External corporate governance and financial fraud: cognitive evaluation theory insights on agency theory prescriptions

Abstract

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 financial fraud. Our findings indicate that external pressure from activist owners, the market for corporate control, and securities analysts increases managers' likelihood of financial 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 SummaryMany 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 financial 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. We find this to be the case. When top managers face more stringent external control mechanisms, in the form of activist shareholders, the threat of a takeover, or zealous securities analysts, they are actually more likely to engage in financial misbehavior. Running title: External Corporate Governance and Financial Fraud 3Strategy scholars and policymakers have devoted renewed attention in recent years to 'external' mechanisms of corporate governance, such as the monitoring and control by stakeholders that are not inside the organization. For example, a recent review of this literature seeks to 'bring external corporate governance into the corporate governance puzzle' more fully (Aguilera et al., 2015).Governance research has yielded important insights about these external governance mechanisms (Coffee, 2006), but few have considered their potentially adverse ramifications. Toward this end, we incorporate a behavioral perspective of managers into our understanding of external governance to highlight how the expectations imposed by external governance could impose on managers' motivation, and we thus uncover the potential harm such governance mechanisms might introduce.

State ownership and securities fraud: A political governance perspective

“…Competitive pressure can also sow the seed of misconduct (Bennett, Pierce, Snyder, & Toffel, 2013). In addition, pressure from investors can lead firms to engage in misconduct (Hadani et al, 2011;Shi et al, 2017). Shi et al (2017) argue that "subject to unrelenting external expectations from dedicated institutional investors and activists, [managers] may feel compelled to make financial reporting decisions not from their own beliefs, but merely to satisfy the expectations of the firm's owners" (p. 1272).…”

“…We argue that political governance associated with state ownership can deter managers from committing securities fraud, advancing our knowledge about the role of state ownership in corporate governance. Second, the role of ownership structure has been a core topic in corporate misconduct (Burns, Kedia, & Lipson, ; Cheng & Firth, ; Hadani, Goranova, & Khan, ; Shi et al, ). We extend and test this body of work within the context of concentrated ownership, more salient outside North America, contributing to corporate governance research in emerging economies (Armitage, Hou, Sarkar, & Talaulicar, ).…”

Navigating geographic and cultural distances in international expansion: The paradoxical roles of firm size, age, and ownership

“…Similarly, firm age is a central construct in theories ranging from population ecology to institutional theory (Bakker & Josefy, 2018). Ownership is fundamental to firms' governance and strategic decisions and has received substantial attention from strategy scholars (Boyd & Solarino, 2016;Connelly, Hoskisson, Tihanyi, & Certo, 2010;Connelly, Shi, Hoskisson, & Koka, 2018;Shi, Connelly, & Hoskisson, 2017). This is particularly true in our empirical context-China-in which state-owned enterprises (SOEs) differ significantly from non-SOEs (Zhou, Gao, & Zhao, 2017).…”

Stock market manipulation: A comparative analysis of East Asian emerging and developed financial markets

“…Because the dependent variable for this study is binary/dummy, therefore, the following Stock and Watson (2003) panel logit regression (nonlinear) model is used to estimate the probability of dependent variable. We followed the methodology of Imisiker and Tas (2013) and Shi et al (2017) and used manipulation as a dummy variable to find its relationship with explanatory variables. Applying bootstrap robustness, both fixed effect and random effect have been used.…”