Internal Control Weaknesses and Financial Reporting Fraud.
Donelson, Dain C.; Ege, Matthew S.; McInnis, John M. Auditing: A Journal of Practice & Theory. Aug2017, Vol. 36 Issue 3, p45-69.
This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. There is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. Further, there is no evidence on the mechanism linking control strength to fraud risk. We find a strong association between material weaknesses and future fraud revelation. We theorize that this link could be attributable to weak controls (1) giving managers greater opportunity to commit fraud, or (2) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support for the opportunity explanation, but not through specific accounts linked to control weaknesses. Instead, consistent with the PCAOB's assertion, weaknesses in entity-wide controls, not process-level controls, are associated with a higher risk of reporting fraud.
Trump's Infrastructure Plan Isn't Much of a Plan.
. 7/12/2017, p1-1.
Prompting the Benefit of the Doubt: The Joint Effect of Auditor-Client Social Bonds and Measurement Uncertainty on Audit Adjustments.
KACHELMEIER, STEVEN J.; VAN LANDUYT, BEN W. Journal of Accounting Research. Sep2017, Vol. 55 Issue 4, p963-994.
We design an incentivized experiment to test whether measurement uncertainty elevates the risk that social bonds between auditors and reporters compromise audit adjustments. Results indicate that, when audit evidence is characterized by some residual uncertainty, the adjustments our auditor-participants require are sensitive to whether auditors have an opportunity to form a modest but friendly social bond with reporters. In contrast, although auditors do not adjust fully even when misstatements are known with certainty, social bonding has no effect in this scenario. Accordingly, our experiment contributes beyond the main effects of social bonding and measurement uncertainty demonstrated in prior research by showing that these forces interact. A practical implication is that regulators and practitioners should consider both the technical and the social challenges facing audits of complex estimates.
Supporting and Assessing Agents.
LAUX, VOLKER. Journal of Accounting Research. Sep2017, Vol. 55 Issue 4, p995-1016.
This manuscript proposes a theory of why and when organizations 'support' their employees with resources, time, and freedom beyond what seems economically optimal. The idea is that support plays an information-generating role in that it renders output more informative about employees' abilities. This effect reduces the need to gather additional information about ability via costly monitoring and commits the firm to make replacement/promotion decisions that are more sensitive to performance. Consequently, support indirectly strengthens employees' career concern incentives and reduces the pressure on costly bonus payments. I apply the model to tech companies, academia, and capital budgeting.
Blockholder exit threats in the presence of private benefits of control.
Hope, Ole-Kristian; Wu, Han; Zhao, Wuyang. Review of Accounting Studies. Jun2017, Vol. 22 Issue 2, p873-902.
Exit theory predicts a governance role for outside blockholders' exit threats, but this role could be ineffective if managers' potential private benefits exceed their loss in stock-price declines caused by the blockholders' exits. We test this prediction using the Split-Share Structure Reform (SSSR) in China, which provided a large exogenous and permanent shock to the cost for outside blockholders to exit. We find that firms whose outside blockholders experience an increase in exit threats improve performance more than those whose outside blockholders experience no increase. The governance effect of exit threats also is ineffective in the group of firms with the highest concern for private benefits of control. Finally, a battery of theory-motivated tests shows that the documented effects are unlikely explained by outside blockholder intervention or some well-known intended effects of SSSR.