Unfrugal, Lawbreaking CEOs and Auditor Reputation: New At University of Chicago Booth School of Business

The summer lull in other academic activity gives the professors at University of Chicago Booth School of Business time to work on research.  Some great papers have been published recently and I’m writing about them at the Chicago Booth Capital Ideas Blog and for the Chicago Booth Capital Ideas Magazine.

Do audit firms care about reputation? No, it’s a shame, and neither does the government is a blog post from early last week.  It’s one of the most important characteristics of a profession – reputation – and I don’t think the Big Four firms care what you think of theirs. I discuss Professor Doug Skinner’s paper about PwC’s experience in Japan after the Kanebo scandal.  Skinner and his fellow researcher came to a slightly different, but not convincing to me, conclusion.

Deloitte is the best example of a new-style, post- Sarbanes-Oxley Big Four audit firm, one that looks more and more like any other multinational corporation hiding behind myriad separate legal entities than a global professional services partnership providing “seamless” service delivery.

When the NY State DFS first made its allegations against Deloitte last year, I said that  “reputation risk” is an oxymoron. Bankers, and the audit firms that support them, aren’t worried about reputation because no one that matters to them is. Auditors play Switzerland when providing tax, audit, consulting, risk and compliance, and valuation services to banks and the regulators who regulate them. The audit firms, and their clients, are repeatedly the subject of settlements, consent decrees, non-prosecution agreements, cease and desist orders and the rest of the regulator arsenal and they all stay in business for the sake of jobs, growth and financial system stability.

Later in the week I looked at the news about Microsoft executive Don Mattrick’s new job as CEO of Zynga.

Accounting for big-spender executives

CEOs with expensive taste, legal troubles more likely to commit fraud

Professor Abbie Smith’s paper examines the impact of expensive toys and repetitive brushes with the law on a CEO’s propensity to commit fraud and his firm’s probability of experiencing material misstatements. Mattrick is not known to be a law breaker but recent reports say he does live like a “Saudi prince”.  Better examples of the messes one CEO can get in, but still stay rich, are Jack Welch of GE and Jonah Shacknai of Medicis Pharmaceuticals.

Here’s an excerpt:

Mattrick may be a classic “low frugality” CEO, based on a definition in a 2011 working paper by Abbie Smith of Chicago Booth and her colleagues Robert Davidson of Georgetown University and Aiyesha Dey of the University of Minnesota. “Executives’ “Off-The-Job” Behavior, Corporate Culture, and Financial Reporting Risk” describes how two kinds of CEO and CFO behavior outside the workplace—prior legal trouble and ownership of luxury goods—are related to the likelihood of financial misstatements and fraud.

Prior legal trouble, according to Smith, includes driving under the influence, drug related charges, domestic violence, reckless behavior, disturbing the peace, and speeding tickets. The researchers interpret a CEO’s prior legal troubles as a symptom of “a relatively high disregard for laws and lack of self-control and predict a direct, positive relation with his propensity to perpetrate fraud.”

Consumer psychology research has defined frugality as “a distinct psychological trait characterized by the degree to which a consumer is restrained in acquiring and resourceful in using goods and services to achieve long-term goals.” The researchers hypothesize that CEOs who own luxury goods, “unfrugal” CEOs, are less likely to “run a tight ship” than frugal CEOs. Favorite luxury assets for these CEOs are expensive cars and boats. One executive in both the fraud and non-fraud samples owned an aircraft.

The researchers found a significant increase during the tenure of “unfrugal” CEO in the probability of fraudulent corporate reporting, of other insiders being named in fraud, and of restatements caused by material reporting errors. Firms run by CEOs with legal troubles and by “unfrugal” CEOs are also significantly more likely to meet or barely beat analysts’ forecasts, according to the research. Finally, “unfrugal” CEOs are also more likely to hire “unfrugal” CFOs. It’s about social “fit.”