Industry norms are more effective than sanctions in
encouraging good corporate behavior
CEOs are under immense pressure to deliver on earnings performance, a
pressure which only intensifies in difficult economic times. So it is not
surprising that so many CEOs—up to 74 percent in one study—believe it is
acceptable to manipulate their earnings reports to achieve performance goals.
Manipulation of corporate earnings through income smoothing, earnings
management, or explicitly fraudulent behavior is more common than many would
like to admit, but it is easy to understand. It is hard to be honest when the
alternative is to lay off workers or close the doors.
When discrepancies between report and reality become apparent, some public
firms restate their reported financial earnings voluntarily. Others are forced
to restate by a law-enforcement body like the Securities and Exchange Commission
(SEC). Voluntary disclosure of wrongdoing creates an initially negative response
from stakeholders, often reflected in a decline of the firm’s market value. It
can generate civil lawsuits and result in the loss of income or position for
corporate executives. What would motivate a firm to voluntarily restate its
earnings despite the negative impact?
Recent research by two Smith School professors, Ken G. Smith, Dean’s Chaired
Professor of Business Strategy, and Kay Bartol, Robert H. Smith Professor of
Management and Organization, indicates that social forces may be more effective
than sanctions in compelling firms to do right. In other words, good behavior is
Bartol and Smith examined 919 firm restatement announcements from 845 firms
between 1994-2001, taken from a report issued by the U.S. General Accounting
Office (GAO). The publicly-traded, relatively large firms were selected from the
Execucomp database, which includes more than 2,500 past and present members of
the S&P 1,500. Firms in the database restated their earnings due to accounting
irregularities that included aggressive accounting practices, intentional misuse
of facts, and fraud. Of these restatements, 170 were considered to be voluntary.
Restatements due to innocent mistakes, human error or discontinued operations
were excluded from the sample.
Firms were more likely to voluntarily restate earnings when their peers,
industry leaders and network associates also voluntarily came forward to restate
earnings. Coming forward voluntarily can mitigate punishment and lessen the
damage to a firm’s reputation, a process that everyone in the industry can
observe. Seeing peers, industry leaders and other members of their network
weather the initial negative impact and emerge stronger and healthier for it
encourages other firms to also brave the initial negative consequences that
accompany a voluntary disclosure of wrongdoing.
Network connections also play an important role. Indirect connections such as
personnel exchange, board interlocks, membership in trade associations, and
shared auditors may communicate norms and values through a social context. When
network members voluntarily restated earnings, it increased the likelihood that
a firm in the network would follow suit.
Some argue for additional or more stringent oversight, controlling firm
behavior through stricter regulation and control. But Smith and Bartol found
that formal regulatory forces actually discourage voluntary restatements, a
result the authors found surprising and counter-intuitive.
“If you were speeding on the freeway and saw other cars being pulled over,
you’d slow down,” says Smith. But seeing other firms being prosecuted for
wrongdoing doesn’t seem to inspire firms to amend their behavior or come forward
to restate their earnings. It may be that CEOs believe that enforcement agencies
have the wherewithal to prosecute only a certain number of wrongdoers. CEOs may
be gambling on the chance that their firm will not be among the small number
caught and prosecuted.
The authors also found that the higher the status of a firm, the less it
feels pressure to conform to industry norms or social regulatory forces. “These
companies—the Enrons of the world—may feel immune to the negative consequences
of restatement because of their history of success and their status in the
industry,” says Smith. So neither the fear of punishment nor the effect of peer
pressure seems to influence the behavior of the biggest and most influential
Bartol agrees. “Our finding, that network connections influence firm
behavior, suggests that it may be possible to identify better connected firms in
an industry and elicit their aid in encouraging more positive corporate
citizenship,” says Bartol. “Such a direction is warranted because strong
regulatory sanctions do not seem to work and may even be counterproductive.”