Cumulative Prospect Theory and Managerial Incentives for...

research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations

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Title:

Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting.

Practical Implications:

The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual-level behavioral implications on firm-level archival data, the study re-conceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real-world setting of fraudulent financial reporting.

Citation:

Fung, M. K. 2015. Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting. *Contemporary Accounting Research*, 32 (1): 55-75.

Keywords:

fraud, probability theory, reporting, restatements

Purpose of the Study:

Risk-taking is fundamental to the survival and development of a firm. Nevertheless, some managerial risk-taking behaviors, like fraudulent financial reporting with an intention to deceive or mislead investors, are potentially disastrous to firm value. Fraudulent reporting of financial results is a risky way to improve the firm’s financial appearance, and thus the incidence of fraudulent reporting is expected to be associated with the manager’s propensity to take risks. In the current study, reference gains and losses (i.e., performance outcomes) are respectively defined as positive and negative deviations of the firm’s actual accounting-based performance from a reference point. The reference point is defined as the mean performance of industry peers. The study extends the cumulative prospect theory, CPT, fourfold pattern of managerial incentives to fraudulent financial reporting, hypothesizing that a manager is more likely to engage in fraudulent financial reporting over low-probability reference gains or high-probability reference losses, and is less likely to do so over high-probability reference gains or low-probability reference losses. The intuition is that a manager is more likely to be risk-seeking when he is faced with a high (low) probability of underperforming (outperforming) the rivals, and is more likely to be risk-averse if he is faced with a high (low) probability of outperforming (underperforming) the rivals.

Design/Method/ Approach:

To compile the misstatement sample, a list of firms that have restated their financial statements during the period of 1997–2005 for accounting irregularities was taken from the U.S. Government Accountability Office (GAO), which were then matched with the COMPUSTAT database. The sample contains 12- misstating firms and 152 misstated firm-years. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers.

Findings:

- The findings show that fraud incidence is positively related to the probability of a loss; more sensitive to the probability of a loss; and more sensitive to an extra unit of the probability at a high- or low- probability level (i.e., nonlinear probability weighting function.
- The findings also show that fraud incidence is negatively related to the probability of a gain; less sensitive to the probability of a gain; and less sensitive to an extra until of the probability at a medium- probability level.
- The study empirically substantiates the fourfold incentive pattern characterized by loss aversion and shows that fraud incentives are nonlinear in the probabilities of performance outcomes due to CPT’s nonlinear probability weighting function.
- Imperfect information faced by managers about competitors’ performance is a possible concern arising from framing performance outcomes relative to peer performance.

Author 1:

Michael K. Fung

Category:

Accountants' Reporting, Risk & Risk Management - Including Fraud Risk

Sub-category:

Management Integrity, Restatements