Executives' "Off-The-Job" Behavior, Corporate Culture, and Financial Reporting Risk

Abstract

We examine how executives' behavior outside the workplace, as measured by their ownership of luxury goods (low "frugality") and prior legal infractions, is related to financial reporting risk. We predict and find that CEOs and CFOs with a legal record are more likely to perpetrate fraud. In contrast, we do not find a relation between executives' frugality and the propensity to perpetrate fraud. However, as predicted, we find that unfrugal CEOs oversee a relatively loose control environment characterized by relatively high probabilities of other insiders perpetrating fraud and unintentional material reporting errors. Further, cultural changes associated with an increase in fraud risk are more likely during unfrugal (vs. frugal) CEOs' reign, including the appointment of an unfrugal CFO, an increase in executives' equity-based incentives to misreport, and a decline in measures of board monitoring intensity.

Masculinity, Testosterone, and Financial Misreporting

“…While a vast literature has examined the determinants of misreporting (see, e.g., Dechow, Ge, and Schrand [2010], Fields, Lys, and Vincent [2001]), the number of studies that link accounting practices to the personal characteristics of senior management is small. Nevertheless, a growing literature originating in accounting, finance, and economics considers "managerial styles" and their effect on corporate actions (Brunnermeier, Bolton, and Veldkamp [2010], Borghans et al [2008], Davidson, Dey, and Smith [2013], Fee, Hadlock, and Pierce [2013], Malmendier and Tate [2005]).…”

“…Other studies go a step further and examine a specific managerial style (e.g., "integrity" or "overconfidence") rather than document managerial fixed effects in financial reporting (Dikolli, Mayew, and Steffen [2012], Law and Mills [2014], Schrand and Zechman [2012]). These results are intriguing and suggest that a CEO's personal characteristics are associated with financial reporting (Davidson, Dey, and Smith [2013]). Nevertheless, given the available measures, it proves difficult to determine whether integrity or overconfidence are the outcome of corporate governance practices, incentives, and other situational factors or of something that is innate; that is, a stable, nonfakeable individual characteristic of the manager.…”

“…We also find a positive (negative) association between the misreporting proxy in the Cox proportional hazard regressions (ordered logistic regressions) and leverage (volatility of monthly stock returns and an indicator variable for firms that report a negative net income). The variable %Misreporting industry members controls for the industryrelated incidence of misreporting (Davidson, Dey, and Smith [2013]). As expected, it is positively associated with a given firm's misreporting risk.…”

“…While in the strict neoclassical model, the personal characteristics of managers do not matter for corporate decision making, an emerging stream of work in accounting and finance recognizes that financial reporting practices vary predictably with specific individual traits of executives (Davidson, Dey, and Smith [2013], Dikolli, Mayew, and Steffen [2012], Schrand and Zechman [2012]). We argue that facial structures meaningfully capture variation in those CEO personal characteristics that are associated with financial reporting.…”

A Critical Analysis of Databases used in Financial Misconduct Research

“…Many researchers identify their empirical tests by comparing the characteristics of firms identified in one of the four databases (i.e., treatment firms) with those of other (i.e., control) firms (e.g., Davidson et al, 2014). Such comparisons will be affected by which firms are placed into the treatment and control groups.…”