The effect of accounting fraud on future stock price crash risk

Abstract

Accounting fraud constitutes serious misconduct that damages investor confidence in capital markets. While accounting fraud revelations trigger declines in stock prices, it remains unclear whether firms’ past accounting fraud revelations (ex-post) or predicted future likelihood of fraud (ex-ante) affect their future risk of stock price crashes. Hence, we examine the effect of accounting fraud on future stock price crash risk. We find that both ex-post and ex-ante accounting fraud are significantly and positively related to future stock price crashes. Channel analysis shows that the relationship is magnified for firms with opaque information environments. This supports our theoretical mechanism that accounting fraud affects stock price crash risk through information opacity. Cross-sectional analysis is also conducted to explore potential heterogeneity across firms. We find that the relationship is magnified in firms with managerial entrenchment, CEO power, and CEO-board cooption. • Accounting fraud has significant predictive power on future stock price crash risk. • Ex-post and ex-ante accounting fraud are linked to more risk of stock price crashes. • An opaque information environment is the mechanism that magnifies the relationship. • Managerial entrenchment, CEO power, and CEO-board cooption also amplify the link.