Tournament Culture and Corporate Misconduct: Evidence using Machine Learning

For a long time, economists have been avoid discussing the term ‘culture’. The main reasons for this are that culture does not fit well with the rational agent theory of neoclassical economics, is difficult to define or measure, or considered firm-level unobservable. However, recent research on culture shows that countries prefer to trade with culturally similar countries, that individuals from countries with a strong culture of trust participate in the stock market more and that a country's cultural norms or values are reflected in the activities of emigrated individuals. Such work on national culture or cultural markers of an individual’s home country uses ‘trust’ as an underlying element. Recent papers and surveys of CEOs and CFOs have shown that culture is also an essential ingredient in the firm. Similar to a nation’s culture, defining and measuring firm culture is equally difficult. Our paper attempts to fill that gap and shows what type of firm culture leads to corporate misconduct.

Unlike past papers, we use a competing value framework (CVF) to understand the culture types in a firm and compute them using the management’s tone in 10-K reports, an annual report required by the US Securities and Exchange Commission. CVF uses 30 organizational effectiveness criteria and, according to it, there are four types of cultures in a firm—Collaborate, Control, Compete, and Create. Each type of culture has its benefits and challenges.  

According to this framework, for the firms with predominantly a create culture, the effectiveness criteria is ‘innovation’ and, therefore, such firms would allocate abundant resources to excel on that criteria. The observed artefacts of such firms are ‘risk-taking, creativity, and adaptability’. Similarly, for the firms with a compete culture, effective criteria are ‘increased market share, product quality, profit, and productivity’. The observed artefacts in firms dominated with such culture are ‘gathering customer and competitor information, goal setting, planning, task focus, competitiveness, and aggressiveness’. In firms with predominantly a control culture, the effectiveness criteria are ‘efficiency, timeliness, and smooth functioning' and the observed artefacts are ‘conformity and predictability’. Such firms use tools such as ‘communication, routinization, formalization, and consistency’ to ace in their effectiveness criteria and their focal point is to maintain stability—financially as well as at the organizational level. Lastly, in firms with predominantly a collaborate culture, the effectiveness criteria are ‘employee satisfaction and commitment’. The observed artefacts in such firms are ‘team-work, participation, employee involvement, and open communication’ and the main element in such firms is value for human affiliation.

For each listed US firm between 1996 and 2014 we estimate the four corporate culture types by counting the number of times the synonyms of these culture types occur in its 10-K document. We construct each of the four culture variables, ie, collaborate, control, compete, and create, by dividing its count of synonyms by the total number of words (computed as a percentage). For example, if there are 5 synonyms for ‘competition’ among 100 words, then we represent the compete culture as 5%.

In order to show the role of culture in corporate misconduct, we first examine the relation between firm-specific risk and culture types for a sample of US firms, spanning the time period of 1996-2014. We then show how this increase in firm-specific risk leads to misconduct such as earnings management, restatements, and accounting fraud. We measured these culture types from the 10-K reports using textual analysis (dictionary method, more specifically). How managers respond to the tension created between these competing values will shape a company’s culture, practices, products, incentive structure, and, ultimately, how it innovates and grows. Empirically, we find that an internal compete culture (aka tournament culture) increases firm-specific risk, even after controlling for firm fundamentals, board characteristics, systematic risk, market competition, and CEO effects. Furthermore, we also show that this type of corporate culture is also associated with misconduct activities such as higher earnings restatements, earnings management, and accounting fraud.  In an economic sense, a 1% increase in internal competitive culture increases firm-specific risk by 5%. This increase in firm-specific risk increases earnings management by 2.6%, restatements by 5%, and also increases the possibility of accounting fraud. These results are robust to external validity tests of culture constructs and endogeneity concerns.

In sum, this paper provides evidence that a higher degree of an internal 'compete' culture (aka tournament culture) increases the firm-specific risk. Hence, such a corporate culture is associated with corporate misconduct activities such as restatements, earnings management, and accounting fraud.

Jitendra Aswani is a Doctoral Student at Fordham University, New York City.

Franco Fiordelisi a Professor of Banking and Finance at Essex Business School, University of Essex.