The consequences to managers for financial misrepresentation

We track the fortunes of all 2,206 individuals identified as responsible parties for all 788 Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions for financial misrepresentation from January 1, 1978 through September 30, 2006. Fully 93% lose their jobs by the end of the regulatory enforcement period. Most are explicitly fired. The likelihood of ouster increases with the cost of the misconduct to shareholders and the quality of the firm's governance. Culpable managers also bear substantial financial losses through restrictions on their future employment, their shareholdings in the firm, and SEC fines. A sizeable minority (28%) face criminal charges and penalties, including jail sentences that average 4.3 years. These results indicate that the individual perpetrators of financial misconduct face significant disciplinary action.     

Internal corporate governance,CEO turnover,and earnings management

The likelihood and speed of forced CEO turnover – but not voluntary turnover – are positively related to a firm's earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.     

Common auditors and internal control similarity: Evidence from China

This study investigates how important common auditors are to internal control similarity between two firms. Based on a less concentrated audit market in China, we find that firm-pairs with common auditors enforce a similar internal control system. This inference holds after accounting for other social connections, examining internal control components, using alternative measures of internal control, adopting finer industry classifications, constructing alternative internal control similarity, running auditor switch tests, and addressing endogeneity problems. Additional analyses indicate that auditor style and information sharing serve two underlying mechanisms to undergird the documented relationship. Finally, our evidence suggests that high-centrality firms in auditor networks are associated with better financial reporting.     

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.     

Political relationships,global financing,and corporate transparency: Evidence from Indonesia

This study examines the role of political connections in firms’ financing strategies and their long-run performance. We view political connections as an example for domestic arrangements which can reduce the benefits of global financing. Using data from Indonesia, we find that firms with strong political connections are less likely to have publicly traded foreign securities. As a result, estimates of the performance consequences of foreign financing are severely biased if value-creating domestic arrangements such as political relationships are ignored. Connections not only alter firms’ financing strategies, they also influence long-run performance. Tracking returns across several regimes, we show that firms have difficulty re-establishing connections with a new government when their patron falls from power, leading closely connected firms to underperform under the new regime and subsequently to increase their foreign financing.     

A study of firms surrounding the threshold of Sarbanes–Oxley Section 404 Compliance

This study examines whether firms surrounding the Sarbanes–Oxley Section 404 market value compliance threshold behave opportunistically to reduce their market value to avoid compliance with Section 404. We find evidence that those firms reduce their market value temporarily during threshold measurement quarters, whereas control firms experience increasing market value. We find strong evidence of dampened stock returns and some evidence of insider trading as means to reduce the float. Additionally, we find that downward earnings management is used as a mechanism to alter investors’ expectations of firm value in order to temporarily reduce stock prices. We consider this opportunistic evidence of regulatory avoidance. Finally, we find that the likelihood of avoidance increases with the power of the CEO and decreases with the strength of the monitoring of the CEO, which suggest that avoidance is more likely to happen in firms with poor corporate governance mechanisms.     

What Are You Saying? Using topic to Detect Financial Misreporting

We use a machine learning technique to assess whether the thematic content of financial statement disclosures (labeled topic) is incrementally informative in predicting intentional misreporting. Using a Bayesian topic modeling algorithm, we determine and empirically quantify the topic content of a large collection of 10-K narratives spanning 1994 to 2012. We find that the algorithm produces a valid set of semantically meaningful topics that predict financial misreporting, based on samples of Securities and Exchange Commission (SEC) enforcement actions (Accounting and Auditing Enforcement Releases [AAERs]) and irregularities identified from financial restatements and 10-K filing amendments. Our out-of-sample tests indicate that topic significantly improves the detection of financial misreporting by as much as 59% when added to models based on commonly used financial and textual style variables. Furthermore, models that incorporate topic significantly outperform traditional models when detecting serious revenue recognition and core expense errors. Taken together, our results suggest that the topics discussed in annual report filings and the attention devoted to each topic are useful signals in detecting financial misreporting.     

How Common Are Intentional GAAP Violations? Estimates from a Dynamic Model

This paper uses data on detected misstatements—earnings restatements—and a dynamic model to estimate the extent of undetected misstatements that violate GAAP. The model features a CEO who can manipulate his firm's stock price by misstating earnings. I find the CEO's expected cost of misleading investors is low. The probability of detection over a five‐year horizon is 13.91%, and the average misstatement, if detected, results in an 8.53% loss in the CEO's retirement wealth. The low expected cost implies a high fraction of CEOs who misstate earnings at least once at 60%, with 2%–22% of CEOs starting to misstate earnings in each year 2003–2010, inflation in stock prices across CEOs who misstate earnings at 2.02%, and inflation in stock prices across all CEOs at 0.77%. Wealthier CEOs manipulate less, and the average misstatement is larger in smaller firms.     

Earnings quality effect of state antitakeover statutes

Existing theories suggest two opposite effects that antitakeover protection may have on earnings management: the exacerbating effect and the mitigating effect. We use the introduction of state antitakeover laws during the mid- to late-1980s as a natural experiment to test the relationship between antitakeover protection and earnings quality. The results show that firms incorporated in states that passed the laws have lower magnitudes of abnormal accruals and higher levels of earnings informativeness in the post-passage periods, suggesting that antitakeover protection mitigates earnings management and enhances earnings quality. Further evidence shows that reductions in earnings management are concentrated in firms with low firm-level antitakeover protection and in firms with serious agency problems, and that the earnings management effect of state antitakeover laws is likely to be of short-term duration.     

Litigation environment and auditors’ decisions to accept clients’ aggressive reporting

This study contributes to accounting and auditing literature by addressing two empirical questions: (1) whether litigation environment affects auditors’ decisions to accept clients’ aggressive reporting and (2) whether litigation environment, client business risk, and client retention pressure interact and jointly affect auditors’ decisions to go along with clients’ preferred accounting choices. Fifty-nine (59) US and sixty-one (61) Hong Kong auditors employed by the Big-4 accounting firms participated in this study. The result shows that litigation environment has a significant effect on auditors’ decisions. Auditors who practice in more litigious environments tend to be less willing to go along with clients’ aggressive reporting than those who practice in less litigious environments. This study also confirms that there is a significant interactive effect between litigation environment, client business risk, and client retention pressure on auditors’ decisions to accept clients’ aggressive reporting choices. Implications of the empirical findings for policymakers, standard-setting organizations, and international accounting firms, as well as directions for future studies, are discussed.     

Converging to International Accounting Standards: Views from Japan

Many countries, including the European Union member states and Australia, adopted international accounting standards in 2005. This year was also critical in Japan for convergence activities. Based on a review of 2005 financial statements and a survey of securities analysts, this study identifies key issues for convergence of Japanese and international accounting standards. We find that accounting requirements relating to fair value measurement, comprehensive income items, leases and business combinations are relevant to Japanese firms. A survey of 974 members of the Security Analysts Association of Japan about these issues indicated support for convergence and the use of fair value measurement, disclosure of comprehensive income, recognition of leases and use of the purchase method for consolidation. We report support for several positions favoured by the International Accounting Standards Board (IASB), a positive signal for achieving convergence goals in Japan, which will be of interest to capital market participants in Japan and other countries .     

Information Content of Internal Control Weaknesses: The Evidence from Japan

This paper investigates how capital markets in a code-law country, Japan, react to the disclosure of internal control weaknesses (ICW). The Japanese government attempted to implement a more concise, efficient, and, thus, less strict internal control reporting system than Section 404 of the US-SOX. In fact, for the first two years, the disclosure rate of ICW has been much lower in Japan than in the U.S. While market reactions to the disclosure of ICW are not significantly different from zero in our event study analysis, they become significantly negative after controlling for other information released around the disclosure date, audit quality, and other firm attributes. Our results are consistent with the notion that the disclosure of ICW is informative to the market because it is less frequent and exceptional in Japan.     

Accounting disclosure and firms' financial attributes: Evidence from the UK stock market

This paper focuses on the disclosure of accounting information in the financial statements of UK firms. The primary objective of the study is to analyse the financial characteristics of firms that provide extensive disclosures, and assess the financial impact of their motives, such as for example the need to raise equity finance. The study examines the financial attributes of firms that disclose information about key accounting issues including risk exposure, changes in accounting policies, use of international financial reporting standards and hedging practices. Firms are inclined to disclose accounting information in order to assure the market participants that their accounting policies are consistent with the accounting regulation and meet the information needs of their stakeholders. The study shows that in order to raise finance in the capital and debt markets, firms tend to provide extensive accounting disclosures. Firms that provide informative accounting disclosures appear to display higher size, growth and leverage measures. The findings also show that the disclosure of sensitive accounting information has not adversely affected firms' profitability. In fact, firms that provide detailed accounting disclosures tend to exhibit higher profitability. The implementation of international financial reporting standards enhances the quality and the comparability of financial statements; hence it promotes consistency and reliability in financial reporting and facilitates companies in raising capital internationally.     

International Mergers and Acquisitions Laws,the Market for Corporate Control,and Accounting Conservatism

Exploiting the staggered enactment of country‐level mergers and acquisitions (M&A) law as an exogenous increase in corporate takeover threat, this paper examines how a disciplinary market for corporate control affects accounting conservatism. Following M&A law adoption, we find increased accounting conservatism, with more pronounced effects in countries with weak shareholder protection and in those experiencing larger growth in takeover activity. Further analysis reveals that elevated takeover threats increase conservatism through changes in capital structure and investment decisions as well as improvements in board monitoring. Our findings highlight the importance of the market for corporate control in shaping financial‐reporting outcome.     

Whistleblowers and Outcomes of Financial Misrepresentation Enforcement Actions

Whistleblowers are ostensibly a valuable resource to regulators investigating securities violations, but whether there is a link between whistleblower involvement and the outcomes of enforcement actions is unclear. Using a data set of employee whistleblowing allegations obtained from the U.S. government and the universe of enforcement actions for financial misrepresentation, we find that whistleblower involvement is associated with higher monetary penalties for targeted firms and employees and with longer prison sentences for culpable executives. We also find that regulators more quickly begin enforcement proceedings when whistleblowers are involved. Our findings suggest that whistleblowers are a valuable source of information for regulators who investigate and prosecute financial misrepresentation.     

Russian Accounting System: Value Relevance of Reported Information and the IFRS Adoption Perspective

In this paper I perform an empirical investigation into the value relevance of information reported by Russian public firms from two distinct perspectives. First, I document that prior to 2011, investors relied on information incorporated in the book value of equity. The value relevance of reported earnings, however, is different for “growth” versus “value” stocks. Second, I document that Russian leading firms listed on the London Stock Exchange that report in accordance with IFRS produce more value-relevant reports compared to their local peers that report under the Russian standards. This suggests that the mandatory IFRS adoption in Russia that will be completed by 2015 is likely to result in improved information quality.     

Accountability of independent directors: Evidence from firms subject to securities litigation

We examine which independent directors are held accountable when investors sue firms for financial and disclosure-related fraud. Investors can name independent directors as defendants in lawsuits, and they can vote against their reelection to express displeasure over the directors’ ineffectiveness at monitoring managers. In a sample of securities class action lawsuits from 1996 to 2010, about 11% of independent directors are named as defendants. The likelihood of being named is greater for audit committee members and directors who sell stock during the class period. Named directors receive more negative recommendations from Institutional Shareholder Services, a proxy advisory firm, and significantly more negative votes from shareholders than directors in a benchmark sample. They are also more likely than other independent directors to leave sued firms. Overall, shareholders use litigation along with director elections and director retention to hold some independent directors more accountable than others when firms experience financial fraud.     

IFRS adoption in Europe and investment-cash flow sensitivity: Outsider versus insider economies

We examine the economic consequences of the mandatory adoption of IFRS in EU countries by showing which types of economies have the largest reduction in investment-cash flow sensitivity post-IFRS. We also examine whether the reduction in investment-cash flow sensitivity depends on firm size as well as economy type.We find that the investment-cash flow sensitivity of insider economies is higher than that of outsider economies pre-IFRS and that IFRS reduces the investment-cash flow sensitivity of insider economies more than that of outsider economies. Also, we find that small firms in insider economies have the highest sensitivity of investment to lagged cash flow pre-IFRS, and that they are no longer sensitive to lagged cash flow post-IFRS. Overall, our results suggest that IFRS adoption might have improved the functioning of capital markets in relation to small firms in insider economies.     

Financial fraud,director reputation,and shareholder wealth

We investigate the reputational impact of financial fraud for outside directors based on a sample of firms facing shareholder class action lawsuits. Following a financial fraud lawsuit, outside directors do not face abnormal turnover on the board of the sued firm but experience a significant decline in other board seats held. This decline in other directorships is greater for more severe allegations of fraud and when the outside director bears greater responsibility for monitoring fraud. Interlocked firms that share directors with the sued firm also exhibit valuation declines at the lawsuit filing. Fraud-affiliated directors are more likely to lose directorships at firms with stronger corporate governance and their departure is associated with valuation increases for these firms.     

Accounting for investments and the relevance of losses to firm value

Recent research has documented investment in research and development as a key driver of the market value of currently unprofitable firms (hereafter loss firms) in a knowledge-based economy. We broaden this argument to consider the influence of accounting for investments in general on the relation between current profitability and firm value for loss firms. Specifically, in the context of a resource-based economy, we find that exploration costs, cash flow measures of investment, and research and development costs help to explain the value of loss firms and reduce the negative relation between current profitability and firm value.