Looking for the Red Flags of Fraudulent Financial Reporting

I recently read an article that describes the results of a study that contends in some company bosses are being placed in a position of power when the company needs “aggressive earnings reports”. In such cases, recruiters are more likely to suggest job candidates with “dark personality traits” who would be willing to inflate or manipulate earnings and income data. Conversely, managerial candidates who displayed a strong sense of ethics and willingness to consult with others are usually passed over in such situations.

If the results of the study are true, a red flag should be raised about the motivation for hiring or promoting to manager employees with negative traits. The only advantage they have in comparison to more ethical candidates is their willingness to bend the rules.

If there are personality traits that make it more likely that a manager will be more willing to use questionable accounting practices to meet financial goals, then the next question is what those personality traits are and what is their influence on ethical decision making.

Barry Epstein and Sri Ramamoorti discuss the existence of the dark triad deviant personalities, “Whose behaviors may imply different risk profiles for audit – and financial reporting fraud – risk assessments, engagement planning and so-called audit execution”. They suggest that “the existence and prevalence within the ranks of such personalities challenge the logic of applying the most commonly cited fraud risk models” including the Cressey Fraud Triangle.

The Fraud Triangle describes the red flags that can increase fraud risk including incentives/pressures to commit fraud; opportunity to commit fraud; and rationalization for the fraud.  We could say that the existence of dark triad personality traits makes it more likely a manager will compromise their integrity and take the opportunity to engage in fraudulent behavior and apply those traits to committing fraud and rationalizing such behavior.

Kari Joseph Olsen conducted research into personality characteristics and accounting and found there is a growing prevalence today of individuals with dark triad personality tendencies. Narcissistic personalities can bias cognitive processing to suit a person’s self-view. These persons are obsessed with power, prestige, and vanity and are mentally unable to see the destructive damage they cause to themselves and others.

The results of Olsen’s research led to the conclusion that personality tendencies of the CEO influence and motivate accounting decisions. He suggests that earnings per share (EPS) is a potential avenue through which narcissistic CEOs can receive needed praise and affirmation to support their inflated sense of self-importance.

Journalist Jay Ronson interviewed Al Dunlap, former CEO of Sunbeam, who was responsible for a turnaround at the company best illustrated by an increase in EPS from $12.50, on the day he was hired in 1997, to a peak of $52.50 in 1998 when the board doubled his salary to $2 million. Dunlap gained the nickname “Chainsaw Al” because of his “gleeful fondness for firing people and shutting down factories”.

Those decisions worked at first to improve the earnings outlook, but Dunlap hit a snag once those maneuvers had all been played out. He turned to fraudulent techniques to inflate earnings including recording bogus revenue. Ronson observed that Dunlap had a “Grandiose sense of self-worth” – which would have been a hard one for him to deny because he was standing underneath a giant oil painting of himself. When asked about it, Dunlap said: “You’ve got to like yourself if you’re going to be a success”.

If it is true that managers’ dark personality traits increase their tendency to engage in disruptive and unethical organizational behaviors, including accounting earnings management, then assessing those tendencies becomes essential to controlling for fraudulent behavior. Of course, those organizations that knowingly choose a manager because of those traits are unlikely to do anything about them and that is why the culture of an organization is the most important red flag in assessing when and if financial statement fraud will occur.

The aforementioned research also has implications for accounting ethics education. Right now, very few textbooks even discuss dark triad personalities, although the Accounting Ethics textbook by Steven Mintz does in the context of fraudulent financial reporting. In the textbook, Mintz applies and "Ethics IQ Test" that can be modified to identify and discuss dark triad personality traits.

What is needed next is for accounting educators to discuss these issues in the classroom with the intent to open the eyes of students to the dangers of emphasizing self-interest above the public interest.

Posted by Dr. Steven Mintz, The Ethics Sage, on April 14, 2021. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.