One of the most widely discussed corporate governance issues is excessive CEO pay and the widening gap between compensation levels of CXOs and other employees in the organisation.

At the root of executive compensation is the problem associated with separation of ownership and management — known as the principal agent problem.

While shareholders may be inclined to own a company that will pay a steady dividend and provide a long-term increase in their equity, CEOs and management often receive higher bonuses through taking extraordinary risks that generates huge short-term profits but could threaten the well-being of the organisation over the long term.

It is this misalignment of incentives, especially at financial institutions, that has contributed to the global financial crisis that began with the sub-prime crisis in the US.

Other avatars

If that’s the risk of executive incentives gone wrong, what could be the effect of executives’ “off-the-job” behaviour?

This is what three business school professors have tried to explore in their recent academic paper.

Research by Robert Davidson, Aiyesha Dey and Abbie Smith describes how two kinds of CEO and CFO behaviour outside the workplace — prior legal trouble and ownership of luxury goods (low “frugality”) — are related to the likelihood of financial misstatements and fraud.

Prior legal infractions include driving under the influence of alcohol, drug-related charges, domestic violence, reckless behaviour, disturbing the peace and speeding tickets.

Legal infractions are a symptom of a relatively high disregard for laws and lack of self-control.

The authors predict and find a direct, positive relation between CEOs’ and CFOs’ prior records and their propensity to perpetrate fraud, as reflected in the executive being named for fraudulent corporate reporting in an SEC Accounting and Auditing Enforcement Release (AAER).

Their second measure of executive behaviour is the ownership of luxury goods, including expensive cars, boats, and houses — a symptom of relatively low “frugality”.

The authors predict that CEOs who refrain from acquiring luxury goods (“frugal CEOs”) are likely to run a “tight ship” relative to unfrugal CEOs.

They find that the probabilities of both fraudulent reporting and erroneous reporting are higher in firms run by an unfrugal CEOs.

Fraud risk

Further, the increase in fraud risk over the tenure of unfrugal CEOs is related to changes in several aspects of corporate culture, including an increase in executives’ equity-based incentives, a decrease in measures of board monitoring and the appointment of an unfrugal CFO.

According to the research, firms run by CEOs who are unfrugal or have legal troubles are also more likely to meet or marginally beat analysts’ forecasts through increased earnings management.

In a related study focused on the relation between CEO frugality and corporate investment behaviour, the researchers find preliminary evidence that unfrugal CEOs engage in more acquisitions, invest less in organic growth (R&D), and generate lower future accounting and stock returns per dollar invested than frugal CEOs.

Clearly, both the incentives and characteristics of CEO/top management determine corporate culture, strategies and the fate of organisations to a large extent.

(The author is a business consultant. The views are personal. Feedback can be sent to >perspective@thehindu.co.in )

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