Financial Misstatements Research Articles

Managerial Self-References in Corporate Disclosures: An Analysis of MD&A

This study examines strategic pronoun usage in the Management Discussion and Analysis (MD&A) section of annual reports. Through automated textual analysis of a large sample of MD&As, we find that managers of firms with higher earnings growth tend to use more self-inclusive pronouns(e.g., “ we, ” “ us, ” and “ our ”) and fewer self-exclusive words (e.g., “the company ”). This self-referential language pattern is associated with a higher likelihood of future financial restatements. Our findings contribute to the literature on corporate narrative disclosures and identify a potential new indicator of financial misstatements. The results have implications for investors, analysts, auditors, and regulators.

Relationship between Auditor Independence and Financial Statement Quality in Rwanda

Purpose: The aim of the study was to assess the relationship between auditor independence and financial statement quality in Rwanda. Methodology: This study adopted a desk methodology. A desk study research design is commonly known as secondary data collection. This is basically collecting data from existing resources preferably because of its low cost advantage as compared to a field research. Our current study looked into already published studies and reports as the data was easily accessed through online journals and libraries. Findings: The study demonstrated that when auditors maintain a high level of independence, they are more likely to detect and report financial misstatements or irregularities accurately. This leads to higher-quality financial statements that investors and stakeholders can rely on for decision-making purposes. Conversely, when auditor independence is compromised, such as through close relationships with management or financial incentives, there is a greater risk of overlooking errors or fraudulent activities, ultimately reducing the quality of financial reporting. Regulatory bodies and professional standards, such as the Sarbanes-Oxley Act and the International Standards on Auditing, emphasize the importance of auditor independence to safeguard the integrity of financial information. Companies that prioritize auditor independence and engage independent audit firms tend to have stronger financial statement quality, which contributes to market confidence and investor trust in the transparency and accuracy of financial reporting. Implications to Theory, Practice and Policy: Agency theory, institutional theory and stakeholder theory may be used to anchor future studies on assessing the relationship between auditor independence and financial statement quality in Rwanda. In terms of practical implications, it is essential to encourage audit firms and companies to adopt best practices that ensure auditor independence. From a policy perspective, collaboration with regulatory bodies is essential to review and enhance existing audit regulations, standards, and guidelines.

Partnership Disparity and Audit Quality

This study explores the effects of partnership disparity within Chinese audit firms on audit quality using novel data on their partnership arrangements. The results indicate a U-shaped relationship between the partnership disparity extent and the violations assessed by regulators, including financial misstatements of clients. Audit firms with mid-level unequal partnership structures achieve superior audit quality than their counterparts with either “flat” or “high-skewed” partnership structures. Additional analyses confirm the role of client complexity as the boundary condition and indicate that the geographical remoteness of audit firms asymmetrically moderates partnership disparity. These results are robust to different audit quality proxies and alternative research designs including change analyses and after controlling for the effects of engagement partners. This study contributes to research on diversity and performance in the partnership context. This approach opens the “black box” of power-related culture in audit firms and carries managerial implications for the managing partners and audit regulators of audit firms.

Director networks, accounting conservatism and director reputation: Evidence after financial reporting failure

This study examines whether connected boards of directors restore their reputation via conservative accounting after financial misstatements. Using a sample of restating firms from 2004 to 2020, we find central boards of directors are positively related to accounting conservatism in the post-restatement period. More importantly, we find accounting conservatism has positive effects on the reputation restoration of directors in central boards, leading to more prestigious board seats, additional outside directorships, and higher compensation following restatements. The reputation recovery of directors in central boards is more prominent among restating firms that seek external financing where potential benefits of director reputation are greater. The findings suggest that directors in central boards successfully recover their damaged reputation via conservative accounting after restatements and minimize adverse consequences in the director market. Our robustness tests support the causal interpretation of our evidence. Collectively, our study offers novel insights into the monitoring incentives resulted from the reputation restoration of directors in central boards via conservative accounting after financial reporting failures.

Does the integration between litigation and supervision discipline financial misstatement?

This paper explores the positive governance effects of the Procuratorate’s Public Interest Litigation System in China, which combines the powers of litigation and administrative supervision, on the quality of information disclosure by listed state-owned enterprises. We report several findings. (1) The likelihood that listed state-owned enterprises would issue financial restatements and participate in financial fraud decreased significantly in areas selected for pilot implementation. (2) The governance effect is stronger in regulated industries than in unregulated industries. After the pilot implementation, the agency costs decreased, and the increase in legal litigation risks related to false statements faced by enterprises played a deterrent effect. (3) The significance of the above results is stronger when a company’s external and internal governance are weaker. This study provides both new evidence of the effectiveness of the integrated governance mechanism and inspiration for future efforts to widely implement this mechanism in the capital market.

The Role of Auditors in Fraud Prevention and Detection in Companies

The role of auditors in fraud prevention and detection in companies is a critical aspect of corporate governance and financial integrity. Auditors, often external to the company, are responsible for reviewing financial records, internal controls, and operational processes to ensure accuracy, transparency, and compliance with regulatory standards. Fraud poses a significant threat to businesses, ranging from financial misstatements to cyber fraud. Auditors play a crucial role in identifying and preventing such fraudulent activities by applying their expertise in accounting principles, risk assessment, and forensic analysis. In their role, auditors are tasked with assessing a company's financial statements and internal controls to detect any signs of fraud or mismanagement. They conduct thorough examinations of financial records and transactions, looking for irregularities or inconsistencies that may indicate potential fraud. Auditors also evaluate the effectiveness of internal controls designed to prevent and detect fraud, assessing their design and implementation. Moreover, auditors often employ specialized techniques like data analytics and forensic accounting to identify patterns of suspicious activities or potential fraud schemes. By analyzing large datasets and transaction records, auditors can uncover anomalies that might otherwise go unnoticed. In addition to detecting fraud, auditors also contribute to its prevention by recommending improvements to internal controls and processes. They provide valuable insights and recommendations to management and stakeholders on how to strengthen governance practices and reduce the risk of fraud occurring within the organization. Overall, auditors play a critical role in safeguarding the integrity of financial reporting and maintaining trust in corporate operations. Their expertise and independence are essential in ensuring transparency and accountability in the face of evolving fraud risks and regulatory challenges.

Ontological basis of the creative accounting phenomenon as a financial misstatement

PurposeThis article aims to contribute to the accounting knowledge literature by presenting the framework of creative accounting factors and evaluating their identified factors through an argumentation-based total interpretive structural modeling (TISM) approach.Design/methodology/approachThis study adopted mixed, inductive and deductive approaches to develop an integrated framework, validate its practicability and verify its effectiveness in selected manufacturing firms listed on the Tehran Stock Exchange (TSE), respectively. In developing the framework and implementation procedure, the study employed an exploratory data collection (qualitative) approach to review the phenomenon of creative accounting factors. Then, in this study’s second phase, TISM is used to develop the framework of creative accounting design. This study used two types of theoretical sampling in the qualitative part, including theoretical and snowball sampling. Also, the participants in the TISM process in this study were specialized analysts of the TSE.FindingsBased on the mixed method of this study, the result in the qualitative part provides the creative accounting framework of the existence of three categories. There are 6 components and 35 themes during 12 interviews. In the quantitative section, it was determined that two factors, namely the type of ownership firms and intrinsic objectivity, are the most effective drivers for the formation of creative accounting in TSE firms.Originality/valueSo far, it is rare to find preceding studies that have proposed, validated and practically tested an integrated creative accounting framework within the context of financial markets. Thus, the authors understand that this is the very first research focused on the development of a framework for capital market companies to continuously be competitive and could help financial decision-makers, practitioners and academicians in their perception of knowing more about the financial functions of firms.

Lead Independent Director: Impact on Firm Performance and Financial Misstatements

This paper examines whether the presence of a lead independent director improves firm performance and reduces financial misstatements. Using a sample of Fortune 1000 companies in the year 2013, we find that the effect of lead independent directors on firm performance hinges on CEO –Chair duality. For companies with CEO-Chair duality, the existence of a lead independent director is positively associated with improved firm performance as measured by Tobin’s Q. In contrast, we do not find a similar association for companies separating the CEO and board chair positions. In addition, we do not find an association between the existence of a lead independent director and the likelihood of misstatements. These results suggest that the existence of a lead independent director helps improve a company’s corporate governance.

Examining the intervening effect of earning management in governance mechanism and financial misstatement with lens of SDG and ESG: a study on non-financial firms of Pakistan.

In today's corporate world, a company's long-term viability and prosperity depend on its corporate governance practices. The present study investigates the interplay between financial misrepresentation, earnings management, and corporate governance within the context of Pakistan. To estimate the financial data of enterprises obtained from non-financial organizations listed on the Pakistan Stock Exchange a panel regression analysis was conducted. The analysis covered the time from 2009 to 2020 and employed quantitative data. The findings of the study show that the different aspects of corporate governance mechanisms have varying levels of influence. Specifically, remuneration paid to directors had a significant impact on financial misstatement, while the size of the board strongly impacts the earning management. The financial misstatement was also found affected by the earning management. The M score (statistical model used to predict the probability of financial misstatement) positively influenced when board diligence was incorporated in the mediation of earning management. It is important to note that this study only considers the internal governance mechanisms of firms, suggesting that future research could benefit from the inclusion of external governance mechanisms for a more holistic model. This study is aligned with the ESG's governance aspects and SDG-17, providing valuable insights for specialists, financial backers, policymakers, and experts. The results of this study catalyze further research in this area and can aid in achieving SDG 17 by raising awareness of the significance of good governance practices, ethical reporting that leads to sustainable firm performance, and ensuring long-term economic growth and development.

Where's the risk? Material weakness detection in advance of financial misstatement discovery

This study uses material weakness (MW) disclosures to explore whether auditors systematically assign greater risk to specific financial statements and account types. Auditing Standard 2201 mandates auditors adjust their levels of material weakness detection in response to the risk associated with each control being tested. Using a sample of firm years with financial misstatements, I show that auditors are most likely to detect material weaknesses in advance of misstatement discovery when they relate to the income statement, followed by the balance sheet, and to revenues and assets, relative to other income statement and balance sheet accounts. These results suggest that auditors, on average, assign the greatest level of associated control risk to the income statement, then the balance sheet, and that revenues and assets are the drivers of that assignment.

The two sides of corporate social responsibility and the quality of internal control audit opinions

Although corporate social responsibility (CSR) activities provide a strong signal of management integrity, the involvement of the client in irresponsible CSR should alert the auditor to the risk of material misstatement. Framing management integrity assessments by relying on responsible CSR activities can lead to auditors' unintended alignment with their clients' preferred outcomes. Motivated by the increasing frequency of clean internal control opinions (ICOPs) regarding clients that subsequently misstate, we explore whether auditors' overreliance on responsible CSR influences the quality of ICOPs. We find that clients' CSR involvement is associated with fewer adverse ICOPs, but this CSR effect is asymmetric because it is only explained by responsible CSR activities and not by irresponsible CSR activities. Importantly, the ‘good side of CSR’ is associated with fewer adverse opinions being issued to misstated clients. Additional analyses show that only irresponsible CSR activities increase the risk of financial misstatements. Our findings provide support for the Public Company Accounting Oversight Board's warning that certain conditions inherent in the audit environment, such as the assessment of management integrity, can lead to auditors unconsciously favouring confirming evidence (represented by responsible CSR activities) instead of relying on disconfirming evidence (represented by irresponsible CSR activities) that could raise issues about management's integrity and ethical commitment.

Does Differentiated Key Audit Matter in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? Evidence from China*

AbstractThis study examines whether differentiated disclosure of key audit matter (KAM) in China indicates a higher financial misstatement risk. Our empirical study demonstrates that financial statements with less boilerplate KAM are more likely to be subsequently restated than those with more boilerplate KAM. This association is only pronounced for smaller auditing firms in stronger legal environments. Additionally, auditors who report differentiated KAM are likely to disclose more risk‐related information. Moreover, clients are more likely to restate financial reports when the KAM relates to managers' subjective estimations.

Options trading and earnings management: Evidence from the penny pilot program

Using a difference-in-differences approach that relies on the exogenous increase in options trading activity generated by the Securities and Exchange Commission's Penny Pilot Program, we find a negative causal effect of options trading on earnings management. With a reduced magnitude of discretionary accruals, the pilot firms are less likely to marginally beat earnings targets and less likely to have financial misstatements during the pilot period. Cross-sectional analysis shows that the effects are more pronounced among firms with a small or less independent board or a small audit committee. Furthermore, the pilot firms receive more market attention, and their stock price efficiency improves more than the nonpilot firms during the pilot period. The evidence is consistent with the argument that active options trading enhances market scrutiny of firms' reporting behavior, improving financial reporting quality and price efficiency.

Detecting Anomalies in Financial Data Using Machine Learning Algorithms

Bookkeeping data free of fraud and errors are a cornerstone of legitimate business operations. The highly complex and laborious work of financial auditors calls for finding new solutions and algorithms to ensure the correctness of financial statements. Both supervised and unsupervised machine learning (ML) techniques nowadays are being successfully applied to detect fraud and anomalies in data. In accounting, it is a long-established problem to detect financial misstatements deemed anomalous in general ledger (GL) data. Currently, widely used techniques such as random sampling and manual assessment of bookkeeping rules become challenging and unreliable due to increasing data volumes and unknown fraudulent patterns. To address the sampling risk and financial audit inefficiency, we applied seven supervised ML techniques inclusive of deep learning and two unsupervised ML techniques such as isolation forest and autoencoders. We trained and evaluated our models on a real-life GL dataset and used data vectorization to resolve journal entry size variability. The evaluation results showed that the best trained supervised and unsupervised models have high potential in detecting predefined anomaly types as well as in efficiently sampling data to discern higher-risk journal entries. Based on our findings, we discussed possible practical implications of the resulting solutions in the accounting and auditing contexts.

Auditors' Incentives and Audit Quality: Non-Audit Services versus Contingent Audit Fees

I develop a model that provides new insights into the consequences of the provision of non-audit services (NAS) by audit firms to audit clients. I also investigate the joint implications of NAS and contingent audit fees (CAF) for audit quality. In the model, litigation and reputation costs do not provide sufficient incentives to auditors to exert audit effort. Investors of client firms may therefore let auditors provide NAS because of an incentive effect. Indeed, the possibility of providing NAS contingent on detecting financial misstatements increases auditors' incentives to exert audit effort. However, the provision of NAS also reduces auditor independence, which may decrease audit quality and in turn render the provision of NAS by auditors undesirable. Thus my analysis uncovers an interesting tradeoff for regulators between the positive incentive effect and the decrease in auditor independence. Removing the current restrictions on CAF may offset the ex post decrease in audit quality while preserving the ex ante incentives. My analysis also generates a number of testable empirical predictions.

Financial statement fraud in Indonesia: a longitudinal study of financial misstatement in the pre- and post-establishment of financial services authority

Purpose This study aims to investigate cases of fraudulent financial statements that have occurred in Indonesia and explore the similarities of cases that existed in the period before and after the establishment of the Financial Services Authority. Design/methodology/approach This paper provides a descriptive examination of financial misstatements issued by different regimes by listed companies of the capital market and financial institution supervisory agency and the introduction of new financial service authority; among 93 listed companies that were subject to an official investigation arising from the publication of financial misstatements, these assessments were facilitated by mean of content analysis of annual reports following the announcement of an investigation. Findings The findings indicate that each regime has a specific pattern of financial statement fraud. It is found that senior management is responsible for most fraud, and recording a fictitious sale is the most common method of falsifying financial statements. Under the new regime, the publication of cases is limited since the introduction of risk-based supervision. Financial Services Authority is likely to fine and prosecute the director of a company as a perpetrator rather than a corporation as a legal entity. Originality/value This study contributes to the literature on the incidence of financial statement fraud in public companies and provides a detailed descriptive comparison of cases scrutinized by securities exchange commission in an emerging country.

The Pricing of IPO Audit Specialization and Subsequent Issuer Underpricing

SYNOPSISWe study the costs and benefits to the issuer of engaging an initial public offering (IPO) auditor specialist. We measure IPO auditor specialization and then find that IPO specialist auditors earn significant fee premiums relative to IPO auditors without specialization and that clients with an IPO specialist auditor exhibit lower levels of underpricing relative to clients without an IPO specialist auditor. We also demonstrate that IPO specialist auditors provide higher quality audits than IPO auditors without IPO audit specialization, finding that their IPO clients have a lower likelihood of financial misstatement and have lower discretionary accruals. Collectively, our results have important implications for the auditing profession and capital markets because we demonstrate empirical evidence of the costs and benefits of engaging IPO specialist auditors.

Do companies try to conceal financial misstatements through auditor shopping?

AbstractPrior studies on auditor shopping primarily focused on the motivation to avoid unfavorable audit opinions, such as going concern and modified opinion. In this study, we show that companies that misstate their financial statements engage in auditor shopping to try to conceal the financial misstatements. In other words, their misstatements would have been discovered sooner had they made an opposite “replace or retain” auditor decision. We further show that engagement in auditor shopping results in a higher turnover of the CEO, the CFO and audit committee members but only when auditor shopping involves auditor dismissal. Thus, we document the negative consequences of engaging in auditor shopping. Finally, we show that effective monitoring curbs auditor shopping. Our findings should be of interest to regulators who continue to express concerns over this practice as well as to senior managers and audit committee members.

Analyzing earnings management preferences from business strategies

Purpose This study aims to examine the preference for earnings management (EM) strategies according to business strategies, namely, cost leadership strategies and differentiation strategies, Design/methodology/approach This study analyzed 262 samples of manufacturing and service companies listed on the Indonesia Stock Exchange for the period 2019. Logistic regression analysis is used to test the company’s EM strategy preferences based on the applied business strategy. Findings The results prove that business strategy has a significant effect on EM strategy preferences. Companies that implement a cost leadership strategy tend to use an accrual form of EM rather than a real form of EM. Conversely, companies that implement a differentiation strategy tend to use a real form of EM. Research limitations/implications Theoretically, this study confirms that contingency theory can explain EM practice preferences based on business strategy. Practically, this study helps auditors and financial statement analysts in assessing the quality of financial statements, as well as the risk of financial misstatement based on the business strategy adopted by the companies. Originality/value Based on prior literature, research studies on the analysis of EM strategy preferences based on business strategy have been limited.

Industry-Specific Knowledge Transfer in Audit Firms: Evidence from Audit Firm Mergers in China

ABSTRACT Using a difference-in-differences approach, we examine the effect of industry-specific knowledge transfer on audit performance after a merger of two Chinese audit firms with different levels of expertise in an industry. For clients in an industry audited by both merging audit firms, those audited by the audit firm less specialized in that industry belong to the treatment group, while all other clients belong to the control group. We find an economically significant improvement in audit quality (as reflected in a reduction in financial misstatements) for the treatment group relative to the control group in the same merged audit firm. We show the treatment effect is not driven by changes in auditor incentives or personnel movement and is more pronounced when we expect stronger communication between the less and more specialized auditors after the merger. We caution that our findings are specific to China and may not generalize to other countries. Data Availability: Data used in this study are available from public sources identified in the text. JEL Classifications: M42.