C. PAPER 3
2. BACKGROUND AND EXPECTATIONS 1 Criminal record
The criminology literature lends support to the idea that criminal behavior is an observable outcome of a certain inherent personal trait. Gottfredson and Hirschi (1990)7 argue that a lack of self-control is the essential element of criminality, independent of the nature of the crime, and base their theory on the assumption (and observations) that crime provides easily accomplished, immediate gratification, and that these motivations for crime even extend to white-collar crime, which is empirically supported by Blickle et al. (2006). The theory suggests that a lack of self-control increases the propensity of individuals to obtain easy, immediate gratification through crimes, and permeates a nexus of an individual’s analogue behaviors such as the tendency to smoke, excessive drinking, driving fast, and gambling. Those individuals lacking self-control are characterized as impulsive, insensitive, risk-taking, and short-sighted, all characteristics that are closely related to opportunism and short-termism inherent in earnings management behavior.
7 Gottfredson and Hirschi’s book “A general theory of crime” is considered fundamental in the criminal literature (Pratt and Cullen 2006) with more than 12,500 citations on Google Scholar (31 July 2019).
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In a meta-analysis based on 21 studies and 126 size effects Pratt and Cullen (2006) provide empirical evidence supporting Gottfredson and Hirschi’s general theory of crime, across several empirical measures used to quantify “lack of self-control”. Consistently, accounting and finance research links criminal behavior of executives to firm behavior (Davidson et al. 2015; Kallunki et al. 2018), and show that opportunistic behavior is rather a “sticky” trait than a domain specific outcome (Ali and Hirshleifer 2017).
2.2 Corporate culture and executives
Corporate culture is commonly defined as the shared values and beliefs of employees (Van Den Steen 2010; Liu 2016). Van den Steen (2010) shows analytically how corporate culture evolves, and derives that organizations have a tendency to develop homogenous beliefs (i.e.
corporate culture). Two mechanisms through which the corporate culture evolves are screening (a manager will hire an employee with similar beliefs) and self-sorting (employees tend to choose to work with firms with similar beliefs), suggesting that firm managers are important determinants for corporate culture. Labor economics research provides extensive evidence on the sorting mechanism in labor markets8.
Within the finance and accounting literature, researchers find that corporate culture is an important contributor to firm (mis)behavior. For example, the survey and interview evidence of Graham, Grennan, et al. (2016) and Graham, Harvey, et al. (2016) indicate that executives view corporate culture as one of the top drivers of firm value, and that executives believe that corporate culture influences corporate ethics and proxies for earnings management. Specifically, they report that 85% of their respondents believe that poor culture increases the likelihood that employees might act “unethically”, which they proxy by compliance, tax aggressiveness, quality of financial reporting, and importance of meeting or beating earnings benchmarks. From the psychology literature, in a comprehensive meta-analysis Kish-Gephart et al. (2010) provide evidence that unethical culture is linked to unethical corporate outcomes, such as misrepresentation in financial reports or lying to customers.
8 For example, prior labor economics research provides evidence that risk-averse workers sort into occupations with low earnings risk, and vice versa (Bonin et al. 2007; Cornelissen et al. 2011), that workers sort into certain jobs that match their profiles and thereby increase their wage (Dechter 2015; Jinkins and Morin 2018), and that honest workers self-sort into the public sector (results based on a low corruption country) (Barfort et al. 2019).
151 A large body of quantitative research measures corporate culture based on executives’ beliefs and values. For example, Biggerstaff et al. (2015) find that executives who benefit from option backdating are more likely to engage in other forms of corporate misbehavior, such as financial reporting fraud, meeting or beating analyst forecasts, and accrual earnings management in order to meet or beat analyst forecasts, and Ali and Hirschleifer (2017) find that executives with opportunistic insider trades are related to outcomes of firm misconduct, such as earnings management, restatements, SEC enforcement actions, and shareholder litigation, suggesting that opportunistic firm behavior is driven by a certain corporate culture that tolerates or even encourages such behavior9.
Other studies use “off-the-job” traits of executives and link those personal traits to corporate behavior. For example, Liu (2016) finds that the corruption index of executives’ country of ancestry is related to firms’ engagement in earnings management, accounting fraud, option backdating, and opportunistic insider trading, claiming that executives’ corruption attitudes proxy corporate culture and a firm’s general attitude towards opportunistic behavior. Davidson et al. (2015) find that criminal behavior of the CEO and CFO is positively related to the propensity to misreport (executives named in SEC AAERs), and further find that insiders (other than the CEO) in firms with low frugality10 CEOs are more likely to be named in AAERs. They explain the latter results with a culture explanation, where CEOs influence the corporate culture.
Cline et al. (2018) find that executives with personal indiscretions disseminated by news media (allegations of dishonesty, substance abuse, sexual misadventure, accused of violence) are more likely to manipulate earnings, amongst other opportunistic corporate outcomes. Indeed, corporate culture and opportunistic firm behavior are influenced by managers and their beliefs.
To the extent that the presence of a criminal record is an observable outcome measure for certain values and beliefs, and that firm managers influence corporate culture based on those values and beliefs, I predict that firms with criminal executives are relatively more prone to use earnings management. Albeit not the main hypothesis of this paper, for completeness and to link my results to related research, I formally state the following hypothesis:
H1: Firms with criminal executives are relatively more prone to manage earnings
9 Biggerstaff et al. attribute their findings to “unethical culture”. Ali and Hirschleifer suggest that their results are driven either by corporate culture or having “a set of managers who are inherently prone to cheating” (p. 491).
10 Frugality is a psychological trait that reflects discipline in buying and using consumer goods and services to achieve long-term goals. Davidson et al. measure frugality using executives’ ownership of luxury goods, such as expensive cars, boats, or expensive houses. See Davidson et al. for further discussion of frugality.
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2.3 Corporate culture and employees
Consistent with the view of Van den Steen (2010), O’Reilly (1989) view corporate culture as shared beliefs and expectations by an organization’s members. O’Reilly argues that individuals are influenced by the common expectations by other individuals within the group, because individuals seek to be accepted and live up to peer individuals’ expectations and therefore ought to conform to other individuals’ beliefs and expectations. Hence, corporate culture functions as a
“social control” system. This view is broadly supported in the literature, for example by Hackman (1992) and social norm theory (Elster 1989).
Whereas Van den Steen (2010) models corporate culture as an outcome of the manager’s decision to employ employees with similar beliefs (the sorting channel), O’Reilly (1989) recognizes that employee beliefs do not necessarily conform to top management beliefs, and note that the management’s beliefs capture how things are ought to be, whereas employee beliefs define “how things actually are” (p. 13). Further, Van Den Steen (2010) extend his theory and note that corporate culture can persist even when the original managers who contributed to defining the corporate culture have left the firm. From a theoretical standpoint it seems that employees have a say in corporate culture.
There are several channels through which employees can influence firm financial reporting.
Accounting data originate far from the C-suite, and many employees participate in the generation of financial reporting data, because the firm’s final report is compiled of several sub-reports within the firm. Through thus channel, employees can choose to submit (or not submit) opportunistic sub-reports. This phenomenon is a well-recognized issue in the management accounting literature, where budget targets provide subordinates incentives to manage earnings (Libby and Lindsay 2010; Courty et al. 2004; Jensen 2003). Employees can manage their earnings estimates they submit to superiors to personally gain reputation and/or obtain bonus payments. Also through this channel, employees can choose to comply (or not comply) with opportunistic managers’ request to help managing earnings, which is what happened in for example the HealthSouth case. In this case, employees might succumb to a manager’s pressure and help manage earnings in order to keep his/her job.
Beyond their participating role in the accounting information generation, employees play an important governance role and may (or may not) take corrective action or report intentional financial misreporting. For example, in the case of HealthSouth an employee was one of the first to inform the firm’s auditors about severe accounting problems in the Accounting Department.
153 Dyck et al. (2010) find that employees detect fraud more often than both the SEC and firm auditors and Call et al. (2016) find that firms involved in financial reporting violations take actions to motivate employees not to report financial misconduct emphasizing the importance of employees as a governance mechanism.
In the finance and accounting literature empirical research on employees, corporate culture and financial reporting is limited, likely because employee beliefs are difficult to quantify.
Therefore, researchers have resorted to proxy corporate culture using executive traits (as discussed in the previous section) or used proxies such as the level of religiosity (McGuire et al.
2012; Dyreng et al. 2012) or education (Call et al. 2017) at the geographic proximity of a firm’s headquarter11. A notable exception is the research by Guiso et al. (2015), who use employee survey responses administered by the Great Place To Work Institute, and find that firms in which employees score their executives high on integrity experience higher profitability.
By exploiting a hack of the infidelity website Ashley Madison, Griffin et al. (2019) find that financial advisors active on the webpage are significantly more likely to engage in misconduct12, and that individuals active on the webpage are significantly more likely to be defendants of SEC litigation alleging fraud and white-collar crime, suggesting that employees’ actions in their professional lives are shaped by their personal traits and beliefs.
Because of employees’ influence on corporate culture and their ability to affect financial reporting, I predict that firms with relatively criminal employees are relatively more prone to use earnings management, and I expect this association to be incremental to the association between criminal executives and earnings management. I point out that criminal employees may influence financial reporting themselves, or through their influence on corporate culture and thus non-criminal employees’ behavior, because individuals seek to conform to group norms.
H2: Incremental to the effect of executives, firms with a criminal workforce are relatively more prone to manage earnings.
Lastly, because I expect criminal executives and criminal employees to capture two distinct but correlated aspects of corporate culture, I predict that firms with both criminal executives and criminal employees are relatively more likely to engage in earnings management. The hypothesis is motivated by anecdotal evidence (for example the case of HealthSouth) where it is
11 I point out that McGuire et al. and Dyreng et al. argue that managers (end not employees) even self-select or conform to local norms, whereas Call et al. use a geographic proxy to capture traits of a firm’s workforce.
12 The forms of misconduct include customer disputes, employment separation, regulatory, and criminal violations.
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evident that firm executives need the cooperation of a nexus of employees to push through their opportunistic accounting gimmicks. Therefore, firms with criminal executives who employ criminal employees are expected to engage the most in earnings management.
H3: Firms with both criminal executives and a criminal workforce are relatively more prone to manage earnings