Financial statement fraud : capital market effects and ameliorating management actions

The purpose of this research is to examine the effects that financial statement fraud announcements and certain strategic actions have on the perceived validity of financial disclosures. This study posits that: (1) Financial statement fraud announcements damage the perceived validity of future financial disclosures, and (2) certain strategic actions performed subsequent to a fraud announcement improve the perceived validity of financial disclosures. The hypotheses are based upon the prior literature that uses the earnings response coefficient (ERC) to measure earnings quality. In a similar light, this study uses the ERC to measure the perceived validity of financial disclosures. Based on prior academic literature, anecdotal evidence, and data availability, the following four strategic actions were chosen for examination and are hypothesized to improve the ERC following a financial statement fraud announcement: change the external auditor, increase the percentage of outsiders comprising the board of directors, form an audit committee, and change upper management. The OLS regression results provide evidence that a financial statement fraud announcement is associated with a decrease in the ERC, and that the strategic actions of changing external auditor and increasing the percentage of outsiders comprising the board of directors following a fraud announcement improve the ERC. These results suggest that financial statement frauds reduce the perceived validity of future financial disclosures, and that the strategic actions of changing external auditor and increasing the percentage of outside directors help mitigate this reduction.