Sociological study reflects high financial malfeasance rates in largest US corporations

June 2, 2010

The need to "fix" or restate financial statements is an admission by corporate management that these reports (prior to their being corrected) to the government and the investing public misrepresented the corporations' financial positions, Texas A&M University sociology professor Harland Prechel reports in a research paper published in the June 2010 issue of the American Sociological Review (ASR).

Prechel and Theresa Morris of Trinity College in Hartford, Connecticut, examined the revised statements from hundreds of the largest U.S. companies between 1995 and 2004, then co-authored the paper, titled "The Effects of Organizational and Political Embeddedness on Financial Malfeasance in the Largest U.S. Corporations: Dependence, Incentives, and Opportunities."

The researchers' analysis examines restatements that occurred after Congress passed the 2001 Sarbanes-Oxley Act, which held chief financial officers (CFOs) and chief executive officers (CEOs) personally responsible for corporate violations of security and exchange laws. Soon after this legislation was passed, the number of financial restatements rapidly increased. After eliminating the legitimate reasons for financial restatements such as accounting rule changes, their analysis shows that over 21 percent of the corporations in their study group restated their finances at least once, and some as many as seven times, during the study period.

Their research centers on financial statements, corporate structure, and politics. And the findings have important implications for public policy, Prechel says. "The corporate and state structures enacted in the late 20th century were the outcome of a long-term, well-financed and systematic political strategy that provided managers with unprecedented power, autonomy, and opportunity to engage in financial malfeasance," the paper's summary states.

There are three main findings from their quantitative analysis. First, capital dependence on investors creates incentives to engage in financial malfeasance. Second, managerial strategies to increase shareholder value create incentives to engage in financial malfeasance. Third, the multilayer-subsidiary form and the political structure permitting corporate political action committees' (PAC) contributions create opportunities to engage in financial malfeasance.

A key point of the analysis, Prechel says, is that the multilayer-subsidiary business model, where parent companies own multiple legally independent subsidiary corporations, creates opportunities for managers to engage in financial malfeasance by overstating the value of the assets in these corporate entities. Prechel says that one case of improper reporting involved Enron, which overstated the value in one of its subsidiaries by $256 million.

He says he and Morris focus on the concept of "malfeasance"—an act that violates a law or a rule (or violates their intent) established by a government agency or a nongovernmental organization responsible for corporate financial oversight—rather than "crime," because behaviors that are legal may still mislead investors, especially small investors, due to information asymmetry (i.e., when one party (e.g., the company) has access to information that the other (e.g., investor) lacks).

Individual investors are vulnerable when they invest in corporations directly or via mutual funds, Prechel says. "There are opportunities for management to engage in financial malfeasance that investors aren't even aware of," he explains. "Management is aware of the true financial picture, while individual investors are not."

Companies that do not use the multilayer subsidiaries form file revisions less frequently, Prechel says.

"The more subsidiaries a parent company has, the higher the likelihood it will restate its finances," he says. "But, in the cases that were included in the analysis, there is no good reason for management to not understand their corporation's financial status."

He says Congress could fix the problem by reinstating the tax on capital transfers that it removed in 1986.

Explore further: Corporate social responsibility: less profit, more value

Related Stories

Corporate social responsibility: less profit, more value

February 7, 2008

Companies that operate in a socially responsible manner 'pay' for this with a loss in financial profit. Yet at the same time, socially responsible business practices can enhance a company's value. Dutch economist Lammertjan ...

Green firms rewarded by financial markets

May 29, 2008

When a company improves its environmental performance, it is common to think that the accompanying economic improvements are based on the company's more efficient use of resources. However,

Risk management critical to corporate strategy

January 7, 2009

With the consequences of the current financial crisis spreading to the real economy, lawmakers are exploring new regulations to govern the financial markets. The concern among market participants is that policy-makers do ...

Recommended for you

Chimpanzees shed light on origins of human walking

October 6, 2015

A research team led by Stony Brook University investigating human and chimpanzee locomotion have uncovered unexpected similarities in the way the two species use their upper body during two-legged walking. The results, reported ...

How much for that Nobel prize in the window?

October 3, 2015

No need to make peace in the Middle East, resolve one of science's great mysteries or pen a masterpiece: the easiest way to get yourself a Nobel prize may be to buy one.

The dark side of Nobel prizewinning research

October 4, 2015

Think of the Nobel prizes and you think of groundbreaking research bettering mankind, but the awards have also honoured some quite unhumanitarian inventions such as chemical weapons, DDT and lobotomies.

Who you gonna trust? How power affects our faith in others

October 6, 2015

One of the ongoing themes of the current presidential campaign is that Americans are becoming increasingly distrustful of those who walk the corridors of power – Exhibit A being the Republican presidential primary, in which ...


Please sign in to add a comment. Registration is free, and takes less than a minute. Read more

Click here to reset your password.
Sign in to get notified via email when new comments are made.