Culture of weak compliance and financial reporting risk

Prior work has under-emphasized the role of deviant organizations (“bad barrels”) in favor of the role of deviant individuals such as senior managers (“bad apples”) in explaining corporate misconduct. We seek to redress that imbalance by investigating whether a culture of weak compliance is associated with financial misreporting risk. We measure culture of weak compliance using firm-level data for the years 1994-2011 covering 22,885 firm-years related to enforcement activities of the Food and Drug Administration (FDA), the Department of Justice (DOJ), Federal Trade Commission (FTC), Mine Safety and Health Administration (MSHA), Occupational Safety and Health Administration (OSHA), Office of Federal Contract Compliance Programs (OFCCP), Wage and Hour Division (WHD), and the Environmental Protection Agency (EPA). As predicted, we find a statistical and economically significant association between a culture of weak compliance and a firm’s proclivity to start financial misreporting, proxied as earnings restatements, SEC AAERs, and securities class action lawsuits. Additional analysis suggests that a culture of weak compliance is associated with higher equity based compensation for the CEO, a weaker governance and internal control environment, a lower threat of a takeover, a diversified organizational structure, and a higher level of CEO dominance. This paper contributes to the newly emerging literature that seeks to understand the role of corporate culture in driving deviant behavior. In particular, we join the ongoing debate that shifts the focus from deviant individuals to deviant organizations themselves as the unit of analysis in trying to understand the root causes of corporate infractions

Keywords: compliance, product safety, environmental safety, labor safety, financial reporting risk, corporate culture. JEL Classification Codes: G30; G34; G38