Causes of Corporate Misconduct, Article Critique Example

The article that I have chosen to critique is called “Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation,” appearing in Organizational Science and written by Jared Harris and Philip Bromiley.  The problem discussed in this article is the challenge of gaining a more thorough understanding of the causes of corporate misconduct, which the authors believe has not been adequately researched. By examining financial reports that were triggered by suspicious accounting practicesthat were targeted by the Government Accountability Office, the researchers developed support for theirpremise that executive compensation and performance exerts a significant influence on the misrepresentations found on these financial statements. This paper will review and critique the article, discussing the methods utilized, hypothesis, and conclusions; it will also include data from other journal articles that are similarly focused.

The researchers conducted their study based on behavioral theory, examining two factors which they believe have an impact on corporate misrepresentation: managerial incentives as well as organizational goals vs. performance (Bromiley.) This study makes the point that over the past several decades, financial incentives for managers have grown from more than 100 times the typical salary of an average worker in 1990 to between 350 and 570 times the typical worker’s salary (Bromiley.) Many other studies have examined variations of the subject, but the authors of this research believe that the work done prior to theirs was inadequate in establishing a significant understanding of the factors involved incorporate financial misrepresentation.  The focus of other studies was related to,but not exclusively concentrated on the goal of the current research discussed.  For example, a study conducted by The Ethics Resource Center was focused on understanding the culture of ethics in organizations, and the factors that are barriers to ethical behavior (Verschoor.) That paper centered on the significance of important ethical principles practiced by and modeled by the people at the top of the corporate ladder in laying the foundation for others throughout the company to establish ethical guidelines and behaviors. This work emphasizes the importance of not only having written materials promoting ethical behavior, but ensuring that managers in such organizations verbalize as well as demonstrate strong ethical practices in order to enhance the chances that everyone in subordinate positions, as well as those at the top, will maintain an ethical culture.

Another report found that decreases in earnings and increases in risk were discovered to coexist with incidence of misconduct, and looked at whether allegations of misconduct leads to predictable changes in profitability and risks of the accused offender (Murphy.) Another study discussed the importance of clarity of responsibility in corporations as well as political organizations as a way to reduce the level of corruption (Tavits.) A study that was closely related to the issue studied in this paper confirmed that companies which have greater financial opportunities and incentives are more likely to commit accounting irregularities (Elayan.)

The researchers in the Harris/Bromiley study make the point that while other effortshave focused on a variety of types of organizations and misconduct, they have solely concentrated on the issue of corporate financial mismanagement.  They present an exhaustive study of the literature pertaining to corporate misconduct and the many forms that it can take; the research is extremely detailed and comprehensive, so much so that it actually becomes difficult to keep track of the various studies, their goals and conclusions and their relevance to the current work.  For example, early on in the section that covers the problem of financial misrepresentation, there are so many works cited that it is difficult to stay focused on their inquiry into causes of financial misrepresentation.  I believe that it might have been more effective if the researchers had utilized a smaller number of studies but had included a bit more detail about each study in order to clarify those findings and help the reader distinguish one study from another. Instead, they included so many different research trials with only a sentence or two about the results that it was really difficult to integrate all of those findings in a relevant way. The authors have clearly done a tremendous amount of work in conducting their literature review, but the effect is that the sheer volume of data overwhelms the reader.

Nevertheless, Harris and Bromiley clearly have examined their subject from every angle imaginable; my reaction is simply that perhaps the information could have been more streamlined in order to facilitate thepresentation of their findings as unique, both in their approach as well as their findings.The purpose of the study is made clear at the beginning of the article, in the abstract: the authors briefly identify the issue of corporate misconduct, and describe the inadequacy of previous scholarly work in understanding its causes, as well as its mechanisms (Bromiley.) The introduction then goes on to discuss the detrimental impact of corporate misconduct on businesses, and presents the theory which will be utilized in this study: behavioral theory that is applied in order to understand corporate malfeasance, and the reason that the researchers believe that this is an ideal framework to be applied to this area of study. This research was conducted by examining financial statements of companies that had come to the attention of the GAO because of irregularities that appeared in their accounting reports. These corporate restatements occurred between January, 1997, and June, 2002, and consisted of 919 documents provided by 845 firms (Bromiley.) They did not utilize random sampling because the incidence of restatements occurs so infrequently that it simply was not feasible to use that method. Instead, the researchers employed matched-sample designs, comparing and associating each restating firm with an industry that had similar sales and which had the same industry classification code. Those firms which could not be matched with similar organization were dropped from the study. Other factors that prevented corporations from being utilized were those with zero sales, no identifiable CEO or CEOs that did not receive any financial compensation. In addition, the only firms that were included were those that were “first-time offenders,” i.e., those who had to reinstate financial information only once, rather than multiple times.

The results reported in this study clearly supported the authors’ hypothesis that executive compensation and performance exerts a significant influence on the misrepresentations found in  financial statements. The tables attached plotted the predicted probabilities of misrepresentation compared with the percentage of compensation as options, and determined that transferring from zero options to 100% options increase the probability of misrepresentation from 5.7% to 13%, a result that more than doubled the probability (Bromiley.) All of the researchers’ hypotheses regarding factors that influence corporate misconduct were supported, although one surprise was recorded: the amount that firms perform higher than their prior levels positively affected the probabilities of financial misrepresentation (Bromiley.) The data indicated that the record of the firms’ sales figures positively and significantly had an impact on the probability of financial record-keeping misconduct.

This study considered a wide variety of controls in establishing valid results: independence of the corporations’ Boards, ownership of large blocks of stocks, restriction of stock ownership by CEOs, and large holdings of outside stock ownership. The one variable that they were not able to factor in was the more personal one: the personalities, ethical codes and values of the operations’ officers, managers, and personnel. This study gleaned information from other studies containing numerical data, so that factors such as past ethical breaches of practice and behaviors as well as evaluations of staff that might contain information that hinted at misconduct, past or present, could not be included. These are variables that, I believe, could be important determinants of corporate malfeasance and predictors of future financial misconduct, but which were not available to these researchers. It might have made the results more comprehensive if there had been some way to measure tendencies of the people working for a corporation to engage in behavior that is unethical or illegal.

The authors had an underlying assumption that corporations with extremely low performance by the industry as compared to other similar industries’ performances, coupled with a high proportion of CEO compensation that is received as stock options increases the chances of financial misrepresentation (Bromiley.) They did not generalize their findings to other corporations necessarily, however, and believe that further research must be done to validate the results. They concluded that managers may not necessarily engage in financial misrepresentation unless they have exhausted all other options first; however, they were clearly convinced that offering stock options to CEOs as part of their compensation packages will greatly increase the likelihood that they will engage in financial malfeasance in order to have the company appear to be more successful than it may actually have been. I believe that the researchers placed appropriate emphasis on this issue, since the recent Wall Street scandal has demonstrated that there is a segment of financial experts who will be willing to engage in unethical and blatantly illegal activities if they believe that they will personally benefit financially, even as they know that other people are going to experience devastating financial loss. This study had a great deal of relevance in light of that recent event because it was designed to shed light on the factors that contribute to such criminal behaviors. As a result, the results of this research are important to the field of finance, accounting, and business because it can possibly result in companies evaluating ways in which they can reward employees by other means without giving them incentives to falsify financial records.

This research was presented with enough detail that it could be duplicated to further explore the subject, and the research design was appropriate to its purposes although, as stated, I believe that some of the studies that were mentioned very briefly were unnecessary to include. The conclusions are instructive for corporations because they highlight the need to find ways of motivating executives and financial officers without pressuring them to engage in misrepresentation of the company’s financial records. These results were alarming: they found that during a five year period, a publicly traded company has a more than 8% chance of being caught in a financial misrepresentation, which may seem like a small percentage but which actually represents a significant portion of the world of financial corporations. It would be beneficial to conduct more research on companies who have developed ways of motivating their employees and executives with innovative best practices to see whether the rate of financial misrepresentation would decline if people were evaluated based on factors other than their financial reports.

Works Cited

Curtis Verschoor. “Ethical Culture: Most Important Barrier to Ethical Misconduct.” Strategic Finance (2005): 19-20.

Deborah Murphy, Ronald Shrieves, and Samuel Tibbs. “Understanding the Penalties Associated with Corporate Misconduct: An Incurable Examination of Earnings and Risk.” Journal of Finance and Quantitative Analysis (2009): 55-83.

Fayed Elayan, Jingyu Li, and Thomas Meyer. “Accounting Irregularities, Management Compensation Structure and Information Asymmetry.” Accounting and Finance (2008): 741-760.

Margit Tavits. “Clarity of Responsibility and Corruption.” American Journal of Political Science (2007): 218-229.

Philip Bromiley and Jared Harris. “Incentives to Cheat: The Influence of Executive Compensation And Firm Performance on Financial Misrepresentation.” Organization Science (2007): 350-367.