Do Accounting Errors Breed Fraud?

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2590155

Do Accounting Errors Breed Fraud?

Vivian W. Fang University of Minnesota – Twin Cities – Department of Accounting

Allen Huang Hong Kong University of Science and Technology – Department of Accounting

Wenyu Wang Indiana University – Kelley School of Business – Department of Finance
April 5, 2015
Kelley School of Business Research Paper No. 15-29

Abstract: 
This paper links accounting errors to firms’ incentives for fraud. While errors discourage fraud by lowering the value relevance of reported earnings, they also incentivize fraud by providing camouflage. We analyze the two effects in the framework of Fischer and Verrecchia (2000) and generate hypotheses. Using intentional and unintentional misstatements as empirical proxies for fraud and errors, respectively, we document a hump-shaped relationship between an industry’s prevalence of fraud and that of errors. This result is robust to using SEC enforcement actions or the likelihood of meeting or marginally beating analyst consensus forecasts as alternative proxies for fraud. Motivated by three causes of errors (i.e., transaction complexity, regulation ambiguity, and staffing deficiency), we use firms’ number of items in their quarterly filings, rules-based characteristics of accounting standards, and state boards’ CPA requirements as alternative proxies for errors. These proxies are associated with fraud in a similar fashion as errors. Our results highlight an important economic implication of accounting errors and shed light on the recent debate on “principles-based” versus “rules-based” accounting systems.

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