CLS Blue Sky Blog

Weak Corporate Culture Creates Risk of Inaccurate Financial Reporting

After almost every major financial-reporting scandal, news stories and congressional speeches inevitably follow, detailing how corporate culture encouraged and enabled fraud. For example, in September 2016, Wells Fargo CEO John Stumpf testified before the House Financial Services Committee regarding the bank’s phony accounts scandal. The bipartisan outrage was captured by Representative Mike Capuano of Massachusetts: “You… have run an enterprise that has a culture of corruption. You encourage subordinates to abuse existing customers by opening fake bank accounts. You charge those victims illegal fees, interest, and late charges, and then you send some to collection agencies because they didn’t pay them. Then, you fired 5,300 workers—as if you care—to cover everybody’s tracks.” Representative Blaine Luetkemeyer exclaimed, “A thousand people a year! The only one way that that can happen [is] a culture that allows it to happen year after year after year (United States Congress 2016).”

Apparently, observers view corporate culture as an enabling or deterring factor to committing fraud. Indeed, numerous academic studies have also cited corporate culture as a significant determinant of fraud (Graham et al., 2005; Davidson et al., 2015), but empirical researchers have struggled to directly explore the relationship of culture and fraud (Graham et al., 2015). Researchers have tried to capture corporate culture via “tone at the top” management by surveying top management (see Graham et al., 2015) or by indirect measures of management, including executive personal pronoun usage, signature size, legal infractions, luxury good ownership, or undiversified personal portfolios.

Our recent paper, “Corporate Culture and Financial Reporting Risk: Looking Through the Glassdoor,” takes a more direct approach, utilizing data consisting of employee ratings of public firms to examine the relationship between corporate culture and financial misreporting. Employees experience a firm’s culture firsthand, and so their views are probably a more direct way to measure it.

We utilize novel data consisting of 1,112,476 employee ratings of 14,282 public firms in the period 2008-2015, obtained from the website Glassdoor, to examine the relationship between corporate culture as perceived by employees and financial misreporting. The survey that Glassdoor uses is concise and opts for descriptive succinctness to encourage more reviews in the data-gathering process. Employees define and assess their firms’ culture and values on their own terms. We argue that employee reviews of a firm capture, at least in part, the quality of the protocols employed by the firm. For example, a firm might use new protocols to exert pressure on employees to meet performance targets. This might include rewarding or punishing types of behavior thought to lead to the goal. The ratings reflect the opinion of the employees of the effectiveness of such protocols. We further posit that pressure to meet ambitious goals, to a degree that can drive employees to behave unethically, would result in dissatisfaction. We would expect to find no association between our measures of corporate culture and financial reporting risk if other drivers of employee dissatisfaction, such as low salaries or an unfriendly work environment, dominated our findings.

We expect pressure to meet performance targets at a given firm to vary over time, and expect employee ratings to reflect this change. Consistent with this hypothesis, we find that employee ratings in a year in which fraud occurs, and the preceding year, predict SEC fraud enforcement actions and securities class-action lawsuits. Moreover, ratings in the year following a fraud do not predict SEC fraud enforcement. This finding suggests that employee ratings can be a proxy for real earnings management. In periods when managers struggle to reach performance targets, they may pressure employees to start burning the candle at both ends and impose aggressive performance targets on them (Caskey and Ozel, 2016). Increasing pressure on employees to meet performance metrics may cause them to become dissatisfied and thus the approach may not be sustainable.  Our results are consistent with managers striving towards performance targets by pressuring employees, resulting in employee dissatisfaction. If those high pressure actions toward employees alone are insufficient to reach the targets, managers may resort to financial misreporting. Consistent with this we also find that low-rated firms are also associated with an increased likelihood of narrowly meeting or beating market earnings estimates, suggesting that managers under pressure to beat benchmarks have an impact on their firm culture.

At the other end of the spectrum, companies with employees who have higher levels of job satisfaction and positive opinions about senior management are associated with more conservative estimates of financial performance. We also find that the association between firms’ culture and financial reporting risk is stronger for firms with weaker board independence. Thus the work environment, as perceived by employees, appears to play a critical role in financial-reporting risk.

This post comes to us from Professor Yuan Ji of The Hong Kong Polytechnic University and professors Oded Rozenbaum and Kyle Welch of George Washington University School of Business. It is based on their recent paper, “Corporate Culture and Financial Reporting Risk: Looking Through the Glassdoor,” available here.

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