Are Positive Reactions to Bad News Plausible? The Consideration of Fraud in Audit and Reporting Delays

Abstract

I formulate a model to emphasize the fraud detection role of auditors in the financial market and relate the role to audit and financial reporting delays. In the model, an auditor considers whether to perform extended audit procedures after observing a red flag generated from regular audit procedures. An audit delay is represented by the event of extending audit procedures and manifested as a financial reporting delay observed by the market. I derive a simple closed-form condition characterizing when a positive market reaction to a delay is possible. The condition provides a theoretical basis for formulating empirically testable hypotheses. I discuss why the fundamental logic behind the counter-intuitive positive-reaction result also applies to other contexts such as internal control weakness disclosure. Documented evidence in the literature suggests that “positive reactions to bad news” (PR2BN) is a general phenomenon. I also discuss other empirical implications of the model, with suggestions for regression equation specifications.