Corporate Misconduct and the Impact of Market Forces, Regulatory Change, and Auditor-Provided Services

Abstract

My dissertation addresses the fundamental economic question of whether regulation that restricts free markets can reduce corporate misconduct. I investigate different aspects of this issue in four related papers. They use different theories that all relate to basic economic decision-making theory. If the expected benefits of rule-abiding behavior or the expected costs of misconduct increase, decision-makers tend to develop a greater preference for rule-abiding behavior over misconduct and vice versa. Conversely, if the expected benefits of misconduct or the expected costs of rule-abiding behavior increase, decision-makers prefer misconduct. I study three forces, for which I argue that they may influence the balance of these four groups of benefits and costs. The two ends of a spectrum of regulation, regulatory changes and free market forces, can each shape the expectations of the decision-maker. As a third force, the auditor as a monitor in markets with information asymmetries can curb misconduct emerging from the abuse of these asymmetries. Because both regulation and free markets also shape auditor behavior, auditor-provided services are an indirect, third channel, through which the first two forces also affect behavior. In my first paper, I conduct an experiment on perceptions of managers regarding misconduct punishment. I ask 71 board members of German listed companies about their expectations of detection likelihood and punishment severity upon detection. My findings suggest that detection perceptions are larger than estimates of factual detection likelihood from prior literature. However, managers underestimate both individual and organizational punishment severity. In an experiment with only 28 of the board members, I further find that teaching them about factual losses in market value for fraudulent firms decreases their tendency to commit misconduct. However, this is not the case when I also teach them about factual individual consequences for the perpetrator. In conclusion, I find that existing market forces are surprisingly strong, but biased perceptions make them ineffective. The second paper is an in-depth qualitative study of how non-financial firms install anti-money laundering systems. Based on interviews in eight multinational organizations, I develop a Grounded Theory of the implementation process. A key takeaway is that the implementation benefits from clear regulatory structure and guidance. While I find that similar guidance can emerge among peers in the free market, I find some clear indications that regulation is important for effective systems designed to curb misconduct in this case. My third paper contains another experiment. It studies reactions of 128 private investors to a company that suspects misconduct internally when internal investigation and public detection are certain. The company can either obtain a credibility signal from using forensic services from a Big 4 to investigate or investigate with internal audit. The issue and investigation become public either by self-disclosure of the company or a press article. I find that, when the company engages the forensic services, self-disclosure improves investor perceptions over press disclosure. With the internal audit investigation, this is not the case. In the context of this dissertation, the unregulated market for forensic accounting can thus provide an improvement for investors and arguably the public (through greater transparency) under the strong assumptions of certain investigation and detection. The fourth and final paper contains an archival analysis of two non-audit service scandals of KPMG. I aim to study whether, through reputation effects, the negative signals from these scandals spill over to the audit practice of KPMG. If this were the case, it would suggest that some market forces are strong enough to deter misconduct even across the different domains in which a company is active. In a short-term event study, I find abnormal negative returns for the average KPMG audit client. However, in longer-term analysis, I find that KPMG does not significantly lose clients or gain fewer clients in the first year after the scandals. Similarly, audit fees do not change. However, for the second scandal, there is some evidence that audit quality suffers. In conclusion, I infer a small reputation spillover from my results that has no substantial economic consequences for KPMG.