CEOs with lower integrity cost their firms money, both in higher audit fees and poorer long-term performance, according to new research from Professor Bill Mayew at Duke University’s Fuqua School of Business.
“Integrity is a valued asset in leaders, but it’s also a nebulous, multi-faceted concept that’s hard to measure,” Mayew said.
CEO Behavioral Integrity, Auditor Responses, and Firm Outcomes is forthcoming in the journal The Accounting Review.
Collaborating with Shane Dikolli of the University of Virginia, Thomas Keusch of INSEAD, and Thomas Steffen of Yale University, Mayew first had to figure out how to assess integrity.
Existing methods for studying CEO integrity involved surveying employees or even mining police reports for evidence of past bad behavior. But very little data is available for either approach. The researchers used computational linguistics to create a measure that could be applied widely. They focused on one aspect of integrity - behavioral integrity – that has implications for how words are used. Behavioral integrity is the consistency between word and deed, the knowledge that someone can be trusted to follow through on promises.
“We’re asking whether CEOs ‘walk the talk,’” Mayew said.
The researchers used instances of excessive explanations by CEOs in shareholder letters to identify low integrity, and found that such excessive explanations were related to higher audit fees and poorer financial performance.
Because individuals are less trusting of people believed to lack behavioral integrity, the researchers reasoned that CEOs with low integrity would have to explain themselves more. So they analyzed more than 30,000 CEO letters to shareholders, looking for explanatory words and phrases – “because,” “hence,” “therefore,” and so on.
Of course, CEOs might provide explanations due to issues related to the business that may have nothing to do with integrity.
“CEOs have to explain a lot, especially, for example, when their firms are complex,” Mayew said. “To help ensure the explanation was particular to the CEO and not the business, we compared each shareholder letter with text from other firm filings in the same year that were written by other executives and measured their explanatory words as a benchmark. We also used statistical techniques to purge CEO shareholder letter explanations of other business fundamentals. The remaining amount of explanations we took as our proxy for CEO behavioral integrity.”
To help validate their linguistic integrity measure, the team compared their results to past research findings on integrity. Their measure was associated very highly with CEO integrity ratings obtained from a proprietary sample of CEO subordinates. Past research found CEOs with higher integrity have happier employees. Consistent with this finding, Mayew and his co-authors observed a positive correlation between the CEO integrity measure and workplace reviews of the CEO.
But what are the implications of having a low-integrity CEO? The researchers found their rating is an incremental predictor of higher audit fees.
Auditing standards require auditors to consider the integrity of management. As part of their work, auditors interview CEOs, see how they respond to requests for information, and whether they follow through, and over time develop a sense of their integrity, Mayew said.
“We don’t know how many interactions it takes before auditors figure this out,” he said, “but they do.”
Mayew said there are two reasons why auditors might charge higher fees for a firm with a low-integrity CEO.
“They could charge more because they suspect potentially undetectable fraud, and require compensation for expected damage to their own reputations,” he said. “Or they could charge more because they are working harder to uncover potential fraud before it happens. Consistent with this idea, we found no association with accounting misstatements or lawsuits. While indirect, this evidence is consistent with auditors potentially charging more to prevent fraud from happening when firms have low-integrity CEOs.”
Mayew and his co-authors also found that low integrity CEOs had more frequent instances of option backdating, a legal but frowned-upon event that auditors would notice but aren’t required to address.
“Auditors appear to respond to integrity within the confines of the auditing standards that requires an assessment of CEO integrity,” Mayew said.
A natural question is why a firm would ever hire a low integrity CEO. Mayew said firms might tolerate any negative implications of a low-integrity CEO, such as higher audit fees, because they think that the leader will build long-term value, perhaps through other attributes like creativity. But that conclusion is not consistent with the data.
“We find firm performance decreases in the future when our measure indicates the CEO has low integrity,” he said. This finding is consistent with other recent research that finds firms with a general culture of high integrity outperform other firms.
“Our study suggests the integrity of the CEO may play a role in this more general finding,” Mayew said, “but it remains a puzzle as to why and how firms let low integrity hold back their performance.”