BUSI 715Qualitative Data Analysis AssignmentAs you have foun.docx

BUSI 715
Qualitative Data Analysis Assignment
As you have found through the reading, study, and assignments
in this course, there are several designs within qualitative
research. Selecting the appropriate design for the research topic
is important. To correctly execute qualitative research, after a
design is selected and data is collected, calculative and
intentional data analysis is the next step. Finally, the qualitative
researcher must present the data in a way that adequately
conveys the findings and compares findings to published
literature. This assignment will give you some experience with
analyzing qualitative data on a small scale.
After reviewing the Reading and Study material for the module,
please address the following in an APA-formatted paper:
Introduction (1-2 pages)
Statement of the problem
· This section should include a clearly articulated problem
statement and should be directly linked to/aligned with the
research question(s)
· Why did the study need to be done?
The research question(s)
· What was the study seeking to answer?
· The research question should be able to be answered via the
type of data collected
· Qualitative research questions begin with “What,” “How,” or
“Why”
· Hint: The research question is different from the interview
questions. Do not provide the interview questions here.
Purpose of the study and how study will be delimited
· What was the intent of the study?
· What delimiters were put in place to manage the size and
scope? Who/what will be excluded and why?

Procedures (1-2 pages)
Qualitative research strategy
· What design is most appropriate for the problem
statement/research question?
Role of the researcher
· What was the researcher (you) responsible for (what you did
to collect data and analyze it in this course)?
· How does personal bias impact the study?
Data collection procedures
· What steps did you take to collecting and analyzing data
(think recipe card)
Strategies for validating findings
· Hint: Refer to Discussion Board on Validity and Reliabity
Anticipated ethical issues (2 paragraphs)
· What ethical issues may arise specific to the topic and
research approach?
· Include a paragraph in this section with your prescribed
approach to these issues supported by scripture and the Keller
text.
Emergent Theme Analysis and Discussion (5-8 pages)
Journals
· What are the emergent themes in the journal entries you
selected?Provide a name for each theme, a description of the
meaning of each theme, and evidence (i.e. quote excerpts) of
each theme.
Letters
· What are the emergent themes in the letters to prospective
students you selected? Provide a name for each theme, a
description of the meaning of each theme, and evidence (i.e.
quote excerpts) of each theme.
Interviews
· What are the emergent themes in the interviews you
conducted? Provide a name for each theme, a description of the
meaning of each theme, and evidence (i.e. quote excerpts) of
each theme.
Collective Themes and Relationship to Literature Review

· What themes are common across the journal entries, letters,
and interviews?Remember, the themes should answer the
research question.
· How do these themes compare or contrast with the sources you
analyzed for the literature review?
· What are the implications of these themes for practitioners and
researchers?
Submit this assignment through the SafeAssign link by 11:59
p.m. (ET) on Friday of Module/Week 8.
The Role of Power in Financial Statement Fraud Schemes
Chad Albrecht • Daniel Holland • Ricardo Malagueño •
Simon Dolan • Shay Tzafrir
Received: 24 June 2011 / Accepted: 12 December 2013 /
Published online: 7 January 2014
� Springer Science+Business Media Dordrecht 2014
Abstract In this paper, we investigate a large-scale
financial statement fraud to better understand the process
by which individuals are recruited to participate in financial
statement fraud schemes. The case reveals that perpetrators
often use power to recruit others to participate in fraudulent
acts. To illustrate how power is used, we propose a model,

based upon the classical French and Raven taxonomy of
power, that explains how one individual influences another
individual to participate in financial statement fraud. We
also provide propositions for future research.
Keywords Financial statement fraud � Organizational
corruption � Recruitment � Collusion � Power and
influence
Introduction
In recent years, fraud and other forms of unethical behavior
in organizations have received significant attention in the
business ethics literature (Uddin and Gillet 2002; Elias
2002; Rockness and Rockness 2005; Robison and Santore
2011), investment circles (Pujas 2003; Albrecht et al. 2011),
and regulator communities (Farber 2005; Ferrell and Ferrell
2011). Scandals at Enron, WorldCom, Xerox, Quest, Tyco,
HealthSouth, and other companies created a loss of confi-
dence in the integrity of the American business (Carson
2003) and even caused the accounting profession in the
United States to reevaluate and reestablish basic accounting

procedures (Apostolon and Crumbley 2005). In response to
the Enron scandal, the American Institute of Certified
Public Accountants issued the following statement:
Our profession enjoys a sacred public trust and for more
than one hundred years has served the public interest.
Yet, in a short period of time, the stain from Enron’s
collapse has eroded our most important asset: Public
Confidence. (Castellano and Melancon 2002, p. 1)
Financial scandals are not limited to the United States
alone. Organizations in Europe, Asia and other parts of the
world have been involved in similar situations. Notable
cases include Parmalat (Italy), Harris Scarfe and HIH
(Australia), SK Global (Korea), YGX (China), Livedoor
Co. (Japan), Royal Ahold (Netherlands), Vivendi (France),
and Satyam (India). The business community worldwide
has experienced a syndrome of ethical breakdowns,
including extremely costly financial statement frauds.
An organization’s financial statements are the end

product of the accounting cycle and provide a representa-
tion of a company’s financial position and periodic per-
formance. The accounting cycle includes the procedures
C. Albrecht (&) � D. Holland
Huntsman School of Business, Utah State University, Logan,
UT, USA
e-mail: [email protected]
D. Holland
R. Malagueño
University of Essex, Colchester, UK
S. Dolan
ESADE Business School, Universidad Ramon Llull,
Barcelona, Spain
S. Tzafrir
Faculty of Management, University of Haifa, Haifa, Israel
123
J Bus Ethics (2015) 131:803–813

DOI 10.1007/s10551-013-2019-1
http://crossmark.crossref.org/dialog/?doi=10.1007/s10551-013-
2019-1&domain=pdf
http://crossmark.crossref.org/dialog/?doi=10.1007/s10551-013-
2019-1&domain=pdf
for analyzing, recording, classifying, summarizing, and
reporting the transactions of a business or organization.
Financial statements are a legitimate part of good man-
agement and provide important information for stake-
holders (Power 2003; Epstein et al. 2010). Financial
statement fraud has been defined as an intentional mis-
representation of an organization’s financial statements
(National Commission on Fraudulent Financial Reporting
1987).
Financial statement fraud is primarily a top-down form
of fraud that negatively impacts individuals, organizations,
and society. As a result, it is important to understand why
individuals become engaged in financial statement fraud.
While research has suggested how a single individual

becomes engaged in financial statement fraud (Ramos
2003; Wolfe and Hermanson 2004; LaSalle 2007; Nocera
2008), we still do not understand how groups of individuals
become involved. In this paper, we seek to contribute to the
literature by considering how top management recruits
others to participate financial statement fraud.
Literature Review
Various efforts have been made to curb fraud and other
forms of organizational corruption. For example, legisla-
tion such as the Sarbanes–Oxley Act that was passed in
2002 by the United States Congress was created to mini-
mize financial statement fraud. One of the top priorities of
the Public Company Accounting Oversight Board
(PCAOB) has been to minimize the occurrence of fraud
(Hogan et al. 2008). Other organizations, such as the
Association of Certified Fraud Examiners (ACFE) were
created to educate and train professionals to detect and
prevent fraud.

Research that addresses the behavioral aspects of fraud
has generally focused on various theories of management,
especially that of agency theory (Albrecht et al. 2004).
Agency theory assumes a principle-agent relationship
between shareholders and management (Jensen and Mec-
kling 1976). Under agency theory, top managers act as
‘‘agents,’’ whose personal interest do not naturally align
with company and shareholder interest. Agency theory
assumes that management is typically motivated by self-
interest and self-preservation. As such, executives will
commit fraud because it is in their best, personal, short-
term interest (Davis et al. 1997). In order to limit financial
statement fraud and other forms of organizational corrup-
tion, researchers suggest that organizations provide
employee incentives that better align management behavior
with shareholder goals. Furthermore, shareholders seek to
institute controls that will limit the possibility that execu-
tives will maximize their own utility at the expense of

shareholders (Donaldson and Davis 1991).
In the last few years, there has been an increased volume
of research by scholars within the management community
that addresses fraud and other forms of corruption from a
humanistic approach. Recent research in this area has
addressed circumstances that influence self-identity in
relation to organizational ethics (Weaver 2006), collective
corruption in the corporate world (Brief et al. 2000), nor-
malization and socialization, including the acceptance and
perpetuation of corruption in organizations (Anand et al.
2004), the impact of rules on ethical behavior (Tenbrunsel
and Messick 2004), the mechanisms for disengaging moral
control to safeguard social systems that uphold good
behavior (Bandura 1999), and moral stages (Kohlberg
1984). In addition to this work, there has been substantial
research into the various aspects of whistle blowing.
(Dozier and Miceli 1985; Near and Miceli 1986).
Classical Fraud Theory and the Initiation of Financial

Statement Fraud
Classical fraud theory has long explained the reasons that a
single individual becomes involved in financial statement
(or any type of) fraud. This theory suggests that there are
three primary perceptions or cognitions that influence
individuals’ choices to engage in fraud. These three factors
are often represented as a triangle and consist of perceived
pressure, perceived opportunity, and rationalization (Suth-
erland 1949; Cressey 1953; Albrecht et al. 1981).
The first element in the fraud triangle is that of pressure
or motivation. Motivation refers to the forces within or
external to a person that affect his or her direction, inten-
sity, and persistence of behavior (Pinder 1998). At a very
basic level, motivation starts with the desire to fulfill fun-
damental needs, such as food, shelter, recognition, financial
means, etc. These desires lead to behaviors that the indi-
vidual believes will result in the fulfillment of such needs.
In financial statement fraud, the motivation or pressure

experienced by the initial perpetrator is often related to the
potential negative outcomes of reporting the firm’s true
financial performance. Financial statements are used by
shareholders to measure the performance of the firm versus
expectations. The results have a significant influence on the
company’s stock price. Executives’ job security and
financial compensation are often dependent on maintaining
strong financial performance and rising stock prices. Thus,
top managers feel tremendous pressure to meet or exceed
investors’ expectations and may even consider using
fraudulent means to do so.
The second element of the fraud triangle is that of
opportunity. Perpetrators need to perceive that there is a
realistic opportunity to commit the fraud without facing
grave consequences. Opportunity is largely about per-
ceiving that there is a method for perpetrating the fraud that
804 C. Albrecht et al.
123

is undetectable. A person that perceives a reasonable
opportunity for fraud typically senses that he or she will not
get caught, or it would be unlikely that any wrongdoing could
be proven. If an individual perceives such an opportunity, he
or she is much more likely to consider the possibility of
initiating unethical actions. Of course, shareholders or
boards of directors strive to reduce the perception of
opportunity by implementing systems and controls (e.g.,
auditing procedures) that make it more difficult to perpetuate
a fraud. However, some people, particularly executives with
considerable authority, may suppose that they can manipu-
late and control their environment in a way that will reduce
the likelihood of detection.
Rationalization is the third element of the triangle. Most
people are basically honest and have intentions to be eth-
ical. Thus, even the consideration of committing fraudulent
acts results in significant cognitive dissonance and negative

affect (Aronson 1992; Festinger 1957). In order to over-
come such dissonance, fraud perpetrators generally try to
find a way to reconcile their unethical cognitions with their
core values. As a result, they seek out excuses for their
thoughts, intentions, and behaviors through logical justifi-
cation so that they may convince themselves that they are
not violating their moral standards (Tsang 2002). Typical
excuses for financial statement fraud may include, ‘‘This is
our only option,’’ ‘‘Everybody is doing it,’’ ‘‘It will only be
short-term,’’ or ‘‘It is in the best interest of the company,
shareholders, or employees.’’ Such rationalizations aim to
reduce the perception of unethicality or to shift the balance
of the equation to a more utilitarian ‘‘it may not be ideal,
but it is for the greater good.’’
Classical fraud theory suggests that fraud is most likely
to take place when all three elements are perceived by the
potential perpetrator. However, the three factors work
together interactively so that if more of one factor is

present, less of the other factors need to exist for fraud to
occur (Albrecht et al. 1981). It is also important to note that
the theory is based on perceptions. In other words, the
pressures and opportunities need not be real, only per-
ceived to be real.
Collusion between Perpetrators
Recent research into financial statement fraud has sug-
gested that nearly all financial statement frauds are per-
petrated by multiple players within the organization
working together (The Committee of Sponsoring Organi-
zations of the Treadway Commission 2002; Association of
Certified Fraud Examiners 2012; Zyglidopoulos and
Flemming 2008, 2009; Burke 2010). As such, it is neces-
sary to understand the relationship that takes place between
the initial perpetrator of a fraudulent act and any additional
conspirators.
Research on the perpetuation of fraud in organizations
has focused on diffusion (Strang and Soule 1998; Baker

and Faulkner 2003), social networking (Brass et al. 1998)
and the normalization of deviant practices (Earle et al.
2010). While each of these studies has enhanced our
understanding of fraud in organizations, there remains a
significant gap in our knowledge regarding how individuals
are influenced to join a fraudulent scheme. In others words,
we still do not know the processes by which one individ-
ual—after he or she has become involved in a financial
statement fraud—recruits other individuals to participate.
While the fraud triangle explains why a single individual
becomes involved in financial statement fraud, the theory
does not inform us as to how large groups of individuals
become involved. The fraud triangle is limited in that it
only provides a psychological glimpse of a single person’s
perceptions, and why he or she may choose to participate in
fraudulent behavior through pressure, opportunity, and
rationalization. We build on this theory by considering how
the leading perpetrator may influence the perceptions of

pressure, opportunity, and rationalization in a subordinate
during the recruitment process.
We start by presenting an illustrative strategic case of a
large public financial statement fraud. Next, we propose a
power-based, dyad reciprocal model to explain the process
of how collusive acts, particularly those of financial
statement fraud, occur in organizations. In so doing, we
offer propositions regarding how individuals within an
organization are oftentimes successfully recruited to par-
ticipate in financial statement scandals. We conclude with a
discussion and recommendations for future research.
Strategic Case: A Fortune 500, Billion-Dollar Fraud
In order to better understand how individuals are recruited
to participate in financial statement fraud, we investigated a
large financial statement fraud that recently occurred at a
U.S. ‘‘Fortune 500’’ company. At the time of the fraud, the
company was publicly traded on the New York Stock
Exchange and was considered to be one of the leading

growth companies in the United States. Because the fraud
is still under trailing litigation, we are not authorized to
disclose the name of the company. However, it should be
noted that the case is one of the well-publicized, financially
significant, financial statement frauds that occurred in the
United States over the last few years. By signing confi-
dentiality agreements, we were able to interview expert
witnesses and gain access to various court documents
including depositions, complaints, pre-trial motions,
amended complaints, and exhibits. We spent hundreds of
hours studying these documents.
In our investigation, we discovered that the financial
statement fraud started when significant financial pressure
The Role of Power in Financial Statement Fraud Schemes 805
123
was put on management, including the CFO and others.
Management was concerned that not meeting publicly

available earnings forecasts would result in significant
declines in the market value of the stock. By analyzing the
financial statements, it is possible to see the exact amount
that was manipulated each quarter in order to meet earnings
forecasts. In fact, in every quarter, management guided the
analysts to increasing earnings per share. Management
would then manipulate the financial statements in exactly
the amount needed to meet the consensus of the analyst’s
forecasted expectations. For example, if real earnings per
share were $.09, and Wall Street’s consensus expectation
was $.19 per share, management would manipulate the
statements to add $.10 per share for a total of $.19 per
share.
The chief executive officer (CEO), the chief financial
officer (CFO), and the chief operating officer (COO) all felt
substantial pressure to meet the analyst’s forecasted
expectations for the organization. At first, management
used acceptable but aggressive accounting methods to

reach the desired numbers. When aggressive accounting
methods no longer achieved the desired targets, the top
management team pressured the CFO to do ‘‘whatever was
necessary’’ to meet the published numbers. The CFO was
left to himself to decide how to meet the objective. At first,
the CFO reached into future reporting periods to pull back
a few expected revenue transactions into the current period.
When that was no longer plausible, the CFO used ‘‘topside
journal entries’’ (accounting entries made to the trial bal-
ance with no support), false-revenue recognition, and
understatement of liabilities and expenses to perpetrate the
fraud.
From our research, it is clear that while pressure came
from the CEO and COO, the CFO was the primary
manipulator of the financial statements. Unfortunately, we
could not (neither could the courts) determine how much
knowledge the CEO and COO had about the different types
of fraudulent financial transactions that were taking place.

However, in order to keep stock options valuable (the
CEO, COO, and CFO all had stock options worth tens of
millions of dollars) they were motivated to maintain high
stock prices by meeting Wall Street earnings expectations
every quarter.
Because so many people were involved in preparing the
financial statements of this large corporation, the need to
involve others in the fraud became necessary. The CFO
recruited the controller, the vice president of accounting,
the vice president of financial reporting, and the director of
financial reporting into the fraud. This ‘‘inner circle’’ of
perpetrators understood most elements of the fraud, and
recruited others to manipulate individual fraudulent trans-
actions (including various controllers at the company’s
subsidiaries). Subsidiary controllers then recruited others
within their own organizations to help perpetrate the fraud.
Though the number of people involved in the fraud
expanded over the years, the detailed knowledge of the

overall fraudulent behavior was generally limited to the
persons in higher level positions. Yet, even the principal
perpetrators hadn’t known how many people were actually
involved or the full extent of the financial statement losses.
Court documents suggest that those in the third and fourth
generations had very little knowledge of the scope of the
fraud, yet, still manipulated certain transactions that
enabled the fraud to be executed.
Court documents suggest that those who participated in
the fraud did so for various reasons. Several individuals,
especially those at the executive level, became involved
because they were promoted and received higher salaries.
Nearly all the participants received, as a result of a higher
stock price, more valuable stock options. Other individuals
participated because of fear of dismissal or reprisal. Third
and fourth generation participants, usually with little
knowledge of the overall scheme, participated because
their superiors told them to do something, or because they

felt they did not understand exactly what was going on.
Within the inner circle, individuals participated because
they trusted their colleagues and because, at first, the
fraudulent amounts were small. As a whole, the group
rationalized their actions as acceptable by making ‘‘seem-
ingly small rationalizations’’.
The total amount of the financial statement manipulation
was between $1 billion and $3 billion. Before the fraud was
discovered, more than 30 people participated in the fraud.
Many of these individuals had different levels of knowl-
edge regarding the fraud. While some of the perpetrators
had complete knowledge of the unethical acts that were
occurring, others performed tasks simply because they
were ‘‘asked to.’’ Those who had full knowledge of the
fraud rationalized their acts as acceptable. They believed
that the unethical financial statement manipulations would
only be necessary for a limited time. However, when reg-
ulators discovered the fraudulent financial statements, the

fraud had been occurring for over 4 years.
Power and the Decision to Commit Financial Statement
Fraud
As illustrated in the case, fraud schemes are replete with
the use and abuse of power. Perceptions of personal power
and social power influence the initial decision to initiate the
financial statement fraud and also the recruitment of others
to assist and abet in the scheme. Personal power has been
described as the ability that a person has to carry out his or
her own will despite resistance (Weber 1947). Social power
is the ability to control the resources and outcomes of
others (Overbeck and Park 2001).
123
Extensive research has shown that power is often mis-
used by individuals and may lead to an array of negative
consequences. For example, power often impairs cognition

and judgments. Powerful people are more likely to have
flawed assessments of others’ interests and emotions
(Keltner and Robinson 1997), to use stereotypes in forming
opinions of others (Fiske 1993), to seek out information
that confirms their own preferences and beliefs (Ebenbach
and Keltner 1998), and to objectify others and treat them as
a means to an end (Gruenfeld et al. 2008). Power can have
a significant effect on the way individuals think about
problems and the consideration of potential solutions to
overcome the obstacles.
In evaluating the role of power in financial statement
fraud, we will first consider the decision to initiate a financial
statement fraud and the decision-maker’s power in this pro-
cess. When viewed through the lens of the fraud triangle, we
argue that power differentially affects the perceptions of
pressure, opportunity, and rationalization. Personal power is
likely to be inversely related to pressure. An individual that is
high in power feels in control of his or her outcomes and is

less susceptible to external pressure (Pfeffer and Fong 2005).
Power tends to reduce the threat of losses (Inesi 2010) which
alters the motivational mechanisms within individuals. For
example, a powerful CEO that is also Chairman and feels in
control of the board of directors will likely feel less threat of
negative consequences from unmet expectations than one
with less power. Similarly, the CEO/Owner of a private
company is in a position of power relative to an executive of
a public company regarding the personal outcomes associ-
ated with the company’s performance. Thus, the owner of the
private company would typically feel significantly less
pressure to fudge the numbers.
Proposition 1 The more personal power that an indi-
vidual has, the less likely he or she is to perceive external
pressure to perpetrate a financial statement fraud.
On the other hand, power is likely to increase the per-
ception of opportunity. Power tends to reduce the influence
of constraints on the pursuit of goals (Keltner et al. 2003).

When constraints are discounted, the opportunities look
more plausible. Having power tends to deactivate the
behavioral inhibition system that generally sends the
warning signals about potentially detrimental behaviors
(Anderson and Berdahl 2002). Thus, power increases the
likelihood of risk-seeking behavior (Anderson and Galin-
sky 2006) and the disregard for social norms (Galinsky
et al. 2008). Such power related biases are liable to influ-
ence the viability of an opportunity to accomplish a goal by
any means necessary, even financial statement fraud. For
instance, a CFO with substantial power is more likely to
believe that he or she could manage a fraud scheme without
getting caught than a CFO with less power.
vidual has, the more likely he or she is to perceive an
opportunity to perpetrate a financial statement fraud.
Rationalization is the third element of the fraud triangle
that contributes to unethical decision-making. Research

suggests that individuals with high power are often sus-
ceptible to moral hypocrisy and are less strict than the
powerless in the moral judgment of their own behavior
(Lammers et al. 2010). They often feel a sense of entitle-
ment even if their behavior may cause harm to others
(Rosenblatt 2012). The powerful are more prone than those
with less power to the rationalization of self-interest
(Keltner et al. 2006). The rationalization may be so com-
pelling that the individual makes seemingly irrational
judgments of the morality of his or her behavior. It was
recently reported that Dennis Kozlowski, the disgraced
former CEO of Tyco International, rejected a plea deal that
would have reduced his prison sentence because he was
living in a ‘‘CEO-type bubble’’ and had ‘‘rationalized’’ that
he was not guilty (Dolmetsch and Van Voris 2012).
vidual has, the more likely he or she will develop ratio-
nalizations for perpetrating a financial statement fraud.

Power and the Recruitment of Co-conspirators
Social power has been repeatedly studied by management
and social psychology scholars, and a number of theories
and taxonomies of power have emerged. The most prom-
inent of these approaches includes the power-dependence
theory (Emerson 1962), Kipnis et al.’s (1980) typology of
influence tactics, and the French and Raven (1959)
framework of power. Recent research argues that these
theories of power have become the most commonly ref-
erenced frameworks for understanding social power in
management (Kim et al. 2005). In applying these different
taxonomies to the case study, we determined that the
French and Raven (1959) framework provides the most
insight into the recruitment process as it is the only
framework that suggests how power is derived between
two individuals. Such a perspective is important when
analyzing the relationship that takes place in the recruit-
ment of individuals in a financial statement fraud (Dapiran

and Hogarth-Scott 2003).
French and Raven’s theory suggests that there are five
different sources of social power. The power possessed by
person A is based on person B’s perception of A’s role,
characteristics, and relationship with B. Specifically, the
types of power possessed by A may include (1) coercive
power (B perceives that A has the ability to punish B if B
does not comply with A’s demands), (2) reward power (B
perceives that A has the ability to reward B if B does
123
comply with A’s wishes) (3) expert power (B perceives
that A possesses special knowledge or expertise that merits
deference) (4) legitimate power (B perceives that A has a
legitimate role or position that obligates B to follow A’s
direction), and (5) referent power (B identifies with,
admires, or respects A so B wishes to emulate A). It is

important to note that in the case of power, perception
becomes reality (Wolfe and McGinn 2005). In other words,
even if A would not be deemed to have any rightful power
over B by impartial observers, if B perceives A to have
power, then A does have power.
Drawing upon these five types of power, we propose that
a power-based model to help explain how individuals use
power to recruit others to participate in financial statement
fraud. In developing the model, we propose that a person in
a position of power (Person A), such as a CEO will use
power to influence another individual (Person B) to par-
ticipate in the fraudulent scheme. In so doing, A seeks to
apply pressure on B, help B perceive a reasonable oppor-
tunity, and provide possible rationalizations for B. This
process is shown in Fig. 1:
Pressure
Pressure is a key component of recruiting co-conspirators to
participate in a fraud. People in positions of power often

have the ability to apply pressure on targets of interest.
Perceived reward power is the ability of the conspirator to
convince potential co-conspirators that he or she will
provide desired benefits through participation in a financial
statement fraud. The recruiter may encourage the individual
to participate in the scheme through the promise of a large
bonus, rewards from valuable stock options, other types of
equity payments, or possibly even a job promotion.
Perceived coercive power is the ability of the conspir-
ator to make the potential co-conspirator perceive potential
punishment if he or she doesn’t participate in a financial
statement fraud. This potential punishment is usually based
on fear (Politis 2005). If the potential co-conspirator per-
ceives that the perpetrator has the ability to punish him or
her in any way, the perpetrator begins to exercise a form of
coercive power over that individual. From a coercive
power perspective, the recruiter may pressure a potential
co-conspirator to participate in the scheme by suggesting

they may lose their job, receive public humiliation, be
victimized as a whistle-blower, or be punished in some
other way. While not as common, expert power may be
used to pressure individuals to participate in the scheme by
suggesting that the recruiter has expert knowledge about
the business and how it should run. Similarly, since
financial statement fraud typically occurs from the top-
down, conspirators may pressure employees to participate
because he or she ‘‘is the boss.’’ Finally, referent power
may be used to pressure trusted friends and colleagues to
participate in the scheme.
Proposition 4 Reward power and coercive power are the
most effective forms of social power that may be used to
apply pressure on potential co-conspirators.
Fig. 1 Dyad reciprocal model
123

Opportunity
A personthat is being recruited to participate in fraud may feel
ample pressure to take part and thus have the desire or moti-
vation to do so. However, another important element in the
process is the perception that there is a reasonable opportunity
to commit the fraud. Much of the perception of opportunity is
related to the person’s own job responsibilities and skills. For
example, an accountant that has primary responsibility for
managing division accounts may feel some sense of oppor-
tunity to alter the numbers by virtue of his or her position. Yet,
senior management may further influence the perception of
opportunity through the use of social power.
It is likely that the original conspirator will influence his
or her target of influence so that they believe their actions
can be made without threat of serious consequence. Based
on our case analysis, we propose that the most common
type of power used to create perceived opportunities
includes expert and legitimate power. Perceived expert

power is the ability of the conspirator to use influence
through means of expertise or knowledge. From an expert
power perspective, perpetrators influence victims to believe
that they have insight and knowledge about the financial
transactions of the firm, including how the transactions are
to be observed and recorded. An example of a financial
fraud that appears to have been the result of perceived
expert power is Enron. Certain members of management
claimed to have expert knowledge regarding complicated
business organizations and arrangements.
1
Individuals,
who would have otherwise refused to join the conspiracy
based upon personal ethical standards, convinced them-
selves that the conspirators knew more about the complex
transactions than they did.
Perceived legitimate power is the ability of Person A to
convince Person B that A truly does have real power over
him or her. In business settings, individuals such as the CEO,

or other members of management, claim to have legitimate
power to make decisions and direct the organization—even if
that direction is unethical. In this way, conspirators assume
authoritative roles and convince potential co-conspirators
that their authority is legitimate. Such perceptions may help
the recruit feel that the opportunity is indeed reasonable since
the leader supports and/or condones the action.
Proposition 5 Expert power and legitimate power are the
most effective forms of social power that may be used to
increase the perception of opportunity for potential co-
conspirators.
Rationalization
We propose that fraud perpetrators use power to encourage
victims to rationalize their actions as acceptable. While
perpetrators will use all five types of power to do this, we
suggest that perpetrators most often use referent, legiti-
mate, and expert power for rationalization. Perceived ref-
erent power is the ability of the conspirator to relate to the

target of influence (co-conspirators). Conspirators using
referent power will build relationships of confidence with
potential co-conspirators. Perpetrators often use perceived
referent power to gain confidence and participation from
potential co-conspirators when performing unethical acts.
Many individuals, when persuaded by a trusted friend to
participate in a financial statement fraud, will rationalize
the actions as being justifiable. Perpetrators may influence
their friends and co-workers to participate in the fraud by
portraying attitudes such as, ‘‘everyone is doing it,’’ ‘‘it’s
no big deal,’’ ‘‘it’s only temporary’’ or ‘‘it’s necessary.’’
Furthermore, perpetrators will influence colleagues and
friends simply by modeling inappropriate behavior. When
perpetrators openly engage in dishonest acts, it suggests
that inappropriate behavior is acceptable and within the
norms of the organization.
From a legitimate power perspective, perpetrators will
encourage subordinates to rationalize the fraud as accept-

able. Perpetrators may do so by labeling the fraud as
acceptable and by suggesting that, ‘‘this is how things are
done around here.’’ When individuals within the organi-
zation see their bosses engaging in fraudulent behavior, it
sends a message that such behavior is acceptable. ‘‘If it
wasn’t acceptable,’’ these people rationalize, ‘‘the boss
wouldn’t be doing it.’’
Finally, from an expert-power perspective, many
potential victims simply accept that they must engage in
such unethical behavior because ‘‘others know more than I
do about the operations of the business, market, industry,
etc.’’Such an attitude may be even more compelling in
fraudulent financial scandals when lower-level personnel
see both internal and external auditors signing off (or
accepting) the fraudulent transactions.
Proposition 6 Referent power, legitimate power, and
expert power are the most effective forms of social power
that may be used to help potential co-conspirators form

satisfactory rationalizations regarding fraudulent behavior.
Summary of the Model
In our model, we propose that whether or not the individual
(person B) is recruited into the financial statement fraud
depends upon various factors such as the individual’s
desire (Person B) for a reward or benefit, the individual’s
1
While some financial statement frauds involved easily
understood
transactions (e.g., WorldCom), Enron was a very complicated
fraud
that involved off-balance sheet Special Purpose Entities (SPOs,
now
called Variable Interest Entities), and transactions that occurred
between Enron and these various off-balance sheet entities.
123
fear of punishment, the individual’s perceived level of
personal knowledge, the individual’s level of obedience to

authority, and the individual’s personal relationship needs.
The model displayed is interactive meaning that these five
types of power often work together to influence a potential
perpetrator. For example, if reward power were being used
to influence another person, and the individual in position
B had a specific need for a reward or benefit, then the
perceived reward or benefit that A must provide doesn’t
have to be as significant as if B were not in need of such a
reward or benefit. In this sense, when successful recruit-
ment occurs, there is a balance between B’s susceptibility
of power and A’s exertion of power.
Once the potential co-conspirator (position B) becomes
involved in the unethical scheme, this person often switches to
position A, and becomes another perpetrator of the fraud
scheme. Using his or her own perceived power with his or her
subordinates, this person will often recruit others to participate
in the unethical acts. This spillover effect continues until an
individual either blows the whistle or until the

scheme(s)becomes so largeandegregiousthatit is discovered.
As the fraud scheme continues to grow, we propose that
there is a direct effect on the organizational culture of the
firm. Culture has been explained as, ‘‘the collective pro-
graming of the mind that manifests itself not only in values,
but also in superficial ways, including symbols, heroes, and
rituals’’ (Hofstede 2001, p. 1). It has been suggested that
spoiled organizational images often transfer to additional
organizational members (Sutton and Callahan 1987).
Therefore, the once ethical organization, with no members
involved in the financial statement fraud scheme, gradually
transforms itself into an organization that fosters unethical
behavior. In the process, individuals, as a result of social-
ization (Anand, et al. 2004) and diffusion (Myers 2000;
Baker and Faulkner 2003), begin to understand and accept
the scheme as justifiable.
Evaluation of the Model with the Case
Using our proposed model, we can better understand the

process of recruitment as illustrated in the case study. The
model suggests that unethical acts begin with an individual
conspirator or, in some cases, a small group of conspira-
tors. These individuals are usually motivated because they
rationalize that the consequences (lack of rewards or pen-
alties) of not committing the act are worse than the con-
sequences of the act itself. To this end, individuals begin to
perpetrate unethical acts, and, on an ‘‘as-needed basis,’’
recruit others to participate in the scheme.
With nearly 30 individuals involved in perpetrating the
fraud, our investigation suggests that all five types of power
were used. For example, in court documents, perpetrators
often discussed stock options (reward power), the promise
of promotions (reward power), the fear of a lower stock
price (coercive power), the fear of being unsuccessful
(coercive power), whistle-blower fears (coercive power),
trust between co-workers (referent power), obedience to
management (legitimate power), as well as the lack of

knowledge that many of them had (expert power).
Discussion and Opportunities for Future Research
While our model on the recruitment of individuals into
financial statement fraud schemes is grounded in power
theory, it is difficult to empirically test the model (this is
true with most fraud models). First, many acts, because of
public embarrassment and legal fears, are handled quietly
and never made public. Second, even when the fraud is
made public, most of the details about colluding perpe-
trator relationships never surface. Despite these challenges,
we are hopeful that our model can be tested empirically.
Auerbach and Dolan (1997) suggest that understanding
the various types of power does not tell us how power is
used to influence others. Rather, they explain that it is
important to understand the strategies that are employed by
individuals—in the case of this research—the strategies
used to influence others to participate in financial statement
fraud. Future research must help identify the exact strate-

gies that perpetrators use to recruit others to participate in
financial statement fraud schemes.
With financial statement frauds being perpetrated
throughout all parts of the world, there is a need to address the
international aspects of power. We must better understand
how a country’s culture affects the strategies that are
employed by individuals to influence others. This research
must address issues such as whether one type of power is more
dominate than the other types of power regardless of culture.
There are now several excellent frameworks for study-
ing cultural values including Hofstede (1980), Schwartz
(1992, 2005), and Trompenaars (1993) as well as the
framework provided by House et al. (2004).
Similarly, it is important to understand if one type of
power always plays a dominant role in organizational
corruption or if power is situational. Along this same line
of reasoning, research must address if individuals are
inherently susceptible to certain types of power. Future

research must examine how differences in personalities and
backgrounds affect responses to power, especially the way
that different personalities respond when coupled with the
influence to participate in financial statement fraud and
other forms of organizational corruption.
Some basic descriptive studies might address the range
of criteria that individuals use to define the relationships
they have with those who are in positions of power. This
area must address how the various types of power are
defined. Furthermore, various constructs such as the desire
123
for a reward or benefit, the fear of punishment, the lack of
knowledge, the level of obedience, and relationship needs
must be more fully understood. Understanding the emo-
tions surrounding these constructs may help us understand
why some people become involved in organizational cor-

ruption while others do not.
Conclusion
In this paper, we have proposed a power-based, dyad
reciprocal model to explain the process by which fraud
perpetrators recruit individuals to participate in financial
statement frauds. Previous research has suggested that a
key element of fraud prevention is educating employees
and others about the serious of fraud and informing them
what to do if fraud is suspected (Albrecht et al. 2011).
Educating employees about fraud and providing fraud
awareness training helps ensure that frauds that do occur
are detected at early stages, thus limiting financial exposure
to the corporation and minimizing the negative impact of
fraud on the work environment. The model provided in this
paper provides shareholders with a valuable tool to educate
employees and others about fraud.
The model presented fills an important void in the fraud
literature. For many years, the fraud triangle, with its

limited predictive ability, has provided the accounting and
criminology fields with a basis as to why individuals par-
ticipate in fraudulent behavior. The fraud triangle has been
used to further education, research, and practical agendas.
As such, it has provided a framework to reference when
establishing safeguards and other controls to protect busi-
nesses from fraud. Furthermore, the fraud triangle has
allowed the scientific community to better understand the
constructs that are at play when an individual becomes
involved in financial statement fraud.
Our model provides a valuable corollary to the fraud
triangle. Used together, we can not only understand how a
single individual becomes involved in fraud, but how entire
management teams become involved in fraud. If the model
described in this paper is used by organizations in their fraud
prevention programs, employees can better identify and
understand the types of power that may possibly influence
them to participate in fraud schemes. The practical appli-

cation of the model is that it empowers individuals within an
organization against negative and/or unethical influence.
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The Role of Power in Financial Statement Fraud
SchemesAbstractIntroductionLiterature ReviewClassical Fraud
Theory and the Initiation of Financial Statement FraudCollusion
between PerpetratorsStrategic Case: A Fortune 500, Billion-
Dollar FraudPower and the Decision to Commit Financial
Statement FraudPower and the Recruitment of Co-
conspiratorsPressureOpportunityRationalizationSummary of the
ModelEvaluation of the Model with the CaseDiscussion and
Opportunities for Future ResearchConclusionReferences
Restraining Overconfident CEOs through
Improved Governance: Evidence from the
Sarbanes-Oxley Act
Suman Banerjee
College of Business, University of Wyoming
Mark Humphery-Jenner
UNSW Business School, UNSW Australia
Vikram Nanda
Rutgers University and University of Texas at Dallas
The literature posits that some CEO overconfidence benefits
shareholders, though high
levels may not. We argue that adequate controls and
independent viewpoints provided by
an independent board mitigates the costs of CEO
overconfidence. We use the concurrent
passage of the Sarbanes-Oxley Act and changes to the
NYSE/NASDAQ listing rules
(collectively, SOX) as natural experiments, to examine whether
board independence

improves decision making by overconfident CEOs. The results
are strongly supportive:
after SOX, overconfident CEOs reduce investment and risk
exposure, increase dividends,
improve postacquisition performance, and have better operating
performance and market
value. Importantly, these changes are absent for overconfident-
CEO firms that were
compliant prior to SOX. (JEL G23, G32, G34)
Overconfidence can lead managers to overestimate returns and
underestimate
risk. The literature suggests that even though some CEO
overconfidence
We acknowledge the thoughtful comments of David Hirshleifer
(the editor) and two anonymous reviewers.
We thank the seminar participants at University of Calgary,
Fudan University, IIMC Kolkota, Kobe University,
Massey University, Nanyang Technological University,
National University of Singapore, Peking University
HSBC School of Business, UNSW School of Business,
University of Technology Sydney, the J.P. Morgan ESG
Quantferance (2013), American Finance Association Meeting
(2015), American Law and Economics Association
Annual Meeting (2014), Asian Bureau of Finance and Economic
Research Conference (2014), Australasian
Finance and Banking Conference (2013), Conference on
Empirical Legal Studies (2014), Conference on
Global Financial Stability (2013), Financial Management
Association Annual meeting (2013), and the Paul
Woolley Conference on Capital Market Dysfunctionality (2014).
The paper also benefited from comments
from Itzhak Ben-David, Gennaro Bernille, Oleg Chuprinin, Wai
Mun Fong, Jarrad Harford, Gerard Hoberg,
Russell Jame, Jon Karpoff, Asad Kausar, Andy Kim, Jaehoon

Lee, Angie Low, Kasper Nielsen, Thomas Noe,
Terrence Odean, Nagpurnanand Prabhala, David Reeb, Anand
Srinivasan, Geoffrey Tate, Stephen Taylor, Robert
Tumarkin, John Wald, and Emma Zhang. Suman Banerjee
gratefully acknowledges the SUG Tier 1 research
grant from the Ministry of Education, Singapore. Mark
Humphery-Jenner acknowledges the support of the ARC
DECRA grant# DE150100895. Supplementary data can be found
on The Review of Financial Studies web site.
Send correspondence to Vikram Nanda, Naveen Jindal School of
Management, University of Texas at Dallas,
Richardson, TX 75080 & Rutgers University, Rockafeller Road,
New Brunswick, NJ 08854; telephone: (404)
769-4368. E-mail: [email protected]
© The Author 2015. Published by Oxford University Press on
behalf of The Society for Financial Studies.
All rights reserved. For Permissions, please e-mail:
[email protected]
doi:10.1093/rfs/hhv034 Advance Access publication June 1,
2015
at :: on Septem
ber 29, 2015
http://rfs.oxfordjournals.org/
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ow
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Restraining Overconfident CEOs

can benefit shareholders, a highly distorted view of risk-return
profiles can
destroy shareholder value. An intriguing question is whether
there are ways
to channel the drive and optimism of highly overconfident
CEOs while
curbing the extremes of risk taking and overinvestment
associated with such
overconfidence. We explore such a possibility in this paper.
Specifically,
we investigate whether appropriate restraints on CEO discretion
and the
introduction of diverse viewpoints on the board serve to
moderate the actions
of overconfident CEOs and thus benefit shareholders.
Although governance issues, such as board independence, have
been viewed
mainly through the lens of managerial agency, they have a
bearing in the
context of CEO overconfidence, as well. For instance, even
though the scandals
that precipitated Sarbanes-Oxley Act of 2002 (SOX) and the
changes to
NYSE/NASDAQ listing rules1 are usually attributed to poor
governance and
unethical behavior, they were likely exacerbated in many cases
by managerial
hubris. In the case of Enron, for instance, it is claimed that
overconfidence
may have rendered managers slow to recognize their mistakes
and quick
to engage in risky behavior in their attempt to cover up these
mistakes
(O’Connor 2003). These troubles were likely compounded by a
permissive

board that exhibited groupthink and inadequate oversight. SOX
and the changes
to the NYSE/NASDAQ listing rules were intended to mitigate
such problems
by, inter alia, increasing independent oversight in both the
board and the audit
committee. This package of reforms, combining increased board
and audit-
committee independence, represents a significant strengthening
in oversight
(Clark 2005). The increased oversight, and the diverse set of
viewpoints,
promoted by an independent board, could help to attenuate the
effect of
managerial moral hazard and biased beliefs.
Although the consequences of SOX and the listing rules have
been studied
in the context of poorly governed firms, the question for us is
whether the
increased oversight and other governance changes also helped to
reign in the
more harmful aspects of CEO overconfidence. Evidence that
SOX improved
the decision making of overconfident CEOs would demonstrate
that appropriate
governance structures and advice can help to channel better the
optimism of
overconfident managers toward creating shareholder value.
The double-edged nature of confidence is evident from the
literature.
Confidence is essential for success in myriad domains,
including business (Puri
and Robinson 2007). Not surprisingly, CEOs tend to be more
optimistic, and less

risk-averse, than the lay population is (see e.g, Graham, Harvey,
and Puri 2013).
Overconfidence can be a desirable trait in managers when, for
instance, there are
valuable, but risky, investments to be made in developing new
technologies or
1 For brevity, unless otherwise stated, because these changes
were concurrent, we refer to the set of changes in
SOX and to the listing rules as “SOX” unless otherwise stated
(per Guo, Lach, and Mobbs 2015; Linck, Netter,
and Yang 2009). Indeed, the changes implemented in SOX
precipitated the NYSE/NASDAQ changes, and it is
the combination of increased independence in both the board
(through a majority independent board) and in the
audit committee that improved oversight (Clark 2005).
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The Review of Financial Studies / v 28 n 10 2015
products (see, e.g., Hirshleifer, Low, and Teoh 2012; Galasso
and Simcoe 2011;

Simsek, Heavy, and Veiga 2010). The downside is that
overconfidence can
lead to faulty assessments of investment value and risk,
resulting in suboptimal
decision making.
We use the concurrent passage of the Sarbanes-Oxley (SOX)
Act of 2002
and the changes to the NYSE/NASDAQ listing rules as a natural
experiment
to investigate whether governance changes can moderate the
effect of CEO
overconfidence. In some ways these changes provide an ideal
setting for
such a test: they were exogenous to the circumstances of
specific firms, but
were associated with improvements in governance, disclosure,
and monitoring
(see e.g., Coates 2007), which we briefly discuss in Section 1
By requiring
a fully independent audit committee and a majority of directors
to be
independent, SOX, coupled with the NYSE/NASDAQ rule
changes, is believed
to have helped bring new perspectives and greater scrutiny into
the board
room. Consequently, we would expect SOX to mitigate the
extent to which
overconfident CEOs could hold sway over insider-dominated
boards.
A concern with using SOX as an instrument is that it was
enacted during
a single year and it is, therefore, possible that firm policies and
values were
influenced by other events at the time. We address this concern

in various
ways. An important falsification test is to scrutinize the changes
in firms with
overconfident CEOs that were not effected by the passage of
SOX and the
rule changes, because they were already compliant with its key
requirements
(i.e., by having a majority of independent directors and a fully
independent
audit committee prior to 2002). Further confidence is gained by
a variety of
specific tests such as the performance of subsequent Mergers
and Acquisitions
(M&A) activity that is not easily explained other than by
changes in the nature
of decision making of firms with overconfident CEOs. Our
regressions include
a large number of firms and CEO control variables, in addition
to firm and year
fixed effects.
We use both options-based and press-based measures of
overconfidence. The
premise behind the option-based measures is that a CEO’s
human capital and
personal wealth is tied to his or her company. Because CEOs are
relatively
undiversified, they should exercise rationally deep-in-the-
money options and
cash out the shares as and when they vest. Thus, holding deep
in-the-
money vested options represents a degree of overconfidence.2
We construct
overconfidence measures similar to those in Malmendier and
Tate (2005),
Malmendier and Tate (2008), and Malmendier et al. (2011). We

use a continuous
measure of CEO overconfidence and an indicator that equals
one if the CEO’s
options measure is in the top quartile of the sample. In
robustness tests, we
examine other measures of overconfidence, including press-
based measures of
overconfidence.
2 As confirmed in Malmendier and Tate (2008), the return from
holding these options is poor, inconsistent with an
inside-information explanation for not cashing out.
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We have several important findings. We first examine the
investment choices
by overconfident CEOs. Our results indicate that, prior to SOX,
overconfident
CEOs invest more aggressively than their peers do. However,
after the passage

of SOX, overconfident CEOs appear to moderate their capital
expenditures,
bringing them more in line with the CEOs of otherwise
comparable firms in
their industries. For example, before SOX, the average capital
expenditure/asset
(henceforth, CAPEX/Assets) for our entire sample was about
5.8%, whereas
the average for firms run by overconfident CEOs was about
6.7%. After SOX,
firms with overconfident CEOs reduced CAPEX/Assets
significantly to around
6.02%. SOX is also associated with a reduction in asset growth
and property
plant and equipment (PP&E) growth. The pattern is similar for
sales, general
and administrative expenses (SG&A). In this, we follow the
argument in Chen,
Gores, and Nasev (2013) that overconfident CEOs are less
likely to adjust
SG&A downward, reflecting their inflated beliefs about future
growth prospects
and SG&A needs. Focusing on the firms that were not compliant
with SOX
before its passage, for the median firm, SOX led to a 52%
reduction in CAPEX,
and a 39.7% reduction in PP&E, as compared with the firms that
were compliant
with SOX’s provisions prior to its passage.
SOX also affects the sensitivity of investment to cash flows of
overconfident
managers. As Malmendier and Tate (2005) show, overconfident
CEOs spend
more of their cash flows on capital expenditures, reflecting their
greater

propensity to invest available internal funds. We find that, post-
SOX,
overconfident CEOs’ investment sensitivity to cash flow
decreases. In addition,
post-SOX, firms with overconfident CEOs exhibit a significant
drop in risk, both
systematic and firm specific.
An important question is whether the reduction in investment
and risk taking
works to the benefit of shareholders. In other words, does SOX
curb the value-
destroying tendencies of overconfident CEOs or does it, instead,
hinder value
creation by these CEOs and force them to abandon positive-
NPV projects? For
our tests, we use several measures of firm performance. We use
both market-
based and accounting-based measures of firm performance,
namely Tobin’s
Q, earnings before interest and tax (EBIT), and S&P’s earning
quality (EQ)
measure. We also examine the effect of overconfidence on the
value of research
and development (R&D) and CAPEX. Our results are
unambiguous–along
with the reduction in investment expenditure and risk,
overconfident CEOs
create more shareholder value post-SOX. For example, relative
to other CEOs,
overconfident CEOs are associated with a 0.043 point lower
Tobin’s Q prior to
SOX and a 0.026 point larger Q afterward, representing an
increase of 0.069 in
Tobin’s Q. Similarly, when we focus on the firms that were not
compliant with

SOX prior to its passage, we find that, for the median firm,
SOX improved the
effect of CEO overconfidence on Q by around 13.87% relative
to the firms that
were compliant.
Next we examine the performance of overconfident CEOs in the
context
of acquisitions. Malmendier and Tate (2008) find that
overconfident CEOs
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tend to undertake acquisitions that create significantly less
shareholder wealth.
After the passage of SOX, however, takeovers by overconfident
CEOs create
relatively greater amount of long-term shareholder wealth (or
equivalently,
destroy less shareholder wealth). Another issue is that of
dividend payout.

With the drop in investment expenditure of overconfident
CEOs, firms would
have more free cash flow available to distribute in the form of
dividend payout.
We find that although payout tends to be low for overconfident
firms (see e.g.,
Deshmukh, Goel, and Howe 2013), there is a significant
increase in payout, after
SOX. Although it is difficult to disentangle the effect of SOX
from that of the
(nearly) contemporaneous dividend tax cut, when coupled with
the reduction
in expenditures, SOX appears to encourage overconfident CEOs
to distribute
cash to shareholders.
We conduct a number of robustness tests to increase our
confidence in the
results and their interpretation. As noted above, we conduct
falsification tests
to show that, for the most part, these SOX-related changes are
concentrated in
the companies that were not previously compliant with SOX (in
relation to the
need for an independent audit committee and a majority-
independent board).
Specifically, by using both difference-in-difference-type tests,
and subsample
tests, we find that the effect of SOX on overconfident CEOs
concentrates
in those firms that were previously noncompliant with SOX’s
mandates.3 In
addition, the SOX-related effects observed for overconfident
managers are
not present for CEOs with confidence in the bottom quartile.
Together, these

falsification tests suggest that our results reflect the effect of
SOX in moderating
the implications of CEO overconfidence.
We undertake several additional robustness tests to mitigate
econometric
issues. As noted, we control for various firm, CEO, and
governance
characteristics, and include firm or industry and year fixed
effects. Given
that our results relate to a strong exogenous event (SOX), and
we support
these results with the aforementioned falsification tests,
endogeneity (reverse
causality) is unlikely to drive our results. Nonetheless, we
conduct some
additional robustness tests to mitigate reverse-causality
concerns. We confirm
that overconfidence tends to be “sticky” over time (as
Malmendier and
Tate 2005 have previously shown) suggesting that it is a stable
behavioral
characteristic rather than a function of contemporaneous firm
performance.
We also conduct robustness tests using alternative measures of
CEO
overconfidence: it is shown that results hold when using a
press-based measure
of overconfidence; a Holder67 measure of overconfidence; and
a measure based
on the value of the CEO’s vested-but-unexercised options scaled
by his/her
salary.
3 For many of our tests, we compare compliant firms with firms
that are highly noncompliant. We define a firm as

“highly noncompliant” if it was both noncompliant with SOX
and it was an above-median distance from having
a majority independent board.
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Our results contribute to the literatures on managerial
overconfidence
and market regulation. We confirm that CEO overconfidence
can lead to
excessive risk taking and expenditure. The results provide
(some) support
for exogenously mandated improvements in certain governance
practices.
Although it might be more of an unintended consequence, SOX
appears to
have been beneficial in terms of mitigating significant value
destruction and
in capitalizing on the positive aspects of CEO overconfidence.
Thus, the paper
provides novel evidence on the benefits of SOX: these benefits

go beyond
limiting expropriation and perquisite consumption by powerful
CEOs and are
important in terms of moderating the excesses of highly
overconfident CEOs.
Although there may be questions as to whether our findings
extrapolate to other
types of broad governance changes that may have been proposed
or enacted,
in the specific case of SOX appears to have acted as a beneficial
restraint on
CEO excesses and thus increased shareholder wealth (and social
welfare).4
Our results connect with prior work in the context of
overconfidence and
governance. Our findings also support evidence in Campbell
and others (2014)
that overconfident CEOs are more likely to be dismissed than
are other CEOs
in boards dominated by outsiders, highlighting the centrality of
improved
governance to mitigating the effect of CEO overconfidence. Our
results also
connect with the finding in Kolasinski and Li (2013) that a
majority independent
board can reduce the acquisitiveness of overconfident CEOs.
Our findings differ
from, and extend, those in Kolasinski and Li (2013) in that we
analyze the
value implications of such improved governance, assess myriad
aspects of
corporate behavior (i.e., CAPEX, firm value, operating
performance, the value
of investments, and the value implications of takeovers), and
provide additional

evidence on the efficacy of SOX in the specific context of CEO
overconfidence.
1. Hypotheses
Overconfident CEOs, by definition, are overly optimistic about
their
investments and opportunities. They are more likely to
undertake hubristic
takeovers (see e.g., Roll 1986; Hayward and Hambrick 1997)
and to spend
more resources internally (i.e., in CAPEX or asset growth
Malmendier and
Tate 2008). Overconfident CEOs also engage in increased
personal and
corporate risk taking (see, e.g., Cain and McKeon 2013). The
argument is
that because overconfident CEOs overestimate the expected
value of their
investments and underestimate the downside risk, they are more
likely to
increase corporate risk than are other CEOs.
SOX is ostensibly intended to restrict managerial excesses,
increase
transparency, and improve corporate governance (for a complete
summary, see
4 Such evidence is consistent with prior literature that suggests
that SOX prevents insiders from expropriating
from minority shareholders, and is associated with
improvements in disclosure and governance (see e.g., Arping
and Sautner 2013).
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Coates 2007). These include having an independent audit
committee (Section
301), executive certification of financial reports (Section 302),
disclosure of
managerial assessment of internal controls (Section 404), and a
code of ethics
for senior financial officers (Section 406). SOX also prevents
accounting
firms from providing both auditing and nonauditing services to
the same
firm and increased penalties for corporate fraud. Put together,
the increased
environment of disclosure and monitoring by a more
independent board can
help to moderate managerial excesses. It is an empirical
question as to whether
such constraints can restrain CEO overconfidence and enhance
shareholder
wealth.
There is evidence suggesting that SOX might impose significant

costs on
some companies (see e.g., Iliev 2010; Leuz, Triantis, and Yue
Wang 2008).
However, despite the potential costs, there is evidence that SOX
enables
better protection for minority shareholders against extraction of
value by
insiders, improvements in disclosure and governance (see e.g.,
Arping and
Sautner 2013), and increases in market value (see e.g., Switzer
2007). Overall,
the literature suggests that SOX is generally associated with
better governance
and disclosure. Given that overconfident CEOs might be
expected to overinvest
and to assume more risk than is optimal from a shareholder’s
perspective,
and may be less likely to learn from past mistakes when doing
so (Chen,
Crossland, and Luo 2014), we hypothesize that stronger
governance may
curtail these excesses. This is all the more so in light of prior
evidence that
overconfident CEOs are more likely to be dismissed than are
other CEOs in
boards dominated by outsiders as shown in Campbell,
Gallmeyer, Johnson,
Rutherford, and Stanley (2011). The above discussion gives rise
to the following
hypotheses:
Hypothesis 1. SOX reduces the effect of CEO overconfidence
on corporate
investment.
Hypothesis 2. SOX weakens the effect of CEO overconfidence

on firms’
exposure to systematic and unsystematic risk.
Malmendier and Tate (2005) have argued that overconfident
managers tend
to be more cash constrained, given their high investment levels
and their
reluctance to raise external equity capital. Thus, if there is a
decrease in the
capital expenditure in these firms, we would also expect a
decrease in their
investment-to-cashflow sensitivity. This is tested along with
other tests on the
effect of SOX on investment policies of firms with
overconfident CEOs.
Hypothesis 3. SOX weakens the investment-cash-flow
sensitivity of over-
confident CEOs.
To the extent that SOX reduces excessive risk taking and
wasteful
expenditures by overconfident CEOs, we expect there to be a
positive effect
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on their firms’ operating performance and on other measures of
firm valuation.
We predict, therefore, the following
Hypothesis 4. SOX enhances the effect of CEO overconfidence
on firm
value.
Hypothesis 5. SOX enhances the effect of CEO overconfidence
on operating
performance.
Given that we expect SOX to curb the wasteful expenditure and
excessive
risk taking tendencies of overconfident CEOs, it follows that
SOX can
help to increase the value of the R&D and CAPEX investments
that they
do make.
Hypothesis 6. SOX enhances the value of CAPEX and the value
of R&D
investment in firms managed by overconfident CEOs.
The effect of SOX in moderating CEO overconfidence should
encourage
better takeover decisions. Managerial overconfidence can
induce over bidding
and value destruction in acquisitions (see e.g., Kolasinski and
Li 2013;

Malmendier and Tate 2008). Additionally, poor corporate
governance appears
to facilitate such acquisitions. For example, entrenched CEOs
appear to make
acquisitions that destroy more corporate value (see, e.g.,
Masulis, Wang, and
Xie 2007; Harford, Humphery-Jenner, and Powell 2012). We
might, therefore,
expect SOX to help reduce over bidding in acquisitions and
encourage CEOs to
engage in greater long-term value creation. Kolasinski and Li
(2013) provide
some consistent evidence, suggesting that a strong independent
board reduces
the likelihood that an overconfident manager undertakes an
acquisition. From
an empirical standpoint, we are most interested in long-term
value creation (as
compared with short-run market returns) given the evidence that
the market
can take some time to impound the value implications of
takeovers (see e.g.,
Schijven and Hitt 2012). This leads to the following prediction:
Hypothesis 7. SOX improves the effect of CEO overconfidence
on long-term
value creation in acquisitions.
In addition, Malmendier, Tate, and Yan (2011) argue that
overconfident CEOs
consider their firms under valued and, hence, prefer not to raise
external equity
financing. They choose to retain earnings to finance investments
and therefore
pay lower dividends (see e.g., Deshmukh, Goel, and Howe
2013). We anticipate

that, to the extent SOX curbs overinvestment and other wasteful
expenditures,
it would free more cash for companies to pay as dividends. We
therefore predict
the following:
Hypothesis 8. SOX encourages overconfident CEOs to increase
dividend
payments.
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2. Data
This study utilizes several standard data sets. Our data on CEO
compensation
are from the Execucomp Database. We start with approximately
30,000
observations on CEO compensation between January 1, 1992
and December 31,
2012. After excluding observations with missing data on

essential components
of CEO compensation, we obtain a sample size of approximately
22,000 firm-
year observations for which we can compute the “CEO
confidence” measure.
When creating this sample, we exclude cases where the data are
insufficient to
construct our option-based measure of overconfidence. Next we
merge these
modified Execucomp data with the Compustat and CRSP
databases to obtain the
firm-level variables and the variables on market return required
for our analysis.
We also obtain additional data on the percentage holdings of all
institutional
investors from the Thomson 13f filing database. The acquisition
data set is from
SDC. In robustness tests, we use data from IRRC/Risk Metrics
to examine the
effect of antitakeover provisions.
We construct a continuous “CEO confidence” variable. The
CEO confidence
measure is based on the CEO’s option holdings. The logic is
that CEO’s human
capital is undiversified, and the CEO ordinarily has a large part
of their wealth
tied to the company. Thus, a rational CEO would exercise
options as and when
they vest. Therefore, holding vested in-the-money options
represents a degree
of overconfidence (see e.g., Malmendier and Tate 2005).5
We use Execucomp data to construct the overconfidence
measure. We first
obtain the total value per option of the in-the-money options by

dividing the
value of all unexercised exercisable options (Execucomp item:
opt unex exer est
val) by the number of options (Execucomp item: opt unex exer
num). Next we
scale this value per option by the price at the end of the fiscal
year as reported in
(Compustat item named: prcc f). This gives an indication of the
extent to which
the CEO retains in-the-money options that are vested. This is
analogous to the
variables in Malmendier and Tate (2008). The variables differ
slightly from
those in Malmendier and Tate (2008) because the Execucomp
database does
not provide the same set of variables as their proprietary
database. In our main
tests, we allow the overconfidence measure to vary over time
because of prior
evidence that overconfidence can vary over time based upon
past experience
and performance (see e.g., Billett and Qian 2008; Hilary and
Menzly 2006).
Further, we create an indicator variable that equals one if the
CEO’s confidence
measure is in the top quartile of all firms in that year.6
5 Malmendier and Tate (2005, 2008) highlight that holding such
in-the-money options is indeed a behavioral bias,
and they find no evidence that such options holdings connote
private information. Further, although it is arguable
that CEOs that choose to hold such options are simply well
incentivized, and thus should perform better, such an
interpretation is inconsistent with the finding both in this paper
and in prior work (Malmendier and Tate 2005,
2008), that option-based measures of overconfidence are

negatively associated with corporate performance.
6 We examine a continuous variable, in addition to the indicator
variable, because of prior evidence (in Ben-David
Graham and Harvey 2013) that many executives miscalibrate the
risk/return distribution, suggesting that there
is a continuum of miscalibration and overconfidence.
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In robustness tests, we ensure that the results are robust to
various different
definitions of overconfidence, including newspaper or press-
based measures
of overconfidence. As per Hirshleifer, Low, and Teoh (2012),
we hand collect
data on how the press portrays each of the CEOs from 2000–
2006. We search
for articles referring to the CEOs in The New York Times
(NYT), Business
Week (BW), Financial Times (FT), The Economist, Forbes

Magazine, Fortune
Magazine, and The Wall Street Journal. For each CEO and
sample year, we
record the number of articles containing the words over
confident or over
confidence, optimistic or optimism, reliable, cautious,
conservative, practical,
frugal, or steady. We carefully check that these terms are
generally used to
describe the CEO in question and separate out newspaper
articles describing
the CEO of interest as not confident or not optimistic. We then
construct the
variable “Net News,” which is equal to the number of
“confident” references
less the number of “not confident” references. This alternative
proxy of CEO
over confidence is significantly positively correlated with our
option-based
financial measures.
We also use the Execucomp database to obtain other governance
variables
that might influence corporate performance, including CEO
tenure, CEO age,
the ratio of bonus compensation to fixed salary, and the CEO’s
percentage
ownership.
The acquisition data-set starts with all acquisition
announcements in SDC,
which we then merge with accounting data (from Compustat),
managerial
overconfidence data (from Execucomp) and institutional
ownership data (from
the Thomson 13f filings). To construct this data set, we identify

the acquirer
in an acquisition. We then obtain the relevant explanatory
variables for the
acquiring company, including a set of control variables that are
standard in the
acquisition literature.
We use the firm-year panel to estimate the effect of SOX and
overconfidence
on firm value, expenditure (i.e., CAPEX and asset growth),
corporate risk (beta,
daily stock-return variance, and mean squared error), and,
further, the effect
on the value of cash holdings, CAPEX, and R&D. In all models
we control
for time fixed effects to mitigate issues of unobserved time
effects that could
otherwise bias an examination of SOX. When examining the
firm-year panel of
observations, we examine models that include industry and year
effects, as well
as those that include firm and year fixed effects. In the
acquisition sample, we
use industry and year effects. In robustness tests we also
examine the effect of
SOX on companies that were already SOX complaint to further
ensure that the
reported results are attributable to the governance changes
imposed by SOX.
We report the sample composition by year in Table 1 and
provide summary
statistics in Table 2. The statistics in Table 1 indicate that
overconfidence
is relatively stable over time. This is consistent with the idea
that CEO

overconfidence is a behavioral trait (rather than a transient
reflection of
the corporation’s position). The summary statistics in Table 2
provide some
indication of the nature of our sample. Panel A presents the
statistics for the panel
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Table 1
Sample composition by year
Confidence(t)
Year Obs. Mean Median 25th percentile 75th percentile Std dev
� Confidence
1992 198 0.329 0.301 0.153 0.459 0.241
1993 633 0.348 0.325 0.137 0.525 0.258 0.019
1994 910 0.311 0.274 0.086 0.478 0.259 −0.037
1995 944 0.337 0.319 0.126 0.499 0.252 0.026

1996 998 0.356 0.337 0.132 0.550 0.258 0.019
1997 1,049 0.411 0.418 0.200 0.601 0.278 0.055
1998 1,090 0.365 0.364 0.105 0.584 0.283 −0.046
1999 1,148 0.348 0.292 0.039 0.587 0.316 −0.017
2000 1,190 0.355 0.319 0.043 0.582 0.370 0.008
2001 1,246 0.304 0.251 0.063 0.488 0.276 −0.051
2002 1,374 0.220 0.151 0.004 0.368 0.232 −0.084
2003 1,436 0.322 0.291 0.103 0.487 0.271 0.102
2004 1,513 0.357 0.343 0.156 0.526 0.249 0.035
2005 1,492 0.355 0.330 0.122 0.534 0.287 −0.002
2006 1,510 0.380 0.364 0.165 0.554 0.268 0.025
2007 1,597 0.337 0.300 0.082 0.537 0.298 −0.043
2008 1,546 0.165 0.047 0.000 0.280 0.223 −0.172
2009 1,525 0.201 0.121 0.000 0.338 0.226 0.036
2010 1,468 0.257 0.202 0.050 0.409 0.242 0.056
2011 1,253 0.244 0.179 0.032 0.407 0.242 −0.013
This table contains the sample composition by year. Variable
definitions are in the appendix. Figures are sample
averages. We define � Confidence = Mean Confidence(t) -
Mean Confidence(t-1).
data sample, and Panel B presents statistics for the M&A
sample. The figures
in Panel B are broadly consistent with those reported in prior
literature. In
particular, acquirer CARs are close to zero for CAR(-10, 10) or
slightly negative
for BHAR(-42, 125), which is consistent with prior literature
(see e.g., Masulis,
Wang, and Xie 2007; Harford, Humphery-Jenner, and Powell
2012; Moeller,
Schlingemann, and Stulz 2004). The mean level of managerial
confidence for
the acquirers (0.38) is higher than that for the general sample
(0.31), which
is consistent with prior evidence that managers who are more

confident tend
to undertake more acquisitions (see e.g., Malmendier and Tate
2008). The
following sections use these data to conduct a multivariate
analysis of effect of
SOX on the effect of managerial overconfidence.
3. SOX & Overconfidence: Investment Policy, and Corporate
Risk
3.1 Does SOX restrain overinvestment by overconfident CEOs?
We begin by testing our first hypothesis using a difference-in-
difference
approach. In particular, we test whether changes in the firm’s
investment, asset
growth, and sensitivity of investment to cash flows following
the passage of
SOX are related to the CEO’s overconfidence in the manner
predicted by our
hypotheses.
3.1.1 Capital expenditure following SOX. Our hypothesis is that
the passage
of SOX results in overconfident CEOs becoming less aggressive
in terms of
capital expenditures. We test the relationship between the
passage of SOX,
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Table 2
Summary statistics
Variable Mean Median 25th percentile 75th percentile Std dev
Panel A: Statistics for the panel data sample
Confidence 0.309 0.268 0.062 0.496 0.277
Beta 1.244 1.157 0.799 1.576 0.654
MSE 0.024 0.021 0.015 0.030 0.013
Variance 0.100 0.058 0.031 0.116 0.142
Tobin’s Q 1.324 0.935 0.509 1.649 1.299
Ind adj Tobin’s Q −0.034 −0.195 −0.624 0.240 1.127
EBIT/assets 0.085 0.085 0.042 0.133 0.095
Ind adj EBIT/assets −0.001 −0.001 −0.036 0.040 0.088
Assets 8702 1593 528 5389 24983
PPE/assets 0.535 0.444 0.220 0.782 0.400
LT debt/ assets 0.192 0.170 0.038 0.299 0.168
R&D / assets 0.042 0.000 0.000 0.033 0.100
Intangibles/assets 0.154 0.086 0.011 0.244 0.176
CAPEX/sales 0.076 0.038 0.020 0.076 0.124
Cash/ assets 0.093 0.050 0.016 0.131 0.109
Dividends/ assets 0.010 0.002 0.000 0.015 0.016
SG&A/ sales 0.252 0.216 0.119 0.339 0.177
Bonus/salary 0.726 0.359 0.000 1.002 1.163
CEO tenure 6.726 5.000 2.000 9.000 7.167
CEO age (years) 55.379 55.000 51.000 60.000 7.225

CEO-ownership 0.020 0.003 0.001 0.012 0.048
Inst.-ownership 0.575 0.654 0.399 0.813 0.319
Panel B: Statistics for the M&A sample
CAR(-10,10) 0.002 0.003 −0.055 0.064 0.111
BHAR(-42,125) −0.106 −0.054 −0.314 0.166 0.471
BHAR(-5,125) −0.080 −0.040 −0.255 0.144 0.385
Confidence 0.383 0.364 0.148 0.575 0.274
SOX 0.681 1.000 0.000 1.000 0.466
Diversifying deal 0.439 0.000 0.000 1.000 0.496
Run up 0.003 0.015 −0.326 0.312 0.668
Compted deal 0.014 0.000 0.000 0.000 0.119
Tender offer 0.058 0.000 0.000 0.000 0.233
Public target 0.195 0.000 0.000 0.000 0.396
Cash only 0.400 0.000 0.000 1.000 0.490
Rel deal size 0.136 0.039 0.011 0.130 0.262
ln(transaction value) 4.519 4.430 3.246 5.690 1.756
ln(assets) 7.792 7.613 6.558 8.945 1.705
Tobin’s Q 1.666 1.202 0.749 2.046 1.504
EBIT/assets 0.102 0.098 0.060 0.144 0.080
Intangibles/assets 0.208 0.162 0.041 0.334 0.188
LT debt/ assets 0.178 0.155 0.035 0.276 0.157
R&D/sales 0.052 0.011 0.000 0.065 0.091
Cash/assets 0.099 0.059 0.020 0.137 0.108
CAPEX/sales 0.072 0.038 0.022 0.068 0.119
CEO bonus/salary 0.995 0.657 0.000 1.307 1.392
ln(CEO tenure) 1.742 1.792 1.099 2.303 0.816
ln(CEO age) 3.993 4.007 3.912 4.094 0.132
CEO-ownership 0.016 0.003 0.001 0.011 0.040
Inst-ownership 0.668 0.706 0.559 0.828 0.239
Table 2 shows the summary statistics of all the variables. We
depict sample averages, median, 25th and 75th
percentiles, and standard deviations of all of our variables of

interest and our control variables. These are averages
over all years between 1992 and 2011.
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CEO-confidence, and CAPEX using a regression model of the
following form:
CAPEX/Assetsi,t +1 = α + SOXi,t β
(1) + Confidencei,t β
(2)
+ SOXi,t ×Confidencei,t β(3) + Xi,t θ + λj (i) + φt + εi,t ,
(1)
where, X represents a set of CEO and firm-control variables,
and φt , and λj (i)
are year, and industry (firm) dummies, respectively. SOX is an
indicator that
equals one if the observation occurs in 2002 or later and zero

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