Risk & Compliance

Companies Purposely Hire Fraudsters: Study

Groundbreaking research suggests that when hiring accountants, companies weigh a proclivity toward "earnings management" more highly than any other...
David McCannAugust 19, 2015
Companies Purposely Hire Fraudsters: Study

“Psst — hey you. Yeah, you. We’re onto you, you closeted earnings manager. Don’t give us that look. You know what you are.”

Cooking BooksThree accounting professors from the University of South Carolina have published research that purports to show strong evidence for what accounting academia has long suspected: that company managers who hire accounting professionals are biased toward candidates that appear oriented toward “earnings management.”

In fact, they overwhelmingly display that bias, the research finds. That’s right: in a landslide, study participants were in favor of hiring people who appear predisposed to take actions that in extreme forms could land company officials in prison. At least, that’s what the study results suggest.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The study, presented on Aug.11 at the American Accounting Association’s annual meeting in Chicago, defines “earnings management” as follows: “Ideally senior accounting managers make estimates and judgments in ways that produce accurate and transparent financial statements. In some cases, [they] desire to achieve a particular level of earnings, and they may alter their estimates and judgments to get that outcome.”

“Earnings management,” then, is for all practical purposes a euphemism for reporting what company officials want to report rather than what may have actually occurred.

In order to discover that those who hire accountants prefer earnings managers, the professors would not, of course, have gotten very far by directly asking them to admit it. So they constructed a three-legged survey initiative in a bid to more subtly wring out a de facto “admission.”

Identifying an Earnings Manager

For Study 1, a group of 59 accounting professionals were presented with information on the (1) education, (2) work experience, and (3) personality profiles of two potential hires, Candidate A and Candidate B. The candidate summaries were similar as to (1) and (2), but varied significantly as to (3).

For example, among the personality traits assigned to Candidate A were “results-oriented and willing to rewrite the rules if necessary to achieve goals,” “[looks to the] norms of the organization to determine what behavior is acceptable,” and “believes that leadership achievements require the ability to please those in positions of power.”

Candidate B, meanwhile, was described as “process-oriented” and believing that rules “should not be circumvented to achieve goals and should be changed only after significant deliberation,” having “rigid beliefs about what constitutes acceptable behavior,” and preferring to avoid finding justifications for actions after the fact.

The participants then were asked 14 questions to elicit their views about the two candidates. Their answers indicated their belief that Candidate A was “most likely to initiate efforts to manage earnings, most likely to encourage others to manage earnings, most susceptible to pressure from others to manage earnings, and most likely to believe that the positive consequences of earnings management justify engaging in that behavior,” the professors wrote. Candidate A was also judged to be “more likely to fall prey to accounting-related ethical infractions.”

Identifying the Better Overall Manager

For Study 2, a separate group of 99 participants received the same information on the two candidates, who had vied for a senior accounting manager position, and were told that one of them had been selected for the job. They were also told that the hiring company’s financial objectives included achieving profit goals, maintaining smooth earnings, avoiding earnings volatility, and maintaining a low cost of capital.

The participants reported the extent to which they agreed or disagreed with 27 statements aimed to elicit their views about why one or the other candidate was likely hired. The statements were clustered around six managerial/personal skill sets: (1) managing people, (2) managing the work environment, (3) managing activities, (4) work habits, (5) interpersonal traits, and (6) managing earnings to achieve accounting outcomes.

The results: Candidate A was judged to be superior only in only one of those areas: (6), managing earnings. Candidate B was seen as better at (1), (2), (4), and (5).

Those results, the authors wrote, “suggest that Candidate B is unambiguously considered to be a better manager than Candidate A, so it is reasonable to suggest that Candidate B will experience greater accounting labor market success.”

A Dubious Preference

However, as it turns out, Candidate A is actually the one more likely to be hired.

The professors assembled two other separate groups of participants: 56 company executives highly experienced in making hiring decisions (Study 3), and 41 highly experienced executive recruitment professionals, who evaluate job candidates before they are interviewed by company officials and thus can influence hiring decisions (Study 4). Each group was asked to decide which candidate a company would most likely hire.

To help ensure candid responses, the professors employed a technique called indirect questioning, whose efficacy has been supported by decades of psychology research. You simply ask someone not what they personally would do, but what they think someone else — in this case someone in position to hire a senior accounting manager — would do. “Then they start revealing,” says Scott Jackson, one of the University of South Carolina accounting professors who conducted the research along with Ling Harris and Joel Owens.

Also, to get some different perspectives on decision-making, Study 3 assessed candidate fitness for the job using generic fit measures, while Study 4 used fit measures tailored to accounting. Also, Study 3 had company executives comparatively evaluate the job candidates, while Study 4 had recruiters evaluate only one of the candidates.

The results were startling: 88% of the executives rated Candidate A — identified in the other studies as more likely to be an earnings manager — as the one more likely to be hired. And 81% of the recruiters who evaluated Candidate A were certain that person would be a good fit for the job, while only 35% of those who evaluated Candidate B felt that way.

Jackson was not necessarily surprised by the direction of the results, but he was surprised by their strength.

“It would probably be correct to characterize Candidate A as having a constellation of generally negative personality traits (e.g., narcissism and moral disengagement) that, while allowing the individual to be functional in society, may also predispose the person to do things that discredit the company,” Jackson says in an interview with CFO.

What’s the Takeaway?

Jackson acknowledges that the relationship between earnings management and accounting-employee selection is a “kind of obscure” topic — except in academic circles, where “it has been bantered about for decades.” Still, he states directly, “this is the first and only study to empirically examine this question.”

Still, he cautions against drawing firm conclusions from the results. “It’s not possible for any single study to put an issue to rest in one fell swoop,” he says, although “people might agree that this is a starting point.”

Does the research, then, have any practical ramifications? Perhaps indulging in some wishful thinking, Jackson muses that “hopefully, showing that people and their values are at the root of this problem will help. Companies commonly shine a spotlight on particular employees to demonstrate a commitment to good corporate citizenship. Certainly the proven ethical integrity of a firm’s financial leadership should be a powerful selling point to the investment community.”

Still, Jackson expresses frustration that there may be nothing to be done to significantly rein in earnings management. “So far, the approach has focused on increased regulation and going after corporate wrongdoing,” he says. “But the bottom line is that if you don’t focus on the consequences of hiring decisions, you will never get at the root cause of earnings management.”

The study report makes an eye-raising suggestion in that area: “Regulatory efforts to curtail earnings management may achieve greater success if those efforts concurrently target decisions within firms about who to hire and promote in the accounting function.”

What might that mean? That the SEC should somehow be able to sign off on hiring decisions?

That, of course, would be beyond the government’s scope, not to mention wildly impractical. “It’s not clear to me what regulators should do or what the solution is,” Jackson acknowledges. And given the prevailing corporate culture indicated by the research, it’s also unreasonable to expect companies themselves to police the hiring of earnings managers.

Even the threat of prison for earnings managers doesn’t move the needle too much toward eradication of the practice. “People who engage in extreme forms of earnings management likely don’t believe they’re going to be caught, and in fact, many instances of fraud, malfeasance, deception, and earnings management are likely to go undetected,” Jackson says. “I know that sounds discouraging.”

Photo: ThinkStock