Using Nonfinancial Measures to Assess Fraud Risk

This study examines whether auditors can effectively use nonfinancial measures (NFMs) to assess the reasonableness of financial performance and, thereby, help detect financial statement fraud (hereafter, fraud). If auditors or other interested parties (e.g., directors, lenders, investors, or regulators) can identify NFMs (e.g., facilities growth) that are correlated with financial measures (e.g., revenue growth), inconsistent patterns between the NFMs and financial measures can be used to detect firms with high fraud risk. We find that the  difference  between financial and nonfinancial performance is significantly greater for firms that committed fraud than for their nonfraud competitors. We also find that this difference is a significant fraud indicator when included in a model containing variables that have previously been linked to the likelihood of fraud. Overall, our results provide empirical evidence suggesting that NFMs can be effectively used to assess fraud risk.     

Corporate employment,red flags,and audit effort

U.S. regulatory agencies and congressional oversight committees have expressed concerns that auditors often neglect red flags embedded in the operating characteristics of firms that misstate their financial reports. This study examines whether labor employment decisions, a major part of a firm’s operations, help predict accounting improprieties and consequently play a role in audit planning and pricing. We find that negative abnormal employment changes are associated with a higher likelihood of subsequent financial restatements, accounting irregularities, and lawsuits related to accounting fraud, and generally require greater effort from auditors as manifested by higher audit fees and longer audit report lags. Positive abnormal employment changes are associated with subsequent restatements and longer audit report lags, but not associated with fraud or audit fees. Taken together, the results are consistent with auditors recognizing the individual misstatement risks pertaining to companies’ employment decisions. These results suggest that standard setters, regulators, and practitioners should devote more attention to operational statistics to identify potential red flags.     

Financial reporting consequences of natural disasters: Evidence from the impact of resource constraints at audit offices on non-affected clients

Disaster-affected clients demand significant additional effort from their audit office, and hence strain the audit office’s resources available to other non-disaster-affected clients. We consider audit offices with disaster-affected clients to be strained offices and find that, compared with clients audited by non-strained audit offices, non-disaster-affected clients audited by strained audit offices are more likely to have their financial statements restated. This result suggests the financial reporting quality of companies not directly exposed to disasters could also be negatively affected by the disasters, due to their auditors’ strained-resource issue. We further find such a negative effect is more pronounced when the degree of resource constraints is greater and when the audit office lacks client experience or industry expertise. We offer novel evidence of financial reporting consequences of natural disasters, focusing on the externality of disasters on companies not directly affected by disasters. The findings have important implications for regulators in making disaster-related policies, for auditors in managing their client portfolios, and for companies in making auditor choice decisions.     

Who Blows the Whistle on Corporate Fraud?

To identify the most effective mechanisms for detecting corporate fraud, we study all reported fraud cases in large U.S. companies between 1996 and 2004. We find that fraud detection does not rely on standard corporate governance actors (investors, SEC, and auditors), but rather takes a village, including several nontraditional players (employees, media, and industry regulators). Differences in access to information, as well as monetary and reputational incentives, help to explain this pattern. In‐depth analyses suggest that reputational incentives in general are weak, except for journalists in large cases. By contrast, monetary incentives help explain employee whistleblowing.     

财务舞弊公司董事会变更及其对审计师变更的影响——基于面板数据Logit模型的研究

本文以2002—2005年间因财务舞弊而被证监会、上交所和深交所谴责公告的61家A股上市公司为样本,以舞弊被公告前一年到公告后第三年为研究区间,运用配对样本T检验探讨后续治理中董事会成员和审计师如何变更,并建立面板数据Logit模型研究董事会变更对审计师变更的影响,得出了以下结论:从公告前一年到公告后第三年,财务舞弊公司的董事会发生了显著变更,但只有其非常规性变更才对审计师变更有显著正影响。然而,以控制组公司数据为对象,并未发现董事会变更会影响审计师变更。     

The Impact of Recognition Versus Disclosure on Financial Information: A Preparer's Perspective

We investigate whether recognition on the face of the financial statements versus disclosure in the footnotes influences the amount that financial managers report for a contingent liability. Using an experiment with corporate controllers and chief financial officers, we find that financial managers in public companies expend more cognitive effort and exhibit less strategic bias under recognition than disclosure. This difference appears to be associated with capital market pressures experienced by public company managers as we find that both the cognitive effort and bias exhibited by private company managers are unaffected by placement. As a result, public company managers make higher liability estimates for recognized versus disclosed liabilities. Their liability estimates are similar to those of private company managers for recognition but lower than private company managers’ estimates for disclosure. Our results have implications for auditors and financial statement users in evaluating recognized versus disclosed information for public and private companies.     

Internal audit reporting lines,fraud risk decomposition,and assessments of fraud risk

The main purpose of this research is to examine the effects of internal audit reporting lines on fraud risk assessments made by internal auditors when the level of fraud risk varies. Significant emphasis has been placed on the importance of reporting lines in maintaining the autonomy of internal auditors, but the perceived benefits of requiring internal audit to report directly to the audit committee have not been validated or systematically investigated. Results of an experiment involving 172 experienced internal auditors and additional survey findings indicate that internal auditors perceive more personal threats when they report high levels of risk directly to the audit committee, relative to management. Perceived threats lead internal auditors to reduce assessed levels of fraud risk when reporting to the audit committee relative to when reporting to management. This finding runs counter to the anticipated benefits of requirements that the internal audit function report directly to the audit committee, and it reveals potential conflicts of interest and independence threats created by the audit committee itself. We also investigate the effects of fraud risk decomposition on risk assessments made by internal auditors. We find that fraud risk assessment decomposition does not have the same effects on internal auditors as it has on external auditors, and the effects of decomposition do not align with the expected benefits of decomposition.     

Hedge fund activism,CEO turnover and compensation

This paper examines the governance role of hedge fund activists by analyzing the impact of these activists on CEO turnover, CEO pay, and CEO pay-performance link in targeted companies. Using the difference-in-difference approach, we first find significantly higher CEO turnover following hedge fund activism. After we split target companies into the CEO-turnover and non-CEO-turnover sub-samples, we find that only new CEOs in targeted companies get more compensation following hedge fund activism while incumbent CEO pay does not significantly change. The relationship between CEO bonuses and return on assets following hedge fund activism also differs across the subsamples split by CEO turnover. Pay-performance relationship is enhanced by hedge fund activism for new CEOs, but not for incumbent CEOs. In additional analyses, we document that CEO turnover is positively associated with Tobin’s Q and shareholder votes on Say on Pay in target companies after hedge fund activism.     

保险治理与公司违规——董事高管责任保险的治理效应研究

公司治理机制被认为是影响公司违规的重要因素,然而董事高管责任保险作为一种重要的外部治理机制,是否会影响公司违规尚未得到充分研究。本文研究发现董事高管责任保险显著降低公司违规概率,符合监督效应假说。经工具变量法、Heckman两阶段模型和倾向得分匹配法稳健性检验,上述结论依然成立。影响机制分析表明,董事高管责任保险显著降低了公司违规倾向,显著增加了违规后被稽查的概率,并降低了上市公司的第一类代理成本。对董事高管责任保险的监督职能做进一步分析发现:(1)董事高管责任保险对上市公司经营违规和领导人违规的监督效应更为显著,但对信息披露违规的治理作用并不显著;(2)董事高管责任保险发挥的监督职能与股权属性和保险机构股东治理存在替代效应,与外部审计师治理和董事长CEO二职分离存在互补效应;(3)分组检验结果表明,董事高管责任保险对公司违规的监督效应在外部监管环境较差或者公司内部信息透明度较高的情况下更加显著。本文既提供了保险合约通过公司治理渠道影响公司违规的证据,同时也表明保险机构通过董事高管责任保险为中国资本市场提供了一种较为有效的公司外部治理机制。     

Cooking the books: Recipes and costs of falsified financial statements in China

We examine the causes and consequences of falsified financial statements in China. Using bivariate probit regression analysis, we find that firms with high debt and that plan to make equity issues are more likely to manipulate their earnings and thus have to restate their financial reports in subsequent years. We also find that corporate governance structures have an effect on the occurrence and detection of financial fraud. There are significant negative consequences to fraudulent financial statements. Restating firms suffer negative abnormal stock returns, increases in their cost of capital, wider bid-ask spreads, a greater frequency of modified audit opinions, and greater CEO turnover. We also find that firms located in highly developed regions suffer more severe consequences when they manipulate their accounts.     

Japanese stock market reaction to announcements of news affecting auditors’ reputation: The case of the Olympus fraud

The revelation of accounting fraud by the Olympus Corporation gave rise to shareholder allegations of audit failure against Olympus’ auditors—Ernst & Young ShinNihon LLC and KPMG AZSA LLC—in 2011. In this study, we investigate whether the auditors’ affiliation with Olympus contributes to divergent perceptions of audit quality in the event of news announcements affecting the reputation of Olympus’ auditors. First, we use a nonparametric generalized rank event study methodology on 918 sample firms from the First Section of the Tokyo Stock Exchange (TSE) to observe Japanese investors’ perceptions of auditor reputation as proxied by abnormal returns. Second, we perform a multivariate linear regression on firms’ abnormal returns after controlling for firm-specific variables. We find that Japanese investors do not respond to negative or neutral reputational information arising from news announcements concerning Olympus’ auditors for firms affiliated and not affiliated with those auditors. In the absence of legal penalties imposed on Olympus’ auditors, we argue that Japanese investors consider the Olympus fraud case as an expected occurrence of audit failure due to a lack of evidence suggesting systematic audit failure on the part of Olympus’ auditors and an expectation of lower audit quality in the Japanese capital market. As a result, Japanese investors do not consider news announcements affecting the Olympus auditors’ reputation as sufficient evidence to change their prior expectation regarding the reputations of the audit firms affiliated with the Olympus fraud case.     

An Investigation of Auditors’ Judgments When Companies Release Earnings Before Audit Completion

The majority of U.S. public companies release annual earnings prior to the completion of audit fieldwork. We investigate this phenomenon in a controlled experiment with audit partners and senior managers. We find that releasing earnings before completion of the audit pressures auditors to adopt the goals of management, thereby reducing the likelihood of post‐announcement audit‐adjustment recommendations. We also examine the effect of audit committee (AC) strength in improving auditors’ judgments after annual earnings are released. When ACs are actively involved in accounting issues and proactively communicating with auditors—characteristics currently lacking in most ACs—the negative effects on auditors’ judgments are completely mitigated. Our study provides evidence on potential unintended consequences of early release of earnings and the importance of investing in high‐quality ACs to mitigate adverse effects of client pressures on audit judgment and financial reporting quality.     

The Effects of Alternative Justification Memos on the Judgments of Audit Reviewees and Reviewers

Prior research on justification has typically focused on the differences in judgments between auditors required, or not required, to justify their decisions. However, justification memos can be prepared using different approaches. In this study we examine the impact of using three justification memos: supporting, balanced, and component. Using a comprehensive control environment case based on an actual client that experienced fraud, we find that the justification memo used can affect the judgments of auditors preparing the memos as well as the judgments of auditors who review their work. Specifically, the results indicate that auditors using an unrestricted component memo, who were required to write memos for components of their task by providing important positive and negative evidence, thought that the firm's control environment was more likely to prevent fraud as compared with the supporting and balanced memo groups. Additional analyses suggest that the reason for this result is that an unrestricted component memo focuses auditors' attention on a larger percentage of positive control environment characteristics when a firm's underlying evidence set is mostly positive. This may be problematic because firms can have more positive than negative control environment characteristics, even when fraud is present.     

Do seasoned industry specialists provide higher audit quality? A re-examination

The purpose of this paper is to re-examine the recent findings in Gaver and Utke (2019) (GU) who find that seasoned industry specialist auditors provide higher audit quality. We first illustrate how the magnitude of residuals from the accruals model can vary significantly by industry, thus highlighting the importance of including industry fixed effects when the dependent variable is discretionary accruals. We next replicate GU’s findings. We first attempt to replicate prior literature after including industry fixed effects in the audit quality (discretionary accruals) models. This is an important control, as the relevant benchmark for a firm with an industry specialist auditor is a peer firm in the same industry with a non-specialist auditor. We find that after including industry fixed effects, there is no association between seasoned industry specialist auditors and discretionary accruals. We also find that the association between industry specialization and discretionary accruals is very sensitive to the way in which the researcher calculates specialization. Our findings are informative for shareholders of public companies who vote on auditor ratification.     

Detecting Deceptive Discussions in Conference Calls

We estimate linguistic‐based classification models of deceptive discussions during quarterly earnings conference calls. Using data on subsequent financial restatements and a set of criteria to identify severity of accounting problems, we label each call as “truthful” or “deceptive.” Prediction models are then developed with the word categories that have been shown by previous psychological and linguistic research to be related to deception. We find that the out‐of‐sample performance of models based on CEO and/or CFO narratives is significantly better than a random guess by 6–16% and is at least equivalent to models based on financial and accounting variables. The language of deceptive executives exhibits more references to general knowledge, fewer nonextreme positive emotions, and fewer references to shareholder value. In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words. Finally, a portfolio formed from firms with the highest deception scores from CFO narratives produces an annualized alpha of between ?4% and ?11%.     

Auditors’ going‐concern‐modified opinions after 2001: measuring reporting accuracy

An important change in auditors’ reporting behaviour in the period after the high‐profile corporate collapses in 2001 is that auditors were more likely to issue going‐concern (GC)‐modified audit opinions. Comparing company failure rates subsequent to receiving a first‐time going‐concern (FTGC)‐modified audit opinion in the pre‐ and post‐2001 periods, we find a consistent type 1 error (misclassification) rate (the rate of survival among companies issued an FTGC opinion). Results are indicative of auditors maintaining GC reporting accuracy when comparing the 1995–1996 and 2004–2005 periods. This conclusion is supported after considering the impact of mitigating circumstances surrounding companies that received an FTGC‐modified audit report and survived.     

CEO Connectedness and Corporate Fraud

We find that connections CEOs develop with top executives and directors through their appointment decisions increase the risk of corporate fraud. Appointment‐based CEO connectedness in executive suites and boardrooms increases the likelihood of committing fraud and decreases the likelihood of detection. Additionally, it decreases the expected costs of fraud by helping conceal fraudulent activity, making CEO dismissal less likely upon discovery, and lowering the coordination costs of carrying out illegal activity. Connections based on network ties through past employment, education, or social organization memberships have insignificant effects on fraud. Appointment‐based CEO connectedness warrants attention from regulators, investors, and corporate governance specialists.     

Fraudulent financial reporting in China: Evidence from corporate renaming

Using a sample of listed Chinese companies during 2010–2019, we examine whether corporate renaming is associated with fraudulent financial reporting. We find that companies that change their corporate names without making underlying changes to business fundamentals are more likely to commit financial reporting fraud. The positive association between corporate renaming and financial reporting fraud is more pronounced for non-state-owned enterprises and companies with a lower ownership concentration. There is further evidence that corporate renaming is more likely to be associated with disclosure-related fraud (e.g., failure to disclose or delayed disclosure) and that the likelihood of fraudulent behavior increases with the frequency of corporate renaming. Overall, the findings of this study provide evidence of a new red flag for regulators and investors investigating financial fraud. This study is timely and has policy implications for market regulators hoping to establish and improve emerging capital markets in which the information environment is generally considered weak and opaque.     

How do auditors perceive CEO's risk‐taking incentives?

Prior literature documents that executive compensation influences managerial risk preferences through executives’ portfolio sensitivities to changes in stock prices (delta) and stock‐return volatility (vega). Large deltas discourage managerial risk‐taking, while large vegas encourage risk‐taking. Theory suggests that auditors charge higher audit fees when standard audit procedures do not allow auditors to reduce audit risk including the risk arising from higher business risk. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and audit fees. We also find a negative relation between CEO portfolio deltas and the issuance of going‐concern audit opinions (GCO).     

Perceptions and Price: Evidence from CEO Presentations at IPO Roadshows

This paper examines the relation between cognitive perceptions of management and firm valuation. We develop a composite measure of investor perception using 30‐second content‐filtered video clips of initial public offering (IPO) roadshow presentations. We show that this measure, designed to capture viewers’ overall perceptions of a CEO, is positively associated with pricing at all stages of the IPO (proposed price, offer price, and end of first day of trading). The result is robust to controls for traditional determinants of firm value. We also show that firms with highly perceived management are more likely to be matched to high‐quality underwriters. In further exploratory analyses, we find the impact is greater for firms with more uncertain language in their written S‐1. Taken together, our results provide evidence that investors’ instinctive perceptions of management are incorporated into their assessments of firm value.