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Coming Forward

Mar 01, 2009

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Research by Ken Smith and Kay Bartol

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 catching.

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. 170 of these restatements 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, and 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 firms.

Kay 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.”

“Coming Forward: The effect of social and regulatory forces on the voluntary restatement of earnings subsequent to wrongdoing” was published in Organization Science. For more information about this research, contact ksmith@rhsmith.umd.eduor kbartol@rhsmith.umd.edu.

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