John Hancock.