Auditing Enforcement Releases Research Articles

An Analysis of Accounting Frauds and the Timing of Analyst Coverage Decisions and Recommendation Revisions: Evidence from the US

This paper provides a comprehensive exploration of the types of accounting fraud committed by firms over the period 1995-2009. Using detailed data from US SEC Accounting and Auditing Enforcement Releases (AAER), we examine the likelihood and timing of analyst coverage decisions and recommendation revisions related to fraud firms versus firms without accounting fraud. We find that analysts have a higher probability of taking the more severe action of dropping coverage rather than only revising down recommendations for firms with any type of accounting fraud and also for specific egregious types of accounting fraud. Through the use of competing hazards models, we also find that accounting frauds and their egregiousness are positively (negatively) associated with the timeliness of the analysts’ action to drop coverage (revise only). Overall, we find that analysts’ actions may be useful in determining the occurrence of accounting fraud prior to the public announcement of the fraud.

SEC enforcement releases and audit fees

Purpose – The purpose of this study is to examine whether firms subject to an SEC enforcement action experience audit fee premiums in subsequent years.Design/methodology/approach – The paper uses a test sample with firms that are cited in Accounting and Auditing Enforcement Releases (AAERs) by the US Securities and Exchange Commission (SEC) and two different control samples, and conducts empirical tests using cross‐sectional multiple regressions.Findings – It is found that firms subject to SEC enforcement actions pay higher audit fees in subsequent periods. This finding is robust after controlling for restatements and prior material internal control weakness disclosures. Additional analyses show that executive turnover does not mitigate the audit fee premium.Research limitations/implications – This study relies on AAERs; hence, the test sample is limited by the SEC's investigation selection procedures.Practical implications – Findings in this study provide insights about the consequences of an SEC investi...

Narcissus Enters the Courtroom: CEO Narcissism and Fraud

This study explores the aspects of the relationship between possible indicators of CEO narcissism and fraud. Highly narcissistic CEOs undertake challenging or bold actions to obtain frequent praise and admiration. The pursuit of narcissistic supply may result in a stronger likelihood of a CEO to undertake bold actions with potential detrimental consequences for the organization. The sample consists of all S&P 500 CEOs from 1992 till 2008 with more than 3 years of tenure. The measurement of CEO narcissism is based on 15 objective indicators and fits the main conceptualization of narcissism. This data collection provides a score for all S&P 500 CEOs according to their narcissistic tendencies. The Accounting and Auditing Enforcement Releases on the SEC’s website are the indicators of managerial fraud. The findings confirm the expected influence of plausible proxies for CEO narcissism on fraud by showing a positive relationship. This confirms the psychologic perspective of CEO narcissism as a potential cause of fraud.

A Critical Analysis of Databases used in Financial Misconduct Research

An extensive accounting and finance literature examines the causes and effects of financial misreporting or misconduct based on samples drawn from four popular databases that identify restatements, securities class action lawsuits, and Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement Releases (AAERs). We show, however, that the results from empirical tests can depend on which database is accessed. To examine the causes of such discrepancies, we compare the information in each database to a detailed sample of 1,243 case histories in which the SEC brought enforcement action for financial misrepresentation. These comparisons allow us to identify, measure, and estimate the economic importance of four characteristics of each database that affect inferences from empirical tests. First, these databases contain information on only the event that is used to proxy for misconduct (e.g., restatements), so they omit other relevant announcements that affect a researcher’s interpretation and use of the events. Second, the initial public revelation of financial misconduct occurs, on average, months before the initial coverage in these databases, leading to discrepancies in event study measures and pre/post comparison tests. Third, most of the events captured by these databases are unrelated to financial fraud, and efforts to cull out non-fraud events yield heterogeneous results. Fourth, the databases omit large numbers of events they were designed to capture. We show the extent to which each database is subject to these concerns and offer suggestions for researchers seeking to use these databases.

SEC Accounting And Auditing Enforcement Actions In The Banking Industry

<span>This paper provides insight into several descriptive issues that help clarify the nature of management fraud in the banking and financial services industry. The SECs Accounting and Auditing Enforcement Releases (AAER) Nos. 1 to 400, published between 1984 and 1992, were surveyed to identify a sample of banks and other related entities that were the subject of SEC enforcement action for fraudulent financial reporting. Those cases are analyzed and results are reported in this study. Detailed cases are also presented to illustrate the nature of financial statement fraud relating to valuation problems in investment accounts, misstatement of loan reserves, and non-disclosure of material financial information. Implications for research, practice, and teaching and presented.</span>

The Long‐Term Performance and Failure Risk of Firms Cited in the US SEC's Accounting and Auditing Enforcement Releases

Abstract: We investigate 239 firms cited in the SEC's Accounting and Auditing Enforcement Releases (AAERs). We document significantly negative abnormal operating performance (measured using both cash‐flow‐based and earnings‐based metrics) in the second and third years following AAERs. We also detect significantly negative abnormal stock returns in up to three years following AAERs. We further find that AAER firms are more likely to fail in the post‐AAER period. Taken together, our findings suggest that the negative implications of an AAER citation resulting from egregious financial reporting violations can be long lasting and influence various facets of firm performance and survivability.

Did the Waste Management Audit Failures Signal Lower Firm-Wide Audit Quality at Arthur Andersen? *

This study investigates Arthur Andersen’s audit quality in the decade before the collapse of Enron. Andersen’s involvement in the Waste Management audit failures — which relate to audits of the company’s 1992- 1996 financial statements — led the SEC to accuse Andersen of issuing false and misleading audit reports and resulted in a permanent injunction that prohibited Andersen from further violation of securities laws. We examine whether the Waste Management audit failures were symptomatic of widespread audit deficiencies at Andersen. Using three empirical measures of audit quality — discretionary accruals, clients’ propensity to meet or just beat analyst forecasts, and accounting misconduct identified by Accounting and Auditing Enforcement Releases (AAERs) — we find no overall evidence suggesting lower average audit quality at Andersen relative to the Big 4 during the period 1992-2001 for a sample of S&P 1500 firms. Focusing on high litigation risk firms, however, we find larger absolute and income-increasing accruals and a greater propensity to meet or just beat analyst forecasts for Andersen clients relative to the Big 4 clients in the period August 7, 2000 to December 31, 2001, after Andersen’s divorce from Andersen Consulting. These findings provide some evidence that, after the divorce, Andersen was not able to constrain aggressive accounting where it may have mattered most, that is, among its clients with the highest litigation risk.

Auditor Fees and Fraud Firms

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised SEC requirements that resulted from the implementation of the Sarbanes-Oxley Act (2002) limit non-audit services (NAS) and mandate NAS fee disclosure. The SEC’s requirements are based on the argument that auditor independence could be impairedand hence audit quality may be reducedwhen auditors audit their own work. Economic bonding leads to reduced independence, which may in turn lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC-sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that, while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, leading to reduced audit quality, while higher audit fees do not appear to have the same effect. Our findings of significantly higher NAS fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC’s concerns about NAS, and can be used by policy makers for additional consideration.

CEO turnover around earnings restatements and fraud

PurposeThis paper aims to examine whether restatement firms with certain restatement characteristics are more likely to have chief executive officer (CEO) turnover within a year of the restatement announcement, and whether these same firms are later subject to regulatory action by the US Securities and Exchange Commission.Design/methodology/approachThe empirical analysis uses a logistic regression to test a sample of firms that restated earnings during the years 1996‐1999.FindingsThe results show significant associations between measures of the severity of earnings restatement and the probability of CEO turnover. Also, restatement firms with CEO turnover are more likely to be issued an SEC Accounting and Auditing Enforcement Release in the years after the restatement, indicating that financial fraud has occurred.Research limitations/implicationsThe results may not generalize to a more recent time period because the sample of firms is from the 1996‐1999 time period.Originality/valueThis study provides a link between CEO turnover and restatement characteristics within a sample of restatement firms.

Where were the auditors? Using AAERs in introductory or advanced auditing courses

► Instructions for use of a SEC Accounting and Auditing Enforcement Release assignment by instructors in Introductory or Advanced Audit Courses. ► Students have an opportunity to use knowledge they have gained from their auditing and other accounting courses. ► Students analyze what was done to cause the SEC to issue an AAER and what the external auditors could have done to prevent the AAER from happening. ► Students are able to practice their presentation skills. ► The assignment can lead to class discussion on ethics. I provide instructions for use of a Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement Release (AAER) assignment by instructors in Introductory or Advanced Audit Courses. The assignment gives students an opportunity to use the knowledge they have gained from their auditing and other accounting courses. Students analyze what was done by individuals in a company to cause the SEC to issue an AAER and what the external auditors could have done to prevent the AAER from happening. A secondary feature of the assignment is that students are able to practice their presentation skills by presenting their analysis to their class members and instructor. The assignment can also lead to class discussion on ethics and what ethical dilemmas practicing auditors are faced with.

Enforcement release evidence on the audit confirmation process: Implications for standard setters

The audit confirmation process involves obtaining evidence from third parties about information affecting financial statement assertions. Recently, the confirmation process has drawn the attention of both regulators and practitioners ( AICPA, 2007a; IFAC, 2006, 2008; PCAOB, 2004) due to questions regarding whether this widely used audit procedure provides persuasive audit evidence. This paper examines confirmation-related evidence from relevant Security and Exchange Commission (SEC) Accounting and Auditing Enforcement Releases (AAERs). Our findings integrate the confirmation process and enforcement release outcomes to provide guidance to regulators and researchers. Specifically, we found situations where fraud may have been detected if auditors had confirmed additional items such as material cash balances, marketable securities, and terms of significant transactions. We also noted (1) situations where management requested that auditors not confirm specific accounts, (2) several examples of collusion between the auditee and either vendors or customers, as well as related parties, and (3) cases involving failure to authenticate responses. Our detailed examination of enforcement release evidence provides implications for standard setters and areas for future research.

The changing face of regulators' investigations into financial statement fraud

PurposeThis paper builds on the Committee of Sponsoring Organizations (COSO) Report, which examined US Accounting and Auditing Enforcement Releases (AAERs). The purpose of this paper is to provide valuable insights into the characteristics and realities of financial statement fraud in the post‐Enron regulatory environment.Design/methodology/approachThis paper analyses a sample of AAERs from 2002 to 2005. It also provides case studies of an additional five high‐profile case studies from that period.FindingsThis paper finds evidence of changes in Securities and Exchange Commission (SEC) enforcement activities since the COSO Report. Specifically, it is found that enforcement activities have increased substantially post‐Enron and the companies subject to AAERs are, on average, much larger, more profitable and the frauds are more substantial than those exhibited in the COSO Report. These findings suggest that the SEC has become more aggressive at pursuing larger companies for financial statement fraud in the post‐Enron environment.Research limitations/implicationsThis paper relies on AAERs as the source of analysis of financial statement fraud, its findings must be viewed in light of the limitations of using these documents. Specifically, the prevailing prosecutions agenda of the US SEC may be reflected in these results.Practical implicationsThe study findings are of great practical relevance to accounting regulators and practitioners as they provide valuable insights into the nature and characteristics of financial statement fraud.Originality/valueThe paper provides empirical evidence concerning the changing face of financial statement fraud enforcement and provides a more in‐depth comparison of fraud than possible with most previous studies that have tended to focus on quantitative measures. This is possible because the present investigation utilises qualitative data from AAERs to supplement quantitative findings. Its originality is also due to the use of institutional theory which is not commonly applied in the corporate governance field.

Bankruptcy Classification of Firms Investigated by the US Securities and Exchange Commission: An Evolutionary Ensemble Computing Model Approach

This paper develops an adaptive ensemble model for bankruptcy classification of firms cited in the SEC's Accounting and Auditing Enforcement Releases (AAER). We develop a Genetic Algorithm (GA) model for bankruptcy classification of AAER firms. Our research contributes to the bankruptcy literature in several ways. First of all, it fills a gap in the bankruptcy literature by developing a domain specific model for AAER firms. Secondly, by using financial and non-financial variables, the GA model generates and optimizes a set of 'if-then' comprehensible rules for the financial failure classification of AAER firms. A Genetic Algorithm model can provide a greater degree of accuracy in predicting financial failure of firms than classical statistical models. Thirdly, we develop a model using bagging that incorporates the output from different models or sources. Finally, we demonstrate the key role of the fitness function in determining the successful performance of a financial failure GA model.

Bankruptcy classification of firms investigated by the US Securities and Exchange Commission: an evolutionary adaptive ensemble model approach

This paper develops an adaptive, rule-based model for bankruptcy classification of firms subject to the SEC's Accounting and Auditing Enforcement Release (AAER). In this paper, we use an evolutionary computing method, genetic algorithm (GA), to generate an optimal set of if-then (comprehensible) rules for bankruptcy classification of AAER firms. In particular, we use bagging to improve the model's generalisation accuracy; and to develop a doubly controlled fitness function to guide the operations of the (GA) method. Our research contributes to the bankruptcy literature in several ways. First, it fills a gap in bankruptcy classification by developing a domain specific model for AAER firms. Secondly, the derived set of if-then rules used in an expert system adds to the bankruptcy knowledge base. Thirdly, we use bagging to improve generalisation of bankruptcy classification models. Finally, we demonstrate the key role of the fitness function in successful model performance.

A Summary of Research and Enforcement Release Evidence on Confirmation Use and Effectiveness

SUMMARY: Confirmations are extensively used and are often perceived by practitioners to be one of the most persuasive forms of audit evidence. Yet academic research has found limitations that restrict confirmation effectiveness for many management assertions. In addition, a number of problems with false and forged confirmations are identified in Accounting and Auditing Enforcement Releases (AAERs). The Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) have put confirmation evidence on their respective agendas. Academic research indicates that receivable confirmations can be effective evidence for the existence assertion. Low response rates, as well as respondent errors and directional bias in detecting errors, are key barriers to confirmation effectiveness. Our review of AAERs identified failure to authenticate responses, collusion between auditee management and customers, and concealed side agreements and special terms as specific problem areas. We also identify a number of research questions for future research.

How Objective is Peer Review? Evidence from Self-Regulation of the Accounting Profession

I test whether peer reviews performed under the AICPA's Peer Review Program were objective indicators of audit quality. Using PCAOB inspection opinions of audit firms as a neutral, independent benchmark of audit quality, I find that firms that themselves review other firms consistently receive more favourable opinions from peer reviews than from PCAOB reviews. Firms with peer reviewers who are less likely to be independent (or more likely to be friendly), such as smaller, non-competing firms and firms likely to be `peer review specialists', also receive significantly more favourable opinions from peer review than from the PCAOB. Also, while positive peer reviews from relatively independent reviewers are negatively related to the likelihood of Accounting and Auditing Enforcement Releases, positive peer reviews from more friendly reviewers are not. These findings suggest that not all peer reviews were objective or rigorous, and that some firms were able to control peer review outcomes by choosing friendly reviewers. However, it is unclear whether audit committees impounded the independence of peer review opinions when using these opinions in decisions to hire or fire auditors.

The hiring of accounting and finance officers from audit firms: how did the market react?

This study investigates the market’s reaction to companies hiring accounting and finance officers directly from their external audit firms—the auditor-to-client hiring practice referred to as the “revolving door.” The Sarbanes-Oxley Act (SOX) eliminated this hiring practice, reflecting concerns that such appointments may impair audit and financial reporting quality. However, it was also argued that companies may have benefited from hiring individuals already familiar with their systems, organization and personnel. To determine the prevalence of this hiring practice and how shareholders viewed these appointments, we examine 3-day cumulative abnormal returns around the announcements of newly appointed accounting and finance officers over the period 1985–2002. We find that the proportion of revolving door hires is relatively low (only 6.1% of all hires in our sample), but that when they did occur the market valued the revolving door appointments more positively than other appointments. Further tests reveal that the positive market reaction to revolving door appointments is driven mainly by smaller companies, and that these appointments are not associated with lower financial reporting quality when assessing subsequent discretionary accruals or the receipt of an Accounting and Auditing Enforcement Release (AAER). Overall, the low frequency of occurrence, investors’ positive perceptions, and the lack of association with deteriorated reporting quality indicate that the SOX restriction on revolving door appointments may have been unnecessary and will do little to protect shareholders.

Do Analysts Anticipate Accounting Fraud?

We examine whether analysts anticipate the public disclosure of accounting frauds by studying a sample of companies that have committed fraud as evidenced by the Security and Exchange Commission (SEC) issuance of an Accounting and Auditing Enforcement Release (AAER). We use survival analysis to determine when analysts drop coverage and revise their recommendations down prior to the public disclosure of fraud. Our analyses indicate some evidence that analysts anticipate fraud and use different signals to inform investors about different fraud types. For example, firms that commit larger frauds are significantly more likely to have analysts drop coverage earlier in the period preceding the public announcement, but are not significantly more likely to show downward revisions in recommendations. We also find that analysts appear to be fooled by fictitious frauds - they are no more likely to drop coverage or revise down earlier prior to public disclosure for firms that commit these frauds versus firms that do not commit fictitious frauds. Finally, our results show that the decision and timing of dropping coverage is not correlated with revision of forecasts, indicating that analysts consider different variables for the two decisions.

Can Investors Detect Fraud Using Financial Statements: An Exploratory Study

This study explores the question of whether investors can successfully detect management fraud using a firm's financial statements. Using financial ratios obtained from fraudulent companies’ financial statements, we examine the effectiveness of both logit and discriminant analyses in predicting the likelihood of fraud. Sixty-eight fraudulent companies used in the study are identified from the SEC's Accounting and Auditing Enforcement Releases. Our research design has addressed certain weaknesses present in prior fraud-detection studies. The empirical results suggest that ratio analysis is grossly ineffective in detecting financial statement fraud. We also discuss the implications of our findings on future research.

Corporate Fraud and Real Investment

This paper studies the real investment and financing behavior of firms around the period of fraud identified in SEC Accounting and Auditing Enforcement Releases. In the pre-fraud period, the typical fraudulent firm has a higher valuation, invests more and exhibits higher Q-sensitivity of investment than industry peers. The fraud period, by contrast, is characterized by significant drops in valuation and investment. I find no support for the hypothesis that fraudulent firms waste real resources by overinvesting during periods of fraud to signal value. Fraud appears to be an attempt to cover up bad investments made in response to the market's high valuation in the pre-fraud period.