Assistant Professor Gaoqing Zhang Reveals Pressure to Manipulate Financial Reports
Friday, November 15, 2019
Peer pressure looms large when we’re young. It’s practically a requirement for every parent to ask their kid, “If all your friends jumped off a bridge, would you jump, too?”
It turns out peer pressure can loom pretty large for grownups, too, and we all might feel its effects whether we know it or not. As Assistant Professor Gaoqing Zhang studies the benefits to regulation of financial reporting, he finds that one firm’s practices can have an impact on other firms because of peer pressure.
In other words, if one firm jumps off the “bridge” by manipulating its financial reporting, its peers jump off that bridge and manipulate as well. Regulation such as 2002’s Sarbanes-Oxley Act (SOX), Zhang offers, can counter that.
“When firms manipulate more and reduce their financial reporting, they don’t just hurt themselves, it puts pressure on other firms to manipulate more and that makes everyone else worse off,” he says. “Firms do not think about how they impact other firms.”
Stronger internal controls could benefit industry
The findings are part of an overall research thread by Zhang, who is investigating whether a case can be made for regulation that intervenes in a firm’s internal control decisions. The wave of accounting fraud in the early 2000s involving WorldCom and Enron led to regulations that exist today. Before that, it was believed that those decisions belonged to the firms—and not to regulators. Many still adhere to that belief.
“Regulators are enforcing the rules, but not without pushback from industry,” Zhang says. “We are trying to point out that there is a good benefit from the regulations.”
Through modeling, Zhang found that a firm’s manager manipulates more if he or she expects that peer firms’ reports are more likely to be manipulated. By “manipulation,” Zhang doesn’t necessarily mean firms are doing things illegally, just finding loopholes that lead to creative accounting and, ultimately, a reduced quality of financial information.
“It’s legal, it’s allowed, but it’s also bad for society as a whole,” he says.
When firms manipulate and reduce their financial reporting, they don't just hurt themselves, it puts pressure on other firms to manipulate more and that makes everyone else worse off.
The power of peer pressure
Peer pressure can be used for good, however. If one firm reacts to regulations by investing in better internal controls that reduce manipulation, peer firms follow suit by not manipulating without themselves having invested in further internal controls. The impact of regulations on one firm has a trickle effect on its peers, which can benefit the general public.
Zhang’s research concentrates on the benefits of regulation, but he understands why there is some pushback and is studying other impacts of it, too. For example, firms have a level of expertise the regulator might not, and that can create complications.
“They might not have the same professional judgment as the insiders, and that can make things worse,” he says. “In order to see the full picture of regulation, we have to look at the benefit and the cost, the good side and the bad.”
The effect of peer pressure is important, though, and shows the ripple effects of firms doing the right thing.
“Firms will now do the least of regulation that they have to do, this shows the benefits of doing more,” Zhang says.
This article appeared in the Fall 2019 Discovery magazine
In this issue, Carlson School faculty research highlights the importance of medical device recalls, the cost of streamlining a business, and the benefits of extraversion in the workplace.