Ferraris, Felonies & Fraud: A look at how executives’ “off-the-job” behavior can predict business outcomes

July 30, 2013
Research shows a minor traffic violation or brief shopping splurge may signal more significance than just a mark on a legal record or charge on a credit card. 
 
CEOs with a legal record and lack of frugality are more likely to perpetrate fraud and oversee a loosely controlled work environment, according to new research by Georgetown University’s McDonough School of Business Assistant Professor Robert Davidson and his co-authors. 
 
Published in the Journal of Financial Economics, the study "Executives' 'Off-the-Job' Behavior, Corporate Culture and Financial Reporting Risk' examines how legal infractions and ownership of luxury goods are related to the likelihood of future misstated financial statements, including fraud and unintentional material reporting errors amongst executives in corporations. 
 
Referencing previous studies on management, accounting, decision-making, ethics, criminology and psychology, Davidson examined how and why executives' prior behavior outside of the workplace impacts the likelihood of fraud. Using a sample of fraud firms from all SEC AAERs released through June 2010, Davidson determined that factors of fraud included a CEO's age, average total assets, debt-to-equity ratio and excess stock returns.
 
"While financial reporting errors are unintentional, fraud is intentionally perpetrated by insiders," said Davidson. "This study adds to our understanding of financial reporting risk through an intuitive and intriguing method of examining executives’ off-the-job behavior."
 
Legal Infractions 
The probability of fraud is higher by approximately 120 percent among firms run by CEOs with a legal record than in firms run by CEOs with a clean record. When observing executives’ legal record, examples of infractions include driving under the influence of alcohol, drug-related charges, domestic violence, reckless behavior, disturbing the peace and traffic violations. 
 
Levels of Frugality 
An executives’ level of frugality is implied by the ownership of luxury goods, including real estate, luxury vehicles, boats and motorcycles. Due to similar financial managerial styles, unfrugal CEOs are more likely to hire unfrugral CFOs – creating an environment where financial reporting risk can occur. A more prudent CEO is likely to decrease fraudulent reporting errors, weak board monitoring, equity-based incentives to misreport, hiring of CFOs who lack frugality and the probability of fraud.
 
Impact on Corporate Culture 
It is likely that frugal CEOs without luxury goods will have more control and stronger governance of the work environment. Under this corporate culture, it is more likely that a frugal CFO will be hired with a clean legal record – reducing the opportunities to perpetrate fraud and engage in intentional reporting errors.