Non-fraud Firms Research Articles

Has the COVID-19 Pandemic Changed Firms’ Management Discussion and Analysis Disclosure Approach? Evidence from Japan

ABSTRACT This study examines whether the COVID-19 pandemic changes Japanese firms’ approach to management discussion and analysis (MD&A) disclosure. Based on readability (text genericity) and tone, I investigate whether management obfuscate text during the pandemic or attempt to provide information. Additionally, I examine whether bad news is inherently difficult to read based on the difficulty of the text. During the pandemic, the tone value of MD&A disclosure is negative in fraudulent firms and more negative in nonfraudulent firms. Both types of firms attempt to communicate their company’s situation with honesty, thus satisfying the legitimacy criterion of communicative action theory. This result is not consistent with the results for Europe and the United States, where readability is lower. As a disaster-prone country, Japanese managers may find it easier to share deteriorating firm performance with investors. Nonfraudulent firms also increase textual difficulty during the pandemic, which supports ontology theory. Data Availability: Data are available from sources identified in the paper. JEL Classifications: M41; M42.

Detecting Financial Statement Fraud through Multidimensional Analysis of Text Readability

ABSTRACT This study uses Coh-Metrix to analyze multiple dimensions of readability of the MD&A section of the SEC Form 10-K. We incorporate the five main Coh-Metrix components of text easability (word concreteness, syntactic simplicity, referential cohesion, deep cohesion, and narrativity) into a logistic model to test their predictive power for financial misreporting. We find that compared to the MD&As of nonfraud firms, the MD&As of fraud firms connect clauses and sentences less coherently, use more story-like language, and show a higher number of vague and abstract words. Thus, referential cohesion, narrativity, and word concreteness significantly enhance predictive ability in fraud detection. The Coh-Metrix readability measures enhance the linguistic complexity assessment beyond traditional readability measures, such as the Fog Index and the Flesch Indexes. Financial analysts and investors can utilize the Coh-Metrix readability measures to supplement traditional readability measures and common financial statement variables in predicting financial misreporting. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G32; K42; M41; M48.

State of the art in financial statement fraud detection: A systematic review

Over the past few decades, fraud has been increasingly prevalent, with large businesses like Satyam, Enron, and WorldCom making headlines for their deceptive financial reporting practices. In this research, we conducted a systematic review and bibliometric analysis of the literature concerning fraud detection in financial statements. Following a bibliometric analysis, we identified the leading researchers, publications, sources, countries, and collaboration patterns in financial statement fraud detection. Our systematic review covered the following topics: the data analytics tools used, databases used to identify fraudulent firms, the design of control group samples (non-fraudulent firms), the critical dimension reduction tools used, techniques adopted to address data rarity (imbalanced data), explanatory variables used in the model, theoretical framework supporting the fraud indicators, optimization techniques used, the use of evaluation metrics, and significant findings. The systematic review followed the approach provided by Tranfield et al. (2003), and the bibliometric analysis was conducted using the VOSviewer. Preferred Reporting Items for Systematic Reviews and Meta-Analysis (PRISMA), 2020 reporting criteria were followed for reporting the systematic review's findings. We provide a brief overview of the existing literature, drawing both conclusions and recommendations for directions in which additional study is warranted. Our results provide valuable information that can be used by future academics, auditors, enforcement agencies, and regulators as they work to create the most effective fraud detection algorithms possible.

The Cost of Fraud Prediction Errors

ABSTRACT We compare seven fraud prediction models with a cost-based measure that nets the benefits of correctly anticipating instances of fraud against the costs borne by incorrectly flagging non-fraud firms. We find that even the best models trade off false to true positives at rates exceeding 100:1. Indeed, the high number of false positives makes all seven models considered too costly for auditors to implement, even in subsamples where misreporting is more likely. For investors, M-Score and, at higher cut-offs, the F-Score, are the only models providing a net benefit. For regulators, several models are economically viable as false positive costs are limited by the number of investigations regulators can initiate, and by the relatively low market value loss a “falsely accused” firm would bear in denials of requests under the Freedom of Information Act (FOIA). Our results are similar whether we consider fraud or two alternative restatement samples. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G31; G32; G34; M40.

Who did it matters: Executive equity compensation and financial reporting fraud

In within-firm analysis of 1,805 executives, executives implicated in financial reporting fraud cases have significantly stronger equity incentives than their within-firm peers who are not implicated in the fraud. Executives implicated in fraud cases also have significantly stronger equity incentives than executives at non-fraud firms in similar roles. However, the equity incentives of non-implicated executives at fraud firms are no different than those for executives at non-fraud firms. The results are significant across executive roles and for equity incentives measured as wealth sensitivity to changes in stock price or stock price volatility. Executive-level analysis that considers which executives are implicated in the fraud may provide more precise measurement of the association and statistical significance of the relationship between equity incentives and fraud. Finally, firm-level measures that consider the equity incentives of all members of the top management team may better identify fraud firms than do measures focusing on one executive.

PE‐EDD: An efficient peer‐effect‐based financial fraud detection approach in publicly traded China firms

Financial fraud arises from the exaggeration of business interests, and an accurate detection or prediction is a useful tool for both corporate management and capital market systems. A collection of computer technologies has been made on this problem so far, and one of the most important solutions is unsupervised learning algorithms. Among them, most approaches work by analysing the internal relations in financial data and finding a new description of non-fraud firms. However, current studies focus a lot on the geometry attribute of financial data, while overlooking the obvious behaviour patterns and peer effects among firms. This has limited the accuracy of representation and furthermore the detection performance. In this work, a very general class of functions is allowed to represent firms, constraining them by peer effects between firms and presenting an error-distribution-based financial fraud firm detection approach. Experimental results have shown great performance of the proposed approach.

Does Fraud Experience Make Directors Better Monitors? The Effect of Fraud Experience on Firm Fraud

While past theory and research has highlighted the damaging effect that being involved in a fraudulent event can have on a director’s reputation and future board prospects, in the current study we examine whether serving on a board through a fraud event provides directors with experience that proves to be highly beneficial for the subsequent boards on which they serve. That is, we propose that fraud experience equips directors with requisite expertise to be an effective monitor with respect to preventing fraud at the firms at which they serve in the future. As such, we predict that the presence of fraud-experienced directors on firms’ boards is related to a lower likelihood of fraud occurring at such firms as compared to firms without such directors on their boards. We tested our hypothesis on a sample of firms who had committed fraud (‘fraud firms’) matched with similar peers who had not committed fraud (non-fraud firms) during the study period of 2010-2019.

Stock price contagion effects through investment banks

ABSTRACT This paper investigates how stock market investors react to non-fraudulent firms that share the same investment bank with fraudulent companies. Using a Chinese sample from the period of 2003 to 2018, we find that firms penalized for IPO or M&A fraud induce stock price declines among non-fraudulent firms which share the same investment banks (non-fraudulent contagion firms). The results also show that stock price declines are more pronounced for low-quality investment banks, and investors impose larger penalties on stock prices when non-fraudulent client firms are of lower earnings quality, weaker corporate governance, and higher information asymmetry. Furthermore, we demonstrate that the non-fraudulent contagion firms are more likely to commit accounting fraud and exhibit inferior long-term post-IPO/post-M&A performance. Overall, the findings indicate an important stock price contagion effect occurring at the investment bank level.

Comparative analysis of the relationship between internal control weakness and different types of auditor opinions in fraudulent and non-fraudulent firms

PurposeThis study aims to assess the relationship between internal control weakness and different types of auditor opinions in fraudulent and non-fraudulent firms. The study's main objective is to investigate fraud in business firms and analyze internal controls and types of proposed opinions by the auditor about his desired firm. The outbreak of fraud in firms is of utmost importance to a broad spectrum of society. Internal controls and the auditor's role in preventing and detecting frauds should not be taken for granted.Design/methodology/approachThe present study's statistical population includes 179 listed firms on the Stock Exchange selected as the study sample using the systematic elimination method during 2012–2019. As the study's dependent variable (the type of auditor’s opinion), research hypotheses were analyzed using the Logit regression model.FindingsThe results show that the relationship between internal control weakness and opinion type is significantly different in fraudulent and non-fraudulent firms. Moreover, the relationship between internal control weakness and type of auditor opinion in fraudulent firms and the relationship between internal control weakness and type of auditor opinion in non-fraudulent firms are significant.Originality/valueBy assessing the related literature, the authors have found no study to directly assess the comparative relationship between internal control weakness and the type of auditor opinion, which can be named as the main objective of the study.

Does IRS Monitoring Deter Managers From Committing Accounting Fraud?

We examine whether monitoring by the Internal Revenue Service (IRS) affects managers’ decisions to engage in fraudulent financial reporting. We argue that IRS monitoring provides a disciplining effect reducing managements’ incentives to engage in rent diversion activities such as costly financial statement misreporting. Using information on IRS audit rates and instances of fraud disclosed in Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement Releases (AAERs), we find evidence consistent with IRS monitoring providing positive spillover effects in reducing the likelihood of accounting fraud. Our results are robust to using a matched sample of fraud and nonfraud firms. Altogether, we find evidence that tax authorities provide positive externalities in reducing agency costs through monitoring and enforcement.

Signaling via Earnings Downgrades: How Reputational Concerns Shape Analyst Responses to Corporate Fraud?

This study examines reactions of financial analysts to the disclosure of corporate fraud. We posit that analysts downgrade earnings forecasts of fraud firms after fraud disclosure to signal their quality and integrity. We explore how internal and external contingencies shape analysts’ reputational concerns, influence their motivation to signal via earnings downgrades, and consequently affect their responses to corporate fraud. Using longitudinal data on Chinese publicly traded firms between 2002 and 2013 and employing a difference-in-differences design, this study documents that financial analysts significantly lower their earnings estimates of fraudulent firms after fraud disclosure compared to the control group of non-fraud firms. In addition, post-disclosure earnings downgrades are larger for more experienced analysts, for analysts following firms with stronger analyst coverage, and after the revision of the professional ethics code for analysts. This study provides empirical support to signaling theory. We show that earnings downgrades of fraudulent firms may serve as a signal for financial analysts to indicate their quality and integrity. We document that analysts’ motivation to signal via earnings downgrades is influenced by their reputational concerns, which are moderated by their career experience, peer pressure, professional norm and social expectations.

The Cost of Fraud Prediction Errors

We compare seven fraud prediction models with a cost-based measure that nets the benefits of correctly anticipating instances of fraud (true positives), against the costs borne by incorrectly flagging non-fraud firms (false positives). Our cost-based measure supplements traditional comparison metrics and is estimated separately for auditors, investors, and regulators. We find that the higher true positive rates in recent models come at the cost of higher false positive rates, and that even the best models trade off false to true positives at rates exceeding 100:1. Indeed, the high number of false positives makes all seven models considered too costly for auditors to implement, even when we consider extreme subsamples in which a priori the likelihood of misreporting is greater. For investors, M-Score and, when used at higher cut-offs the F-Score, are the only models providing a net benefit; the other models are only economically viable when applied to extreme subsamples of misreporting risk. For regulators, several models are economically viable as false positive costs are limited by the number of investigations they can initiate, and by the relatively low market value loss a ‘falsely accused’ firm would bear in denials of requests under the Freedom of information Act (FOIA). Our results are similar irrespective of whether we consider fraud or two alternative restatement samples.

Does Ethical Behavior of Management Influence Financial Reporting Quality?

This paper aims to examine the relationship between managerial ethics level and financial reporting quality mainly focusing on accounting conservatism. Recently, there has been evidence to support the argument that managerial ethics level can affect reporting quality in the business world. Hence, this paper seeks to compare both fraud and non-fraud firms in terms of their ethical practice in the business. Furthermore, this study provides a more realistic perspective by making a comparison with previous studies. To test the hypotheses, we chose 243 fraud firms and compared them with the same number of non-fraud firms listed in the KOSPI and KOSDAQ from 2005 to 2012. The analysis using two groups across the time horizon reveals that the measured values of accounting conservatism do not show any meaningful difference between fraud and non-fraud firms. Additionally, fraud firms have greater absolute discretionary accruals than their counterparts. This result suggests that fraud firms are more likely to manipulate their earnings than the non-fraud firms. Also, accruals quality of fraud firms is lower than that of non-fraud firms. The significance of the paper lies in the fact that we used different criteria to judge a company’s comparative ethics level.

Corporate governance, board ethnicity and financial statement fraud: evidence from Malaysia

PurposeThis study aims to examine the relationship between the presence of a Malay director on the board and financial statement fraud in Malaysia. Further, the authors investigate whether financial statement fraud firms improve their governance mechanisms compared to non-fraud firms subsequent to the fraud year.Design/methodology/approachThe authors use hand-collected data comprising 76 financial statement fraud and 76 non-fraud firms over a period of eight years from 2001 to 2008.FindingsUsing a univariate and logistic regression model, the results demonstrate a significant positive relationship between the proportion of Malay directors on the board and the financial statement fraud. The authors also find that fraud firms significantly increase the proportion of independent directors on their boards, increase the frequency of board and audit committee meetings and reduce duality subsequent to the detection of financial statement fraud compared to the non-fraud firms.Originality/valueThe findings of the study are useful to policy-makers, regulators, firms and investors.

Corporate fraud and information asymmetry in emerging markets

PurposeThe purpose of this study is to examine changes in firms’ level of information asymmetry in emerging market of Malaysia for the period of 2000-2016. Specifically, the study focuses on changes in the quoted spread and quoted depth following the fraud announcement.Design/methodology/approachThe study uses a unique set of fraud sample using enforcement action releases (EARs) identified from the Security Commission of Malaysia and Bursa Malaysia. To estimate the result, the authors use event study methodology, OLS regression and simultaneous model on a set of 67 fraudulent firms.FindingsThe results of event study, OLS regression and simultaneous equation models suggest that information asymmetry increases on fraud discovery. The authors also use the analysis on subsamples classified by the type of regulator (who issued the enforcement release) and type of fraud committed. However, the authors find no evidence of a difference in information asymmetry across these groups. Overall, the results support the reputational view of fraud that it damages the firms’ reputation and increases uncertainty in the capital market.Research limitations/implicationsThese findings provide valuable insights into understanding the information asymmetry around fraud announcements, especially for Malaysia, where the majority of the public-listed companies are family-controlled and under significant state control. The results of this study call for the active role that regulators can play to achieve a transparent and liquid capital market.Practical implicationsThe research has practical implications. Specifically, for Malaysia, fraud is the primary area for National Results Areas (NKRA) in the Government Transformation Program (GTP). Therefore, for regulators and policymakers to ensure a liquid and transparent capital market, identifying the factors that elicit the fraudulent behavior and improving the related governance mechanism are necessary steps to prevent the fraudulent practices.Social implicationsDue to increased information asymmetry on fraud announcements, the demand for equity decreases that may affect not only the fraudulent firms but also results in negative externality for non-fraudulent firms, thus impairing their ability to fund equity.Originality/valueA significant majority of studies have focused on corporate frauds in developed countries such as the USA that is characterized by dispersed ownership system and a strong capital market. One of the vocal critics of the agency theory is that it neglects the social and institutional framework within which companies operate. In emerging markets, such as Malaysia, the published academic papers on fraud and information asymmetry are very limited. As emerging markets practice different cultures, corporate governance mechanisms and market regulations, the study is significant to investigate the behavior of investors in such markets.

Real earnings management and financial statement fraud: evidence from Malaysia

PurposeWe examine whether the fraud firms are engaged in real earnings management and accrual earnings management prior to the fraud year in the Malaysian context.Design/methodology/approachOur sample comprises of 65 financial statement fraud and 65 non-fraud firms over a period of eight years from 2001 to 2008.FindingsUsing the abnormal cash flow from operations (CFO) and abnormal production costs as the proxies for real earnings management, we find that financial statement fraud firms engage in manipulating production costs during preceding two years of the fraud event. However, our results show that financial fraud firms engage in manipulating CFO prior to the fraud event. Additionally, we find that financial statement fraud firms prefer to manipulate earnings using accruals relative to real earnings prior to the fraud year.Originality/valueOur results demonstrate that real earnings management is more aggressive in financial statement fraud firms compared to the non-fraud firms in the four years prior to fraud.

Stock Price Contagion Effects of Low-Quality Audits at the Individual Audit Partner Level

SUMMARYWe use Chinese audit partner data to show that partners associated with financial reporting fraud induce share price declines among non-fraudulent firms audited by the same audit partners. In cross-sectional analyses, we find that share price declines are more pronounced when low-quality partners (LQPs) failed to issue modified audit opinions during the period in question and when the LQPs were from one of the Top 10 audit firms. Additional analyses show that investors impose larger penalties on contagion firms when fraudulent firms are larger and the time lapse between sanction and fraud commitment is shorter. The personal characteristics of LQPs (except gender) do not cause a difference in market reaction to contagion firms. Overall, our results speak to the importance of audit partner identity to stock market valuation.JEL Classifications: M41; M42; M48.

Labor Market Consequences for Non-Implicated CFOs in Fraud Firms: Investigating Relative Blame and Nuanced Contagion Effects

We explore labor market consequences for CFOs employed by fraud firms, focusing on contagion effects of blame for CFOs who are not implicated, i.e., not publicly blamed by the SEC for committing the fraud. Studying these individuals is important because they are associated with the fraud, so it is legitimate to question the quality of their governance oversight, and there may exist a lingering suspicion of potential involvement. Further, the labor market serves as a complementary oversight mechanism to ensure the integrity of the capital markets, so understanding how that market operates is important. We compare these non-implicated CFOs to two control samples: CFOs who are implicated and CFOs at non-fraud firms. Using hand-collected social media data, we track consequences for these groups from the fraud event through 2015. We find evidence consistent with the organizational disequilibrium hypothesis, whereby the vast majority of implicated CFOs exit their respective firms following the fraud, but about two-thirds of non-implicated CFOs still experience turnover. Only half of the non-implicated CFOs obtain employment in positions of comparable status in their subsequent three roles. To investigate the nuances of this contagion, we compare the employment status of non-implicated CFOs to that of non-fraud firm CFOs. We find that only about half of the CFOs from both groups achieve comparable employment status in the long run. Taken together, our results reveal close scrutiny of all CFOs who display labor market movements across firms regardless of the underlying reason for their turnover.

Leveraging Financial Social Media Data for Corporate Fraud Detection

Corporate fraud can lead to significant financial losses and cause immeasurable damage to investor confidence and the overall economy. Detection of such frauds is a time-consuming and challenging task. Traditionally, researchers have been relying on financial data and/or textual content from financial statements to detect corporate fraud. Guided by systemic functional linguistics (SFL) theory, we propose an analytic framework that taps into unstructured data from financial social media platforms to assess the risk of corporate fraud. We assemble a unique data set including 64 fraudulent firms and a matched sample of 64 nonfraudulent firms, as well as the social media data prior to the firm’s alleged fraud violation in Accounting and Auditing Enforcement Releases (AAERs). Our framework automatically extracts signals such as sentiment features, emotion features, topic features, lexical features, and social network features, which are then fed into machine learning classifiers for fraud detection. We evaluate and compare the performance of our algorithm against baseline approaches using only financial ratios and language-based features respectively. We further validate the robustness of our algorithm by detecting leaked information and rumors, testing the algorithm on a new data set, and conducting an applicability check. Our results demonstrate the value of financial social media data and serve as a proof of concept of using such data to complement traditional fraud detection methods.

Fraudulent Financial Reporting and Technological Capability in the Information Technology Sector: A Resource-Based Perspective

Motivated by the disproportionately high incidence of fraudulent financial reporting in the IT sector where technological capability is a major source of competitive advantage, this study investigates the possible relationship between technological capability and fraud probability in the IT sector. Technological capability is measured by a firm’s technical efficiency relative to peers in transforming cumulative R&D resources into innovative output, which is a source of competitive advantage, according to the resource-based view (RBV) of the firm. Technical efficiency is estimated via data envelopment analysis. A sample of fraud firms taken from Accounting and Auditing Enforcement Releases is matched with control samples of non-fraud firms. Consistent with the RBV, technological capability is found to have a negative and economically significant effect on fraud probability. Moreover, fraud probability is insignificantly associated with the scale efficiency of innovative activities, as investment in R&D resources per se is not a source of sustainable competitive advantage.