Groupthink tendencies in top management teams and financial reporting fraud

Abstract

I investigate the factors that contribute to financial reporting fraud in firms that are, ex ante, at a high risk of committing fraud. Using propensity score matching, I select a sample of firms with similar ex ante risk for committing fraud. I find that within this sample, interconnectedness among members of the top management team (TMT), specifically connections developed outside the firm, is significantly and positively associated with financial reporting fraud. The effect of TMT interconnectedness on fraud is more pronounced in firms with more powerful Chief Executive Officers (CEOs) and in firms in which non-CEO executives’ wealth is more sensitive to firm risk, as measured by their portfolio vega. In addition, I find that the fraud committed by more interconnected TMTs persists for longer periods of time and is more difficult to detect. Further investigations suggest that the intensity of the connections between team members influences the risk of financial reporting fraud. My findings suggest that TMT interconnectedness promotes ‘groupthink’, which is associated with dysfunctional decision-making processes.