Accounting conservatism, cost of capital, and fraudulent financial reporting

Accounting conservatism, cost of capital, and fraudulent financial reporting

A dissertation submitted to the Kent State University Graduate School of Management

In partial fulfillment of the requirements for the degree of Doctor of Philosophy

by

Karin A Petruska

June 2008

2008

Dissertation written by

Karin A Petruska

B.S.B.A., Youngstown State University, 1989

M.B.A., Youngstown State University, 1993

Ph.D., Kent State University, 2008

ACKNOWLEDGEMENT

I would like to thank above all else, God, for blessing me and truly giving me the faith,

courage, inspiration, and steadfastness to continue on this journey in my life He has always been

there whenever I needed him the most

I would like to thank my dissertation chair, Dr Pervaiz Alam, who has continuously

provided me with meaningful advice during many hours of discussion I feel very fortunate to

have been able to work with Dr Alam over the years He has mentored me throughout my entire

Ph.D program and has shared his experiences, wisdom, and knowledge as a researcher, for which

I am very grateful He has shaped my doctoral experience and provided me with the necessary

skills to be successful in my academic career Without his unwavering help and guidance, this

journey would not have been possible I would also like to thank the other members of my

dissertation committee, Dr Kevin Dow, Dr Wei Li, and Dr David Booth for their guidance,

support, advice, and helpful comments My appreciation is also extended to Dr Michael Hu and

Dr John Thornton for their gracious efforts in presiding at my dissertation defense

I would like to thank my parents, Robert and Ethel, who have always encouraged me and

have taught me to dream big, to never give up on those dreams, and to believe in what you do

They have always kept my spirits soaring and showed me the importance of remaining positive

and providing help to those who need it I dedicate this dissertation to them for providing love,

understanding, and encouragement during the pursuit of this degree To my sisters, Melissa and

Heidi, I thank them for their caring, concern, and understanding

While there are many other people who have contributed to my success in completing

this final degree, I am thankful to Jan Winchell for her computational assistance and to my fellow

Ph.D students who have always made the days seem brighter and have always made me smile

TABLE OF CONTENTS

Page

CHAPTER 1 INTRODUCTION

1.1 Background and Purpose……………… 1

1.2 Litigation Risk……… 5

1.3 Regulation and Standard Setting……… 7

1.3.1 The Private Securities Litigation Reform Act (PSLRA) of 1995……… 8

1.3.2 The Sarbanes-Oxley Act (SOX) of 2002……… 9

1.3.3 Standard Setting……… 11

1.4 Cost of Capital……… 13

1.5 Purpose……… 14

1.6 Motivation for Study……… 16

1.7 Research Contribution……… 19

1.8 Research Expectations and Methodology……… 21

1.9 Sample Selection……… 24

1.10 Organization of the Study……… 26

CHAPTER 2 LITERATURE REVIEW 2.1 Background and Purpose……… 27

2.2 Definition and Relevance of Earnings Quality……… 27

2.3 Definitions of Accounting Conservatism……… 29

2.4 Research Studies on Accounting Conservatism……… 31

2.4.1 Circularity Issue Relating to Accounting Conservatism……… 38

2.5 Determinants of Fraud……… 38

2.6 Limitations of Prior Research Methods……… 41

2.6.1 Accruals……… 41

2.6.2 Frequency Distributions……… 42

2.7 Extensions of the Basu (1997) Model and Alternate Measures……… …… 42

2.7.1 Real Activities Manipulations……….……… 44

2.8 Cost of Equity Capital……….……… 45

CHAPTER 3 HYPOTHESES AND RESEARCH DESIGN 3.1 Hypotheses Development……… 48

3.2 Methodology……… 58

3.2.1 Univariate Descriptive Statistics……… 58

3.2.2 Measures of Conservatism……… 59

TABLE OF CONTENTS (continued)

3.2.2.1 The Basu (1997) Model……… 59

3.2.2.2 Earnings Persistence……… 62

3.2.2.3 Conservatism and the Sarbanes-Oxley (SOX)Period……… 63

3.2.3 Alternate Accounting Conservatism Measures……… 64

3.2.3.1 Accruals Adjusted for Asymmetrical Timeliness……… 64

3.2.3.2 Q-Score……… 67

3.2.3.3 Earnings Variability and Earnings Smoothness……….……… 68

3.2.3.4 Nonoperating Accruals……… ……… 69

3.2.3.5 Skewness of Earnings……….…… ……… 70

3.2.4 Cross-Sectional Variation of Accounting Conservatism……… 70

3.2.5 Measures of Standard Setting……… 72

3.2.6 Measures of Cost of Equity Capital……… 74

3.2.7 Cross-Sectional Variation of Cost of Equity Capital Estimates……… 77

3.3 Sample Selection and Data Sources……… 79

CHAPTER 4 EMPIRICAL RESULTS 4.1 Introduction……… 82

4.2 Sample Identification……… 83

4.3 The Matched Control Sample……… 84

4.3.1 Sample Selection and Distributions……….………… ……… 85

4.4 Econometric Issues…… ……… 90

4.5 The Basu (1997) Model of Aggregate Asymmetric Timeliness……… 94

4.5.1 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings in the Year of the Fraud Manipulation ……… 94

4.5.2 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings Surrounding the Year of Fraud Manipulation………… ……… … 98

4.5.3 Pooled, Cross-Sectional, Time Series Basu (1997) Regression Model………… 101

4.5.4 Asymmetric Timeliness of Operating Accruals, Cash Flows and Earnings……… … 104

4.5.5 Pooled, Cross-Sectional, Time Series Persistent Versus Transitory Earnings… 107

4.6 Sensitivity Tests……… 109

4.6.1 Asymmetric Timeliness of Earnings Using Fraud as a Dummy Variable Indicator… 109 4.6.2 Fama-Macbeth (1973) Statistics.……… ……… 110

4.6.3 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings after Extraordinary Items and Discontinued Operations……… 111

4.6.4 Market-Adjusted Returns……… 112

4.6.5 Alternate Matching of Nonfraud Firms……… 113

4.6.6 Controlling for Large Corporate Scandals……… 113

4.7 Asymmetric Timeliness and the Sarbanes-Oxley Act (SOX) of 2002……… ……… 114

TABLE OF CONTENTS (continued)

4.7.1 Asymmetric Timeliness of Earnings and the SOX Act of 2002 Partitioned by

Alleged Fraud and Nonfraud Firms……… ……… 114

4.7.2 Sensitivity Test of Asymmetric Timeliness of Earnings and the Sarbanes-Oxley Act (SOX) of 2002 for All Firms……… 115

4.7.3 Alternate Sarbanes-Oxley (SOX) Timing Date……… 117

4.8 Asymmetric Timeliness for Firms Reporting Goodwill Impairment……… 117

4.8.1 Asymmetric Timeliness of Earnings for Firms Reporting Goodwill Impairment…… 118

4.8.2 Sensitivity Test of Asymmetric Timeliness of Earnings for All Firms Reporting Goodwill Impairment……… 119

4.9 Firm-Specific Measures of Accounting Conservatism……… 120

4.9.1 Introduction……… 121

4.9.2 Descriptive Statistics and Correlation Coefficients……… 122

4.9.3 Control Variables……… 123

4.9.4 Financial Statement Measures of Variables Representing Accounting Conservatism 125

4.9.5 Sensitivity Tests for Financial Statement Variable Measures of Accounting

Conservatism Relating to the Market-to-Book Ratio……… 128

4.9.6 Sensitivity Tests for Other Additional Financial Statement Variable Measures of Accounting Conservatism……… 130

4.10 Accruals-Based Measures of Variables Representing Accounting Conservatism…… 131

4.10.1 Income-Decreasing Discretionary Accruals Models……… 132

4.10.2 Sensitivity Tests for Firm-Specific Accrual Measures of Accounting Conservatism 135

4.11 Firm-Specific Measure of Accounting Conservatism and the Post-SOX Period…… 138

4.11.1 Financial Statement Measures of Variables Representing Accounting Conservatism and the Post-SOX Period……… 138

4.11.2 Accruals-Based Measures of Variables Representing Accounting Conservatism and the Post-SOX Period……… ……… 139

4.12 Summary……… …… 141

4.13 Cost of Equity, Conservatism, and Fraudulent Financial Reporting……… 142

4.13.1 Introduction……… 142

4.13.2 Empirical Results……… 144

4.13.3 Cost of Equity and Financial Statement Measures of Accounting Conservatism…… 145

4.13.4 Cost of Equity and Financial Statement Measures of Accounting Conservatism Surrounding the SOX Act……… 149

4.13.5 Sensitivity Test for Multiple Disclosure……… 150

4.14 Additional Insights into Accounting Conservatism by Alleged Fraud Firms……… 151

4.14.1 Agency Theory and Earnings Management……… 152

4.14.2 Earnings Management and Disclosure……… 153

4.14.3 Accounting Conservatism and Information Asymmetry……… 153

4.14.4 Theoretical Models of Accounting Conservatism……… 155

4.14.5 Accounting Conservatism and Alleged Fraud Firms……… 158

4.14.6 Conservatism and Earnings Management……… 159

4.14.7 Additional Sensitivity Tests……… 160

TABLE OF CONTENTS (continued)

4.14.8 Alternate Specification of Litigation Risk……… 162

4.15 Industry Effects……… 163

4.16 Controls for Endogeneity/Self-Selection Bias……… 164

CHAPTER 5 SUMMARY AND CONCLUSIONS, LIMITATIONS, FUTURE RESEARCH 5.1 Introduction……… 172

5.2 Summary and Conclusions…….……… 172

5.3 Limitations……….……… 181

5.4 Future Research……… 182

APPENDIX A Additional Measures of Earnings Quality……… ………….…… 184

APPENDIX B Additional Cost of Capital Models……… ……… 187

REFERENCES……… 196

LIST OF FIGURES

Page

FIGURE 1: Time Event Line for Firms Allegedly Accused of Fraudulent Activity as

Evidenced by SEC Enforcements……… …… 191

FIGURE 2: Asymmetric Timeliness of Alleged Fraud and Matched Nonfraud Firms.…… 192

FIGURE 3: Recession and Expansion Sub-Periods Provided by the National Bureau of

Economic Research……… ……… …… 193

FIGURE 4: Summary of Hypotheses………….……… 194

LIST OF TABLES

Page

TABLE 1: Description of Sample Selection Procedure……… 213

TABLE 2: Selected Sample Distributions……… 214

TABLE 3: Descriptive Statistics of Financial Statement Variables and Market-Based

TABLE 4: Pearson and Spearman Correlation Coefficients for Selected Aggregate

Asymmetric Timeliness Model Variables 219

TABLE 5: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t =0) 221

TABLE 6: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t – 1)… 222

TABLE 7: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t – 2)…… 223

TABLE 8: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t –3) 224

TABLE 9: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t + 1)…… 225

TABLE 10: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t +2)…… 226

TABLE 11: Basu (1997) Aggregate Model of Asymmetric Timeliness for Period (t + 3)… 227

TABLE 12: Pooled Basu (1997) Model of Asymmetric Timeliness of Earnings……… 228

TABLE 13: Asymmetric Timeliness of Operating Accruals, Cash Flows, and Earnings…… 230

TABLE 14: Persistence of Price-Deflated Earnings on Prior Period Earnings News……… 233

TABLE 15: Accounting Conservatism for All Alleged Fraud and Nonfraud Firms …… 235

TABLE 16: Asymmetric Timeliness of Earnings Surrounding the Sarbanes-Oxley Act of 2002……… 236

TABLE 17: Asymmetrical Timeliness of Earnings for All Fraud and Nonfraud Firms

Surrounding the Sarbanes-Oxley Act……… 238

LIST OF TABLES (continued)

TABLE 18: Asymmetric Timeliness of Earnings for Partitioned Firms Reporting Goodwill Impairment ……… ………….………… 239

TABLE 19: Asymmetric Timeliness of Earnings for All Firms Reporting Goodwill

TABLE 22: Firm Specific Financial Measures of Accounting Conservatism ………….…… 251

TABLE 23: Firm Specific Accrual Measures of Accounting Conservatism……… 253

TABLE 24: Firm Specific Financial Measures of Accounting Conservatism and the SOX

Act……… 255

TABLE 25: Firm Specific Accrual Measures of Accounting Conservatism and the SOX

Act……… 257

TABLE 26: Descriptive Statistics of Cost of Equity Capital Variables……… 259

TABLE 27: Pearson and Spearman Correlation Coefficients for Cost of Capital and

TABLE 30: Asymmetric Timeliness of Earnings for Firms in Similar Versus Nonsimiliar

Industries as Alleged Fraud Firms……… 269

TABLE 31: Results of Controlling for Self-Selection Bias……… 270

TABLE 32: Results of Controlling for Self-Selection Bias and the Ex Ante Cost of Capital

on Risk Proxies, Fraud, and Measures of Accounting Conservatism……… 272

CHAPTER 1

INTRODUCTION

1.1 Background and Purpose

The lack of availability of reliable and verifiable estimates between managers and

investors can cause uncertainty and information asymmetry in an entity’s business environment

(Watts, 1993) Managers can use conservatism as a means to manage information asymmetry in

their private information and in their financial reporting strategies (Chaney, 2006) LaFond and

Watts (2008) state that conservatism, “is an equilibrium corporate response to mitigate the value

reduction resulting from information asymmetry between informed and uniformed investors.”

Watts (2003a) advocates that “the evidence on conservatism suggests asymmetric verifiability of

estimates is crucial to constraining manipulation and fraud” and a decrease in conservatism may

allow some managers the opportunity to generate fraud (Watts, 2006) However, in light of these

statements, the Financial Accounting Standards Board (FASB) contends that an inherent conflict

is that conservatism may also have the effect of inducing information asymmetry in the

timeliness1 of incorporating economic events in reported earnings by creating bias and noise (Givoly and Hayn, 2002) Bias and noise in the financial statements generate “soft” accounting

numbers2 (Watts, 2006; Mackintosh, 2006) which can also lead to fraud and manipulation

“Extreme conservatism in recognizing income could produce too many false signals” (Watts,

1993)

The objective of this study is to measure the differences in the magnitude, consequences,

and methods used to calibrate accounting conservatism in regards to litigation risk, as well as

regulation and standard setting, between firms that have been allegedly accused of fraud3 and a non-fraud matched control group I specifically address whether firms with higher thresholds of

litigation risk are more inclined to use higher levels of accounting conservatism as a choice in

reducing information asymmetry One of the effects of conservatism could be the responding

change in a firm’s cost of equity capital LaFond and Watts (2008) state that information

asymmetry between equity investors creates “deadweight losses” that in turn reduce the firms’

cash flows and increase the equilibrium return on the firm’s equity Whether the role of

conservatism can mitigate the effect of an increase in cost of capital for alleged fraud firms is

examined in this context

Accounting conservatism can be measured in terms of both the balance sheet and the

income statement While there is no one conventional definition or method employed to measure

accounting conservatism, and due to it not being directly observable and difficult to calibrate at

the firm level, conservatism has been characterized by the traditional adage of “anticipate no

profits, but anticipate all losses” (Bliss, 1924) It has also been referred to as “the accountant’s

tendency to require a higher degree of verification to recognize good news as gains than to

recognize bad news as losses” regarding future cash flows (Basu, 1997) Accounting

conservatism is one factor that may provide information about earnings quality (Francis et al,

2004; Watts, 2003a) as it involves the timely recognition of bad news versus good news in

3

I use the terminology “allegedly accused” because, although the SEC’s enforcements may be issued and filed, the proceedings do not in every instance result in civil or criminal charges For example, some of the

SEC’s Auditing and Enforcement Releases (AAERs) indicate only a cease and desist order pending

restitution in the form of a settlement payment while not admitting to any wrongdoing

earnings It is often termed asymmetric gain and loss recognition, differential timeliness, or

conditional conservatism4 (Gassen et al., 2006) Another form of conservatism, referred to as unconditional conservatism,5 involves reporting low book values of net assets, independent of losses, as often occurs with immediately expensing of intangibles (Ryan, 2006) Gassen et al

(2006) show that conditional conservatism, unconditional conservatism, and earnings smoothing

(a proxy for conditional conservatism) are theoretically diverse concepts which can yield different

earnings distributions

According to the FASB’s conceptual framework, Statement of Financial Accounting

Concepts No 2, Qualitative Characteristics of Accounting (FASB, 1980), the exploitation of

conservatism by managers may create noise or a downward bias in financial reporting.6 Consequently, the FASB has been considering eliminating conservatism from its framework in

order to achieve more “neutrality of information.” They state that in order for accounting

information to be relevant, it has to be verifiable, neutral, and contain representational

4

Conditional conservatism is often referred to as news-dependent or ex post conservatism and involves

firms writing down the book value of assets in a timely manner It includes the impairment write down of tangible and intangible assets (Qiang, 2007), goodwill, the lower of cost or market or historical value rule

in regards to inventory (Ryan, 2006), and GAAP that requires research and development expenditures to be expensed rather than capitalized

5

Unconditional conservatism is often referred to as news-independent or ex ante conservatism It involves

firms committing at inception to recognizing the book value of assets that are below their expected market values during their lives It includes the immediate expensing of internally generated intangible assets and the amortization of long-lived assets (Ryan, 2006) It can involve excess depreciation which lowers book values and reduces subsequent conditional conservatism (Qiang, 2007)

6

The FASB’s Project Update (FASB, 2005), states that conservatism/prudence should remain excluded from the qualitative characteristics of accounting information They assert that neutrality should include freedom from bias, prudence, and conservatism The FASB staff has expressed reluctance to continue to include conservatism or prudence as a list of desirable qualitative characteristics of accounting information together with neutrality The FASB Board has suggested that the notion of conservatism should be eliminated However, they stated that the FASB’s conceptual framework should note the continuing need

to be careful in the face of uncertainty In practice, the idea of conservatism has been altered from FASB’s original intention The FASB’s definition of conservatism as a prudent reaction to uncertainty does not imply that financial statements should always be pessimistic The role of conservatism is for preparers to acknowledge that risks and uncertainties are present in financial information and to adequately account for those risks in the information that is presented to decision makers

faithfulness.7 The FASB’s Conceptual Framework relates to the hierchy of favorable accounting quality characteristics (FASB, 1980) Critics of accounting conservatism claim that it leads to an

understatement of earnings in the current period This can lead to an overstatement of earnings in

future periods by understating future expenses (Penman and Zhang, 2002) at a point in time that

managers determine “selectively fits their operating results” (Massoud and Raiborn, 2003)

While accounting conservatism in this context explains accelerated loss recognition, accounting

conservatism can also be explained in the context of delayed gains recognition (Srivastava and

Tse, 2007) Advocates argue that the elimination of conservatism could affect managerial

behavior and have economic consequences Therefore, the study of conservatism remains

relevant and important

Contemporaneous empirical evidence suggests that the trend in conservative financial

reporting has been monotonically increasing over the past 30 years in the U.S and is also evident

in other common law countries (Ball et al 2000, 2003; Givoly and Hayn, 2000) However,

during this time period, there appear to be waning and waxing period changes Watts (1993)

proposes several theories regarding the existence of conservatism He predicts that conservatism

in U.S accounting should vary with unexpected changes in legal liability Shareholder litigation

produces asymmetric information payoffs such that overstating firm assets should more likely

generate litigation costs for the firm Other theories offered for the emergence of conservatism

have been attributed to the use of financial statements in debt and compensation contracts (the

7

In Statement of Financial Accounting Concepts No 2, Qualitative Characteristics of Accounting (FASB,

1980), relevance and reliability are two primary qualities of accounting information For accounting information to be reliable, it has to provide predictive value, feedback value, and timeliness For accounting information to be relevant, it has to be verifiable, neutral, and contain representational faithfulness The FASB defines the reliability of a measure as “the faithfulness with which it represents what it purports to represent, coupled with an assurance from the user, which comes through verification, that it has representational quality.”

contracting explanation) and the ability to defer taxation The nature of accounting regulation

and standard setting also provides support for the role of conservatism in financial reporting

While there is documented to be an increasing trend in conservatism, research has also

indicated a bias in financial reporting due to opportunistic earnings management For example,

Dechow et al (1996) characterize the majority of their fraud sample as consisting of firms that

have income/revenue overstatements and higher levels of total accruals than their nonfraud

counterparts While earnings management (e.g., one-time “big bath” restructuring charges,

cookie jar reserves, creative acquisition accounting, excessive charges and write-offs, and

abandoning of unprofitable operations) could produce some of the evidence on conservatism, it is

not thought to be the only explanation In times of economic losses, managers exaggerate the

losses through income-decreasing discretionary accruals for purposes of earnings management

However, according to Givoly and Hayn (2002), it is important to note that this does not support

the timely loss recognition argument because they do not predict any relation to cash flows nor

can they fully explain the systematic versus idiosyncratic understatement of net assets Thus,

there is not always a direct relation between asymmetric timeliness and accounting conservatism

While aggressive accounting choices may reduce the degree of reporting conservatism “they

cannot turn the whole tenor of the financial statements into being non-conservative or even

neutral” (Givoly et al., 2007)

1.2 Litigation Risk

Changes in auditors’ liability exposure in recent decades have been documented by

Kothari et al (1989) who found an increasing degree of conservatism in high litigation periods

They categorized liability exposure based on four liability regimes as evidenced from enactments

and events surrounding securities reforms covering the period 1933 through 1985.8 Following Kothari et al (1989), Basu (1997) examined the period 1963-19909 and predicted conservatism measures to increase in periods following liability increases and to remain constant in periods

following court decisions that restricted liability growth For example, Basu (1997) empirically

found a significant increase in conservatism in two high-litigation growth periods and no increase

in low-litigation growth periods, a result consistent with litigation generating different degrees of

conservatism

However, in regards to firm-specific legal liability, the strength of many of these

associations has not been directly established This study aims to fill a void in the literature by

examining the conservative accounting reporting practices of firms that have been specifically

targeted as allegedly committing fraud by the U.S Securities and Exchange Commission (SEC)

as opposed to using only proxies for the litigation period or proxies for auditor litigation Further,

given the proposition that litigation risk has been predicted to cause an increase in accounting

conservatism for U.S firms in general, this is a broad statement, and given that no one firm is

totally immune to litigation risk, it is relevant to refine this concept to specific firms that do

indeed warrant an actual increase in litigation risk Therefore, I examine whether the degree of

accounting conservatism increases surrounding the alleged fraud manipulation date10, when differences in litigation risk are expected to occur Firms with a higher incidence of alleged

fraudulent activity are assumed to be the most vulnerable to the threat of litigation risk Whether

or not firms allegedly accused of committing fraud are more conservative has not been

conclusively documented in the extant literature Since research has considered accounting

conservatism to be a corporate governance mechanism (Guay and Verrecchia, 2007), it would

seem paradoxical if alleged fraud firms predispose themselves to higher levels of conservatism

However, based on the theory proposed by Watts (2003a), I argue that the threat of litigation and

exposure to political costs should induce firms to increase their conservative accounting practices

Since the mechanism of conservatism can be viewed as a corrective action to the over-optimistic

behavior of management, if firms use accounting conservatism while they are also manipulating

earnings and engaging in fraudulent activity, accounting conservatism could have the propensity

to mask fraud Recently, Bagnoli and Watts (2005) report that there is a positive correlation

between conservative financial reporting policies and the likelihood of a firm beating earnings

expectations Thus, there is an indication that firms may be “padding” their financial reports in

order to later exceed earnings expectations (Marshall and Heffes, 2005) Levitt (1998) states that

“if these charges are conservatively estimated with a little extra cushioning, [the] conservative

estimate is miraculously reborn as income when estimates change or future earnings fall short.”

This suggests that corporate fraud could be on the rise again Therefore, the main research

question I address is whether or not the degree of accounting conservatism is higher for firms

allegedly accused of fraudulent activity and examine the point in time that this is most likely to

occur

1.3 Regulation and Standard Setting

In regards to the role of regulation and standard setting, Watts (2003a) predicts that

increased liability from regulation provides managers and auditors with incentives to be more

conservative This can be traced back to financial reporting surrounding the U.S Securities Acts

of 1933 and 1934 Litigation under the Securities Acts encourages conservatism because the

probability of litigation is higher when earnings and net assets are overstated versus understated

Therefore, managers have an incentive to report conservative values for earnings and net assets as

a means to address moral hazard.11 Agency theory postulates that the responsibility of managers and regulatory commissions is to monitor management incentives and behavior (Jensen and

Meckling, 1976) However, regulation to deter fraud is not a new legislative phenomena

(Rockness and Rockness, 2005) In 1987, the Treadway Commission studied the importance of

fraud-risk factors, termed red-flags, that consisted of incentives to commit fraudulent financial

reporting and opportunities that allowed such frauds to occur (Treadway, 1987)

1.3.1 The Private Securities Litigation Reform Act (PSLRA) of 1995

The Private Securities Litigation Reform Act of 1995 (hereafter, PSLRA) altered the

litigation environment by eliminating joint and several liability where auditors could be named as

defendants in lawsuits due to their “deep pockets,”12 or wealth-at-risk effects, rather than culpability It was also the first requirement for auditors to report fraudulent activity to the SEC

The passage of the PSLRA made it more difficult to file class action lawsuits in federal court

Opponents of the PSLRA indicated that it provided relief to auditors from litigation risk, which

resulted in lowering audit quality and ultimately reducing investor confidence (Geiger et al

2006) Lee and Mande (2003) maintain that the PSLRA decreased audit quality as evidenced by

an increase in income-increasing discretionary accruals after the passage of the Act Francis and

Krishnan (2002) found that Big 4 auditors were less likely to issue a going concern report to their

clients after the passage of the Act, a result consistent with decreased audit quality

In terms of accounting conservatism, Chan and Pae (1998) found that the elimination of

joint and several liability of the PSLRA actually caused auditors of firms to adopt even less

conservative accounting practices Extending Basu’s (1997) analysis of asymmetric timeliness

and legal liability, Liu and Thornton (2005) examined the time period surrounding the PSLRA

They convey that asymmetric timeliness declined immediately after the PSLRA and marginally

increased again during the 1997 and 1998 period when litigation shifted to state courts During

1998, conservatism initially declined and increased again when the 1998 Securities Litigation

Uniform Standards Act reversed previous actions and required class action lawsuits to be filed

again in federal courts

1.3.2 The Sarbanes-Oxley Act (SOX) of 2002

In terms of more recent regulation, The Sarbanes-Oxley Act (SOX) of 2002 was enacted

as a direct result of the more well-known and publicized accounting scandals that swept the U.S

in the later 1990s.13 The SOX Act addresses corporate governance and accountability by improving the quality and transparency of financial reports Section 404 of the SOX Act

specifically details detecting weaknesses in internal controls These corporate controls have been

instituted to enforce and control firms from committing fraud Section 302 requires managers to

certify and disclose these material weaknesses (Beneish et al., 2008) Due to the passage of the

SOX Act, information asymmetry should be reduced as firms are required to provide more

transparency in their financial disclosures It is relevant to investigate accounting conservatism in

13

The accounting profession has been plagued by well-known corporate accounting scandals Studies frequently reference Enron, Worldcom, and Arthur Anderson as the most notorious firms involved in these accounting debacles Yet, there are many other firms who have been accused of fraudulent financial activity but are less well-publicized Ironically, it has not only been companies who are allegedly accused

of fraudulent activity, but the leading Big-4,5 public accounting firms such as Arthur Anderson, Deloitte & Touché, Ernst & Young, KPMG, and PriceWaterhouseCoopers, who have been accused of negligence in their duty as auditors and have SEC enforcements issued against them

this context because transparency has been defined as exemplifying the characteristics of both

timeliness and conservatism (Ball et al., 2000) and may be considered a desirable earnings

attribute (Francis et al., 2004; Watts, 2003a)

Depending on the characteristics of a regulatory act, the degree of earnings quality or

conservatism does not always stay the same For example, compared to the PSLRA, it has been

suggested that the SOX Act may have different regulatory effects on corporate reporting As

such, it may be causing companies to become more conservative, rather than less conservative, in

their financial reporting The SOX Act is intended to increase the degree of transparency, increase

the risk of litigation, and hence, increase accounting conservatism among firms, with its intention

of decreasing the level of fraud occurrence Therefore, it is relevant to determine whether

changes in the recent wave of accounting debacles are associated with changes stemming from

government regulation and standard setting.14 The effect of changes in the legal environment has the propensity to alter the degree of earnings quality and subsequent potential fraudulent activity

However, many question how much more effective the SOX Act will be in deterring

unethical and fraudulent management behavior The parallels of the former regulatory periods

compared to the current setting raise doubts as to whether this type of behavior can be legislated

(Rockness and Rockness, 1980) Fraud may also be challenging to predict because of the mere

random acts by a few agents (Cloninger and Waller, 2000) Likewise, a corporation’s culture can

determine how people behave when they are not being watched (Tierney, 2002)

It is important to determine the effect of accounting conservatism for firms allegedly

accused of committing fraud as this would lend support as to why the FASB should still continue

14

According to a 2006 report by the Association of Fraud Examiners, the median fraud loss per scheme for the 2004-2006 period was greater for small organizations than for large organizations (JAcct., 2007) This finding is timely in that the SEC is granting further compliance relief and leniency from Section 404 of the Sarbanes-Oxley Act (SOX) to smaller public companies and many foreign private issuers (SEC, 2006) Small firms have been found to be associated with a greater percentage of loss firms (Klein and Marquardt, 2006)

to monitor and show cause for controlling and providing better disclosure on the increasing

effects of conservatism and whether conservatism introduces additional bias into the financial

statements, thus increasing information asymmetry Therefore, the topic of fraud is still very

important and timely as the environment and economic conditions change

1.3.3 Standard Setting

Accounting conservatism may reduce the political costs faced by, not only accounting

regulators, but by standard setters Research dealing with positive accounting theory has

emphasized interest relating to the influence of political costs on accounting procedure choice

(Watts and Zimmerman, 1979) The influence of the political process on accounting

conservatism is one reason that the SEC has banned upward valuations on assets (Watts, 2006)

Yet, more recent standards appear inconsistent with conservatism as they create estimates that are

not verifiable and may possibly be subject to fraud For example, due to the lobbying and

political interests of investment bankers, Statement of Financial Accounting Standard (SFAS) No

142, Goodwill and Other Intangible Assets, adopted in 2001, changes the way firms calculate

impairment charges Prior to this standard, goodwill was amortized over 40 years as an expense

However, amortization of the goodwill asset did not necessarily reflect economic changes in the

value of an investment Under the new provision, companies annually conduct goodwill

impairment tests If goodwill has permanently declined in value, an impairment loss is taken and

written off as an expense (Duangploy et al., 2005)

Goodwill can be generated internally or through a business combination

“Non-amortization of goodwill and related impairment tests should ‘increase representational

faithfulness’ and improve the transparency of accounting” (Massoud and Raiborn, 2003)

However, this discretion could provide a mechanism to manipulate earnings and lower earnings

quality in order to meet analysts’ or managements’ expectations Sevin and Schroeder (2005)

report that SFAS No 142 enabled companies to engage in earnings management and small firms

were more likely to employ “big bath” charges Thus, eliminating amortization expense and

using impairment tests raises net income with no corresponding increase in cash flows These

write-offs from impairment can signal a loss in economic value In addition, measuring the

impairment of goodwill when different valuation models are employed could inconsistencies

(Lander and Reinstein, 2005) Statement of Financial Accounting Standards (SFAS) No 144,

Accounting for the Impairment or Disposal of Long-Lived Assets, reflects the demise of the pooling-of-interests method of accounting for business combinations and specific assets or asset

groups It also avoids amortization, replacing it with a two-step impairment test Overall, these

two standards require the estimation of non-verifiable and non-contractible future cash flows

which could lead to manipulation Nonverifiability is inconsistent with the original concept of

accounting conservatism and does not lead to more transparency in the financial statements

(Watts, 2003a), but to more manipulation (Sevin and Schroeder, 2005) and the potential for

increased litigation risk

In summary, based on the prior discussion of the role of regulations and standards, in

regards to the Private Securities and Litigation Reform Act of 1995, there is empirical evidence to

suggest that as litigiousness decreases, conservatism may decrease and this relation has the ability

to increase fraud Given that proof of fraud requires the verifiability of accounting numbers,

conservatism should in theory be associated with a decrease in fraud (Watts, 2003b) However,

since the SOX Act has been predicted to be associated with a shift in the information environment

representing more litigiousness, the amount of conservatism is predicted to increase The

standard relating to SFAS No 142, Goodwill and Other Intangible Assets is expected to produce

the opposite results contrary to the SOX Act

1.4 Cost of Capital

Cost of capital is one of the most important benchmarks to evaluate the ability of firms to

invest their funds and to evaluate the quality of their existing investments (Habib, 2006) A

firm’s cost of capital is of interest to regulators, investors, accountants, academicians, and

management for capital budgeting decisions, equity valuation, capital structure, and firm

profitability (Easley and O’Hara, 2004) Arthur Levitt, former Chairman of the Securities and

Exchange Commission, has suggested that “high quality accounting standards…improve liquidity

[and] reduce capital costs” (Levitt, 1998) An increased level of disclosure reduces the possibility

of information asymmetries (Guay and Verrecchia, 2007) and should lead to a lower cost of

capital effect Barth et al (2005) found that firms with more transparent financial statements

benefited from a lower cost of equity capital Financial reporting of low quality earnings

increases the risk of inefficient resource allocation and could increase the cost of capital The

incidence of earnings manipulation by firms adversely affects the financial reports, especially the

information content of earnings (Wilson, 2008)

Since the cost of equity capital serves as a summary measure of investors’ resource

allocations, a decrease in information asymmetry should reduce the cost of capital through

reduced transaction costs and/or a reduction in uncertainty or estimation risk (Botosan, 1997,

Botosan, 2004) Francis et al (2004) document that information asymmetry can be caused by

poor earnings quality and poor earnings quality is positively related to an increase in a firm’s cost

of capital A reduction in information asymmetry through improved accounting disclosures, such

as conservatism, may reduce a firm’s information risk and reduce the cost of equity capital

Based on this relationship, Francis et al (2004) suggest a negative association between

conservatism and cost of capital They state that “high quality earnings, by reducing the

uncertainty in earnings as an informative signal about the pay-off structure, reduce the cost of

capital.”

Cloninger and Waller (2000) state that based on the hedging hypothesis, firms engage in

fraud as a means of enhancing returns or smoothing cash flows, thereby reducing variability.15 The lower variability in firms’ cash flows should translate into a lower market beta Higher post

event betas vis-à-vis pre-event betas could signal that a firm’s market risk has increased as a

result of the disclosure of the fraudulent activity However, lower post event betas could serve as

evidence that the market anticipates lower risk associated with the cessation of the firm’s illegal

activities According to the speculative hypothesis, this serves as evidence that the market

perceives this fraudulent activity as speculative The disclosure and anticipated cessation of the

fraudulent activity could cause a firm’s beta to fall Following this theory, a motivation for firms

to commit fraud could be due to the desire to attract external financing at a lower cost This

motivation has received little attention in the academic literature (Dechow et al., 1996) I

examine the impact of the disclosure of accounting conservatism on alleged fraud firms and its

temporal effect on the ex ante cost of equity capital

1.5 Purpose

Based on the previous discussion, the purpose of this study is to empirically determine

whether the degree of asymmetric timeliness and firm-specific accounting conservatism is higher

surrounding the pre- and post- fraud manipulation date, (t-3 to t+3), for firms accused of alleged

fraudulent activity compared to a control sample I extend the litigation explanation proposed by

Watts (2003a) to take into account firms targeted by the SEC’s Enforcement Division The

15

Using a sample of 129 fraudulent disclosures, Cloninger and Waller (2000) found that 42 of the disclosures had betas that significantly increased, 22 disclosures whose betas did not change significantly, and 65 disclosures whose betas decreased significantly after fraud was discovered

means by which firms who are accused of alleged fraud are scrutinized is through the

announcement and issuance of the SEC’s Accounting and Auditing Enforcement Releases

(AAERs), Litigation Releases, Administrative Releases, and other listings available on the SEC website.16 I examine the period of regulation surrounding the SOX Act of 2002 to determine whether the nature of the Act has caused accounting conservatism to differ between these firms I

examine whether alleged fraud firms that have applied SFAS No 142, Goodwill and Other

Intangible Assets, in their financial statements vis-à-vis a matched control group are associated with more accounting conservatism I also empirically test whether firms allegedly accused of

fraudulent activity are associated with a higher ex ante cost of equity capital Additionally, I

examine if the contagion effect of asymmetric timeliness of earnings is similar, relative to all

firms in the same industry

This study is relevant in that there continues to be a growing market concern over the

increasing complexity of financial reporting The concept of conservatism affects all of the

underlying assumptions in the financial statements (Krishnan, 2005) If accounting earnings are

non-verifiable, the quality of other information is also suspect Ball et al (2000) and Watts

(2003b) state that a feature of accounting conservatism is that it facilitates the effective

monitoring of managers and contracts The accounting profession is helping to lead the charge in

the war on financial disclosure and transparency, as well as the SEC As the SEC’s chairman

Christopher Cox stated, “if the rules become a thicket in which fraudsters can hide instead of a

means to achieve the truth, then we can’t achieve our goals of protecting investors” (JAcct.,

2007) Thus, if accounting conservatism is higher for firms that have been allegedly accused of

fraud, then this calls into question the role of conservatism as a corporate governance mechanism

16

Available at http://www.sec.gov Prior research has identified fraudulent firms by using SEC

enforcements, news releases available on the Lexis Nexis Academic Database (Caskey and Hanlon, 2005),

the Wall Street Journal lndex (Marciukaityte et al., 2006), and publications by the SEC (1989) (Dechow et al., 1996)

The implications of this study should also be of interest to financial analysts Givoly and

Hayn (2002, 2000) and Kwon et al (2006) suggest that an analysis of the financial statements is

meaningless unless there is an adjustment for the effect of varying degrees of conservatism before

comparisons can be made between firms Research indicates that financial analysts are beginning

to make this adjustment when comparing the financial statements of firms when using

cross-country comparisons (French and Poterba, 1991) Adjustments for conservative accounting are

also being incorporated into previous accruals models to attenuate any bias or model

misspecifications (Ball and Shivakumar, 2006)

1.6 Motivation for Study

The extent of fraud also has implications for legislators, regulators, auditors, and

academicians still trying to understand the motivations, root causes, and consequences of fraud

Many enforcement actions involve settlement offers where companies pay off their poor

discretions Many of these companies may have the necessary funds to settle their transgressions

In fact, most recently, BusinessWeek published its 2007 top 50 best performers ranking list

(Foust, 2007) Included on this list are ten companies included in the initial sample that have had

SEC’s AAERs issued against them Therefore, the consequences for firms that have been

accused of fraudulent activity have the propensity to vary

Very few studies have moved beyond the general area of accruals as a metric in

determining the association with fraud In addition, evidence suggests that investors do not fully

see through earnings management as reflected in abnormal accruals While prior studies have

found a positive association between earnings management and those firms that commit fraud,

there are limitations based on using only accruals (Daske et al., 2006; Dechow et al., 2003;

Dechow and Dichev, 2002; Durtschi and Easton, 2005; McNichols, 2002) While some firms that

have managed earnings upwards have shown subsequent stock price declines, other firms that

have managed earnings downwards have had positive subsequent returns (Healy and Wahlen,

1999) This raises the question as to whether or not abnormal accruals can explain the variation

in earnings momentum In addition, this study also has implications for the theory surrounding

accounting conservatism and the types of firms that exhibit higher levels of accounting

conservatism I am not aware of any study which has examined accounting conservatism in an

adverse selection setting with its relation to alleged fraud firms

Prior research has often used firms that have been involved in litigation as suggesting that

they are a proxy for poor earnings quality (Khurana and Raman, 2004, Caskey and Hanlon,

2005) Thus, it has only been inferred that an SEC’s AAER release or a restatement implies that

a firm has poor earnings quality However, this may not always be the case For example, the

incentive to commit fraud may occur to increase managerial executive compensation packages

This would support the notion that earnings are manipulated, not because of poor financial

condition, but because of greed It could be more than just the need to inflate earnings that drives

fraud It has not been formally tested in the literature whether firms that have been issued SEC

Enforcement Releases really possess a lower earnings quality or if they are seeking an abnormal

earnings level One of the caveats lacking in the literature is specifically measuring the earnings

quality of these firms using several alternative metrics Francis et al (2004) suggest that the

benefits of using different earnings attributes are specific to the setting considered due to the

ability of the attributes to capture distinct constructs

Prior research has found that the SEC Enforcement Releases elicit a strong negative

market reaction and the initial disclosure of alleged corporate activities results in significant

negative abnormal returns to shareholders (Cloninger and Waller, 2000; Feroz et al., 1991;

Karpoff and Lott, 1993).17 This often leads to downward revisions in the expected future earnings

of these firms (Dechow et al 1996) Firm value is anticipated to decrease because the expected

stream of cash flows may be lower What is not evident is how much, if any, of the downward

price revision is attributable to an increase in the cost of capital discount rate that investors assign

to future cash flows By determining this cost of equity capital rate, this allows us to discern

whether or not the perceived risk of going forward and recovering from the alleged fraud is

affected by the announcement

If cost of equity capital is increasing at the same time that earnings management is

increasing for these firms, then it remains an empirical question as to whether accounting

conservatism is a good measure to gauge performance along with its relation to the cost of equity

capital This also justifies the need to empirically test the use of different settings by using

alternate measures of accounting conservatism According to Givoly et al (2007), the use of the

Basu (1997) differential timeliness (DT) measure in different research venues needs to be more

selective and qualified because the use of the (DT) measure can lead to anomalous results and

differs across research settings The Basu (1997) differential timeliness component is based on a

sample aggregate attribute and often is not calibrated as a firm-specific measure of conservatism

Givoly et al (2007) also find that asymmetric timeliness is not lower for firms in some situations

where one would expect less conservatism For example, they contend that asymmetric

timeliness is higher for firms that restated their financial statements and issued capital However,

considering the effect that litigation risk has on accounting conservatism, this direction appears

1.7 Research Contribution

This study contributes to the literature by filling a void in what Watts (2003b) has

proposed that finer tests of variations in accounting conservatism during contracting and

expanding regulatory and litigation periods need to be performed in order to determine whether

standard setting generates conservative financial reporting Further, while Watts (2003a) offers

litigation risk as one of the explanations for the increase in accounting conservatism, this

empirical relation has not been formally tested Therefore, I empirically determine whether

litigation and regulation and standard setting encourage conservatism By focusing on these

areas, I aim to fill a void in the literature by also drawing upon Basu (1997) and Kothari et al

(1989) who showed an increasing degree of conservatism in high litigation periods

This study contributes to the literature by determining whether alleged fraudulent activity

is associated with higher levels of accounting conservatism, regulations and standards, and

increases or decreases in cost of equity capital compared to a non-fraud control sample I

examine if accounting conservatism and the cost of equity capital increases surrounding the

relative alleged fraud manipulation date Although there have been numerous studies measuring

the cost of capital of firms in general, and the construction of several alternate specification

models, I am not aware of any study that has examined the association of alleged fraud firms and

their implicit cost of equity capital calculations

I contribute to the literature by examining the period surrounding the Sarbanes-Oxley Act

(SOX) of 2002 Companies have been subject to litigation proceedings long before the SOX Act

became effective Some opponents of the SOX Act argue that the costs of compliance are too

harsh Some even attribute the exodus of publicly-traded firms to the private sector as a result of

too many restrictions imposed by the Act (Morgenstern et al., 2004) The effects of SOX could

cause an increase or decrease in the incidence of fraudulent activity In accordance with Watts

(2003a), I predict that if litigation risk increases, then asymmetric timeliness or accounting

conservatism should increase However, if firms are not being prosecuted but issued injunctions

in exchange for settlements which decrease litigation risk, than the Act has the effect of

decreasing conservatism Likewise I contend that there should be a negative relation between

accounting conservatism and the cost of equity capital because conservatism acts as a disclosure

mechanism

If differences in accounting conservatism and cost of equity capital are not significant

between the fraud and the non-fraud control samples, then this could imply that the government

may have overreacted with the SOX regulations It has been suggested that the government may

have reacted precipitously to the recent scandals, motivated by a political agenda and “based on

anecdotes” without considering the consequences when drafting the Act (DeFond and Francis,

2005)

Finally, I determine whether or not fraud that occurs in one industry will have contagion

effects relative to firms in similar industries in terms of asymmetric timeliness of earnings.18 Prior studies have indicated that the computer equipment sector (Dechow et al., 1996), the

business services sector (Erickson et al., 2006), and other manufacturing sector (Caskey and

Hanlon, 2005) have been characterized as having some of the highest levels of alleged fraudulent

activity Erickson et al (2006), in examining equity incentives, indicate that the business service

sector has had the most fraudulent activity It has also been suggested that firms that are

implicated in fraudulent scandals tend to have widespread industry effects that could affect the

level of asymmetric timeliness within those same industries Using Fama and French (1997) 48

industry classifications to measure these firms, I examine whether the distribution of alleged

fraud firms has changed and whether or not there are contagion effects that significantly comprise

18

Sidak (2003) suggest that “WorldCom’s fraudulent statements may have raised competitors’ costs by inducing inefficient investment in capacity and inefficient expenditures for customer acquisition.”

the sample I am aware of no other study that has examined asymmetric timeliness as a measure

of accounting conservatism for firms in the same industry that have been affected by alleged

fraudulent activity Fraud often occurs because the culture has become infected (Sweeney, 2003)

Basu (2001) states that accounting methods tend to cluster both in time and in particular

industries Balsam et al (2003) find that clients of industry specialist auditors have lower

discretionary accruals and higher ERCs than clients of nonspecialist auditors Their finding

suggests that clients with industry specialists have higher earnings quality than clients of

nonspecialist auditors Kwon et al (2006) suggests that to control for mandated GAAP versus

voluntary conservatism, additional analysis can be conducted at the industry level

1.8 Research Expectations and Methodology

The discussion in this section revolves around the research expectations of the study and

an introduction to the research methodology I begin by examining the main research question of

whether the degree of accounting conservatism increases or decreases surrounding the alleged

fraud manipulation date Following Dechow et al (1996), I examine the t-3 through t+3 period

surrounding the alleged fraud manipulation date in the financial statements, t=0 I draw upon

prior literature that states that higher quality earnings are those earnings that have less evidence of

earnings management and are desirable because they reduce information asymmetry and result in

a capital market advantage (Francis et al 2004) I expect there to be an increase in accounting

conservatism as a response to the anticipation and consequence of fraud and that the magnitude of

conservatism will be higher for the alleged fraud group than for the matched control group

surrounding the relative alleged fraud manipulation date in the financial statements Based on the

theory of litigation and conservatism provided by Watts (2003b) and LaFond and Watts (2008), I

expect the level of accounting conservatism should increase in the period initially preceding and

initially following the relative date of alleged fraud manipulation It is during this period that the

risk of litigation would be highest for a firm allegedly accused of fraudulent activity

Given the prior research on the theory of disclosure levels, it is also possible that the

announcement of fraud, having removed future uncertainty about the firm’s earnings, might

actually reduce future risk (Khan and Watts, 2007) A decrease in litigation risk may cause

conservatism to decrease For example, a firm may have used fraudulent activity to enhance

bonuses, to facilitate the firm over a certain threshold, or to meet a short-term analyst forecast

However, based on the prior discussion, if the risk of litigation increases, accounting

conservatism is predicted to increase

To test the main hypothesis, I begin by using the seminal Basu (1997) model of aggregate

asymmetric timeliness However, the power and reliability of the Basu (1997) timeliness

measure to gauge reporting conservatism may react differently depending on the setting examined

(Givoly, 2002; Ball and Shivakumar, 2006) The results can be contingent on the sample size

attributes, the reliability of the measurement data, and the means used to identify firms targeted as

having allegedly committed fraud Research has indicated that accounting conservatism is

considered to be downwardly biased using the Basu (1997) model because the validity of using a

reverse regression model of earnings regressed on returns may render the results non-interpretable

and subject to measurement errors (Dietrich et al., 2006) Therefore, I also apply alternate

measures of firm-specific accounting conservatism in cross-sectional analysis Using actual and

simulated data, Givoly and Hayn (2002) find that certain characteristics of the information

environment, unrelated to accounting conservatism, affect the sensitivity of the differential

timeliness measure This justifies the need to empirically test the advantages of using different

settings in application of the Basu (1997) differential timeliness measure as well as to compare

and contrast them with alternate measures of accounting conservatism

Next, I examine whether government regulation and standard setting affects firms’

reporting practices Based on the prior discussion regarding the Private Securities Litigation

Reform Act of 1995, the Act was found to decrease conservatism and increase fraudulent

reporting Conversely, the Sarbanes-Oxley Act has been anticipated to increase accounting

conservatism and decrease fraudulent reporting I begin by using the Basu (1997) model and

extend it to take into consideration the SOX regulation period and the extent to which firms have

applied SFAS No 142, Goodwill and Other Intangible Assets The extent to which other

firm-specific accounting measures of accounting conservatism are associated with alleged fraud firms

after the SOX Act became effective are also examined

Furthermore, I examine whether attracting external financing at a lower cost is a

significant motivation for the alleged manipulation that results in SEC enforcement actions A

decrease in accounting conservatism may result in an increase in information asymmetry Based

on prior research, an increase in information asymmetry is associated with an increase in cost of

equity capital Based on this line of reasoning, there should be a negative relation between

conservatism and the cost of capital The level of conservatism used by firms should map into the

effect of the cost of equity capital In terms of potential fraudulent activity, a distinct

disadvantage of earlier research dealing with changes in cost of equity capital estimates is that the

measures were not directly specified, yet only inferred For example, Palmrose et al (2004) did

not find any increase in the bid-ask spread, a proxy for cost of capital surrounding a restatement

announcement Dechow et al (1996) only indirectly examined whether the cost of capital

increased for a select group of SEC-identified firms by examining stock price, bid-ask spreads,

and the number of analysts following the firm While many models have used forecasts based on

analysts’ projections, Easton (2006) states that “there is the potential of bias in estimates of the

expected rate of return due to biases in analysts’ forecasts of earnings.” More optimistic forecasts

will increase forecast error and bias the expected rate of return, upward leading to the conclusion

of a higher cost of equity capital Less optimistic forecasts will bias the expected rate of return

downward leading to the conclusion of a lower cost of capital Forecast models tend to differ due

to the number of periods used to forecast expected earnings Due to these limitations, alternate

measures of the cost of equity capital will be incorporated

Finally, I examine whether or not fraud that occurs in one industry will have contagion

effects relative to firms in other similar industries in terms of asymmetric timeliness of earnings

as a measure of accounting conservatism It has been suggested that firms that are implicated in

fraudulent scandals tend to have widespread industry effects that could affect the level of

accounting conservatism and cost of equity capital within those same industries Gleason et al

(2008) found that firms that restated their financial statements caused decreases in share prices

among peer, non-restating firms in similar industries I construct this analysis by examining the

industries that comprise the highest total proportion of the sample

1.9 Sample Selection

I begin by identifying firms targeted by the SEC with the highest probability of allegedly

committing fraud vis-à-vis a control sample of firms An advantage of using the SEC’s

Enforcement Releases is that the announcements consist of firms that the SEC has targeted as

possessing a higher probability of being successfully found guilty of committing fraud (Feroz et

al., 1991; Dechow et al., 1996; Erickson et al., 2006) It is important to note that

contemporaneous research that investigates restatements differs from accusations of accounting

fraud even though the accounting treatment effect may remain the same Palmrose and Shultz

(2002) found that of 492 restatements examined,19 only 11 percent resulted in an SEC AAER release

The sample used in this study differs from restatements in terms of the intent (scienter) to

deceive and the magnitude of the deception While earnings management, restatements, and

fraud share certain attributes, there are distinctions between them (Erickson et al 2006) Thus,

restatements may involve genuine disagreements regarding GAAP, unlike fraud which involves

intentional applications of misconduct both within and outside the realms of GAAP (Dechow et

al., 1996) A limitation of studying restatements is that they may not capture that intent A higher

threshold test is to study firms allegedly accused of fraudulent activity as this increases the power

of the tests

It is important to note that the SEC’s prosecution practices have themselves been

considered conservative in nature (Bhattacharya, 2006; Caskey and Hanlon, 2005), at least prior

to the SOX Act For example, the penalties inflicted on firms have varied as they often consist of

cease and desist orders, restatements, settlements, injunctions, and civil or criminal prosecution.20 Feroz et al (1991) state that “targets’ managers settle enforcement actions by consenting to an

injunction that prohibits future violations of the securities laws.” A reason stated for the lack of

prosecution of firms allegedly accused of fraud is due to the interpretation that investors have

already been victimized by the market decline associated with the announcement Any additional

fines to the company would only hurt the shareholders, yet again

19

For the period 2002-2005, restatements were initiated internally by company management or internal auditors (58%) and other agencies and external auditors (24%) This is an increase from the 1997-2002 period for restatements prompted by company management or internal auditors (49%) and other agencies and external auditors (16%) (GAO, 2002; 2006)

20

Most recently, options backdating, thought to be the next big corporate scandal, has lost its momentum Many of the original prosecutors on the task force have resigned Legal experts are contemplating how well the backdating issue will fare in court This is due to the fact that many of the prior accounting scandals have failed to produce the expected criminal jail sentences The intent of options backdating in the pre-SOX period were widespread and provided little guidance Thus, it has been interpreted that “not everyone convicted in the court of public opinion suffers the same fate in front of a jury” (Burrows, 2007)

1.10 Organization of the Study

The remainder of this study is organized as follows: In the next section, I review the relevant

prior literature Secondly, I present the hypotheses and research methodology relating to

asymmetric timeliness, firm-specific measures of conservatism, regulations and standards, and

cost of equity capital Next, I discuss the data sources and sample selection process Thereafter, I

present the empirical results Lastly, I summarize the major findings and discuss the limitations

and directions for future research

CHAPTER 2 LITERATURE REVIEW

2.1 Background and Purpose

The purpose of this chapter is to provide a review of the relevant literature regarding

accounting conservatism, fraudulent financial reporting, and cost of equity capital First, I begin

with a discussion of earnings quality given that it remains an empirical issue as to whether

accounting conservatism can be considered an earnings quality attribute Next, I define

accounting conservatism, report the findings and major research contributions, and discuss the

relevance of the research designs utilized in the extant literature Thereafter, I discuss studies on

fraud, limitations of prior research methods and extensions, and a review of the cost of equity

capital

2.2 Definition and Relevance of Earnings Quality

Investors use financial statements in order to forecast firms’ future profitability and for

valuation purposes The goal of accounting information is to reduce information asymmetry or

risk between firms and the stock market Research has attempted to show that, not only is the

quantity of disclosure of financial information important, but also the quality of the financial

information (Francis et al 2004; Schipper and Vincent, 2003; Penman, 2003)

“Earnings quality is an important aspect of evaluating an entity’s financial health Yet

investors, creditors, and other financial statement users often overlook it.” (Bellovary, 2005)

Schipper and Vincent (2003) define earnings quality as “the extent to which reported earnings