Conservatism, SEC Investigation, and Fraud

Posted: 8 Sep 2012

See all articles by Pervaiz Alam

Pervaiz Alam

Kent State University

Karin A. Petruska

Youngstown State University

Date Written: August 31, 2012

Abstract

We present evidence on the relationship between firms that have engaged in fraudulent financial reporting and accounting conservatism. We empirically investigate the extent to which U.S. firms identified by the SEC in their Enforcement Releases demonstrate higher levels of conditional conservatism in order to mitigate information asymmetry and agency problems. Specifically, by assessing the timing of changes in the litigation risk environment for fraud firms, we document how differences in heightened legal liability guide changes in conservative accounting behavior. Compared to a matched non-fraud control sample, we document that fraud firms have significantly lower levels of accounting conservatism in the pre-fraud period. Consistent with changes in potential legal liability, we find an increase in accounting conservatism for fraud firms during the SEC investigation period. Subsequently, during the public discovery of fraud, accounting conservatism converges back to lower levels. Overall, our findings suggest more temporary changes in conservative reporting in the short-term for fraud firms. We also document that increased levels of accounting conservatism for fraud firms are not due solely to the passage of the SOX Act. Our findings aid in explaining fraud firms’ incentives and opportunities for accounting conservatism and lend support for why standard setters, regulators and auditors should continue to monitor and re-evaluate conservatism’s short-term effects that are conditioned on changes in a firm’s risk environment.

Keywords: Accounting conservatism, asymmetric timeliness, firm-year measure, financial reporting, fraud

JEL Classification: M41, M48, G38

Suggested Citation

Alam, Pervaiz and Petruska, Karin A., Conservatism, SEC Investigation, and Fraud (August 31, 2012). Journal of Accounting and Public Policy, Vol. 31, No. 4, 2012, Available at SSRN: https://ssrn.com/abstract=2142175

Pervaiz Alam

Kent State University ( email )

P.O. Box 5190
Kent, OH 44242-0001
United States
330-672-1121 (Phone)
330-672-2548 (Fax)

Karin A. Petruska (Contact Author)

Youngstown State University ( email )

Lariccia School of Accounting & Finance
Williamson College of Business Administration
Youngstown, OH 44555
United States
330-941-1876 (Phone)
330-941-1459 (Fax)

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