Top Management Fraud

8/18/2019 Top Management Fraud

1/26

10.1177/0149206305279598ARTICLEJournal of Management / December 2005

The Antecedents and Consequences

of Top Management Fraud†

Shaker A. Zahra*Carlson School of Management, University of Minnesota,

321 19th Ave. South, Minneapolis MN 55455

Richard L. PriemSchool of Business Administration (S387), The University of Wisconsin–Milwaukee,

Milwaukee, WI 53201

Abdul A. Rasheed Department of Management, College of Business Administration,

University of Texas at Arlington, Arlington, TX 76019

Fraud by top management is a topic that has stirred public interest, concern, and controversy. In

this article, the authors analyze fraud by senior executives in terms of its nature, scope, anteced-

ents, and consequences. They draw on the fields of psychology, sociology, economics, and crimi-

nology to identify societal-, industry, and firm-level antecedents of management fraud and theindividual differences that enhance or neutralize the likelihood and degree of such fraud. The

authorsalso reviewthe consequencesof management fraud onvariousstakeholdergroupssuch as

shareholders, debtholders, managers, local communities, and society.

Keywords: top management fraud; antecedents of fraud; consequences of fraud; financial

misstatements; malfeasance

Zahra et al. / Top Management Fraud

†We are grateful for the extensive and supportive comments of Daniel Feldman and an anonymous reviewer. We

acknowledge with appreciation the research assistance and helpful comments of Tomasz Jasinski, Jeff Trachsel,

Patricia H. Zahra, and Pie Zhang.

*Corresponding author. Tel.: 612-626-6623; fax: 612-626-1316.

E-mail: [email protected], [email protected]

Journal of Management, Vol. 31 No. 6, December 2005 803-828

DOI: 10.1177/0149206305279598

© 2005 Southern Management Association. All rights reserved.

803

at NORTHERN ARIZONA UNIVERSITY on January 24, 2015 jom.sagepub.comDownloaded from

http://jom.sagepub.com/http://jom.sagepub.com/http://jom.sagepub.com/http://jom.sagepub.com/


2/26

Top management fraud has become a worldwide problem that cuts across ideological and

cultural divides.Recentcorporate scandals have rocked theUnitedStates (e.g., Enron, Global

Crossing, and WorldCom), drawing attention to the prevalence and insidiouseffects of mana-gerialfraud (Prentice, 2003). Asian (Ferguson& Majid,2003), European (Jayne, 2003), Latin

American (Organization for Economic Cooperation and Development, 2005), African, and

Australian companies (KPMG Fraud Survey, 1999) also have been afflicted by top manage-

ment fraud. There is a growing realization that fraud by senior managers—often, simply lying

for money—is more widespread than previously believed (Daboub, Rasheed, Priem, & Gray,

1995). Entrusted with protecting and increasing shareholders’ wealth, some executives have

devised elaborate schemes to defraud people who have invested in their companies. In the

UnitedStates, such fraud frequently has involved multiple individualsat different levels in the

organizationand hasprevailed for yearsdespiteexternalaudits by professional companiesand

monitoring by boards of directors staffed with a majority of outside directors.

Management fraud in the United States has increased despite nearly three decades of sus-

tainedefforts to reform corporategovernance, to useeffective compensationsystems to better

align managers and shareholders’ interests, and to institutionalize codes of conduct that

improve managers’ethical performance (Berenson, 2003). Legal and professional codes also

have evolved to protect the public and ensure responsible management (Hansen, McDonald,

Messier, & Bell,1996).Some believe, however, that management fraud hasbecome sosophis-

ticated that auditors seldom discover it (e.g., Hansen et al., 1996). Others even argue that the

laws and regulations enacted to protect shareholders’ interests have become so complicated

that they actuallycontribute to thegrowingincidenceof topmanagerial fraud (Berenson,2003).

In this review, we define types of fraudulent behavior by top managers, linking them to

white-collar crimes. We then identify key societal, industry, organizational, and individual

variables that contribute to such behavior. To do so, we draw on theories from criminology,

psychology, sociology, and economics. Next, we analyze societal, industry, and organiza-

tional effects of top management fraud. The final section of the article suggests important

avenues for future research.

Top Management Fraud

Fraud refers to the deliberate actions taken by management at any level to deceive, con,

swindle, or cheat investors or other key stakeholders. Such fraud can take a variety of forms.

Moberg (1997) identified embezzlement, insider trading, self-dealing, lying about facts, fail-

ure to disclose facts,corruption, andcover-upsas some of these forms.Types of fraud canalso

be specific to an industry. For example, in their study of the Savings and Loan (S&L) crisis of

the 1980s, Calavita, Tillman, and Pontell (1997) identified hot deals (land flips, nominee

loans, reciprocal lending, linked financing), looting (siphoning off funds by thrift insiders),

andcoveringup (hiding insolvency) as thethreemajortypesof managerial fraud that ledto the

S&L debacle. A significant number of recent instances of managerial fraud take the form of “intentional misrepresentation of amounts or disclosures in the financial statements”

(Apostolou, Hassell, & Webber, 2000: 181). Managers might also create schemes to hide or

misrepresent what the firm does or how the firm does it. A key word in this definition is

804 Journal of Management / December 2005




3/26

intentionality, where senior managers willfully undertake actions that materially mislead oth-

ers about therealvalue of the firm’s assets, transactions,or financialposition(Beasley, 1996).

Fraud schemes vary considerably inscope,with some being limited tooneor a few transac-tions (e.g., falsifying a document), whereas others encompass multiple, ongoing activities

across many organizational functions or units. For instance, Adelphia Communications’

founding family wasaccused of fraud when it collected$3.1 billion in off-balance-sheet loans

that were backed by the company. The family also was accused of overstating the company’s

financial results by inflating capital expenditures and hiding debt. Enron, on the other hand,

developed an elaborate “pyramid”-like scheme of new businesses that supposedly generated

new revenues and profits that did not actually exist. The schemes that senior managers use

when they commitfraudalso vary in their magnitude. Some affect only particular unitsor divi-

sions, whereas others permeate all the firm’s operations, as happened in the case of Enron.

Fraud schemes also vary in their duration: The Enron and Worldcom frauds each persisted

more than a decade.

Top Management Fraud as a White-Collar Crime

In this article, we focus on fraud committed by top managers. Such wrongdoing in and by

corporationshasbeen thesubject of study in disciplines asvaried as management, accounting,

psychology, criminology, economics, and law. Researchers have used numerous labels to

describe this phenomenon, such as white-collar crime, corporate wrongdoing, management

fraud, managerial vice, and corporate illegal behavior. The absence of physical violence, the

existence of strong financial motivations, and the involvement of individuals who are other-

wise considered respectable members of society are characteristics of white-collar crimes. A

white-collar crime is “committed by a person of respectability and high social status in the

course of his occupation” (Sutherland, 1949: 9). Such a crime is defined simultaneously by

characteristics of the offender (i.e., high status) and of the offense itself (i.e., work related).

White-collar crimes could be classified in several ways. Clinard and Quinney (1973)

focused on characteristics of the offense itself in differentiating occupational from corporate

crimes. Occupational crimes are those committedagainst a firm for the benefit of the individ-

ual perpetrator and might include embezzlement or padding expense reports. Corporate

crimes, however, are committed by the perpetrator for the benefit of the corporation.

Braithwaite, forexample, defined corporatecrime as “conduct of a corporation, or of employ-

ees acting on behalf of a company, which is proscribed and punishable by law” (1984: 6).

These crimes might include bribery or pollution control violations. Corporate crimes “help”

the firm—for example, to obtaina contract or reduce costs—but these crimesmayalso lead to

indirect benefits for the perpetrator, such as promotions or pay increases. Thus, there are

white-collar crimes in which an individual perpetrator is the sole beneficiary and the firm is

thevictim, in which thefirm is thebeneficiaryandothers in society are thevictims, and finally

in which both the firm and the individual acting on behalf of the firm are beneficiaries andothers in society are the victims.

White-collar crimes canalsobe classifiedaccording to theextent of individual involvement

in the crime. Daboub et al. (1995) distinguished between active participation and passive

Zahra et al. / Top Management Fraud 805




4/26

acquiescence. In the first case, individuals are actively involved in an illegal activity, whereas

in the latter case, managers are aware of illegality within the organization but are unwilling to

take corrective action. A third type of illegal actions is crimesof obedience(Kelman & Hamil-ton, 1989). Here, the individual is caught in the dilemma of either carrying out a directive that

is wrong or disobeying an order and suffering the consequences. A fourth type of illegality,

referred to by Hamilton andSanders (1999) as the“second face of evil,” is theresultof actions

of individualswho occupypositions in organizational hierarchies and make decisions follow-

ing established organizational routines, but where collectively these decisions escalate into

either massive cover-ups or disasters. These illegal or disastrous outcomes are frequently the

results of mistakes “embedded in the banality of organizational life” (Vaughan, 1996: 14),

despite the absence of negligence or intention. Finally, there are errors of negligence or

omission that result in harm.

The above discussion suggests that management fraud can occur as part of either occupa-

tional or corporate crime, can be perpetrated by those at the very top or the very bottom of the

managerial hierarchy, and can result from active participationor passive acquiescence. CEOs,

for example,might activelydivert corporate funds for their own useor might knowinglystand

aside while others in their firms market unsafe products. First-line supervisors, similarly,

could steal from cash registers or might ignoresubordinateswho lieaboutunnecessary repairs

to inflate customer bills. Such crimescanbe committedby executives of business firms, man-

agers of public sector companies, civil servants, or elected officials.Extensive reviews of cor-

ruption by government officials and their consequences are available in Shleifer and Vishny

(1993) and Mauro (1995).

In this article, we focus on fraud by top managers—a subset of white-collar crime that we

believe is particularly important to management researchers for several reasons. Notably, top

management fraud often is highly consequential for a firm’s shareholders and employees and

caneven ruin thefirm.Furthermore, topmanagers’attitudesandactions toward fraud canpro-

mote similar behaviors by others throughout the firm. In addition, fraud by top managers is

truly shocking to many people, as in the recent mutual fund scandals, because it represents aserious betrayal of trust by those who supposedly have been selected specifically for their

leadership, ability, and character. Management fraud is often committed by highly successful

people who already have “made it” but who can lose nearly everything if the fraud is discov-

ered. This leads to the question: Why in the world do such accomplished senior executives do

it? The next section provides some answers to this complex question.

Antecedents of Top Management Fraud

Although the motivation to commit managerial fraud might be deeply embedded in top

managers’personal ambitions, histories, and complex personality structures, several societal,

industry, and organizational factors might encourage and promote fraud. Therefore, Figure 1

highlights three sets of variables—at the societal, industry, and company level—that serve asantecedents to top management fraud. Figure 1 also identifies individual characteristics that

affect the degree to which increasing pressures from society, the industry, or the organization





5/26

are likely to actually make thedecision to commit fraud. Even though these three sets of ante-cedents and the individual-level moderators are often acknowledged in the literature, they

have not been systematically investigated empirically. Our review, therefore, seeks to bring

clarity into the potential effects of these variables on top management fraud. Figure 1 shows

the building blocks of our review.

Societal-Level Antecedents

Sociologists highlight the social nature of criminal behavior and have offered numerous

societal- or group-level theories to explain it. Most of these theories are based on an underly-

ing “cultural deviance” idea: that all humans conform to the norms of their group and, thus,

crime results only when a subgroup’s norms conflict with those of the largersociety regarding

the definition of what is or is not criminal behavior. Sutherland’s (1949) differential associa-tion theory follows this cultural deviance tradition by arguing that the likelihood of criminal

behavior is increased through association with those who define criminal behavior favorably.


Societal

• Differential Association

• Aspirations (Strain)

Industry • Culture, Norms, Histories

• Investment Horizons

• Concentration

• Hostility

• Dynamism

• Heterogeneity

Organization • Board Composition

• Leadership

• Organizational Culture

Antecedents

• Occupational

• Corporate

ManagerialFraud

• Shareholders

• Society

• Local Communities

• Employees

• Managers’ Reputations

Effects

• Age

• Experience

• Education

• Gender

• Self-Control

Individual LevelModerators

Figure 1

A Framework for Examining Management Fraud




6/26

Thus, criminal behavior is learned. ErmannandLundman have further contributed to thedevi-

ance literature, positing that “deviant solutions toorganizational problems become part of the

fabric of institutional life” (1996: 9).At the broader societal level, anomie theory and its more modern version, strain theory

(Merton, 1938), propose that societal norms affect individuals’ aspirations for things like

material goods and other indicators of success. Individuals who are unable to achieve their

aspirations by conventional means experience strain and may seek to relieve this strain by

using deviant means to achieve their desired ends. This, of course, suggests a socialclassbasis

forcrimebecause those in lowersocialclasseswill experience more strain(becauseof poverty

or inequality) and thus are more likely to relieve their strain by turning to criminal behavior.

Cohen’s subculture theory (1955) and Cloward and Ohlin’s (1960) differential opportunity

theory are similar in their arguments: Those who are unable to gain status through conven-

tional means may adopt the delinquent solution through illegal behavior. Conflict theory and

its Marxist versions see the conditions prevailing under capitalist political economies as

primary reasons for crime (Simon & Eitzen, 1993).

Together, these theories suggest potential societal explanations for fraud. White-collar

crimes committed by top managers, however, present a particularly difficult challengeto these

social class/poverty theories of crime because these theories are not effective in explaining

criminality by high-status individuals such as senior executivesof the world’s largest corpora-

tions. Such individuals arewell paid, are in theupper socioeconomic classes, and are likely to

experience little “traditional” strain. They are, however, subject to the strain of inflated

expectations, as we discuss later.

Industry-Level Antecedents

Even though societal and organizational factors might induce and even facilitate top man-

agers’ fraud (Figure 1), industry variables are also likely to have a major effect by creating

conditions that pressure, encourage, or enable fraud. A significant body of research docu-

ments the effects of industry characteristics on top managers’ willingness and ability to com-

mit illegal acts. For example, Baucus and Near found that “knowing that a firm operates in a

given industry may be a good way to predict the likelihood of that firm’s engaging in illegal

behavior” (1991: 28). Although most prior research does not speak directly to senior manag-

ers’fraud, it could be usefulin delineatingpotentialindustryfactors that play a role in this con-

text. Saksena’s (2001) study directly links selectedcharacteristicsof a firm’sexternalenviron-

ment to the incidence of management fraud, concluding that firms associated with fraud

operate in environments that differ significantly from those that do not commit fraud.

Apostolou, Hassell, Webber, and Sumners’s (2001) experimental study asked 140 auditors to

rate the relative importance of 25 risk factors (red flags) embodied in SAS NO 82 (SAS is the

U.S. Auditing Standard Board’s “Statement on Auditing Standards,” issued in 1996, govern-

ing audits regarding potential fraud in financial statements). Their analyses indicated thatchallenging industry conditions are believed to trigger fraud.

Several other industry-related factors might influence the incidence of management fraud

(Figure 1). These factors include industry cultures, norms, and histories; industry investment





7/26

horizons, payback periods, and financial returns; industry concentration; environmental hos-

tility; environmental dynamism; and environmental heterogeneity. We discuss thesevariables

in turn next.

Industry cultures, norms, and histories. Over time, industries develop unique historiesand

norms that shape company, managerial, and individual behaviors. In those industries where

fierce competition prevails, pressures to commit fraud might intensify. The aircraft manufac-

turing industry is an example of this competitive landscape. Conversely, in industries where a

norm of reciprocity and collaboration prevails, managers may be less pressured to commit

fraud. For example, interfirm collaboration is widespread in the biotechnology industry,

where companies usually face long development and regulatory approval cycles. Confronted

with huge development costs andlimited resources, companieshavefound alliancesto be use-

ful in reducing uncertainty in their R&D and other aspects of their operations. Collaboration

helps reduce the odds of failure in new product development and improves companies’

financial performance, thus lowering the incidence of management fraud.

Industries vary also in their experiences with management fraud. A survey of the airline

industry reported several hundred incidents of fraud in the preceding 12-month period

(KPMG International Fraud Report , 1996). These acts of fraud were committed by employ-

ees and management. Other industries have long histories of managers accepting bribes and

working around existing laws and regulations. The petroleum refining, transportation equip-

ment (Baucus & Near, 1991), financial services, and health care industries have had a history

of committing illegal acts and therefore might be more tolerant of managerial fraud. Becker

(1964) observed that individuals who are self-interested usually weigh the cost of their crime

against potential penalties and punishment. The extent to which prior fraud violations com-

mitted in the industry have not been severely punished might play a role in managers’

contemplation of and actually committing fraud.

Industry investmenthorizons, payback periods, and financial returns. Expectations regard-ingpayback periods, time horizons, and acceptable return rates vary also from one industry to

the next. The pharmaceutical industry is accustomed to longer investment horizons coupled

with high payback from successful products. In the software industry, where upgrades are

introduced constantly, investmenthorizonsaremuch shorter anddependingon theclass of the

software products, lower margins are expected. These norms influence stock analysts’ fore-

casts of a company’s financial performance, which in turn pressure managers to smooth their

earnings and, worse, commit fraud. Given that what constitutes fraud is socially defined,

whether practices such as earnings management through smoothing can be considered as

fraud may be open to debate.

Irrational expectations might also take hold of the industry, analysts, and investors (Shiller,

2001). These expectations indicate a belief that new technology or new economy-type indus-

tries generate much higher returns than traditional technologies or sectors of the economy.

Irrational expectations reflect exaggerated expectations of much higher profits than whatwould be a reasonable rate of return. When such irrational expectations become the norm

among investors and analysts, senior executives feel the pressure to commit fraud by

artificially overstating results.





8/26

Theaccounting literature offers evidence that CEOs have financial incentives to meet earn-

ings expectations. Boschen, Duru, Gordon, and Smith (2003), for example, have shown that

unexpectedly good stock performance increases the long-run cumulative financial gains of CEOs. Matsunaga and Park (2001) have also shown that CEOs’ cash bonuses suffer if their

firms fall short of quarterly earnings forecasts. Perhaps not surprisingly, Payne and Robb

(2000), Brown (2001), and Matsumoto (2002) all found that senior executives makeefforts to

avoid negative earnings surprises; CEOs have much to lose if their firms fail to meet

expectations.

Industry concentration. A key tenet of the free market system is that competition disci-

plines management and encourages innovation and entrepreneurial risk taking that creates

growth and improves profitability. When the industry becomes concentrated (i.e., dominated

by a few firms), the possibility of collusion increases. As industries become more concen-

trated, collusionamong companiesbecomes possible andsometimesenduring. Large compa-

nies that dominate these industries can use their resources to influence regulators, escaping

public scrutiny(fora review, seeMcKendall & Wagner, 1997). Still, someresearchers observe

that lower or moderate levels of industry concentration encourage the commission of illegal

acts because it is difficult to follow each of these firms and observe their financial operations

closely. Posner (1970), however, found no relationship between industry concentration and

corporate commission of illegal acts. Finally, although McKendall and Wagner (1997)

reported a positivebut insignificantrelationship between industry concentration and the com-

mission of illegal acts, they found that the ethical climate in the firm attenuated the effect of

industry concentration on the commission of illegal acts.

To summarize, theprecedingdiscussion highlights thedifficulty that researchers encounter

in linking industry concentration to corporate commission of illegal acts. As an industry’s

concentration increases, both the incentives and opportunities for top management to commit

fraud are likely to increase.Executives realize that it is more difficult andcostlyfor companies

to acquire higher market share and profitability as industry concentration rises.

Environmental hostility. Environmental hostility refers to the unfavorability of a firm’s

major industry’s competitive conditions. Hostile environments are characterized by low or

declining demand, strict regulatory rules, intense competition, low profit margins, and a high

rate of organizational failures. Apostolou et al. (2001) reported that auditors believe that com-

peting in a declining industry and increased regulations are two conditions that encourage

management fraud. Companies facing hostile environments often need to invest heavily in

product, process, and administrative innovation. Most of these investments, however, help the

firmto simply stay alive in an increasingly harsh, demanding, and unmanageable competitive

terrain.

Environmental hostilityoften reduces a company’s sales growth and profitability, possibly

encouraging violations of antitrust laws (Szwajkowski, 1985). BaucusandBaucus(1997), for

example, found that companies that were convictedof illegal acts hadexperienced lower salesgrowth during the prior 5 years than firms that were not convicted of these crimes. Hostile

environments also reduce any slack resources the firm might have and dampen its ability to

absorb any adverse effects on itsoperations (Staw & Szwajkowski, 1975). Cutthroat competi-





9/26

tion thrives in hostile environments, promoting unethical behavior even among salespeople

(Robertson & Anderson, 1993). These unethical behaviors not only hide the truth about the

firm’s performance but also seek to match competitors’ unethical behavior (Robertson &Anderson, 1993). Along these lines, Hansen et al. (1996: 1024) noted that the incidence of

management fraud is likely to be higher in declining industries or when bankruptcy is com-

mon, reinforcing the finding that firms in industries where performance is below the national

average will be characterized by more illegal acts (Staw & Szwajkowski, 1975).

Environmental hostility has other, indirect effects on managerial fraud. As hostility rises

and organizational performance deteriorates, some senior executives might centralize their

operations and restrict communication about the firm’s financial position or its performance.

This makes it difficult for outsiders to evaluate what is happening internally. As hostility

increases, investors often give executives the benefit of the doubt in managing adverse eco-

nomic and competitive conditions. Increased centralization enables willing executives to

commit fraud without fear of immediate detection. Loebbecke, Eining, and Willingham

(1989) found that in 75% of the fraud cases they analyzed, a single person dominated operat-ing and financial decisions, making it difficult to spot and stop managerial fraud in a timely

fashion. Overall, high levels of environmental hostility might encourage centralization that

gives senior executives the opportunity to commit fraud and conceal it from others.

Environmental dynamism. Technological advances, market changes, and competitive

moves reflect environmental dynamism, which refers to the speed and unpredictability of

change in a given industry. Dynamism creates opportunities that companies can exploit to

achieveprofitability andgrowthby creating new businesses or acquiringcompanies in current

or new industries. Companieshaveto invest heavily in identifying theseopportunities andcre-

ate the infrastructure necessary to exploit them. These investments may lower a firm’s short-

term performance. Consistent with these observations, Hansen and colleagues (1996) have

concluded that whenthe industry isgrowing fast, theprobabilityof managerial fraud increases.

Another reasonforexpecting higher incidenceof topmanagement fraud in dynamic indus-tries is the increased specialization of the company’s key personnel. As the firm expands its

operations, environmental dynamism allows each division or unit to work independently.

Fraudulent acts might be concealed by this growing differentiation of roles. As Baucus and

Near (1991) argued, differentiation leads companies to spread responsibilities among differ-

ent individuals, and no single individual has enough information to spot or stop managerial

fraud. Indeed, using this logic, Baucus and Near (1991) reported a curvilinear relationship

between environmental dynamism and corporatecommission of illegal actsof different types.

Firms competing in less dynamic environments or in highly turbulent environments were

more likely to commit illegal acts than those in moderately turbulent environments. We

believe the same logic applies to management fraud.

Environmental heterogeneity. Environmental heterogeneity can also influence the inci-

dence of managerial fraud (Figure 1). When a firm competes in different markets, targetingdifferent customer groups who have divergent needs and expectations, its business environ-

ment is considered heterogeneous. This heterogeneity is a major source of complexity

because it is difficult for managers to predict changes in their firm’s external environments





10/26

accurately or control the forces that lead to these changes. Heterogeneous environments are,

therefore, complex business settings. In these complex settings, with correspondingly com-

plex organizational structures, it is hard to fully comprehend the various transactions a firmmightundertake.Thus,organizationalcomplexity providesmoreopportunity for managers to

commit fraud. Indeed, Saksena (2001) found that companiesexperiencing management fraud

were characterized by greater environmental heterogeneity compared with organizations that

did not experience fraud. Interestingly, Baucus and Near (1991) have found that

environmental heterogeneity had a curvilinear relationship with the firm’s commission of

illegal acts.

Clearly, several industry variables might individually or jointly pressure senior managers

to commit fraud or might provide particularly attractive opportunities for those who wish to

undertake such fraud. Still, the paucity of empirical research on several industry antecedents

to top management fraud makes it difficult to draw concrete conclusions about the effects of

these variables. Furthermore, thefew studies reported havenotexamined theeffect of industry

variables on the severity or duration of fraud, leaving major gaps in our knowledge.

Firm-Level Antecedents

Jensen (1993) identified four firm-level factors—three external and one internal—that

combine to promote effective corporate governance. These are legal and regulatory systems,

capital market (i.e., takeover) controls, competition in product and factor markets, and the

firm’s internal control systems. The internal controls are headed by the board of directors and

include leadership and culture. This section of the article covers these internal issues, starting

with the firm’s board: the apex of its governance system.

Board composition. A fundamental characteristicof modern corporations is the separation

of ownership and control. Stockholders of large publicly held corporations delegate decision

making to hired managers while diversifying their risk by owning a portfolio of securities

(Fama,1980). This cancreatea free rider problem where no individual stockholder hasa large

enough incentive to devote the resources necessary to monitor senior managers (Grossman &

Hart, 1980). Absent close monitoring by stockholders, some executivesareapt to actopportu-

nistically, enriching themselves or foregoing long-term value-creating activities such as

building the firm’s technological competencies through R&D.

Theprimary responsibility for monitoring topmanagers rests with theboard of directors in

public corporations. As a result of shareholder activism (Neubaum & Zahra, in press) on one

hand and threat of litigation on the other hand, boards are increasingly transforming them-

selves from “rubber stamps” for managerial decisions into more active and vigilant monitors.

Agency theorists propose that boards that are dominated by outside directors who act inde-

pendently from management arebetterpositioned to monitor executivesandcurb their oppor-

tunistic behavior (Fama & Jensen, 1983; Zahra & Pearce, 1989).Even thoughKesner, Victor, andLamont(1986) found no evidence that addingoutsiders to

boards will lessen a firm’s likelihood to engage in illegal activities, Beasley’s (1996) study

reported that firms committing financial statement fraud had fewer outside board members.





11/26

Beasley also concluded that the likelihood of financial statement fraud decreased as outside

director ownership andoutside director tenure increased. Thepresence of an audit committee,

surprisingly, did not make a significant difference. These findings supported the propositionthat outside directorsbecamevigilant of managerial actions when directorshada vested inter-

est in company performance (e.g., owning company shares or maintaining their tenure with

the company, which is a source of income). In a subsequent study, Beasley, Carcello,

Hermanson, and Lapides (2000) found that companies committing fraud had weaker gover-

nance mechanisms characterized by fewer audit committees, less independent audit commit-

tees andboards, and fewer audit committee meetings.Consistent with these findings, Figure1

suggests thatboardof directors’composition can influencethe incidenceof managerialfraud.

The accounting literature also has identified several potential predictors of financial state-

ment fraud such as rapid company growth, auditor change, a commitment to achieve unrealis-

tic forecasts, and insider trading (Summers & Sweeney, 1998). Of these, rapid company

growth is considered as a significant “red flag” fraud indicator (Loebbecke et al., 1989). That

is,if reported growthis toorapid, itmaywell be theresult of financial manipulationratherthan

actual growth. If the company is facing financial distress, senior executives may place undue

emphasis on earnings and profitability, possibly increasing the likelihood for financial state-

ment fraud. The National Commissionon FraudulentFinancialReporting(AmericanInstitute

for Certified Public Accountants, 1987: 29) suggests that new public companies are more

likely to be involved in financial statement fraud because senior management is under

considerable pressure to meet earnings expectations.

Accounting research, by and large, has focused on identifying potential indicators or “red

flags” rather than establishing direct causes or antecedents. However, one antecedent factor

that hasattractedthe attentionof accounting researchers is therole compensationplans play in

spurring self-serving or even fraudulent decisions by CEOs. For example, Barton (2001)

found that managers ina sampleof Fortune 500firmspurposelymanaged earnings to increase

their cash compensation, whereas Guidry, Leone, and Rock (1999) provided evidence that

earnings management is associated with CEOs’bonuses (see also Healy, 1985; Hirst, 1994).Similarly, DuCharme, Malatesta, and Sefcik (2001) reported that managers manipulate earn-

ings to increase their proceeds from initial public offers (IPOs), at the expense of investors. In

sum, the accounting literature indicates that senior executives sometimes make company

decisions to maximize their own wealth.

There are conflicting views on how stock ownership by board members and senior execu-

tives affects financial statement fraud. Agency theory (Fama & Jensen 1983) suggests that

stock ownership by management can reduce agency problems. Yet, Loebbecke et al. (1989)

argued that stock ownership by executivesmotivatesthem to inflate stock pricesby fraudulent

financial reporting. Theconcentration of power in thehands of theCEOcould facilitate finan-

cial statement fraud (Dunn, 2004). Such concentration of power is often reflected in the CEO

also serving as board chairperson or having long-termtenureon the job. Beasley (1996) found

that the likelihood of financial statement fraud decreases as directors’ stock ownership

increases and outside directors’ tenure on the board increases.

Senior leadership. The ethical climate of an organization is set by or significantly influ-

enced by the actions of top management, especially the CEO. Ethical leadership encourages





12/26

analysis and critical evaluation of those who are in power. It also sets a norm of honesty

throughout the organization. When leaders who espouse ethical values are in charge, one

would expect top management fraud to be limited, if not extinct. However, when leaders donot follow these ethical values, fraud might become more widespread. Even when the CEO

does not engage in wrongdoing, he or she can still encourage it by rewarding, condoning,

ignoring, or covering up (Baucus, 1994). Ashforth andAnand (2003) noted that therole of the

CEO becomes even more significant in cases where the CEO is charismatic, a quality that

leads to greater identification, trust,andreflexiveobedienceby subordinates. In this case, sub-

ordinatesare likely to emulate theCEO’s behavior. Charismatic leaders areoften able to build

coalitions of followers who do not question their actions or fail to probe their leaders’failings.

These leaders are skilled in silencing dissent and critical evaluation, neutralizing their “ene-

mies.” When these leaders are at the helm of organizations and commit fraud, it is hard for

employeesto come forward andblow thewhistleon their leaders’corruptbehaviors. Thus, top

leaders’lackof commitment toethical behavior could encourageandfacilitate fraud (Figure1).

Interestingly, as we reviewed the literature on the effect of leadership on top management

fraud, we were struck by the lack of serious and persuasive empirical analyses of this issue.

This came as a surprise to us,given thevoluminous literature on leadership and theabundance

of anecdotalevidenceon therole of ethical values (or lack thereof) andcharismatic leadership

in organizationalcrises. Indeed, Berenson’s (2003) book is replete with stories of how charis-

matic leaders were able to consolidate their powers, to introduce fraudulent schemes, and to

use their personal magnetism to mislead others in and outside their companies. These leaders

also shape their firms’ cultures.

Organizational culture. Over time, some organizations develop deviant cultures in which

wrongdoing is rationalized and institutionalized. Some scholars, who focus primarily on cor-

porate crime, argue that such businesses’organizational cultures imbue lawbreaking with the

normative statusof “business asusual”andthus produce criminal behavior inwhite-collarset-

tings (e.g., Reed & Yeager, 1996). Enron and BCCI are two prime examples. Another recentexample of this situation is the case of Columbia/HCA and other hospital chains arguing that

keeping two sets of books—one “aggressive” set to submit to Medicare and one “conserva-

tive” set as a fallback—was a common industry practice.

Trice and Beyer (1993) identified several characteristics that lead to the emergence of

strong subcultures: high within-group task interdependence and low between-group interde-

pendence, accountability for performance goals but not means, group-based versus individ-

ual-based rewards, member stability and cohesion, peer-based socialization, and physical

proximity. Ashforth and Mael (1989) explained the prevalence of unethical subcultures as the

result of compartmentalization of identities. That is, a subculture holds values that are apart

from theoverallsocial norms andeven individual ethical normsby applying thedeviantvalues

only in thecontext of their subcultural identity. Conversely, some organizations develop posi-

tive ethical climates that reduce the likelihood of fraudulent actions. McKendall and Wagner

(1997), for instance, found that strong ethical climates neutralize the relationships betweenindustry or organizational factors and the illegal behavior of environmental violations.





13/26

Individual-Level Moderators

We have just seen how societal, industry, and firm characteristics would likely affect theincidence of top management fraud. Society, for example, establishes an individual’s values

through both aspirations and associations (Merton, 1938; Sutherland, 1949). At the industry

level, highly concentrated industry structures, resource scarcity, and rapidly changing envi-

ronments allhavebeen found to be antecedentsof various corporate illegalities (Daboub et al.,

1995; McKendall & Wagner, 1997). Organizational-level variations, such as firm size and

organizational slack, alsoinfluencethe likelihood of white-collar crime. Larger companiesare

morecomplexand often decentralize their operations, providingan opportunity for illegal acts

while reducing chances of detection (Baucus & Near, 1991; McKendall & Wagner, 1997).

Furthermore, top managers at firms with little or no organizational slack may feel that they

must commit illegal actions just to survive (Baucus & Near, 1991; Daboub et al., 1995).

Yet, thecommission of fraud at thehighest levels in organizations ultimately involves indi-

vidual decisions to participate or acquiesce. This leads us directly to theconsideration of indi-

vidual-level factors that might affect the incidence of managerial fraud. In Figure 1, we show

the individual-level factors as “neutralizing” or “enhancing” variables (Howell, Dorfman, &

Kerr, 1986: 89) that either weaken or strengthen the previously discussed relationships

between industry-level or firm-level antecedents and the incidence of top management fraud.

That is, rather than predicting fraud directly, the individual characteristicswe discuss next can

affect the degree to which increasing pressures from society, the industry, or the organization

are likely to actually result in the decision to commit fraud or acquiesce when fraud is

observed. Figure 1 suggests that age, education, experience, gender, and self-control are

potentially important individual characteristics that have received some empirical support as

affecting the likelihood of managerial fraud given a particular industry and organizational

environment. Of these, the first four are demographic variables, whereas the last one is an

individual trait.

The use of demographic variables in top management team research is based on the argu-ment that they are proxies for other underlying managerial traits (Hambrick & Mason, 1984).

They have been widely used in research, partly because demographic data are relatively easy

to collect. However, organizationaldemographyresearchhas comeunder increasing criticism

lately for inferences based on unmeasured variables (Lawrence, 1997), inability to suggest

actionable prescriptive conclusions (Priem, Lyon, & Dess, 1999), and relying entirely on

archival data (Pettigrew, 1992). Given the pervasiveness of these factors in the literature, we

address each of these individual-level factors next.

Age

Age influences individuals’decisions concerning both common “street”crimes and white-

collarcrimes (e.g., Shover& Hochstetler, 2002).Generally, youth is associated with risk seek-ing and with an inability to delay gratificationor accurately evaluate long-term consequences

(Gottfredson & Hirschi, 1990). Maturity, on the other hand, has been found to be associated





14/26

with moral development, as shown by research findings that age is inversely related to

Machiavellianism and unethical decisions by marketers (Kelley, Ferrell, & Skinner, 1990).

Furthermore, managers’ increasing age is associated with deliberateness in decision mak-ing, seeking more information for the decision, more accurate diagnosis of the information

gathered, less confidence in being right, and greater willingness to reconsider (e.g., Child,

1974; Taylor, 1975). This suggests that older senior executives are less likely to make precipi-

tousdecisionsunder the swayof industryor organizational pressures,dampeningthepotential

relationships between industry and organizational factors and the incidence of top managers’

fraud (Daboub et al., 1995).

Experience

Given its relationship with age, it is perhaps not surprising that experience may also influ-

ence the likelihood of corporate illegalities in particular industry and organizational environ-

ments (Figure 1). The simple lengthof a manager’s tenure is one experience factor, with moremobile, short-tenured senior executives more likely to engage in illegal activities (Clinard,

1983). Daboub et al. (1995), however, argued that long-tenured executives maybecome“stale

in thesaddle” (Miller,1991: 34) and, although less likely to activelyparticipate in fraud because

of their resistance tochange, might also becomemore likelyto passivelyacquiesceto fraud.

Functional background is another experience-related factor that may contribute to fraud

(Figure 1). Simpson and Koper (1997), for example, found that manufacturing companies

headed by CEOs with finance and administrative backgrounds were more likely to engage in

antitrustviolations than CEOswith other backgrounds. Scholars havealso suggestedthat mil-

itary experience mayaffect the likelihood of corporate illegalities. For example, Daboub et al.

(1995) observed that the ideals and values associated with military leadership may reduce the

likelihood of active participation in fraud, but that thehigh valueplacedon group solidarity in

the military may increase the likelihood of passive acquiescence. Consistent with this latter

explanation, Williams, Barrett, and Brabston (2000) found that prior military service among

members of Fortune 500 companies’top management teams (TMTs) strengthens the relation-

shipbetween firm sizeand corporatecriminal activity. In sum,experience-related factors such

as tenure in the job, functional experience, and military service may influence individuals’

decisions to commit fraud when faced with challenging environments.

Education

An individual’s educational background also can contribute to the likelihood of fraud, as

indicated in Figure 1. The level of education typically is positively associated with the level of

moral development (Rest & Thoma, 1986). Yet, some believe that business education may

causea decline in moral development, perhaps because thestudyof normative expectedutility

theory (von Neumann & Morgenstern, 1944) in business programs increases self-interestedbehavior (see, e.g., Frank, Gilovich, & Regan, 1993). Consistent with this argument, Kelley

et al. (1990) found that marketing researchers with graduate business degrees provided the

least ethical self-ratings, whereas Williams et al. (2000) found that the relationship between





15/26

organizationalsizeand corporatecriminalactivitywasstrongest whenFortune 500 TMTshad

more graduate business education. Ferraro, Pfeffer, and Sutton (2005) reviewed evidence that

suggests that economics education is related to a number of morally questionable behaviorssuch as free riding, defection, and selfishness. Ghoshal (2005) argued that by teaching ideo-

logically inspired amoral theories, business schools have freed their students from any sense

of moral responsibility. Mintzberg (2004) has voiced similar observations. Obviously, these

observations invite debate on what business schools teach their students (Feldman, 2005) and

how these values might influence senior managers’ tolerance (or commission) of fraud.

Gender

Some research has related gender to the proclivity for illegal activities. Daly (1989), for

example, related gender to different types and levels of white-collar crime. Betz, O’Connell,

and Shepard (1989) found male business students to be more willing than their female coun-

terparts to accept unethical behavior in achieving their goals. Whan (2003) recently foundmale librarians to be more willing than femaleones to behave unethically in response to orga-

nizational pressure. Thus, a person’s gender might influence the strength of the relationships

among industry or organizational pressures and managerial fraud, although, as Whan (2003)

noted, little theory exists explaining the mechanisms through which this effect takes place.

Self-Control

Hirschi and Gottfredson (1987; see also Gottfredson & Hirschi, 1990) offered self-control

theory to explain both white-collar and common crimes. They argued that crime is associated

with one stable individual trait—low self-control—that is shared by both white-collar and

common criminals. Individuals with low self-control are apt to be risk takers who, when the

opportunity presents itself, opt for the immediate gratificationassociated withcriminalbehav-ior. Thus, the firm provides a setting within which opportunities for white-collar crimes

aboundfor topmanagers whoareso inclined.According to this view, thecharacteristicsof the

firm are not major causal factors in managers’ propensity toward criminal behavior.

Critics counter that senior executives must have a certain level of self-control to have

advanced upward through the organizational hierarchy and suggest that this restriction of

range may limit the usefulness of Hirschi andGottfredson’s theory in explaining top manage-

ment crime (Reed & Yeager, 1996). The extent of any restriction of range for the self-control

trait among senior managers remains an empirical question. Also, there are certainly at least

some instances in which individuals who have reached the highest levels (e.g., Bill Clinton)

have at times exhibited relatively low self-control.

Consequences of Top Management Fraud

Unlike street crimes, which disproportionately victimize the poor and the marginal, top

management fraud is more pervasive and wide reaching in its impact (Moore & Mills, 1990).





16/26

Management fraudhas serious consequences to shareholders, employees, the communities in

which firms work, and society at large (Figure 1). Fraud can also damage managers’ reputa-

tions, end their careers, lead to their firing, and cause their imprisonment. Understandably,recent revelations of massive and widespread management fraud have stirred a heated debate

about the roles of auditing firms, corporate boards of directors, and regulatory agencies in

uncovering and, more important, preventing such activities.

Effect of Fraud on Shareholders and Debtholders

Shareholdersare invariably thefirstvictims of topmanagement fraud. When news of fraud

by a firm becomes public knowledge, it immediately reduces the stock market value of the

companies involved (Davidson & Worrell, 1988). Bondholders and othercreditorsof the firm

can also end up bearing thenegative effects of management fraud. If thecompany’s credit rat-

ing is lowered when fraud is revealed, bonds issued by the firm lose value, and the bondhold-

ers immediately suffer. In many cases, banks may have lent money against either overvaluedor nonexistent collateral or inflatedcash flow projections.Notonly does this make recoveryof

loans problematic, but indirectly even shareholders of banks may end up paying a price

because of the decline in the share prices of the bank itself, if the amounts involved are

substantial.

Revelations of top management fraud also have shaken the public’s faith in the ability of

boards of directors to monitor management and protect shareholders’wealth. Through fraud-

ulent accounting practices, WorldCom wasable to conceal $3.5billion in lossesfrom itsdirec-

tors (Thompson, 2003). The use of demographic variables in TMT research is based on the

argument that they are proxies for other underlying managerial traits (Hambrick & Mason,

1984). They have been widely used in research, partly because demographic data are rela-

tively easy to collect. However, organizational demography research has come under increas-

ing criticism lately for inferences based on unmeasured variables (Lawrence, 1997), inability

to suggest actionable prescriptive conclusions (Priem et al., 1999), and relying entirely on

archival data (Pettigrew, 1992). Given the pervasiveness of these factors in the literature, we

address each of these individual-level factors next.

Paradoxically, recent management fraud episodes have led to a reexamination of the rela-

tive importance of shareholders to other stakeholders. In some cases, shareholders are now

being given priority over creditors when fines and penalties are paid out. Traditionally, credi-

tors were always paid first. However, with Sarbanes-Oxley, shareholders are considered the

biggest victims and therefore entitled to the relief provided by the penalty. Interestingly, one

of the most far-reaching consequences of management fraud may be increased activism and

vigilance by shareholders and other affected stakeholder groups. For example, reacting to the

portfolio lossesof the rank andfile, labor unions have brought as much as 40% of shareholder

resolutions during the annual meetings in recent years, and the American Federation of

Labor–Congress of Industrial Organizations is pushing for rules that would give small inves-tors even moreclout (Weiss, 2002). Fraud by senior executives has angered shareholders who

are increasingly fightingback,proactivelyseeking reparations for the losses theyhad endured.





17/26

Top management fraud has negative consequences on other stakeholders as well. Arthur

Anderson’s demise was a direct consequence of its implicit complicity in Enron’s fraudulent

financial reporting. There have also been instances of accounting firms paying substantialpenalties for their failure to detect fraud during audits (Wells, 2000).

Societal Consequences of Fraud

Although there areno exactestimatesof theeconomic costs of management fraud, thecost

to society is considered staggering. In 2002 alone,“anestimated$600 billion, or about $4,500

per employee, was lost. . . asa resultof on the-job fraud and abuse”(Thomas & Gibson, 2003).

Other estimates range from $200 billion (Touby, 1994) to $600 billion (Schnatterly, 2003). An

analysis of well-known cases like Enron reveals a variety of direct and indirect negative soci-

etal consequences such as the loss of several thousand jobs; loss of employees’ pensions,

which wasparticularlyhard on older employees; andloss of taxrevenue to thecity of Houston

where the company had its headquarters and was a major employer.Illegal acts, such as managerial fraud, also depress the moral climate in a society

(Szwajkowski, 1985).Fraud canlead to a general lack of faith in theintegrity of seniormanag-

ers; erosion in confidence in the free market system including its political institutions, pro-

cesses, and leaders; and a general growthof cynicismin a society (Moore& Mills,1990). The

most corrosive consequence of an environment in which individuals do not trust the leading

institutions of society such as large corporations is the destruction of social capital. Authors

such as Fukuyama (1995) have argued that the economic success of capitalist societies is

based on the level of trust and resultant cooperative behavior prevailing in those societies.

High-trust societies tend to have lower costs of doing business. The recent wave of corporate

scandals in the United States has led to legislation that imposes significant compliance costs

on corporations. This, in turn, is causing small and medium firms to delist from stock

exchanges. It has also discouraged many private firms from going public. The failure on the

part of accounting firmsto detectmanagerial fraud hasalso ledto less faith in audited financial

statements. Worse still, many believe that the accounting firms compromised their own integ-

rity because of the lure of lucrative consulting contractsfrom thefirms they were auditing.Not

surprisingly, recent occurrences of senior management fraud have caused society to take a

much harder line regarding punishment of white-collar criminals and holding them

responsible for their crimes.

Effect of Fraud on Local Communities

The communities that house companies found guilty of fraud also frequently pay a heavy

price for management’s actions, although it is difficult to quantify the exact amount of finan-

cial losses. Unemployment; loss of endowments for the arts and schools; depleted stock port-

folios; and decreased demand for secondary businesses, such as restaurants and gas stations,all serve to hurt local communities. Examples of communities that have suffered thedevastat-

ing effects of top management fraud include Clinton, Mississippi, a small college town that





18/26

housed the world headquarters of WorldCom, and Houston, Texas, that was home to Enron.

During the heyday of these companies, these cities enjoyed a period of unprecedented boom.

Although Houston, Texas,wasbigenough to survive the fall of Enron, it wasnonetheless hurtby theEnron implosion. Thenegative impactof Enron’s fraud extends well beyond those who

lost their jobs. Companies adversely affected included hotels, restaurants and catering ser-

vices, transportation providers, florists, and even the full-time locksmith Enron once

employed.For Clinton, Mississippi,the fall of Worldcom proved tobe far more devastating.

Effect of Fraud on Employees

Employees of companies that commit management fraud are often hit the hardest, even

though they areoften unaware of their managers’illegal activities.Fraud cancause employees

to lose their jobs, their retirement savings (whichareoftentied up incompany stock), andtheir

reputations. Frequently, the very fact that they worked for a fraudulent company taints their

resume to the point that some employees find it difficult to find alternative employment. Oneunexpected consequence of management fraud is that companies are starting to develop in-

house whistle-blowing programs to try and stop fraud. These programs encourage employees

to discretely and anonymously disclose concerns about accounting and operational issues

(Murdock, 2003).

Effect of Fraud on Managers’ Reputations

Fraud also damages the reputations of the individuals and firms involved. In his analysis of

managerial fraud, Beasley (1996) found that in many cases senior managers have been

indicted, forced to resign, or terminated. Indeed, the past few years have seen a sharp increase

in the number of white-collar criminals facing fines and even jail time.

An Agenda for Future Research on Top Management Fraud

We nowhave examined key societal-, industry-, and firm-level antecedents to top manage-

ment fraud; the individual-level factors that affect thepropensity toward fraud when pressures

from the antecedents occur; and the consequences of management fraud. Our review has cap-

tured much of the current knowledge landscape regarding top management fraud (Figure 1).

In this section, we suggest directions forexpanding this knowledgethrough futureresearch.

Leads From Criminology Research

We anticipate increased interest in the management literature in studying management

fraud, and we believe such interest is warranted. Many directions are possible, however, and

not all may be equally fruitful. One approach would be to follow the leads of major research

streams in criminology. Two recent management papers have done just that, and may offer

guidance forfuture work. Thefirst isAshforthandAnand’s examinationof corruption inorga-





19/26

nizations. They argued from a strong sociological perspective that three factors—

institutionalization, rationalization, and socialization—can combine to contribute to the “nor-

malization of corruption in an organization” (2003: 3). Through socialization, corrupt prac-tices become embedded in organizational routines; through rationalization, corrupt actions

are legitimated through organizational folklore; and through socialization, newcomers learn

to accept corrupt behavior as normal.

Although Ashforth and Anand noted that their model is not intended to remove personal

responsibility from individuals for corrupt actions, they proposed that “the intertwined pro-

cesses of institutionalization, rationalization, and socialization conspire to normalizeand per-

petuate corrupt practices so that the system trumps the individual” (2003: 37), and thus they

concludedthat thesystem must be repaired to prevent organizationalcorruption.Ashforth and

Anand’s (2003) work, following the tradition of Sutherland’s (1949) differential association

theory, offers a compelling extension to others’previous assertionsthat thenormative status of

“business as usual” contributes to criminal behavior in white-collar settings (e.g., Reed &

Yeager, 1996; see also Luo, 2005).

A secondrepresentative study, this time at the individual level, is the laboratory experiment

by Schweitzer, Ordóñez, and Douma (2004). They argue that individuals’aspirations, repre-

sented by assigned goals, influence their perceptions of thebenefits that might be achievedby

intentionally overstating performance. They found that people are more likely to lie (via writ-

ten overstatements of their performance) if given specific, hard goals rather than “do your

best” goals andthat the likelihood of overstatingperformance increasesas actualperformance

approaches, but still falls short of, the goal. Schweitzer et al.’s (2004) assumption that people

pursue their perceived self-interests, as determined by individual cost-benefit analyses, fol-

lows the classical approach to criminology favored by contemporary economists (e.g.,

Becker, 1964). The task in their study arguably represents a close approximation of the deci-

sions faced previously by senior managers who chose to inflate their firms’ earnings. At a

broader level, Schweitzer et al.’s (2004) work extends the tradition of strain theory (Merton,

1938), that individuals who are unable to achieve their aspirations experience strain and mayseek to relieve the strain by using deviant means to achieve desired ends. But Schweitzer

et al.’s (2004) results extend these ideas by suggesting that at times, strain may actually

increase as a goal approaches but remains unattained.

These two studies show management scholars extending theories from criminology to

white-collarcrime.There areother examples, such as Cullen, Parboteeah, andHoegl’s (2004)

cross-nationalstudyof justifications for ethicallysuspect behaviors(based on anomie theory),

but these remain relatively sparse. One area of considerable debate in the criminology litera-

ture that has not been addressed yet by management scholars is Gottfredson and Hirschi’s

(1990) general theory of crime. They argue that although the firm provides the context for

white-collar criminality, all crime is associated with one stable individual trait—low self-

control—that is shared by both white-collar and common criminals. The debate between

advocates of differential association and low self-control theories concerning relative explan-

atory power remains unresolved in the criminology literature (e.g., Simpson & Piquero,2002). Pratt and Cullen’s (2000) recent meta-analysis,however, shows that low self-control is

an important predictor of crime, suggesting that this individual trait may warrant exploration

by management scholars interested in white-collar crime. These two theories fit easily into





20/26

Trevino and Youngblood’s (1990) classificationof explanations for unethical behavior within

organizations as “bad apple” or “bad barrel” theories. Bad-apple theories attribute wrongdo-

ing to individual factors such as low self-control, whereas bad-barrel theories emphasize therole of organizational and societal factors (i.e., differential association).

Another potential area for top management fraud study involves the construct of trust.

Shapiro (1990) posited that the common thread underlying white-collar crimes is that they all

are violations of trust; that is, senior executives occupy positions of trust that simultaneously

provide the opportunity for crime. Shapiro further observed that “white-collar criminals vio-

late norms of trust,enablingthem to robwithout violenceandburglewithout trespass”(1990).

Management scholars could bring considerable expertise to bear on the trust-related issues

associated with management fraud.

Some Key Research Questions

Clearly, serious gaps remain in our understanding of management fraud. As we reviewedthe literature, we were surprised by the limited and unsystematic empirical research on this

complex topic and thevarious variables in Figure1. Despite thepublicoutrage about theprev-

alenceof fraud, systematic empirical research in this area hasbeen rather limited. Accounting

researchers have increasingly studied financial statement fraud in recent years, and manage-

ment researchers have examined a wider variety of white-collar crimes, but we are still left

with an abundance of anecdotal and journalistic “evidence.” As a result, we still do not know

theanswers to simplequestions such as What motivates certain successful senior managers to

engage in such fraud? We do not know how these managers succeed in co-opting and involv-

ing others in their fraudulent schemes. We do not know why many members of the organiza-

tion who, accidentally or otherwise, uncover fraud fail to report it. What perpetuates such

silence and compliance to corrupt authority? These simple questions deserve careful study to

better understand organizational deviance and its ill effects on employees, companies,

communities, and society at large.

Corporate illegal actions, which have been the subject of analysis, are pervasive and have

corrosive effects on society. We need to better understand howtopmanagement fraud fits into

thebigger schemeof corporateillegalactions.Perhaps we candevelopa typology of corporate

illegal acts that embodies managerial fraud. The development of such a typology may even

help us to identify some perfectly legal and mostly transparent forms of appropriation of

shareholder wealth by corporateexecutives in the formof excessivecompensation and perqui-

site consumption. Alternatively, a typology of the motivations for, and consequences of, top

management fraud could be developed, serving to guide future research. Using this typology,

we can then relate it to the industry, firm, and individual variables discussed throughout our

review (Figure 1).

A promising area for future research is to explore the joint effects of the industry, firm, and

individual variables on the extent and severity of top management fraud. We know very littleabout the effect of these variables on top management fraud, and the few studies to date have

produced inconclusive results. Examining the interactions of industry, firm, and individual

antecedents of top management fraud could be informative. For example, do industry charac-





21/26

teristics (e.g., short payback periods) accentuate the effect of top managers’ self-control,

intensifying their willingness to commit fraud? Do they interact with other aspects of person-

ality (Judge & Bono, 2000)? Do industry characteristics (e.g., hostility) perpetuate dysfunc-tional organizational cultures that, in turn, encourage or facilitate top management fraud?

How do these cultures develop in the first place? Why do they persist?

Earlier in this article, we referred to the bad-apple theory as an explanation for top manag-

ers’ fraud. Essentially, the theory posits that a few corrupt managers commit these actions.

These corrupt behaviors raise several questions that future researchers need to investigate.

Where do these “bad apples” come from? Why do organizational systems fail to identify

them? What role does the organizational culture play in nurturing their behaviors? What role

do managerial rewards and incentives play in this context? How can organizations develop

effective systems that inculcate and enforce ethical behaviors among senior executives? We

concede that these issueshave been thesubject of discussion for decades. Regrettably, despite

decades of discussion andreforms, our efforts arefailing to curb topmanagement fraud. Fresh

thinking and new ideas are needed if progress is to be made.

Some have suggested that society bears some responsibility for top management fraud.

They propose that thepublic expects toomuch from companiesand managers, toleratesuneth-

ical behavior, and punishes offenders lightly. Obviously, this is a part of a larger debate on

societal values and how they might influence corporate, managerial, and even individual

behavior. Still,the contributionof the largersociety to topmanagers’fraud deserves reflection

and examination. It is easy to see how “irrational expectations” of investors could pressure

senior executives and their companies to work harder. In an environment where competitors

falsify financial statements, overstate earnings, and mislead shareholders, the pressures to

commit fraud by senior managers can also intensify. Of course, these pressures do not justify

fraud.

Calavita et al. (1997) suggested that the prototypical crime of the current era is “collective

embezzlement.” Unlike well-documented cases of corporate malfeasance in earlier decades,

modern corporate crimes have little or nothing to do with the production or manufacturing of goods. Instead, they invariably involve the manipulation of money and information. Collec-

tive embezzlement is “crime by the corporation against the corporation” (Calavita & Pontell,

1990: 322). Although this type of crime is for the personal gain of the top management, it

occurs at the expense of the institution and with the implicit or explicit sanction of its senior

management. Collective embezzlement is thus fundamentally different from earlier types of

white-collar crime described in studies such as Other People’s Money (Cressey, 1953). Mod-

ernfinancecapitalism spawnsvast new opportunities forfraud inwhich highlyplaced insiders

steal from their own institutions. These crimes are difficult to detect in the short run, complex

in their design and therefore difficult for even those who are financially sophisticated to fully

comprehend, several orders of magnitude larger than manufacturing sector crimes of earlier

years, and extremely difficult to prosecute and obtain convictions because of the various

means available to top executives to cover their tracks.

Inaddition to theeffect of societalnormsandinstitutional context,we believegreater atten-tion to individual variables is needed. We have identified several key individual moderators

that could influence the propensity to commit top management fraud. Future research would

gain from probing four additional issues.





22/26

The first is how senior managers frame their fraudulent acts. The way managers go about

framing these actions reflects their deeply held values and the context in which they commit

fraud. The second is executives’ motivation to commit fraud. As noted earlier, multiplemotives might intertwine, causing senior executives to go astray. How much of this fraud is

motivated by greed or a desire to succeed at any cost? How much of it is driven by self-

preservation? How much of topmanagement fraud is intended to save thefirmand itsemploy-

ees? The third variable of interest is the opportunity to commit fraud . We have discussed sev-

eral conditions that provide opportunities in which fraud could be committed and go unre-

ported. Future researchers would improve our knowledge by identifying industry and

organizational landscapes where fraud might occur. The fourth and final variable is the per-

ceived risk associated with committing fraud. How do managers gauge the possibility of get-

ting caught and the potential penalties for their fraud? Understanding these four variables

could improve our knowledge about the way senior executives perceive opportunities for

fraud, their motivation to proceed and commit fraud, and how they weigh the risks associated

with their actions.

Theabove observationsalso highlight theneed to examine the intimate links between soci-

etal norms, public policy, and top management fraud. Societal norms influence public dis-

course on the role of the firm, ethical managerial behavior, and the best ways to protect share-

holders’ interests. Recent reforms in corporate governance systems and executive

compensation policies reflect this intricate and complex link. Future researchers would bene-

fit, therefore, from exploring how societal norms might influence governance and compensa-

tion decisions and, in turn, fraud by senior managers.

Conclusion

Top management fraud is a topic that hasstirred passion, concern, debate, and controversy.

This fraud has devastating consequences for shareholders, employees, communities, compa-

nies, and society at large. Our discussion of the effects of top management fraud serves as areminder of the critical importance of ethical and responsible senior leadership. Boards of

directors must make the recruitment, retention, nurturing, and promotion of such executives a

priority. Organizationsmustalsostrive to developorganizational cultures thatencouragereve-

lations of abuses and fraud and protect whistle-blowers when they come forward with their

findings (Ashforth & Anand, 2003; McKendall & Wagner, 1997). Such cultures would also

emphasize ethical behavior in hiring, evaluating, rewarding, and promoting employees and

managers alike, while setting and reinforcing realistic performance expectations at every

managerial level. Clearly, human resource management systems have important roles to play

in identifying potential offenders and creating countervailing mechanisms that discourage

fraud (Schnatterly, 2003).

Our review reveals the complexity of the societal-, industry, company, and individual-

related factors that lead to, facilitate, or accentuate fraud. The multiplicity of these variablesand paucity of empirical research that has been conducted on them invite thoughtful analyses.

We hope that our review stimulates systematic and insightful scholarly research into this

important and controversial topic. Where top management fraud exists, we all lose.





23/26

References

American Institute for Certified Public Accountants. 1987. Report of the National Commission on Fraudulent Finan-cial Reports. New York: Author.

Apostolou,B., Hassell, J. M., & Webber, S. A. 2000. Forensic expert classificationof management fraudrisk factors.

Journal of Forensic Accounting, 1: 181-192.

Apostolou, B.,Hassell, J. M.,Webber,S. A.,& Sumners, G. E. 2001.The relativeimportance of SASNo. 82 manage-

ment fraud risk factors. Behavioral Research in Accounting, 13: 1-24.

Ashforth, B. E., & Anand, V. 2003. The normalization of corruption in organizations. Research in Organizational

Behavior , 25: 1-52.

Ashforth,B. E.,& Mael,F.1989. Socialidentitytheoryand theorganization. Academyof ManagementReview,14:20-

39.

Barton, J. 2001. Does the use of financialderivatives affect earnings managementdecisions? The AccountingReview,

76: 1-26.

Baucus, M. S. 1994. Pressure, opportunity and predisposition:A multivariate modelof corporate illegality. Journalof

Management , 20: 699-721.

Baucus, M. S., & Baucus, D. A. 1997. Paying the piper: An empirical examination of longer-term financial conse-

quences of illegal corporate behavior. Academy of Management Journal, 40: 129-151.Baucus, M. S.,& Near,J. P. 1991. Canillegal corporatebehavior be predicted? An eventhistory analysis. Academy of

Management Journal, 34: 9-36.

Beasley, M. S. 1996. An empirical analysis of the relation between the board of director composition and financial

statement fraud. The Accounting Review, 71: 443-465.

Beasley, M.S.,Carcello,J. V., Hermanson, D. R.,& Lapides,P. D.2000. Fraudulentfinancial reporting:Consideration

of industry traits and corporate governance mechanisms. Accounting Horizons, 14: 441-454.

Becker, G. S. 1964. Crime and punishment: An economic approach. Journal of Political Economy, 76: 169-217.

Berenson, A. 2003. Thenumber: Howthe drive for quarterly earnings corrupted Wall Street andcorporate America.

New York: Random House.

Betz, M.,O’Connell,L. O.,& Shepard,J. M.1989.Gender differences in proclivity forunethicalbehavior. Journalof

Business Ethics, 8: 321-314.

Boschen, J. F., Duru, A., Gordon, L. A., & Smith, K. J. 2003. Accounting and stock price performance in dynamic

CEO compensation arrangements. The Accounting Review, 78: 143-168.

Braithwaite, J. 1984. Corporate crime in the pharmaceutical industry. London: Routledge.

Brown,L. D. 2001. A temporal analysis of earnings surprises: Profits vs.losses. Journal of Accounting Research, 39:221-241.

Calavita, K., & Pontell, H. N. 1990. “Heads I win, Tails you lose”: Deregulation, crime, and crisis in the savings and

loan industry. Crime & Delinquency, 36: 309-341.

Calavita, K.,Tillman,R.., & Pontell, H. N. 1997. Thesavings andloan debacle, financial crime,and thestate. Annual

Review of Sociology, 23: 19-38.

Child, J. 1974. Managerial and organizational factors associated with company performance: Part I. Journal of Man-

agement Studies, 11: 175-189.

Clinard, M. B. 1983. Corporate ethics and crime. Beverly Hills, CA: Sage.

Clinard, M.B., & Quinney, R.1973.Criminal behaviorsystems:A typology. NewYork:Holt, Rinehart & Winston.

Cloward, R. A., & Ohlin, L. E. 1960. Delinquency and opportunity: A theory of delinquent gangs. New York: Free

Press.

Cohen, A. K. 1955. Delinquent boys: The culture of the gang. New York: Free Press.

Cressey, D.1953. Otherpeople’s money: A studyof thesocial psychology of embezzlement . Glencoe,IL: Free Press.

Cullen, J. B.,Parboteeah,K. P., & Hoegl,M. 2004.Crossnational differences in managers’willingness to justify ethi-

cally suspect behaviors: A test of institutional anomie theory. Academy of Management Journal, 47: 411-421.

Daboub, A. J.,Rasheed,A. M. A.,Priem, R. L.,& Gray, D. A. 1995.Topmanagementteam characteristics andcorpo-

rate illegal activity. Academy of Management Review, 20: 138-170.

Daly, K. 1989. Gender and varieties of white-collar crime. Criminology, 27: 769-793.



Documents

Top Management Fraud