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  • Jennifer M Mueller-Phillips
    The Impact of Authority on Reporting Behavior,...
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of Authority on Reporting Behavior, Rationalization and Affect.
    Practical Implications:

    These results increase the understanding of how an authority figure’s directions to misreport impact the rationalizations and resulting reporting decisions. Situational inducement can be a powerful force on behavior and affect. The authors show that the situational inducement of being told to misreport enables individuals to mitigate the emotional cost of misreporting. The authors document the apparent ease with which misreporting individuals rationalize misreporting behavior in the presence of authority. This result can also be prevented by a good culture and leadership.

    Citation:

    Mayhew, B. W., & Murphy, P. R. 2014. The Impact of Authority on Reporting Behavior, Rationalization and Affect. Contemporary Accounting Research 31 (2): 420-443.

    Keywords:
    accounting fraud, rationalization, fraudulent reporting, fraud triangle
    Purpose of the Study:

    The authors conduct an experiment to examine reporting choices, rationalizations, and emotional responses when an authority figure directs participants to misreport. Several accounting scandals reportedly involved an authority figure instructing subordinates to perpetrate fraudulent financial reporting. The authors utilize the fraud triangle in their research setting to connect the theory of moral disengagement to the rationalization leg of the triangle. The fraud triangle suggests that three elements are necessary for fraud to occur: opportunity, motivation, and attitude/rationalization.

    The experimental reporting setting provides opportunity by allowing participants to report any income within the range of possible income. It also provides motivation by paying participants the income they report rather than the income they earn. The authors manipulate the setting to allow for ease of rationalization, by using an authority figure who instructs participants to misreport. When told to misreport, participants can rationalize their misreporting behavior by displacing responsibility. In a mixed design, the authors vary when the authority figure instructs participants to misreport, either on the first or second of two reporting opportunities. This design allows us to open the “black box” of whether and how an easily accessible rationalization impacts behavior and resulting emotion (affect).

    Design/Method/ Approach:

    The authors conduct an experiment using 88 participants recruited from an intermediate accounting class at a North American university. The average age of participants is 21 years. Participants listen to a lecture and complete two different multiple-choice quizzes. Each quiz culminates in an earned income based on the participant’s answers. Upon completing each quiz, participants learn their earned income and are then asked to report an income. They are paid what they report. The evidence was collected prior to 2014.

    Findings:
    • When not told to misreport before the first quiz, 49 percent of participants misreported. When the same participants were told me misreport 76 percent misreported.
    • When a separate set of participants were told to misreport after the first quiz, 72 percent misreported. They were not told to misreport after the second quiz, and 74 percent misreported.
    • When participants are told to misreport by an authority, they are significantly more likely to do so.
    • Misreporters rationalize their decision by displacing responsibility when they are told to misreport.
    • Misreporters in the authority treatments displace responsibility by saying, “I was told to” at significantly higher rates. The use of displacing responsibility fully mediates the relation between misreport instructions and misreporting behavior.
    • There are higher levels of guilt and discomfort (negative affect) among misreporters than honest reporters.
    • Misreporters feel increased negative affect. However, negative affect is significantly lower for misreporters who are instructed to misreport than those who misreport on their own volition.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity
  • The Auditing Section
    The Impact of Management Integrity on Audit Planning and...
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 02.03 Management Integrity Assessments, 06.04 Management Integrity, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of Management Integrity on Audit Planning and Evidence
    Practical Implications:

    The results of this study are important because, while severe cases of low integrity may be weeded out during client acceptance, auditor firms tend to retain clients with a wide spectrum of integrity levels that must be managed throughout the audit process. Thus evidence regarding how the integrity of management influences auditors (1) assessment of risk, (2) planning of audit procedures, and (3) identification of misstatements may be useful for developing training materials or best practices for approaching audits on the lower end of the integrity spectrum.

    Citation:

    Kizirian, T.G., B.W. Mayhew, and L.D. Sneathen, Jr. 2005. The impact of management integrity on audit planning and evidence. Auditing: A Journal of Practice & Theory 24 (2): 49-67.

    Keywords:
    Audit risk model, management integrity, evidence
    Purpose of the Study:

    Management integrity (i.e., “tone at the top”) is a key determinant of the client’s risk structure and provides the foundation of internal control. As a result, it is important that auditors incorporate this risk component into their audit judgments. Furthermore, auditors rely on management to provide a great deal of audit evidence. Thus, auditors must carefully evaluate management integrity to assess the credibility of management-supplied evidence. To determine the extent to which auditor judgments are influenced by perceptions of management’s integrity, this study examines the effect of auditor-assessed management integrity on three aspects of the audit: (1) auditors’ assessments of risk of material misstatement (RMM), (2) audit planning, and (3) audit outcomes (i.e., identification of misstatements).

    Design/Method/ Approach:

     The authors collected their data from working papers of 60 clients of a U.S. Big 4 auditing firm. The working papers used were from engagements performed between 1996 and 1999. In all of the selected engagements, the auditors had documented an explicit assessment of management integrity as either “strong,” “moderate,” or “weak.”

    Findings:
    • Auditor-assessed management integrity is negatively related to the auditor’s assessment of RMM (i.e., high integrity is related to low risk assessments). However, the primary driver of auditors’ risk assessments appears to be whether or not the auditors identified a misstatement during the prior year audit (i.e., identification of a prior year error leads to higher assessments of RMM). In the case of a prior year misstatement, management integrity has no additional impact on assessments of RMM.
    • The auditor responds to low management integrity by requiring more persuasive evidence to support audit assertions. Additionally, management integrity was not related to the timing or extent of audit procedures. This suggests that when management integrity is low, the auditor goes outside the client for independent data verification rather than simply increasing the analysis of the client’s information.
    • When the auditor assesses that management is of low integrity, they are more likely to discover misstatements. Furthermore, the authors find that this is not just because the auditor tends to be more diligent in their testing when management is of low integrity. This suggests that management integrity is a good indicator of the likelihood that the financials are misstated.  
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Client Risk Assessment, Management Integrity, Assessing Risk of Material Misstatement, Earnings Management, Earnings Management
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  • Jennifer M Mueller-Phillips
    The Ties that Bind: The Decision to Co-Offend in Fraud.
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Ties that Bind: The Decision to Co-Offend in Fraud.
    Practical Implications:

    The phenomenon of co-offending is an important key to understanding fraudulent behavior. Understanding co-offending is best approached through a study of social ties. The reasons for co-offending vary according to the type of bond that exists between the co-offenders. Internal controls, such as job rotation policies, mandatory holidays with role replacement, forensic audits and surprise audits, that are specifically geared toward unraveling organizational cliques and subcultures help uncover fraudulent activities within a firm. This research suggests that the fraud triangle presents an overly parsimonious explanation of offending, and should incorporate materialistic, cultural, and affective considerations.

    Citation:

    Free, C., & Murphy, P. R. 2015. The Ties that Bind: The Decision to Co-Offend in Fraud. Contemporary Accounting Research 32 (1): 18-54.

    Keywords:
    fraud, forensic accounting, insider trading in securities, money laundering, co-offending
    Purpose of the Study:

    This article investigates the reasons why individuals co-offend in fraud. It is frequently observed that fraud has a greater economic impact on society than any other category of crime. “Co-offending” here refers to the perpetration of a fraud by more than one person and includes criminal cooperation at different times and places, a process in which individuals willingly pool their resources in the pursuit of shared but illegal goals. The focus of the article is on why some offenders opt to co-offend rather than offend alone in committing fraud. In the case of fraud, co-offending carries the risk that one party will cheat an accomplice, divulge his or her identity to authorities, or increase the latter’s likelihood of detection or arrest. In spite of these risks, in the many cases it is only by building a co-offending group that the opportunity can be accessed.

    Design/Method/ Approach:

    The authors researched instances where the fraud was perpetrated by a group of co-offenders. The data for this study is drawn from semi-structured interviews with 37 participants in the United States, 31 of whom were serving a sentence for fraud, and 6 of whom had completed their prison sentences. In each instance, the fraud was perpetrated by a group of two or more co-offenders. Each inmate had to volunteer to be interviewed. The evidence was collected prior to June 26, 2014.

    Findings:

    Two dimensions of fraudulent co-offending were identifiedthe primary beneficiary of the fraud and the nature of group attachmentto derive three distinct archetypes of bonds between co-offenders: (1) individual-serving functional bonds, (2) organization-serving functional bonds, and (3) affective bonds.

    • The findings suggest that the social nature of fraud is not merely an incidental feature of the crime but is instead a potential key to understanding its etiology and some of its distinctive features.
    • 60 percent of responders committed fraud as a co-offender.
    • The largest portion of participants (21 of 37) fell in the individual-serving functional bounds category. Usually, under this category, one person suggests that fraud and others follow.
    • Some individuals often feel a need to emulate others outside of greed or financial need.
    • In some instances organizational costs and benefits are more salient to offenders than self-interest.
    • Group norms of loyalty, trust and distrust, and even antagonism toward other parties can cement a group together while providing easy rationalizations for perpetrating fraud.
    • Some participants felt that societal and cultural factors effectively sanctioned fraud.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity
  • Jennifer M Mueller-Phillips
    Tone Management.
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Tone Management.
    Practical Implications:

    The evidence indicates that tone manipulation succeeds in misleading investors, and that this effect is incremental to the effect of accruals management. An abnormally positive tone incites an overly optimistic immediate stock price response to the earnings announcement and a subsequent return reversal. The evidence indicates that abnormal positive tone contains negative information about future firm fundamentals, that firms tend to engage in tone management particularly when incentives to manipulate investor perceptions are high, and that investors are misinformed by tone management.

    Citation:

    Huang, X., Teoh, S. H., & Zhang, Y. 2014. Tone Management. Accounting Review 89 (3): 1083-1113.

    Keywords:
    behavior finance, earnings management, market efficiency, qualitative disclosure, tone management, management integrity
    Purpose of the Study:

    The tone of the qualitative text in earnings press releases can be too optimistic or pessimistic relative to concurrent disclosures of quantitative performance. The authors call the choice of the tone level in qualitative text that is incommensurate with the concurrent quantitative information tone management. The authors investigate whether managers engage in tone management for informative or strategic purposes, and whether and to what extent the capital market discounts for strategic motives, if any, when reacting to earnings announcements.

    Earnings press releases, being voluntary, are not subject to explicit rules about the disclosure, so management has wide latitude in the qualitative presentation of the quantitative information. The authors are interested in studying how the tone of the press release affects readers’ response to the communication, and whether and how tone can be used as a tool to affect investors’ perception about the firm. As the old adage goes, “It’s not what you say; it’s how you say it.”

    A key goal for this paper is to test whether tone management in earnings press releases informs or misinforms investors. The authors examine how abnormal positive tone relates to future firm performance, whether abnormal tone is more likely used in situations where managerial strategic incentives to manipulate investor perception are present, and whether and how investors react to tone management at the time of, and subsequent to, the earnings announcements.

    Design/Method/ Approach:

    The authors obtain a sample of 14,475 observations of firm-year abnormal positive tone from the text of annual earnings press releases from PR Newswire and Business Wire, historical financial data from Compustat, stock returns from CRSP, analysts’ earnings forecasts data from I/B/E/S, seasoned equity offering (SEO) and merger and acquisition (M&A) effective dates from SDC, and option grants data for CEOs from ExecuComp. The sample period was 19972007.

    Findings:

    The evidence indicates that abnormal positive tone is associated with a more positive immediate market response to the earnings announcement and a more negative market response in one and two quarters subsequent to the announcement. The return reversal in the post-announcement period is strong evidence of an over-reaction to abnormal positive tone at the earnings announcement. Among firms that use both accruals and tone management in a consistent direction, the authors find that tone management is more likely in older firms and firms facing higher balance sheet bloat, as proxied by lagged assets scaled net operating assets, and so are more constrained in further upward accruals management. Abnormal positive tone is usually higher when firms just meet or beat past earnings or analysts’ consensus forecasts, when earnings are upwardly biased to such an extent as to require a future restatement, and before a new equity issuance or a merger or acquisition activity. When firms award stock options to CEOs, with an associated managerial incentive to reduce the share price, they prefer to manipulate abnormal tone downward. Overall, the evidence suggests that managers use tone management to mislead investors and other financial statement users.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Management Integrity