02.13.08
Financial Fraud
In today’s show, adapted from an article published on the Oscar web site written by Melissa Maki, we look at business ethics and strategy through the eyes of Jared Harris, assistant professor at the University of Virginia’s Darden School of Business and his search for the answers to these questions:
“What motivates a company to cook the books? AND What happens to businesses that get caught committing financial fraud?”
Arthur Anderson… Enron…The Mortgage Loan Crisis, these names and events are synonymous with corporate malfeasance. They symbolize a loss of business ethics that occurred when financial profits were prioritized above all else, even to the long-term detriment of the firm. So, what motivates a company to cook the books? And what happens to businesses that get caught committing financial fraud?
Such business ethics and strategy questions drive the research of Jared Harris, assistant professor at the University of Virginia’s Darden School of Business. Harris joined Darden’s faculty in 2006 and has taught ethics and strategy courses for the MBA program as well as a doctoral seminar on corporate governance and ethics. His teaching responsibilities in business ethics and strategy align with his research interests. Harris said, “at the Darden School, cross-disciplinary work is valued… we take ethics seriously, not only within the classroom but also in our research, it’s a great fit for me.”
Harris recently won accolades for his dissertation research at the 2007 annual meetings of the Academy of Management — one of the foremost professional associations dedicated to the study of management and organizations. His work titled, “Financial Misrepresentation: Antecedents and Performance Effects” won the Best Dissertation Award from the academy’s Social Issues in Management Division and was also one of six finalists in the academy’s Business Policy and Strategy Division, an unusual cross-disciplinary accomplishment.
Harris’ thesis builds his academic theory through two related empirical studies. He examined nine years of data from a large sample of publicly traded corporations that were identified by the Government Accountability Office, the GAO, as having misrepresented their financial information.The first study, featured as the lead article in the May-June 2007 issue of Organization Science, focuses on predictors of a company’s propensity toward financial fraud.
In his study, Harris found two factors — relative performance and CEO incentive pay — were highly influential. That is, companies performing below average for their industry are more likely to compensate by misrepresenting their financial data. And surprisingly, the higher a CEO’s stock options as a percentage of total pay, the more likely a company is to cheat — running counter to the notion that incentive pay aligns the individual aspirations of management with the collective ambitions of a company. Harris controlled for other possible predictors, such as increasing board independence by having outsiders on the board and separating the CEO and chair roles in a firm, but he notes that they had “no effect whatsoever on preventing the cheating.”
In the second study, Harris looked at what happens to these companies once ethical violations are announced to the public. Predictably, they see an immediate downturn in their stock prices, but he also found that a firm’s operating performance was severely impaired. This negative impact on profitability was more persistent than market-based effects; even a year or two later, companies were still feeling the effects of their transgressions. On average, the companies’ operational profits dropped by nearly 50 percent. Harris said, “Firms do worse by doing bad. If they cheat, they take a big hit in overall performance.”
But, as with much of life…public perception matters more than reality. Despite his earlier finding that an autonomous board does not deter companies from committing financial fraud, Harris noted that corporations are able to recover from some of this negative fallout if they took swift steps to increase the number of outsiders on their board and replace their CEO. Harris went on to say, “the research shows that stakeholders value these things. Firms get rewarded for making such changes because we all think it is part of good governance — yet in the case of something like board independence, this is ironic, given that the data shows it has no actual preventative effect.”
You’ve been listening to the Oscar Show, I’m Jacob Canon. Join us next week when our topic will be the research of Dr. William Petri who directs a U.Va.-led research team doing research on a parasite said to kill nearly 100,000 people each year.