A recent study finds that corporate financial managers do a great job of detecting signs of potential fraud, but are less likely to voice these concerns externally when their company is under pressure to meet a financial target.
"One of the take-away messages here is that auditors, investors, regulators and other stakeholders should be prepared to identify red flags on their own, rather than expecting management to raise the issue," says Joe Brazel, corresponding author of a paper on the work and Jenkins Distinguished Professor of Accounting at North Carolina State University. "That could be challenging, since research suggests many of these stakeholders aren't as skilled as financial managers at detecting fraud red flags."
For this study, researchers recruited 204 financial managers - such as chief financial officers (CFOs) and controllers - who worked for private or publicly held companies based in Italy. Study participants were given a suite of financial and nonfinancial information, similar to the materials that CFOs are asked to review at the end of a fiscal year, and asked to respond to a series of questions as if they were acting in the role of CFO.
The study participants were split into four groups. One group was told that the company was under significant pressure to meet a financial target and was also given data that included inconsistencies that could be viewed as red flags, or indicators of potential fraud. One group was under pressure but received no red flags. One group received the red flags but was not under pressure to meet the target. And one group had no red flags and no pressure to meet a target.
The researchers found that the financial managers were adept at identifying the red flags, and that the presence of red flags made it more likely that participants would report internally to their chief executive officer (CEO) about any potential departures from accepted accounting practices. Participants who discovered red flags and were not under financial pressure were also more likely to take their concerns to external parties, like their auditor, if the company didn't address the potential fraud.
However, if under pressure, financial managers became significantly less willing to approach external parties.
"In other words, in really important scenarios - when the pressure is on - executives don't blow the whistle," Brazel says. "They shut down."
The researchers also found that two other variables played a significant role. Executives who had been with their company for a longer time were more likely to keep quiet about their concerns. And CFOs who came from accounting backgrounds were much more likely to go public with their concerns than CFOs from a finance or banking background.
"Broadly speaking, when a company was under pressure to hit a financial target, managers felt that the short-term harm of blowing the whistle on red flags was too high to risk - even though it could lead to professional ruin if any fraud ever came to light," Brazel says. "That's likely because, in the scenarios we presented, there was the possibility that reporting red flags to the external parties could result in a failure to meet financial target - and that could lead to the company's bankruptcy.
"In short, while financial managers are very good at identifying red flags, and can be relied on to report internally, they're reluctant to report potential fraud publicly when the pressure is on.
"It's also worth noting that this study was done with participants in Italy, but it was inspired by issues that are of global concern," Brazel says. "And the findings are consistent with what we would expect to see in other large markets - including the United States."
The paper, "Reporting Concerns About Earnings Quality: An Examination of Corporate Managers," is published in the Journal of Business Ethics. The paper was co-authored by Lorenzo Lucianetti of the University of Chieti and Pescara, and by Tammie Schaefer of the University of Missouri-Kansas City.