Mohammad J. Abdolmohammadi
William J. Read
Abstract: We identify a sample of 36 publicly-held companies with financial fraud in their 2003 financial statements. We use industry-specific summary corporate governance ratings (CGQ-Y) from RiskMetrics Group (formerly Institutional Investor Services), to select a sample of control firms with governance ratings similar to the fraud firms. We trace changes in CGQ-Y ratings as well as numerous governance mechanisms over the period of 2003-2006 to identify those with significant differences between the fraud firms and control firms. Specifically, we identify two corporate governance mechanisms with theoretical justification for their effects on differences due to fraud. The first is the extent of non-audit services, as proxied by the dollar magnitude of ‘audit-related’ and ‘other’ non-audit fees, provided by incumbent auditors. We hypothesize and find that significantly fewer fraud firms received substantial non-audit services compared to the control sample. The second governance variable is board election, where we hypothesize and find that fraud companies elect all directors annually, more often than control firms, which have more staggered terms for their directors.
We used the Compustat data base to codify a number of control variables identified from prior literature as impacting governance and investigated differences by fraud and control firms. We do not find significant differences between fraud and control firms with respect to return on assets, the proportion of executive ownership of the firm, or firm size. However, we find that fraud firms have significantly more financial need, lower Z-scores, and more audit committee meetings in the fraud year than control firms. Finally, when compared with control firms, we find that fraud firms improve their overall governance rating in the year following the fraud, but revert to lower ratings in the following two years.
Keywords: Corporate governance; financial fraud.
Data Availability: Performance and financial data are available from Compustat. Financial fraud data were obtained from public sources and corporate governance ratings were obtained from RiskMetrics Group.
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A Preliminary Investigation of the Necessary Skills, Education Requirements, and Training Requirements for Forensic Accountants | Full Article (PDF)
Dorothy A. McMullen
Maria H. Sanchez
Abstract: Forensic accounting, recently a seldom heard term, has quickly become a hot new area for students, professionals, and researchers. However, given that it is such a new field, there is little existing research in this area, especially in the area of forensic accounting education. Many schools are rushing to offer courses, minors, and even majors in forensic accounting, yet so far there has been little academic research to investigate the demands of the profession. In this study, we examine the professional community’s perceptions of the necessary skills for forensic accountants, as well as the education requirements and the training requirements considered important to the profession. We developed a survey through interviews with practicing professionals and a review of the limited existing literature. The survey was administered to over 150 fraud and forensic accounting professionals.
Keywords: Forensic accounting skills; careers in forensic accounting.
Auditors Moving from Guidance to Requirements: Arriving at the Risk Assessment Standards | Full Article (PDF)
Brian Patrick Green
Abstract: For many years, AICPA audit standards offered minimal guidance for risk-based audit planning. While some leading CPA firms developed risk-based audit plans, practitioners did not apply such standards consistently. But by 1980 the AICPA developed auditing standards that provided more structured guidance for auditors’ (1) assessment of identified risks, (2) audit planning with a focus on strengths and weaknesses of an organization’s internal control environment, and (3) plans to respond to risks of error and fraud. These auditing standards evolved into the audit risk assessment standards that require auditors to gain an in-depth understanding of an organization’s control environment, rigorously assess the risk of financial statement misstatement based on that understanding, and specify audit procedures that respond to the assessed risk. The purpose of this paper is to describe the evolution of risk assessment and discuss the possible effect of the current standards on future practice and the profession. Understanding the evolution of risk assessment forms a key part in designing and evaluating audit procedures to control, detect and report on fraudulent activities.
Risk assessment standards; audit guidance; expectation gap; internal controls.
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Section 404 Material Weaknesses: Using Communication Strategies to Predict Bankruptcy, Mergers, or SEC Reporting Problems within the Computer Industry | Full Article (PDF)
Sheri L. Erickson
Abstract: We use Benoit’s (1995) image restoration typology to analyze the communication strategies computer firms apply to disclose their material weaknesses in Section 404 reports. The results of this study indicate that although the majority of firms report corrective actions, some firms use non-corrective action strategies in response to material weaknesses and these firms experience significant increases in the incidence of mergers, bankruptcy, and regulatory noncompliance. The occurrence rate is nearly double for non-corrective action firms compared to the industry. In addition, firms that use non-correction action strategies appear to have significantly more control environment material weaknesses than firms that use corrective action strategies.
Keywords: SarbOx; Material Weaknesses; Internal Control; Communication Strategies.
Data Availability: Data is available from the authors upon request.
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Abstract: It is generally accepted that litigation against firms could result in significant losses to stockholders. In a bid to mitigate investor losses, research is needed to identify factors that could be used in predicting litigation against firms. The purpose of this study is to contribute to the literature by investigating whether there is an association between audit fees and subsequent client litigation. If there is an association, then audit fees may be used as an early warning signal of client litigation. We hypothesize and find a positive association between audit fees and subsequent client litigation. Change in audit fees is also significantly higher for litigation firms. Our findings suggest that audit fees may be used as an early warning signal of subsequent client litigation.
Keywords: Audit Fees; Legal Cost; Litigation; Risk.
Data Availability: Data is publicly available.
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Clark M. Wheatley
Abstract: SEC registrants have suggested that Section 404 of the Sarbanes-Oxley Act (Section 404) has significantly increased the work associated with an audit and that in the post Sarbanes-Oxley period auditors are much more likely to resign from clients perceived to be risky. This has important implications, from a forensic standpoint, for both current and successor auditors. We examine auditor changes during 2005 for 2,923 non-financial firms that filed their initial Section 404 opinions. We find that there is a significant association between the disclosure of internal control problems and subsequent auditor resignations. This result provides empirical grounding for the controversy surrounding auditor resignations from risky clients in the post Sarbanes-Oxley period.
Internal controls; auditor resignations; auditor changes; section 404 disclosures.
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A Comparative Analysis of the Bootstrap versus Traditional Statistical Procedures Applied to Digital Analysis Based on Benford’s Law | Full Article (PDF)
Ik Seon Suh
T. Christopher Headrick
Abstract: This study develops a bootstrap procedure applied to digital analysis based on Benford’s Law. It shows that the developed procedure provides accurate diagnoses of fraud as opposed to traditional statistical procedures. The traditional procedures such as the chi-square goodness-of-fit test exhibit the problem of excessive power as the volume of transactions becomes large. This problem may lead auditors to expend unnecessary fraud investigation costs. In contrast, applications of the proposed bootstrap procedure to reported annual earnings of S&P 1500 companies, Federal Election Commission data, and extremely fraudulent data demonstrate the robustness of the proposed procedure over different periods of time and across small or large financial data sets.
Benford’s Law; Bootstrap; Confidence Interval; Cosmetic Earnings Management; Digital Analysis; Fraud; Power.
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Stephanie R. Sipe
Cheryl T. Metrejean
Abstract: There are many different kinds of pension fraud, but the type most likely to have significant adverse systemic consequences on an already strained national economy involves under-funding by employers of defined benefit pension obligations through two distinct types of fraud: nondisclosure and misrepresentation. This paper seeks to present a primer on the laws that regulate defined benefit plans, the problems presented by the understaffing of the Employee Benefits Security Administration and the under-funding of and lack of oversight by the Pension Benefit Guaranty Corporation, and the potential for escalating pension fraud in today’s troubled corporate environment and depressed financial markets.
Defined Benefit Pension Plans; Pension Fraud; Earnings Management.
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Changes in Litigation Risk: An Analysis of Post-Sarbanes Oxley Audit Portfolios | Full Article (PDF)
Jerry L. Turner
Abstract: Despite passage of the Private Securities Litigation Reform Act in 1995, litigation against auditors and their clients threatens the viability of many audit firms. Turmoil in the audit profession in the early 2000s resulted not only in the demise of Arthur Andersen and the resulting realignment of audit portfolios, but in increasingly large lawsuits and increased scrutiny of the audit profession. As a result, auditors once more are seeking regulatory and legal relief to protect themselves from damaging lawsuits. While regulatory and legal relief may be achieved at some point, audit firms and their clients likely have been proactive in otherwise reducing exposure to litigation. This study uses three different surrogates for litigation risk ‘estimated discretionary accruals, relative risk of restatement, and degree of financial distress’ to compare the relative riskiness of the largest six audit firms and to evaluate changes in their litigation risk over time. Results indicate that the audit portfolios of five of the six firms likely reduced litigation risk between 2002 and 2005. Results also identify significant differences in litigation risk between the Big 4 and the two non-Big 4 firms examined.
Litigation risk; estimated discretionary accruals; relative risk of restatement.
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Internal Control Liability Concerns Post Sarbanes-Oxley: Perspectives on Legal Liability and Reasonableness | Full Article (PDF)
Roberta Ann Barra
Martin E. Taylor
Abstract: Differing internal control perspectives by accountants and lawyers make future internal control research imperative. Attorneys and accountants view the world of internal control very differently. The Sarbanes-Oxley Act (SarbOx) has made internal control part of the legal realm. Now, more than ever, it is important that accountants understand how attorneys view internal control before court battles begin. Attorneys find a lack of research in this area. Attorneys also differ from accountants in how they perceive reasonableness, effectiveness, cost/benefit, and the inherent limitation of internal control. Accountants should not be complacent that their view of internal control will be accepted by courts of law when SarbOx is inevitably tested.
Sarbanes Oxley; Internal control; Attorney; Legal Action.
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Technical, Legal and Internal Control Implications of Today’s Digital Multifunctional Devices | Full Article (PDF)
Richard J. Dippel
Abstract: Traditional forensics professionals use among other tools, fingerprint, blood splatter and ballistic analysis, DNA typing, and forensic pathology to make their case. Infosec professionals have to develop new tools for collecting, preserving, examining and evaluating electronic evidence in an effort to establish intent, culpability, motive, means, methods and loss, resulting from cyber-based crimes.
Considering the increasing complexity of technology and as a result, the devices which may contain latent and incriminating digital evidence, due to a migration from aged analog devices to state-of-the-art digital multifunctional devices (MFDs), this article discusses these MFDs, their potential legal exposures, their importance/role in IT audit and cyber forensic investigations and the exposure, which they may represent to un- and under- prepared organizations.
Multifunction Devices; Cyber Forensics; IT Audit; Internal Control Exposures; Privacy; Common Vulnerabilities and Exposures; Data Loss; Latent Electronic Evidence; Data Security; e-discovery.
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Abstract: We examine the stock price reaction to announcements that firms are being questioned for possible fraudulent financial reporting or manipulating earnings, using the firms cited by the Securities Exchange Commission (SEC) in its comment letters issued after August 1, 2004 through the end of 2006. These SEC letters concerning financial reporting issues were issued to public companies filing with the SEC. The final sample was 300 companies which included all the major SIC industries. To assess these reporting issues, six well established models and ratios were used: quality of earnings, quality of revenues, Sloan’s accrual measure, Altman’s bankruptcy model, Beneish’s fraud model, and the Dechow et al. fraud model. After adjusting for general price movements in the stock market, companies that had four or more of these six possible red flags for financial reporting had stock price declines of 40% to 80% over the two years following the release of these SEC comment letters. Forensic accountants, auditors, investment managers, and short sellers can use these six models to identify financial factors for assessing earnings management and fraud possibilities and related investment decisions.
Keywords: Earnings manipulation; Fraudulent financial reporting; Detection models; Stock market reactions.