A new study has found 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 financial targets.
In a paper titled “Reporting concerns about earnings quality: an examination of corporate managers” – published in the Journal of Business Ethics – researchers have identified evidence that financial pressures may make it less like that a chief financial officer will blow the whistle and approach external parties.
Lead author Joseph Brazel said: “One of the takeaway 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. That could be challenging.”
The study recruited 204 financial managers (mostly CFOs and controllers), all of whom were given a suite of financial and non-financial 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.
Split into four groups, the participants were presented with various scenarios: 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 indicators of potential fraud, the second group was under pressure but received no red flags, the third received the red flags but was not under pressure to meet the target, and the fourth group had no red flags and no pressure to meet a target.
According to Dr Bob Murray, the joint CEO at consulting firm Fortinberry Murray, the researchers found that 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 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, under pressure, financial managers became significantly less willing to approach external parties,” Dr Murray reflected.
“In other words, in really important scenarios – when the pressure is on – executives don’t blow the whistle. They shut down,” Mr Brazel added.
There were two other variables that played a significant role, Dr Murray continued: 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,” he said.
“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,” said Mr Brazel.
“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.”
Reflecting on the findings, Dr Murray said the research was interesting in that prior studies have shown that the same dynamic occurs with bullying and harassment in the workplace.
“When a business is on the edge financially or when there is a danger that the targets set for the financial period are not going to be met then there is a great temptation to not report or punish bad behavior – especially when the person concerned is deemed to be important to the financial wellbeing of the business,” he posited.