Intentional Misstatements Research Articles

Comment on IASB/FASB 2011 ED on Revenues from Contracts with Customers

The Committee is concerned with a number of options and exceptions introduced by the 2011 ED. These options and exceptions allow alternative accounting models. Their retention on a contract-by-contract basis may create confusion for both preparers and users of financial reporting. It may leave room for intentional misstatements and structuring opportunities to anticipate profits and delay losses. As a result, the Committee believes that the initial purpose of this project (i.e., creating a comprehensive revenue recognition model that clarifies the principles for recognizing revenue and that can be applied consistently across various transactions, companies, industries, and capital markets) is not achieved and convolution and inconsistency have been introduced. One of the reasons for preparing this standard was to establish one comprehensive standard for revenue recognition, instead of separate standards concerned with distinctive industries or sectors. However, distinct standards help preparers and users clearly understand and interpret the respective models that are applied, while the ED does not. Methods and problems that are specific to some sectors may then spread to others, involving hazardous changes in accounting practices. Our Committee has already criticized the revenue recognition project, while arguing for an alternative approach that stresses the need for prudence in revenue and income recognition. The alternative suggested above focuses on the ongoing flow of enterprise activity to determine when a good or service is being transferred to the customer, or by convention on a period-by-period basis. This aspect is clearer under the model already applied in IAS 11. Well-targeted guidance may fix the issues related to specific business models not only for construction contracts, but also sophisticated long-term agreements and continuous service provision. ED involves a number of major and critical options that are included as exceptions and entirely left to preparers’ discretion on a contract-by-contract basis. This accounting modeling by exception factually leads to a plurality of accounting methods and approaches that are neither clearly defined for preparers nor clearly presented to users. These options include: • Contracts which last less than one year or more than one year; • Variable customer consideration estimated at its expected value or its most likely payment; • Revenue allocation (step4) and recognition (step5) based on transfer of (control over) an asset that occurs “over time” or “at one point in time”; • Updating and unwinding of time value of money. The ED does not introduce a single model of revenue recognition. It fails to design an understandable and feasible approach to revenue and income recognition. It even fails in providing clearly defined alternative options. The ED may then result in confusion and generate an increased variety of under-identified practices. At the same time, it introduces high complexity for and a burden of high costs on preparers. The Committee recommends the Boards should apply the control model to ordinary sales but not to long-term contracts (construction contracts, continuous service contracts). If the Boards aim to allow several accounting models, the Committee recommends these models be distinguished under clearly defined alternatives that are to be consistently applied to large categories of contracts with customers, not idiosyncratically, on a contract-by-contract basis. These categories should be presented and disclosed separately in financial statements in a meaningful way. In conclusion, the ED, in its current form, would not represent an effective improvement over existing IAS 11 and IAS 18 which did not raise major difficulties and shortcomings in the large majority of cases. Instead of issuing a new standard, well-targeted guidance may fix the issues related to business models characterized by sophisticated long-term agreements and continuous service provision.

Executive overconfidence and the slippery slope to financial misreporting

A detailed analysis of 49 firms subject to AAERs suggests that approximately one-quarter of the misstatements meet the legal standards of intent. In the remaining three quarters, the initial misstatement reflects an optimistic bias that is not necessarily intentional. Because of the bias, however, in subsequent periods these firms are more likely to be in a position in which they are compelled to intentionally misstate earnings. Overconfident executives are more likely to exhibit an optimistic bias and thus are more likely to start down a slippery slope of growing intentional misstatements. Evidence from a high-tech sample and a larger and more general sample support the overconfidence explanation for this path to misstatements and AAERs.

The Effect of Section 404 of the Sarbanes-Oxley Act on Earnings Quality

In this article, the authors study the effect of Section 404 of the Sarbanes-Oxley Act on two primary characteristics of earnings quality, reliability and relevance in combination. Using a difference-in-differences method, they find that firms that were required to comply with Section 404 during the first 2 years of its implementation improved the reliability of their reported earnings more than control firms that were not required to comply. The results also suggest that the regulation helped to reduce intentional misstatement, which may contribute to the improvement in earnings reliability. Furthermore, the improvement in reliability did not come at the expense of the relevance of earnings. On the contrary, the authors find a significantly larger improvement in the predictive power of current earnings over future earnings and future cash flows associated with complying firms. As earnings quality improved, investor confidence appears to be restored, in that they reacted more strongly to earnings surprises of complying firms than to those of the control firms in the post-404 period. The results of this study suggest that Section 404 helped to achieve the main goal of the Act: protecting investors and restoring their confidence in the stock market by improving the accuracy and reliability of corporate disclosure.

Executive Overconfidence and the Slippery Slope to Financial Misreporting

A detailed analysis of 49 firms subject to AAERs suggests that approximately one-quarter of the misstatements meet the legal standards of intent. In the remaining three quarters, the initial misstatement reflects an optimistic bias that is not necessarily intentional. Because of the bias, however, in subsequent periods these firms are more likely to be in a position in which they are compelled to intentionally misstate earnings. Overconfident executives are more likely to exhibit an optimistic bias and thus are more likely to start down a slippery slope of growing intentional misstatements. Evidence from a high-tech sample and a larger and more general sample support the overconfidence explanation for this path to misstatements and AAERs.

Accounting Fraud Detection: Is it Possible to Quantify Undiscovered Cases?

Accounting fraud is defined as intentional misstatement of financial reports, in violation of generally accepted accounting principles, with the objective of making certain people act in detriment to their best interests. It is possible to identify the determinants of fraud using an econometric model, but the dependent variable (occurrence of fraud in a given company) is vulnerable to misclassification: Not every case of fraud will be detected, thus false negatives are possible. This paper estimates the percentage of undiscovered frauds and also estimates a probit model to detect fraud in US companies. The dependent variable was built using the instances of fraud discovered by the Securities and Exchange Commission (SEC). The model was estimated only with frauds that occurred between 1998 and 2002 (since many cases of fraud from the last years are still unknown). The independent variables were chosen using the concept of fraud triangle. The financial statement data were obtained using Compustat. The results show that the likelihood of fraud is negatively related to the current ratio, to the cash change (scaled by total assets) and to the fixed assets (also scaled by total assets). Companies that changed their auditors or receive a qualified auditing report are more susceptible to fraud. The probability that a case of fraud is not detected was estimated as 97.61%; this means just a small part of fraud cases are discovered by the SEC.

The aftermath of public attention on accounting improprieties: Effects on securities class action settlements

This research examines the effect on securities case settlements from the public focus on accounting fraud immediately following Enron and other large accounting debacles. In addition, to the extent that an ‘Enron-effect’ occurred, behavioral theory suggests that such an effect would likely dissipate over time. Therefore, I also investigate whether in very recent years an impact from the prior attention on accounting fraud diminishes with the passage of time. Results indicate that following the increased media and public attention upon accounting fraud, characteristics of securities cases that were the focus of this increased attention are associated with incrementally higher settlement amounts – specifically large cases involving financial restatements and cases involving intentional misstatements, i.e., accounting irregularities. Findings regarding whether an ‘Enron-effect’ has dissipated with the passage of time are mixed. Overall, results contrast with prior research, which did not find support for an ‘Enron-effect’ on securities case settlements, and suggest that future events that capture public attention may cause defendants in certain securities cases to pay higher amounts, not necessarily because of their own culpability.

The Importance of Distinguishing Errors from Irregularities in Restatement Research: The Case of Restatements and CEO/CFO Turnover

ABSTRACT: Research on restatements has grown significantly in recent years. Many of these studies test hypotheses about the causes and consequences of intentional managerial misreporting but rely on restatement data (such as the GAO database) that contains both irregularities (intentional misstatements) and errors (unintentional misstatements). We argue that researchers can significantly enhance the power of tests related to restatements by distinguishing between errors and irregularities, particularly in recent periods when the relative frequency of error-related restatements is increasing. Based on prior research, the reading of numerous restatement announcements, and the guidance that boards receive from lawyers, auditors, and the SEC on how to respond to suspicions of deliberate misreporting, we propose a straightforward procedure for classifying restatements as either errors or irregularities. We show that most of the restatements we classify as irregularities are followed by fraud-related class action lawsuits as compared to only one lawsuit in the group of restatements classified as errors. As further validation of our proxy, we report that the market reaction to the restatement announcement for our irregularities sample (−14 percent) is also significantly more negative than it is for our errors sample (−2 percent). Finally, we demonstrate the importance of distinguishing errors from irregularities by showing the impact it has on inferences about the relation between restatements and CEO/CFO turnover over time.

Internal control audits: Judges' perceptions of the credibility of the financial reporting process and likely auditor liability

Abstract This paper reports the results of a study in which fifty-seven sitting United States judges participated in a behavioral experiment to assess the perceived credibility of the financial reporting process and the legal risk auditors bear under conditions where they provide an internal control audit report (vs. no report) under two corporate governance environments. We find that participating judges believe internal control audits provide enhanced assurance that intentional misstatements do not exist and also serve to provide elevated protection to the public, but only under conditions of a strong corporate governance environment beyond current regulatory requirements. We also find that, after being informed of an undetected material fraud, judges who currently have high expectations of the auditing profession find auditors more liable when an internal control audit report has been issued (as compared to when no such report has been issued).

The Effect of Section 404 of the Sarbanes-Oxley Act on Financial Reporting Quality

In this paper we study the effect of Section 404 of the Sarbanes-Oxley Act on earnings quality. Using a difference-in-differences method we find that firms that were required to comply with Section 404 during the first two years of its implementation improved the quality of their financial reporting more than control firms that were not required to comply. Our testing results also provide some evidence that the reduction in intentional misstatement contributes to the improvement in financial reporting quality of complying firms. Investor confidence appears to be restored, in that they react more strongly to earnings surprises of complying firms than to those of the control firms in the post-404 period. These results are robust to various sensitivity tests. Our results suggest that Section 404 helped to achieve the main goal of the Act: protecting investors and restoring their confidence in the stock market by improving the accuracy and reliability of corporate disclosure.

Attention to Evidence of Aggressive Financial Reporting and Intentional Misstatement Judgments: Effects of Experience and Trust

This study extends prior research by examining the effects of dispositional trust, induced skepticism, and fraud-specific audit experience on attention to aggressive financial reporting practices and judgments of potential misstatement. In an experimental analysis using 125 practicing auditors, this study finds that auditors who are less trusting of others attend more to evidence of aggressive reporting than do more trusting auditors, and higher levels of induced skepticism increase attention to aggressive reporting. Further, auditors who pay more attention to evidence of aggressive reporting are more likely to believe that intentional misstatement occurred. General audit experience was not a predictor of auditors' attention to aggressive reporting or auditors' judgments about intentional misstatements. Auditors with more fraud-specific experience, however, were more likely than auditors with less fraud-specific experience to believe that intentional misstatement had occurred when evidence of aggressive reporting exists.

The Effect of SOX Internal Control Deficiencies and Their Remediation on Accrual Quality

This paper investigates the effect of internal control deficiencies and their remediation on accrual quality. We first document that firms reporting internal control deficiencies have lower quality accruals as measured by accrual noise and absolute abnormal accruals relative to firms not reporting internal control problems. Second, we find that firms that report internal control deficiencies have significantly larger positive and larger negative abnormal accruals relative to control firms. This finding suggests internal control weaknesses are more likely to lead to unintentional errors that add noise to accruals than intentional misstatements that bias earnings upward. Third, we document that firms whose auditors confirm remediation of previously reported internal control deficiencies exhibit an increase in accrual quality relative to firms that do not remediate their control problems. Finally, we find firms that receive different internal control audit opinions in successive years exhibit changes in accrual quality consistent with changes in internal control quality. Collectively, our cross-sectional and inter-temporal change tests provide strong evidence that the quality of internal control affects the quality of accruals.

The Effect of SOX Internal Control Deficiencies and Their Remediation on Accrual Quality

This paper investigates the effect of internal control deficiencies and their remediation on accrual quality. We first document that firms reporting internal control deficiencies have lower quality accruals as measured by accrual noise and absolute abnormal accruals relative to firms not reporting internal control problems. Second, we find that firms that report internal control deficiencies have significantly larger positive and larger negative abnormal accruals relative to control firms. This finding suggests internal control weaknesses are more likely to lead to unintentional errors that add noise to accruals than intentional misstatements that bias earnings upward. Third, we document that firms whose auditors confirm remediation of previously reported internal control deficiencies exhibit an increase in accrual quality relative to firms that do not remediate their control problems. Finally, we find firms that receive different internal control audit opinions in successive years exhibit changes in accrual quality consistent with changes in internal control quality. Collectively, our cross-sectional and intertemporal change tests provide strong evidence that the quality of internal control affects the quality of accruals.

A Risk Perspective on Fraudulent Financial Reporting

This paper analyzes the relationship of fraud risk assessments to other risk assessments by auditors. The PCAOB (2005, 17) notes this is a problem area of current practice. The major findings are as follows. First, the study identifies the crucial role of benchmarks in forensic accounting to help differentiate between intentional and unintentional misstatements. Second, the paper shows the importance of not allowing the major categories of risks identified here from getting too high. This explains the need to set acceptable levels of these risks either by standard setters as a matter of broad policy, or by individual practitioners as part of the terms of specific engagements. Third, this paper clarifies how the fraud risk of SAS No. 99 relates to the traditional audit risk model framework.

The Enron debacle: more than a perfect storm

Despite the claims from several accounting authorities, the Enron matter was much more than a “perfect storm,” i.e., a concurrence of unpredictable, rare and unusual conditions that combined to create a unique, devastating event. While the effects of Enron seriously and adversely affected the accounting profession, a critical analysis of Enron’s financial statements shows that a corporate collapse was inevitable. The collapse arose in part from accountants moving away from competently auditing financial statements that would have provided real assurance to their readers. The purpose of this paper is to show that if accountants had ethically applied the lessons of the financial reporting literature on fraud to produce effective and informative audits the Enron debacle would likely never have happened. In fact, what some deemed accounting errors were most likely intentional misstatements. The Enron debacle suggests that the profession should adopt more of a “back to basics” approach to auditing.

The Circumstances and Legal Consequences of Non‐GAAP Reporting: Evidence from Restatements*

AbstractOur study examines the circumstances of non‐GAAP financial reporting by 492 U.S. companies that announced restatements from 1995 to 1999. We focus on income statements to analyze the occurrence and resolution of litigation over restatements and explore the role of accounting items in bringing and resolving this litigation. We provide evidence on the pervasiveness of accounting misstatements, describe their nature, and show how, if at all, they affect litigation. We assess the nature of restatements by determining whether regular, recurring earnings from primary operations (core) or other components of earnings (noncore) are misstated, and we assess their pervasiveness by estimating the number of primary accounts misstated. In our sample, companies with core restatements have higher frequencies of intentional misstatements (fraud) and subsequent bankruptcy or delisting. Likewise, these companies have, on average, more material misstatements, more negative security price reactions to restatement announcements, and more negative security price changes over the six months preceding and following restatement announcements. However, controlling for these and other factors, we find a significant association between accounting items and litigation, whether occurrences or resolutions. Specifically, core restatements — driven primarily by misstatements of revenue, a component of core earnings — and more pervasive restatements each play a role, while misstatements of noncore earnings alone do not.

An Experimental Investigation of Auditor-Auditee Interaction Under Ambiguity

This study experimentally investigates the interaction between the auditor and auditee in a strategic setting where intentional misstatements may arise. Our approach draws from analytical studies that employ game theory to examine management fraud (e.g., Newman and Noel [1989] and Shibano [1990]), descriptive studies of auditor judgment and decision making (e.g., Loebbecke, Eining, and Willingham [1989] and Zimbelman [1997]), and psychological studies on ambiguity aversion, i.e., a preference for options with known versus unknown probabilities (Camerer and Weber [1992]). Like the analytical studies, our experiment represents a strategic setting defined in terms of the players' information, decisions, and joint payoffs. Like the descriptive studies, our hypotheses assume that auditors and auditees cannot necessarily anticipate each other's best response strategy at equilibrium (Camerer [1990; 1997]); that

Wisconsin's Acid Rain Battle: Science, Communication, and Public Policy, 1979–1989

Whenever science is drawn into the public eye as a component of some controversial issue, it is likely to be distorted during the process of generalization and simplification. Sometimes the media tend to sensationalize emerging scientific controversies, which often alienates scientists and further impedes the flow of information. Couple this tendency with intentional misstatements by special interest groups, and considerable public confusion can result. An example of this occurred in the DDT controversy of the 1960s, when chemical companies deliberately withheld evidence of the risk of DDT, issued false statements, and engaged in a campaign to discredit citizens and scientists who challenged the use of the insecticide.' Yet, although some misunderstanding of science may arise as a by-product of public participation in complex technical