External corporate governance and financial fraud: cognitive evaluation theory insights on agency theory prescriptions
| Author | Brian L. Connelly,Robert E. Hoskisson,Wei Shi |
| DOI | http://doi.org/10.1002/smj.2560 |
| Date | 01 June 2017 |
| Published date | 01 June 2017 |
Strategic Management Journal
Strat. Mgmt. J.,38: 1268–1286 (2017)
Published online EarlyView 27 October 2016 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2560
Received 18 September 2015;Final revision received20 April 2016
EXTERNAL CORPORATE GOVERNANCE AND
FINANCIAL FRAUD: COGNITIVE EVALUATION
THEORY INSIGHTS ON AGENCY THEORY
PRESCRIPTIONS
WEI SHI,1*BRIAN L. CONNELLY,2and ROBERT E. HOSKISSON3
1Kelley School of Business, Indiana University, Indianapolis, Indiana, U.S.A.
2Raymond J. Harbert College of Business, Auburn University, Auburn, Alabama,
U.S.A.
3Jesse H. Jones Graduate School of Business, Rice University, Houston, Texas,
U.S.A.
Research summary: Agency theory suggests that external governance mechanisms (e.g., activist
owners, the market for corporate control, securities analysts) can deter managers from acting
opportunistically.Using cognitive evaluation theory, we argue that powerful expectations imposed
by external governance can impinge on top managers’ feelings of autonomy and crowd out their
intrinsic motivation, potentially leading to nancial fraud. Our ndings indicate that external
pressure fromactivist owners, the market for corporate control, and securities analysts increases
managers’ likelihood of nancial fraud. Our study considers external governance from a top
manager’s perspective and questions one of agency theory’s foundational tenets: that external
pressure imposed on managers reduces the potential for moral hazard.
Managerial summary: Many of us are familiar with stories about top managers “cooking the
books” in one way or another. As a result, companies and regulatory bodies often implement
strict controls to try to prevent nancial fraud. However, cognitive evaluation theory describes
how those external controls could actually have the opposite of their intended effect because
they rob managers of their intrinsic motivation for behaving appropriately. Wend this to be the
case. When top managers face more stringent externalcontrol mechanisms, in the form of activist
shareholders, the threat of a takeover, or zealous securities analysts, they areactually more likely
to engage in nancial misbehavior. Copyright © 2016 John Wiley & Sons, Ltd.
INTRODUCTION
Strategy scholars and policymakers have devoted
renewed attention in recent years to “external”
mechanisms of corporate governance, such as the
monitoring and control by stakeholders who are
not inside the organization. For example, a recent
review of this literature seeks to “bring external
Keywords: External governance mechanism; Financial
fraud; Ownership; Takeoverdefenses; Securities analysts
*Correspondence to: Wei Shi. 801 W. Michigan St, BS 4020,
Kelley School of Business-Indianapolis, Indianapolis, IN 46202,
phone: 317-274-0939. E-mail: ws7@iu.edu
Copyright © 2016 John Wiley & Sons, Ltd.
corporate governance into the corporate governance
puzzle” more fully (Aguilera et al., 2015). Gov-
ernance research has yielded important insights
about these external governance mechanisms (Cof-
fee, 2006), but few haveconsidered their potentially
adverse ramications. Toward this end, we incorpo-
rate a behavioral perspective of managers into our
understanding of external governance to highlight
how the expectations imposed by external gover-
nance could impose on managers’ motivation, and
we thus uncover the potential harm such governance
mechanisms might introduce.
Recent developments in agency theory research
relax the theory’s assumption of purely economic
External Corporate Governance and Financial Fraud 1269
agents (Wiseman and Gomez-Mejia, 1998). For
example, behavioral agency theory reevaluates
predictions in view of more realistic assumptions
about agent behavior, with particular emphasis
on internal governance (Pepper and Gore, 2015).
Researchers have incorporated prospect theory
(Martin, Gomez-Mejia, and Wiseman, 2013) and
equity theory (Pepper, Gosling, and Gore, 2015)
into agency theory predictions about how compen-
sation structures inuence managerial behavior.
We build on the notion of overlaying cognitive
biases onto agency theory prescriptions and extend
this approach to external governance mechanisms.
In particular, we inquire into how agents feel
about external monitoring and control and what
this means for their intrinsic motivation to behave
ethically.
Cognitive evaluation theory (Boal and Cum-
mings, 1981; Deci, 1971, 1975) is particularly
informative in this regard because it explains how
external controls can actually be counterproductive.
The fundamental tenet of cognitive evaluation the-
ory is that intrinsically motivated behavior isa f unc-
tion of a person’s need to feel self-determining in
his or her decisions (Phillips and Lord, 1981). The
theory asserts that external monitoring and controls
“crowd out” an individual’s motivation to behave
in ways the controls are designed to ensure (Frey
and Jegen, 2001). In our context, this would sug-
gest that pressure from external governance lessens
managers’ feelings of autonomy, thereby decreas-
ing their intrinsic motivation to behave in ways that
the governance mechanisms are supposed to safe-
guard against (Deci and Ryan, 2000). In this study,
we ask whether external governance weakens man-
agers’ intrinsic motivation to act in the interest of
shareholders and behave appropriately in the con-
text of nancial reporting.
Managerial nancial fraud (e.g., inappropriately
booking revenue, improperly valuing assets, not
disclosing material information) is a phenomenon
that is drawing extensive industry and regula-
tory attention (Eaglesham and Rapoport, 2015). In
fact, in 2014 alone, the Securities and Exchange
Commission (SEC) announced 93 investigations
against publicly traded companies for alleged nan-
cial misconduct. As a result, governance scholars
are acutely interested in how to predict and prevent
the occurrence of nancial fraud. Agency theory
suggests that internal governance reduces informa-
tion asymmetry between those inside and outside
the rm, and consequently, decreases the likelihood
of fraud (Dalton et al., 2007). We, however, sug-
gest and nd that pressure from external governance
may impose hidden agency costs as managers shift
their locus of causality outward and lose their intrin-
sic motivation to ethically report their respective
rm’s performance, thus resulting in a greater like-
lihood of nancial fraud.
Our study introduces a key behavioral consider-
ation into agency theory’s predictions about exter-
nal governance, uncovering some counterintuitive
relationships. For instance, we found that the “high-
est quality” principals (Higgins and Gulati, 2006)
are positively associated with the likelihood of
fraud. Conversely, organizational provisions that
many thought would lead to managerial entrench-
ment, such as poison pills and golden parachutes
(Bebchuk, Cohen, and Ferrell, 2009), actually bear
a negative association with the likelihood of nan-
cial fraud.
THEORETICAL DEVELOPMENT
Agency theory
Recent agency theory formulations focus on how
agents behave in boundedly rational ways (Wise-
man and Gomez-Mejia, 1998). The behavioral
agency model (BAM) was developed largely to
overcome criticisms regarding static assumptions
about executives’ risk preferences (Wiseman and
Gomez-Mejia, 1998). Empirical research on behav-
ioral agency theory to date has focused mainly
on behavioral risk propensities and internal gov-
ernance using prospect theory arguments (Chris-
man and Patel, 2012). For instance, this line of
study re-examines compensation risk, highlight-
ing the importance of individual problem framing
to explain how risk inuences executive behavior
(Larraza-Kintana et al., 2007; Martin et al., 2013).
Following this model, we extend agency the-
ory by applying behavioral considerations to three
forms of external governance (we dene external
as being those forms of governance that operate
without full access to the rm’s inside informa-
tion). Within agency theory, one form of external
governance is a rm’s owners, which serve as a
market-based governance mechanism (Baysinger,
Kosnik, and Turk, 1991). From an agency per-
spective, managers are also subject to the market
for corporate control, which researchers sometimes
describe as a governance mechanism of last resort
Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 1268–1286 (2017)
DOI: 10.1002/smj
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