Financial Reporting Risk Research Articles

The Influence of Turnover among Other Top Executives on Financial Reporting Risk

SUMMARY We explore the impact of turnover within top executive teams, with particular emphasis on executives other than the CEO and chief financial officer (CFO), on auditors’ perceptions of financial reporting risk. Consistent with upper echelon theory, we find that non-CEO/non-CFO executive team turnover increases perceptions of financial reporting risk even with continuity of the CEO and CFO. Additionally, we find that the effect of CEO and CFO turnover on perceptions of risk is primarily driven by concurrent turnover with other top executive team members. Further, the effect of other top executive turnover is more pronounced among firms that had higher-ability managers and that face greater constraints in replacing top talent. This effect is partially mitigated when the firm has an effective financial reporting environment and when the CEO who remains in place has greater operational involvement. These findings highlight the importance of other top executive turnover in risk assessments. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G30; M12; M41; M42.

Does Discussing Audit Procedures in Critical Audit Matter Disclosures Calibrate Financial Reporting Risk Assessments?

Does Discussing Audit Procedures in Critical Audit Matter Disclosures Calibrate Financial Reporting Risk Assessments?

Tempering Financial Reporting Risk through Board Risk Management

Recent corporate governance failures have heightened stakeholder expectations that the board of directors engage in robust oversight of the firm’s risk management processes. This expectation is in line with widely embraced enterprise risk management frameworks, which assert that strong board risk management is a key component of an entity’s risk management process. We use a hand-coded measure of board engagement in risk management from the recent literature to measure the robustness of that oversight for a sample of large, publicly traded U.S. firms and examine the relationship between robust board risk management (board risk management) and firm-wide strategies for mitigating financial reporting risk. While controlling for board composition-related characteristics, we found a positive association between robust board risk management processes and two avenues for mitigating financial reporting risk (i.e., more effective internal control over financial reporting and the selection of industry specialist auditors). Our results indicate that firms with more robust board risk management are associated with fewer actual instances of materially misstated financial statements and less earnings management.

MD&A Disclosure of Critical Accounting Policies and Financial Reporting Risk: Evidence From Restatements

In this study, I examine whether management discloses areas with higher financial reporting risk as critical accounting policies (CAPs) and how investors react to restatements of areas previously disclosed as CAPs. Through CAPs, management annually discloses the accounting policies that it views as most crucial to the portrayal of the firm’s financial condition and results and require its most difficult, subjective, and/or complex judgments. I find that CAPs covering four areas are predictive of subsequent restatements: revenue, derivatives, accruals and short-term liabilities, and capitalization of expenditures. In tests of investor reactions to restatements, I find that cumulative abnormal returns to restatements are more severe (negative) when the areas restated were previously disclosed as CAPs. Collectively, these findings support that management discloses area-specific financial reporting risk through CAPs in some, but not all, areas and that investors view restatements of CAP areas as more egregious than restatements of non-CAP areas.

The Effect of Top Management Team Turnover and Local Market Characteristics on Financial Reporting Risk

Upper echelon theory posits that defining, executing, and overseeing an organization’s strategy is a shared activity among top executive teams. Prior research has applied this theory to improve our understanding of firm performance and strategy. In this study, we explore the boundaries of upper echelon theory by examining its application to managements’ financial reporting oversight function. Specifically, we examine whether greater turnover among the members of a firms’ top executive group other than those with direct financial reporting oversight responsibilities (i.e., the CEO and CFO) influences key stakeholders’ concerns about financial reporting risk or whether consistency in the CEO and CFO positions is sufficient to alleviate any such concerns. Consistent with upper echelon theory, we find that turnover among top executives other than the CEO and CFO is positively associated with increased perceptions of financial reporting risk among auditors and audit committees. Building upon labor economics literature, we then explore whether local market characteristics that should affect firms’ ability to replace top executive talent moderates this effect. We find that the positive association between executive team turnover and perceptions of financial reporting risk is greater for companies headquartered in areas with more limited local labor pools and companies that are market leaders in their local areas or industries. Further analyses suggest that the perceptions of financial reporting risk in response to executive team turnover offsets deterioration in financial reporting quality.

MD&A Disclosure of Critical Accounting Policies and Financial Reporting Risk: Evidence from Restatements

In this study, I examine whether management discloses areas with higher financial reporting risk as critical accounting policies (CAPs) and how investors react to restatements of areas previously disclosed as CAPs. Through CAPs, management annually discloses the accounting policies that it views as most crucial to the portrayal of the firm's financial condition and results and require its most difficult, subjective, and/or complex judgments. I find that CAPs covering four areas are predictive of subsequent restatements: revenue, derivatives, accruals and short-term liabilities, and capitalization of expenditures. In tests of investor reactions to restatements, I find that cumulative abnormal returns to restatements are more severe (negative) when the areas restated were previously disclosed as CAPs. Collectively, these findings support that management discloses area-specific financial reporting risk through CAPs in some, but not all, areas and that investors view restatements of CAP areas as more egregious than restatements of non-CAP areas.

The Influence of Management Bonding on Firms’ Financial Reporting Risk

I investigate how top management cohesiveness/bonding affects firms’ financial reporting risk. I operationalize team cohesiveness/bonding by measuring the social connections among the top executives of firms through four types of social networks: educational background, employment history, off-the-job organization activities, and board positions. Using a sample of firms identified in the Accounting and Auditing Enforcement Releases (AAERs), I find that top management who are more cohesive and bonded through social connections are more likely to commit accounting misconduct. The cohesiveness/bonding among top management teams is associated with more years of financial misstatements and lower probability of misstatement detection. These results are consistent with a well-documented “groupthink” phenomenon in social psychology that is associated with dysfunctional decision-making processes. The results highlight the importance of considering social bonding status as a risk factor in investigating and detecting financial fraud.

Does Controlling Shareholders’ Financial Risk Affect Auditors’ Perceptions of Firms’ Financial Reporting Risk? Evidence from Share Pledging

We examine whether controlling shareholders’ financial arrangements and financial risk affect auditors’ assessments and perceptions of firms’ financial reporting risk. Adopting a sample of Chinese firms covering the years 2003 to 2016, we find that audit fees are higher for firms where controlling shareholders have shares pledged as collateral to secure their private debt. This effect is more pronounced with Big Four auditors, newly assigned auditors, and firms with opaque information environment. We also find that firms with share pledges have more: earnings management, related-party guarantees and transactions, and a higher likelihood of irregularity. In addition, we do not find evidence that share pledging impairs auditor independence as proxied by the propensity to render modified audit opinions, which suggests that our results are inconsistent with the collusion hypothesis that auditors charge higher fees to tolerate firms’ aggressive behaviors. Our results are robust to endogenousity and measurement error concerns. Collectively, our results suggest that the uncertainty introduced by controlling shareholders’ pledging increases auditors’ assessments and their perceptions of firms’ financial reporting risk.

Are Internal Audits Associated with Reductions in Operating, Financial Reporting, and Compliance Risk?

We examine whether internal auditing provides value to organizations by reducing risk. We compare the changes in risks between audited business units and matched non-audited units within the same company. This design allows us to isolate the importance of an internal audit while holding constant changes in risk due to the organization and time period. Based on ratings from the heads of audited and non-audited units, we find that managers of audited units perceive a greater decline in risk as well as a greater increase in performance compared to managers of non-audited units. We also find that companies that have had a quality assurance review and are used as a management training ground are associated with greater reductions in risk and improved overall performance. Our study contributes to the academic literature by documenting a new facet of internal audit benefits—risk reduction—and internal audit characteristics that increase risk reduction.

Corporate Culture and Financial Reporting Risk: Looking Through the Glassdoor

We study whether financial reporting risk is associated with job satisfaction, company culture, and opinions of senior leadership. We use novel data on employees’ perspectives obtained from the website Glassdoor, covering 14,282 firm-years in the period 2008-2015. We argue that poorly implemented performance objectives leads to pressure and creates a boiler room effect, negatively impacting the corporate climate of the firm and increasing the propensity to manipulate performance metrics. We find that firms with lower levels of job satisfaction (as measured by employees) and lower levels of “culture and values” are more likely to be subjected to SEC fraud enforcement actions and securities class action lawsuits. Consistent with the boiler room effect, we find that a negative corporate climate is also associated with an increased likelihood of narrowly meeting or beating market earnings expectations. Conversely, we find job satisfaction and positive employee opinions of senior leadership to be associated with lower abnormal accruals. We also find that the association between firms’ culture and financial reporting risk is stronger for firms with weaker board independence. Thus, the work environment, as perceived by employees, appears to play a critical role in financial reporting risk.

Do CEO Succession and Succession Planning Affect Stakeholders' Perceptions of Financial Reporting Risk? Evidence from Audit Fees

ABSTRACT In this paper, we examine how CEO succession and succession planning affect perceptions of financial reporting risk among stakeholders who are responsible for and oversee firms' financial reporting (e.g., auditors, management, and audit committees). Management succession introduces uncertainty about firms' future operations, financial policies, and potential motivation for earnings management, which we predict elevates the perceived risk of financial reporting improprieties. Consistent with this prediction, we find that audit fees are higher for firms with new CEOs. Importantly, however, we note that careful CEO succession planning (i.e., promoting an “heir apparent”) attenuates perceptions of higher risk, as evidenced by a lack of an audit pricing adjustment. These results are robust to several alternative specifications and analyses designed to mitigate the concern that the association between audit fees and CEO succession and succession planning is driven by factors leading to the CEO change. We also show that audit fee increases dissipate over time as the new, non-heir CEO stays longer at the firm, reinforcing the inference that audit fees increase in response to the uncertainty surrounding a new CEO. Additionally, we do not find evidence of a deterioration in audit quality with new CEOs, independent of the succession plan. JEL Classifications: G30; M12; M41; M42.

Executives’ “Off-the-Job” Behavior, Corporate Culture, and Financial Reporting Risk

Executives’ “Off-the-Job” Behavior, Corporate Culture, and Financial Reporting Risk

Is Operational Control Risk Informative of Financial Reporting Risk?

This study provides evidence concerning the significance of assessing operational control risks as part of an integrative evaluation of internal controls. We examine whether operational control weaknesses can be used as cues to potential unreported financial reporting control weaknesses, and in turn, relate to subsequent financial reporting deficiencies. We find positive relations between operational control weaknesses and future financial reporting control weaknesses, restatements, SEC comment letters, and audit fees, even after controlling for contemporaneous financial reporting control weaknesses. These findings question the completeness and accuracy of regulated assessments of financial reporting control weaknesses, and suggest that operational control risk is informative of potential financial reporting deficiencies.

Executives’ 'Off-the-Job' Behavior, Corporate Culture, and Financial Reporting Risk

We examine how executives’ behavior outside the workplace, as measured by their ownership of luxury goods (low “frugality”) and prior legal infractions, is related to financial reporting risk. We predict and find that CEOs and CFOs with a legal record are more likely to perpetrate fraud. In contrast, we do not find a relation between executives’ frugality and the propensity to perpetrate fraud. However, as predicted, we find that unfrugal CEOs oversee a relatively loose control environment characterized by relatively high and increasing probabilities of other insiders perpetrating fraud and unintentional material reporting errors during their tenure. Further, cultural changes associated with an increase in fraud risk are more likely during unfrugal (vs. frugal) CEOs’ reign, including the appointment of an unfrugal CFO, an increase in executives’ equity-based incentives to misreport, and a decline in measures of board monitoring intensity.

The Association between Financial Reporting Risk and Audit Fees before and after the Historic Events Surrounding SOX

SUMMARY: This study investigates whether the association between financial reporting risk and audit fees changed during 2000–2003: a time period marked by momentous and historic events for auditors. We find a positive statistically and economically significant relationship between financial reporting risk and audit fees paid to Big 4 auditors. More importantly, we predict and find that the relation between financial reporting risk and audit fees strengthened significantly in 2002 and 2003, consistent with a shift in the way auditors priced risk, likely in response to the events surrounding the Sarbanes-Oxley Act of 2002. Finally, we provide evidence that a commercially developed, comprehensive risk measure effectively proxies for an element of risk beyond what has traditionally been captured by various risk measures in audit fee models: namely, the risk that financial statements have been intentionally misstated. We believe this risk measure will be of interest to future researchers.