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

Abstract:     
We examine how and why two aspects of CEO behavior outside the workplace, as measured by prior legal infractions and the ownership of luxury goods, are related to the likelihood of misstated financial statements, including fraud and material reporting errors. We interpret an executive’s prior record of legal infractions, including charges of driving under the influence, other drug related charges, domestic violence, reckless behavior, disturbing the peace, and speeding tickets, as a symptom of a relatively low regard for laws and a lack of self-control. Hence we predict and find that record holders have a relatively high propensity to perpetrate fraud. We interpret an executive’s prior ownership of luxury goods as a symptom of low frugality. We predict and find that the risk of fraudulent corporate reporting, the risk that other insiders are named in perpetrating fraud, and the risk of unintentional reporting errors increase over the tenure of “unfrugal CEOs”, consistent with a deterioration in the culture/control environment. Also consistent with a loosening of the culture, we find a decline in measures of board monitoring intensity and an increase in the equity-based incentives of top executives during the tenure of unfrugal CEOs, and some evidence that these changes distinguish fraud from nonfraud years of the fraud sample. Further, unfrugal CFOs are more likely to be appointed by unfrugal CEOs than by frugal CEOs, and the relation between CFO type and fraud risk is more pronounced in firms run by unfrugal CEOs, consistent with a relatively weak control environment. Finally, we find a positive relation between less egregious earning management and CEOs’ prior records and asset ownership, providing additional assurance that our results are not driven by a potential relation between executive type and SEC detection or enforcement.

Number of Pages in PDF File: 73

Keywords: frugality, fraud, corporate culture, corporate governance

JEL Classification: G30, G34, G38

working papers series