Managers’ Unethical Fraudulent Financial Reporting: The Effect of Control Strength and Control Framing

In response to numerous recent cases involving materially misstated financial information arising from fraudulent financial reporting, companies, auditors, and academics have increased their focus on strengthening internal controls as a means of deterring such unethical behaviors. However, prior research suggests that stronger controls may actually exacerbate the very opportunistic behavior the controls are intended to curb. The current study investigates whether the efficacy of an implemented control is conditioned on not only the strength of the control (weaker or stronger), but also on how the firm frames the purpose for implementing the control (e.g., monitoring or coordinating). A monitoring purpose frames controls as reducing managers’ opportunities to engage in self-interested behavior, while a coordinating purpose frames controls as facilitating coordination between the firm and its managers. We posit that the efficacy of stronger controls to reduce unethical fraudulent reporting depends on the control frame. Using an experiment, this study investigates the interactive effect of control strength and control frame on managers’ fraudulent reporting decisions. As predicted, our results show that when controls are framed for monitoring purposes, stronger controls result in less fraudulent reporting than weaker controls. Conversely, when controls are framed for coordinating purposes, stronger controls result in more fraudulent reporting than weaker controls. Our results suggest that an inconsistency between the firm’s choice of the control strength and the control frame reduces the efficacy of the implemented control to curb unethical reporting behaviors. Furthermore, supplemental analysis shows that managers’ rationalization helps explain the interactive effect of control strength and communicated control purpose on fraudulent reporting.

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Notes

Prior research finds that the negative effects of formal controls on trust differs depending on the whether the source of the control (e.g., supervisor, supply-chain partner, regulators, consultant, etc.) is certain (endogenously imposed) or uncertain (exogenously imposed). Results indicate that when the source of the control is uncertain/unknown, the effect of the control on trust is reduced if not eliminated. In the current study, we investigate the effects of formal controls in a context where the control is implemented by top management instead of directly by the manager’s immediate supervisor. Thus, as in practice, organizations may implement firm-wide or team-wide controls in a top-down fashion in which the source of the control is uncertain. Following prior literature, we expect the effect of the control implemented on perceived trust to be reduced in such a setting compared to one in which the control source is certain (Christ 2012; Falk and Kosfeld 2006).

Controls may be preventive or detective. Preventive controls attempt to curb improper behavior (ex ante). In doing so, preventative controls limit managers’ autonomy by prohibiting unwanted behaviors (Christ et al. 2012b). For instance, a common preventive control is segregation of duties where improper behavior requires collusion and, thus, is less likely to occur. In contrast, detective controls are designed to identify improper behavior that has occurred (ex post). For instance, an independent bank reconciliation can identify improper, unrecorded check disbursements. Prior literature suggests that detective controls have less impact and consequences on employees’ perceptions than preventative controls with respect to restricting autonomy and intrinsic motivation (e.g., Christ et al. 2008, 2012b). Thus, in the current study we focus on preventative controls, since, unlike detective controls, they do not allow the manager to maintain decision rights, and thus limit the manager’s autonomy (Christ et al. 2012b).

Alternatively, it is possible that managers may perceive the stronger control implemented to be consistent with the firm’s message to implement the control for coordinative purposes. That is, stronger controls are necessary to achieve greater levels of coordination. Our study allows us to test the veracity of this alternative expectation. However, given that the very nature of implementing formal controls has been found in prior literature to result in negative behavioral consequences (e.g., decreased effort, less honest reporting, and lower firm profits) and perceptions (e.g., Arvind et al. 2010; Christ et al. 2008; Falk and Kosfeld 2006; Tenbrunsel and Messick 1999), we posit that the framing of controls for coordinative purposes is more likely to be viewed as inconsistent with the firm actions to implement stronger controls that limits managers’ reporting discretion.

We do not include an actual principal in our experiment, which is consistent with business practice where a firm-wide or team-wide control is imposed in a top-down fashion. Employees are informed of top management’s control decisions but do not typically interact directly with any single individual from the top management group.

This experimental feature is consistent with instances when top management or corporate headquarters are aware of only the possible range and/or probability distribution of project costs but relies on project managers to report actual project costs. This feature is also consistent with prior studies that examine managerial reporting decisions (Evans et al. 2001; Hannan et al. 2006; Rankin et al. 2008).

Our manipulation of stronger controls does not make the control 100 % effective in preventing fraudulent reporting. This design choice is consistent with the notion that even the strongest controls have inherent limitations, such as management override and collusion, and thus may not effectively prevent or detect all misstatements (COSO 1999). Thus, controls are designed to provide “reasonable assurance” about the prevention or detection of material errors or fraud. Also, our design choice is consistent with firms’ implementation of controls in a decentralized system, which provides some reporting discretion to managers so they are able to make decisions.

Our manipulation of control frame emphasizes the “profit-sharing component” of the manager’s incentive contract in the coordinating condition, but not in the monitoring condition. Although such a treatment is theoretically consistent with prior literature of monitoring and coordinating controls (e.g., Edmunds et al. 2010; Garrison et al. 2011; Nicolaou et al. 2011; Patterson and Smith 2007; Roth and Nigh 1992), we acknowledge that the differential salience of profit sharing may trigger differential fairness concerns when participants make their reporting decisions. To explore whether such wording triggers different reciprocity/fairness concerns across control framing conditions, we examine a post-experimental question related to “fairness,” i.e., “I wanted to treat the firm fairly (TFAIR).” Untabulated results show that the average responses to this question under monitoring and coordinative conditions are 5.15 and 5.19, respectively. Untabulated ANOVA analysis with TFAIR as the dependent variable indicates that the main effect of control frame is not significant (p = 0.956). Results of this additional analysis rule out perceived fairness as an alternative explanation for our control frame results.

Prior research views attitude and rationalization as two distinct constructs (Desai et al. 2013; Murphy 2012). In the context of the current study, attitudes and character traits determine an individual’s predisposition toward fraudulent reporting (Carpenter and Reimers 2005; Murphy 2012). On the other hand, rationalization is a psychological process that allows individuals to justify a problematic (“bad”) behavior in order to reduce or to avoid the negative affect (feelings) that would normally accompany such behavior (Fointiat 1998; Murphy and Dacin 2011; Murphy 2012; Sloane 1944).

Six participants answered the manipulation questions incorrectly in each of the following three conditions: (weak, monitoring); (strong, monitoring); and (weak, coordinating).

Figure 2 shows a decline in fraudulent reporting levels in period 7 for the four treatment conditions likely due to the following reasons. The randomly generated actual cost in period 7 is 859, which leaves a narrow misreporting space of 141 (1,000–859). The motivation for fraudulent reporting weakens and the desire to appear honest likely grows stronger, since the potential economic gain is limited. Similar reasoning can also be applied to the observed decline in fraudulent reporting levels in period 3, when the randomly generated actual cost is 841. All the other periods have randomly generated actual cost below 800, providing greater misreporting space and thus greater incentives to report fraudulently.

Our experiment also included a control group in which no internal control was implemented by the firm. While the absence of internal controls is not a feasible option for public companies that are required to comply with SOX Section 404, the no controls condition in our study serves as a benchmark to demonstrate the potential negative effects of controls on managers’ propensity to engage in fraudulent reporting. Untabulated results show that the mean FRAUD in the no control condition is 45 % compared to 66 % in the presence of controls (both weaker and stronger). This finding is consistent with prior economics and management accounting research which shows that implementing formal controls has unintended consequences that may not reduce, but may even induce, managers’ self-interested behavior that is detrimental to the firm (e.g., Evans et al. 2001; Falk and Kosfeld 2006; Rankin et al. 2008; Tayler and Bloomfield 2011). In addition, contrast tests indicate that FRAUD level in the no control condition is lower than those in both the weak monitoring condition (F = 7.26, p = 0.01) and the strong coordinative condition (F = 5.77, p = 0.02). These results are consistent with H1, suggesting that when control frame is misaligned with signals conveyed by control strength, the efficacy of implemented controls is reduced. Furthermore, contrast tests show that FRAUD level in the no control condition is not statistically different from that in either strong monitoring condition (F = 2.33, p = 0.13) or that in weak coordinative condition (F = 0.36, p = 0.55). These results are consistent with H1, indicating that when control frame is aligned with signals conveyed by control strength, FRAUD level is lower and the dysfunctional effects of implementing controls are eliminated.

PERIOD is significant at (F = 3.84, p < 0.05), indicating a period effect. However, the interaction between PERIOD and either FRAME or STRENGTH is not statistically significant, suggesting that the period effect is not different across treatment conditions.

An alternative interpretation of the interactive effect is that the framing effect is conditioned upon control strength such that framing may not matter under the stronger control conditions. This is because when stronger preventative controls are implemented there is less flexibility for managers to engage in fraud, thus creating a ceiling effect on the likelihood of fraud. To test this conjecture, we conducted contrast tests to examine the framing effect under weak and strong control conditions, respectively. Our results show that the coordinative frame induces less FRAUD than the monitoring frame when controls are weak (0.50 vs. 0.81, t = −5.89, p < 0.01, two-tailed), while it actuates greater FRAUD when controls are strong (0.71 vs. 0.62, t = 1.87, p = 0.06, two-tailed). These results suggest that the framing effect is significant even when stronger controls are implemented and, therefore, do not support the above conjecture.

The measure of sampling adequacy presents the partial correlations between each pair of variables controlling for all other variables (the negative anti-image correlations).

We also asked a question on the extent to which the reporting decision was a business decision versus an ethical decision (response scale: business decision = 1 to ethical decision = 10). However, unlike our other rationalization questions that all have a singular dimension (e.g., WHONEST: I wanted to report honestly.), BORE may be perceived as ambiguous because this question can be rephrased as two distinct questions, i.e., “the production cost reporting decision is a business decision” versus “the production cost reporting decision is an ethical decision.” Because of this ambiguity and the fact that this variable did not significantly load on the rationalization factor, we did not include it in the mediation analysis.

Two rationalization questions, i.e., NTRUST and TRUINT, have loadings less than 0.5 from PCA. If we exclude them from PCA, and use the other five questions to construct the factor for mediation analyses, we obtain qualitatively similar results and identical conclusions. Further, we obtain similar results and conclusions if we use the average score of the seven individual rationalization questions to proxy for RATIONALIZATION.

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Author information

Authors and Affiliations

1. D’Amore-McKim School of Business, Northeastern University, Boston, MA, USA Xiaotao Kelvin Liu & Arnold M. Wright
2. Department of Accountancy, Weatherhead School of Management, Case Western Reserve University, Cleveland, OH, USA Yi-Jing Wu

1. Xiaotao Kelvin Liu