Executive Pathologies – The Relationship Between CEO Narcissism and Fraudby Lindsay Myers, MBA, MPHc | April 16, 2014
Research suggests an association between CEO personality traits and fraudulent behavior. Narcissism has been linked to manipulation of financial results, which has implications for the executive selection process, board oversight, and the structuring of executive compensation packages.
The celebration of financial misconduct in movies like The Wolf of Wall Street tends to focus on the enthralling aspects of the perpetrator’s personality, rather than the economic woe that ensues for other, less glamorous stakeholders such as the average investor or the employee who loses his or her job in the wake of a scandal.
The Committee of Sponsoring Organizations report Fraudulent Financial Reporting 1998-2007: An Analysis of U.S. Public Companies analyzed 347 fraudulent financial reporting occurrences investigated by the SEC from 1998 to 2007, and found CEO and/or CFO involvement in 89 percent of the cases, with the CEO specifically implicated in 72 percent of those cases.
The report also found that the magnitude of losses from financial misstatement and misappropriation has been on the rise: 300 of the cases together resulted in over $120 billion in losses.
Allegedly, one of the first instances of financial statement fraud at a publicly traded company occurred in the 1600s at the British East India Company. Economist Adam Smith, in his 1776 Inquiry into the Nature and Causes of the Wealth of Nations, mentioned shareholders suffering from the effects of fraud as well. Fraud is everywhere. More than 80 percent of respondents to a 2012 FINRA national survey on Financial Fraud and Fraud Susceptibility in the United States indicated that they had been solicited to participate in a potentially fraudulent offer. Of concern, many Americans appear to be unable to discern signals of potential fraud, such as unreasonable rates of return or “fully guaranteed” investments. Accounting scandals also show the failure of auditors to detect or report financial results fraud by executives.
Models explaining factors contributing to fraud behavior have evolved from the fraud triangle, consisting of three points that criminologist Cressey proposed must be present at the same time: pressure, opportunity, and rationalization. Wolf and Henderson later stretched Cressey’s fraud triangle into a fraud diamond by adding a fourth element: capability, suggesting that capability is what allows the fraudster to identify and take advantage of deficiencies in internal controls and effectively cover up misconduct.
Studies and surveys demonstrate that financial fraud is a slippery slope, with “accidental fraudsters” transitioning into “predators.” When pressure, opportunity, and rationalization combine, Cressey’s fraud triangle explains unethical behavior by a seemingly normal person, the “accidental fraudster”. However, once the criminal mindset takes hold, pressure and rationalization fade into the background, and the remaining condition of opportunity is all that is required for the predatory fraudster. The desensitization that occurs after committing fraud and which leads to more fraudulent behavior has been noted in fraud literature.
“Managing earnings” is often a euphemistic way of referring to deliberate or fraudulent manipulation of financial results to change the picture of a company’s financial position prior to presentation to board members or shareholders by exploiting gray areas in accounting on how and when revenue and expenses are recognized. It’s relatively easy to turn losses into a profit on the books by estimating and recording more revenue in a particular time period.
Researchers have proposed that “financial statement fraud perpetrators often appear to start as accidental fraudsters by managing earnings, trying to buy time for their organization until conditions improve. But sooner or later, managing earnings gives way to financial reporting fraud, and the accidental fraudster becomes a predator.”
Studies show little correlation between income level and fraud. The tendency to compare one’s social status to that of other people, as well as a culture of competition, have been cited in surveys as potential motives for financial fraud committed by otherwise affluent CEOs. Coleman offered that wealth and success, rather than being goals, become entrenched in the individual’s sense of identity.
The “pressure” component of Cressey’s fraud triangle, therefore, may come in the form of internal pressure to preserve one’s image rather than external financial pressure. Among high profile cases, often the CEOs who committed fraud did so for payoffs which seem trivial relative to their very generous legitimate compensation packages. This seems to suggest that personality and other factors contribute to financial fraud behavior by CEOs.
The role of CEO Narcissism
The DSM-IV definition of narcissism encompasses “a pervasive pattern of grandiosity (in fantasy or behavior), need for admiration and a lack of empathy, beginning by early adulthood and present in a variety of contexts.” While Kets de Vries notes that “a solid dose of narcissism is a prerequisite for anyone who hopes to rise to the top of an organization”, and others have suggested that all leadership is inherently narcissistic to some degree, narcissism can be viewed on a sliding scale. Certain levels of narcissistic traits in leadership have been categorized as constructive, having a positive effect on an organization, whereas other more extreme forms of narcissism have had destructive effects on companies and their stakeholders. Dysfunctional, high levels are categorized as Narcissistic Personality Disorder, the prevalence of which is estimated to be between 0.7 to 1 percent of the population.
The “narcissistic paradox” refers to the seeming contradiction where narcissists lack self-confidence and self-esteem and overcompensate by representing themselves as superior to other people. According to Rijsenbilt and Commandeur, “In order to protect themselves from being criticized, narcissistic people constantly look for affirmation and tend to ignore the feelings, words, and behaviors of others and therefore cultivate underdeveloped feelings of empathy.” Investigators of CEO narcissism have expressed the idea that financial reporting, due to its frequent and periodic nature, serves as a regular source of affirmation of the CEO’s greatness.
A study by Chatterjee and Hambrick found a “strong indication” of an association between “large annual fluctuations in accounting returns” and CEO narcissism. In Accounting as a Facilitator of Extreme Narcissism, Amernic and Craig propose that accounting is a choice tool for narcissistic CEOs, allowing them to “construct a narrative about the corporation and themselves using financial accounting measures.” Pointing out that the general public perceives accounting to be rigid, objective, and scientific, when in fact accounting rules are often subjective and malleable, they “suggest that many narcissistic CEOs make accounting policy choices and earnings management decisions to maintain a positive sense of self, defend their egos, and preserve self-esteem.”
Measures of CEO performance often reside in the accounting world, namely financial metrics such as earnings per share (EPS), return on investment (ROI), and net income. Since narcissistic CEOs view these as a reflection of self and personal accomplishment, they are inclined to manipulate them by exercising their power over accounting policies and procedures. These same metrics also serve as a basis for compensation for many CEOs, so there are significant monetary rewards to be reaped from artificially rosy financial ratios.
Several aspects of accounting which appeal to narcissistic CEOs have been described by Amernic and Craig: financial reports regarded as personal report cards, the fact that accounting measures are “amenable to refraction and distortion by them,” and that a company’s financial reporting, “which can produce unflattering self-images, can be tailored easily to reflect a picture of financial performance that is more flattering and ego-satisfying for a CEO.” The perception of accounting by the general public as something more objective and neutral than it really is, as well as the “social patina of presumed external auditor independence” are also cited as reasons accounting manipulation appeals to narcissist CEOS.
A 2013 study by Rijsenbilt and Commandeur followed up on previous research suggesting that narcissists have a propensity to set unrealistic or unattainable goals as a result of the constant “intense need to have their superiority continually reaffirmed.” Using a sample of 953 S&P 500 CEOs from all industries, they found a positive relationship confirming the influence of CEO narcissism on fraud. The researchers used proxies for narcissism, such as the size of the CEOs’ photos in annual reports (2 pages of photos of the CEO alone, rather than with a team, were worth a maximum of 12 points), number of biography lines in the Marquis Who’s Who database, the “Idi Amin phenomenon” of holding multiple titles signaling a consolidation of power, whether the CEO was also chairman of the board, and perquisites. The resulting narcissism score was used in conjunction with the SEC’s Accounting and Auditing Enforcement Releases which name CEOs and their involvement in financial misstatement or fraud.
Narcissistic CEOs, largely ignoring the long term interests of shareholders and employees, may engage in high risk and unethical behaviors which jeopardize organizations.
Studies have linked aggressive merger and acquisition behavior with the propensity to commit financial fraud, and found that executives at high growth firms are more likely to engage in such behavior. The destructive effects of their behavior include tremendous economic damage to multiple stakeholders, including employee job loss and loss of investor money and confidence. Firms with fraud activity are more likely to declare bankruptcy.
The body of literature surrounding narcissism and accounting fraud has implications for the executive screening process, board oversight, auditors, and the design of executive compensation packages. Amernic and Craig propose that understanding narcissism offers insight into CEO involvement in unethical financial reporting practices. Boards and audit committees should pay attention to CEO personality traits and power consolidation. CEO involvement in the auditor selection process also warrants scrutiny. Research demonstrates that the personalities and pathologies of leadership have the capacity to greatly impact various stakeholders.
Amernic, J., & Craig, R. (2010). Accounting as a Facilitator of Extreme Narcissism Journal of Business Ethics, 96 (1), 79-93 DOI: 10.1007/s10551-010-0450-0
Boyle, D., Carpenter, B., and Hermanson, D. (2012). CEOs, CFOs, and Accounting Fraud. The CPA Journal.
Dorminey, J., Fleming, A., Kranacher, M., & Riley, R. (2012). The Evolution of Fraud Theory Issues in Accounting Education, 27 (2), 555-579 DOI: 10.2308/iace-50131
Financial Fraud and Fraud Susceptibility in the United States: Research Report from a 2012 National Survey. FINRA Investor Education Foundation.
Fraudulent Financial Reporting 1998-2007: An Analysis of U.S. Public Companies. (2010). Committee of Sponsoring Organizations of the Treadway Commission http://www.coso.org/documents/COSOFRAUDSTUDY2010_001.PDF
Rijsenbilt, A., & Commandeur, H. (2012). Narcissus Enters the Courtroom: CEO Narcissism and Fraud Journal of Business Ethics, 117 (2), 413-429 DOI: 10.1007/s10551-012-1528-7
Zona, F., Minoja, M., & Coda, V. (2012). Antecedents of Corporate Scandals: CEOs’ Personal Traits, Stakeholders’ Cohesion, Managerial Fraud, and Imbalanced Corporate Strategy Journal of Business Ethics, 113 (2), 265-283 DOI: 10.1007/s10551-012-1294-6
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