Predicting Material Accounting Misstatements

Abstract

We examine 2,190 SEC Accounting and Auditing Enforcement Releases (AAERs) issued between 1982 and 2005. We obtain a comprehensive sample of firms that are alleged to have misstated their financial statements. We examine the characteristics of misstating firms along five dimensions: accrual quality, financial performance, non-financial measures, off-balance sheet activities, and market-based measures. We compare misstating firms to themselves during non-misstatement years and misstating firms to the broader population of all publicly listed firms. We find that managers appear to be hiding diminishing performance during misstatement years. We find that accruals are high and that misstating firms have a greater proportion of assets with valuations that are more subject to managerial discretion. In addition, the extent of leasing is increasing and there are abnormal reductions in the number of employees. Misstating firms are raising more financing, have higher price-to-fundamental ratios, and have strong prior stock price performance. We develop a model to predict accounting misstatements. The output of this model is a scaled logistic probability that we term the F-Score, where values greater than one suggest a greater likelihood of a misstatement.

Keywords: earnings quality, accounting misstatement, fraud prediction, accrual quality, F-Score

JEL Classification: G34, M41