Are Firms with Bad Strategies More Prone to Accounting Scandals?

Enron, WorldCom, Parmalat, Tyco. Over the past five years these names have become synonymous with financial manipulation for the purposes of personal gain. The blame for the recent explosion of accounting scandals has been placed on moral decay in corporations; and a lack of oversight by boards, auditors, investment analysts, regulators, and the media. However, this analysis ignores the importance of the conditions which enabled these scandals to occur in the first place.

Journalists and politicians have identified individuals as being almost entirely responsible for the failures in the above-mentioned firms. Academics have identified the causes as: poor governance mechanisms; weaknesses in accounting practice; and executive incentives that promoted short-term behaviour. Governments in the US and Europe support this view. As a result, new regulation clarifies corporate officers’ roles, and institutes penalties for incompetence and fraud. Additional procedures for corporate governance and reporting have also been introduced. These measures, however, address the symptoms. What is needed is to identify the cause.

The period from the late 1990s into the 2000s showed firms making high level of aggressive accounting and operating decisions, driven by the sense that the “old” economy’s rules of cause and effect no longer applied. Continuous innovations, new business models, new technologies, new approaches, and a focus on performance management seemed to call into question conventional approaches to strategy analysis.

If we look at many US and European companies’ strategies going back around five years before their accounting scandals were identified, it may be possible to understand the circumstances which led to their demise. Although the individual companies might have looked unique (e.g. one producing milk products, another offering telecommunications services); most seemed to pursue similar strategies. The most obvious feature across firms was an aggressive growth orientation (intended or realized), exhibited in rapid asset growth through acquisition. As a result, companies’ cash flow into investment activities exceeded cash flow from expenditure, leading to massive levels of debt. This growth focus was accompanied by an extremely high risk orientation, indicated by tremendous levels of scope expansion (across countries, sectors, product lines, etc.).

In isolation these factors might not have led to disaster. On the contrary, most companies achieved initial success for which they received accolades in the market. However, these strategies were fundamentally misaligned with the firms’ external environments and their internal resources and capabilities. Misalignment led to deteriorating financial results. In an effort to meet market expectations senior executives began to manipulate results, less from a desire to profit personally than in an effort to buy time for the mythical “New Economy” fundamentals to kick in, and for performance to improve.

It seems, then, that one of the problems with the current regulatory focus on compliance is its requirement that boards focus on reporting, rather than on giving input into long-term strategy. Therefore, if firms are to survive, evolve, and provide returns for shareholders over time, they should be encouraged to ensure that strategy is transparent to the board, and draw on board members” different views and knowledge bases to prevent misalignment and its potentially disastrous consequences down the line.

Grant, R.M., & Visconti, M. (2006). “The strategic background to corporate accounting scandals”. Long Range Planning, 39: 361-383.