INDIANAPOLIS, Ind.—When a dishonest executive fraudulently reports his or her company’s earnings, the deception is often hidden behind competitive compensation practices and complex systems- either the finances or the product itself is difficult to understand and thereby difficult to monitor. In an upcoming paper, Curtis Wesley, II, assistant professor of management and entrepreneurship at the Kelley School of Business, examines how the effects of complex information controls affect financial reporting fraud.
“There’s a link between diversifying your company to increase profits and having a company that is so complex that there is less oversight,” said Wesley. “When there is information asymmetry—one manager knows more than anyone else—stakeholders are reliant upon that manager to be honest. The more complex the organization, the more likely bad information can be fraudulently reported.”
This concept is explored in a paper accepted for publication in the Journal of Management titled “Providing CEOs with Cheating Opportunities: The Effects of Complexity-Based Information Asymmetries on Financial Reporting Fraud,” written by Wesley and co-authors Hermann Ndofor of Texas A&M University and Richard Priem of Texas Christian University. Studying reports from the Government Accountability Office, researchers compared companies suspected of fraudulent activity against others who had no such claims to see if complexity of the business or executive compensation were common factors.
“What’s motivating these executives to manage their numbers is their compensation practices and they’re able to manage their numbers because nobody knows what’s in the black box, other than the people reporting those numbers,” explained Wesley. “The other problem is that these firms are operating in complex industries with more risk and that risk is attractive because investors think the reward is going to be greater, even if they don’t know how that company is operating behind closed doors.”
This research offers lessons for both government regulators and the owners of companies that are being mismanaged.
“Essentially, if you’re an owner in the company—especially a company whose processes you might not understand—you must take a look at the numbers with a jaundiced eye,” explained Wesley. “Look at multiple reporting cycles and really understand cause and effect.”
“With respect to the government, we think that there has to be some increased oversight on companies that are in more complex operating environments or have more intangible resources whose value can be manipulated.”
Wesley says the research speaks to his interests in studying companies who are doing an honest job reporting, and understanding how managers create a win-win situation within their companies.
“I’m a firm believer that being successful is an ethical imperative,” he said. “People are depending on you as the CEO to do the right thing. You’ve been given this responsibility to be the steward of the firm with hundreds and even thousands of people depending on you to make the right decision.”
Curtis Wesley can be reached at cuwesley@indiana.edu.