Financial Reporting Fraud and Other Forms of Misconduct: A Multidisciplinary Review of The Literature

Rev Account Stud (2018) 23:732–783
https://doi.org/10.1007/s11142-017-9435-x
Financial reporting fraud and other forms of misconduct:

a multidisciplinary review of the literature
Dan Amiram 1 & Zahn Bozanic 2 & James D. Cox 3 &

Quentin Dupont 4 & Jonathan M. Karpoff 4 &
Richard Sloan 5
Published online: 25 January 2018

# Springer Science+Business Media, LLC, part of Springer Nature 2018
Abstract Financial reporting fraud and other forms of financial reporting misconduct
are a significant threat to the existence and efficiency of capital markets. This study
reviews the literature on financial reporting misconduct from the perspectives of law,
accounting, and finance. Our goals are to establish a common language for researchers
interested in this line of research, describe the main findings and challenges in these
literatures, and provide directions for future research. Although research on financial
reporting misconduct faces challenges, those challenges provide significant opportuni-
ties to advance the literature, as the answers to many questions on financial reporting
misconduct remain unsettled.
Keywords Financial reporting . Fraud . Misconduct . Irregularities . Misreporting .

Misrepresentation
JEL classification A13 . D62 . D82 . G32 . G38 . G41 . K22 . K23 . K42 . M41 . M42 . M48
* Zahn Bozanic
bozanic.1@fisher.osu.edu
1
Columbia Business School, Columbia University, New York, NY, USA
2
Fisher College of Business, The Ohio State University, Columbus, OH, USA
3
Duke School of Law, Duke University, Durham, NC, USA
4
Foster School of Business, University of Washington, Seattle, WA, USA
5
Haas School of Business, University of California, Berkeley, CA, USA
Financial reporting fraud and other forms of misconduct: a... 733
1 Introduction
Financial reporting fraud and other forms of financial reporting misconduct (hereafter,
financial reporting misconduct) are a significant threat to the existence and efficiency of
capital markets. This misconduct impairs the trust between corporations, gatekeepers,
and market participants that is required to engage in commerce. It also undermines
capital markets’ core role of efficiently allocating resources. Because financial
reporting misconduct may involve the manipulation of financial statements by a variety
of economic agents in capital markets under a particular legal regime, we believe that
advances in this literature are more likely to be achieved by combining the knowledge
and perspectives of multiple disciplines. This study thus reviews the literature on
financial reporting fraud and other forms of financial reporting misconduct from the
perspectives of law, accounting, and finance. Our goals are to establish a common
language for researchers interested in this line of research, describe the main findings
and challenges in these literatures, and provide directions for future research.1 Although
research on financial reporting misconduct faces challenges, those challenges provide
significant opportunities to advance the literature, as the answers to many questions on
financial reporting misconduct remain unsettled.
Our first task is to provide common ground by defining financial reporting fraud and
other forms of financial reporting misconduct. To do so, we examine terms that
researchers have used to describe financial reporting fraud and other forms of financial
reporting misconduct. Even casual readers of the literature probably note that researchers
use different terms—for example, fraud, misconduct, irregularities, misreporting, and
misrepresentation—to describe similar events of financial reporting misconduct. This is
presumably because the construct of interest in those studies is financial statement fraud,
and financial reporting fraud per se is not a simple concept to define under U.S. law or to
identify, either ex ante or ex post. The securities laws that define fraud—in particular,
Section 17(a) of the 1933 Securities Act, Section 10(b) of the 1934 Securities Exchange
Act, SEC Rule 10b-5, and case law (e.g., United States v. Simon)—are situational and
define fraud variously.
Nevertheless, relevant laws and rulings share a common feature when defining
fraud, namely, that fraud is a combination of multiple elements. The most basic of
these are that (i) there must be a misrepresentation in the form of a misstatement,
misreporting, or omission; (ii) that misrepresentation must be material; (iii) the person
making the misrepresentation must have done so with some fault in the sense that the
material misrepresentation was committed negligently, recklessly, or with knowledge of
its falsity; and, (iv) in private suits, the misrepresentation is causally related to a loss
suffered by the plaintiff. While additional elements can be considered, the elements
vary depending on the particular type of transaction. Given that fraud can be defined
variously, reliance on common law principles in interpreting the law may yield
distorted consequences in the context of financial reporting, including ex post rational-
ization (Bfraud by hindsight^) in demonstrating fraud. Because very few cases go to
trial, if researchers rely only on court rulings to identify financial reporting fraud, they
are likely to miss a significant portion of fraud events.
1
Consequent to the objectives of this review, we do not purport to provide a comprehensive summary of all
studies on financial statement misconduct, nor a review of all the papers in a select list of journals.
734 D. Amiram et al.
Presumably to avoid the legal nuances and ambiguity in the definition of fraud, the
literature on financial reporting misconduct has offered several definitions that attempt
to bypass these concerns. The definitions offered are typically in the spirit of that
promoted by COSO/ACFE’s Fraud Risk Management Guide (2016), which states:
BFraud is any intentional act or omission designed to deceive others, resulting in the
victim suffering a loss and/or the perpetrator achieving a gain.^ 2 Although this
definition is conceptually valid, it may be unsatisfying from a research perspective,
as it contains subjective elements and thus provides little guidance on how to identify
fraud empirically. That is, empirical researchers need practical, objective, and replicable
ways to identify fraud in their data.
One way to identify financial reporting fraud is to use the presence of fraud charges under
the 1933 and 1934 Acts in regulatory enforcement actions (e.g., Karpoff et al. 2017a).
Specifically, to reduce subjectivity and increase replicability, researchers can identify fraud
through allegations brought under either Section 17(a) of the 1933 Securities Act (fraudulent
interstate transactions)3 or Section 10(b) of the 1934 Securities Exchange Act (manipulative
and deceptive devices).4 Rather than attempting to identify fraud in an ad hoc manner, this
approach essentially relies on Securities and Exchange Commission (SEC) and Department
of Justice (DOJ) attorneys for fraud identification. Although this approach suffers from type
II errors (fraud exists but there is no charge), it is uncommon for the SEC and DOJ attorneys
to lose when they bring fraud charges, so the likelihood of a type I error (a charge is made
but there is no fraud) is relatively small. Alternatively, a researcher can use securities class-
action lawsuits that allege violations of SEC Rule 10b-5; however, many Rule 10b-5
lawsuits may be without merit, forcing the researcher to discriminate between legitimate
and frivolous fraud-related lawsuits. In this study, we refer to all of these allegations as fraud
but urge researchers to discuss in detail their approach to identifying fraud. We also note that
these fraud identification strategies frequently refer to alleged fraud and not fraud per se.
Not all types of financial reporting misconduct that may be of interest to researchers
constitute fraud. We define violations of Section 13(b) of the 1934 Securities Exchange
Act as financial misrepresentation. The language in Section 13(b) requires firms to
keep accurate books and records and mandates a system of internal controls to assure
accurate reporting. In this case, fraud would be an inaccurate characterization of the
sample because only roughly 75% of these cases from 1978 to 2015 include charges of
financial fraud under the 1933 or 1934 Acts. We define violations of Section 13(a) of
the 1934 Securities Exchange Act as financial misreporting. Section 13(a) requires the
timely filing with the SEC of certain financial reports, including 10-K and 10-Q reports.
We define financial irregularities as restatements due to intentional misstatement (as
opposed to restatements due to unintentional errors). Given the foregoing discussion,
we use financial reporting misconduct as an umbrella term to capture financial
reporting fraud, misrepresentation, misreporting, and other irregularities.5
These definitions also make clear the theoretical distinction between earnings
management and financial reporting misconduct. Financial reporting misconduct,
2
Fraud Risk Management Guide (2016), co-sponsored by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) and the Association of Certified Fraud Examiners (ACFE).
3
https://www.law.cornell.edu/uscode/text/15/77q
4
https://www.law.cornell.edu/uscode/text/15/78j
5
The framing for this nomenclature is in part motivated by the work of Jerry Martin, for which we are
indebted.
especially fraud, lies at the far right of a spectrum of discretionary accounting choices,
with Bearnings management^ to convey private information that complies with the
provisions of GAAP on the far left. Figure 1 illustrates this spectrum. While the scope
of this review is on the right side of the spectrum, there is obviously a significant gray
area in the middle. Nevertheless, insights from the earnings management literature have
been used to develop models to predict misconduct. As such, prior literature reveals
that factors such as discretionary accruals and proxies for earnings management are
significant predictors of financial reporting misconduct behavior. We also highlight
some newer methodologies that show promise in predicting misconduct, such as textual
analysis, voice analysis, and distributional anomalies.
Our cross-disciplinary review of the literature reveals several common threads,
insights, challenges, and opportunities that we now turn to summarize. A significant
body of research shows that financial reporting misconduct is associated with an array
of negative consequences. These include loss of future sales, stock price declines,
Fig. 1 This figure illustrates the spectrum of financial reporting choices. Financial reporting misconduct lies
at the right of the spectrum with earnings management on the left. We acknowledge that the figure does not
represent all instances of financial misconduct. For example, case law has established that fraud can occur
even if the firm’s financial statements are GAAP compliant. The Department of Justice (DOJ) is involved in
enforcement activity only when the misconduct triggers criminal charges. Financial restatements and private
securities class-action and derivative lawsuits can be associated with discretionary reporting choices along the
full range of the spectrum, although we anticipate that they become more likely as we move from the left to the
right of the spectrum
increases in the cost of capital, and—perhaps most important—the loss of reputation

and trust. In contrast to the relatively strong conclusions from the research on the
consequences of financial misconduct, there is mixed evidence on the causes of
financial misconduct. Capital market motivations—such as managerial stock options
ownership, the need to raise new financing, and profits from insider trading—do not
seem to consistently explain financial misconduct in the data. Similarly, contracting
motivations—such as meeting the targets of earnings-based contracts and avoiding debt
covenant violations—do not seem to be strong determinants of financial reporting
misconduct.
There is also conflicting evidence on whether internal monitoring and governance
limit financial misconduct behavior. Some findings suggest that a higher proportion of
outside directors and more effective audit committees and boards are associated with
less financial misconduct. Other studies, however, fail to find a relation between
financial reporting misconduct and key governance features, such as classified boards,
board independence, audit committee effectiveness, and Big-N auditors. With regard to
external monitoring, we know relatively little on the SEC’s objective function
pertaining to financial misconduct enforcement and detection. The literature shows
that SEC enforcement actions come in industry-specific enforcement waves that are
partly explained by the agency’s enforcement budget, but there is conflicting evidence
on whether proximity to SEC regional offices affects these actions. In addition, there is
some evidence on the use of artful legal strategies to exploit regulatory loopholes.
There is a relatively large literature examining the effectiveness of public enforce-
ment via agencies such as the SEC versus the effectiveness of private enforcement such
as class-action lawsuits. The evidence shows that both private and public enforcement
are associated with financial market development. Nevertheless, there is a debate about
whether the monetary payments by the firm that committed the misconduct to either
regulators (in the case of public enforcement) or to the plaintiffs (in the case of private
enforcement) are either fair or efficient. One concern is that, while financial reporting
misconduct is perpetrated by managers, the monetary payments are borne by the
shareholders. Shareholders therefore are harmed by both the misconduct itself and
the payments made. We cannot address whether this system is fair, but we note that the
system could still be efficient if we assume that shareholders can force a more efficient
internal monitoring system relative to external monitoring.
Somewhat mitigating concerns over the relative efficiency of public and private
enforcement, and in contrast to popular belief, there is evidence that many executives
engaging in financial reporting misconduct are punished. In particular, the vast majority
of managers who are prosecuted by the SEC for financial reporting misconducted are
replaced, and a sizable minority face criminal charges and jail time. While financial
reporting misconduct has negative career consequences for the culpable executives,
penalties for directors are smaller and the consequences less clear.
Given the large consequences for firms and managers that commit financial
reporting misconduct, why do they do it? There is mixed evidence about whether
misconduct is driven by capital markets or contracting motivations. More recent
advances can be found in research on the relations between personal traits of execu-
tives, social norms, and financial reporting misconduct. Findings in this area indicate
that (i) managers who engage in personal misconduct and who are less frugal are also
more likely to engage in reporting misconduct, (ii) CEO ancestry- and geography-based
social norms are associated with misconduct, and (iii) overconfident mangers who
initially provide optimistically biased statements feel compelled to engage in financial
reporting misconduct to cover up their initial bias. Another important recent finding is
that more than 70% of financial misconduct incidents occur in founder firms and
that this finding is likely due to founder hubris and overconfidence. In addition
to these findings, the literature cannot rule out the possibility that financial
reporting misconduct continues to exist and persists simply because its ex ante
net present value is positive (e.g., it could help firms issue new securities) or
the probability of getting caught is miniscule.
We identify four main challenges in the literature. As noted above, the first is the
variety of definitional problems in identifying financial reporting misconduct. Second,
it is unclear how many firms engage in misconduct yet never get caught and what the
characteristics of those firms are. Our knowledge of financial misconduct comes almost
exclusively from firms that were caught, and the characteristics of those firms may
differ from firms that commit fraud without detection. This problem of partial observ-
ability—which is either ignored or acknowledged as a caveat but rarely addressed—
severely limits the interpretation of some of the prior results found in the literature.
Third, misconduct is associated with numerous other simultaneous factors, such as
firms’ financial conditions, which impedes the disentanglement of cause and effect.
Fourth, different databases of financial misconduct yield different results. The main
reason for this is that each typically captures a different subset of information about an
instance of misconduct. A firm’s financial reporting misconduct usually is revealed to
the public via a complex sequence of announcements that typically spread over
multiple years, and a given database may only capture one of these many announce-
ments. Given these challenges, future researchers should consider revisiting prior
findings using more robust, and possibly yet-to-be discovered, techniques and
methodologies.
Many questions in this literature remain open. These questions include the follow-
ing. (i) Given the pervasiveness of partial observability and database problems in
conducting research on financial reporting misconduct, how robust are the extant
results and inferences? (ii) Why do managers engage in financial reporting misconduct?
(iii) How is financial misconduct disciplined and deterred around the world? (iv) How
do reputational and cultural enforcement interact with public and private enforcement?
(v) How does culture play into financial reporting misconduct? (vi) How significant are
measurement errors in current and previous financial reporting misconduct research?
(vii) To what extent does our current system in both public and private enforcement
systematically commit more Type I than Type II errors? (viii) What is the relation
between macroeconomic conditions and financial reporting misconduct? (ix) Is there a
relation between expected returns and the probability of financial reporting miscon-
duct? (x) What is the role of gatekeepers (e.g., lawyers, auditors, and media) in
detecting misconduct? We revisit these questions at the conclusion of this survey.
Because of this paper’s multidisciplinary intent, we draw on perspectives from a
leading expert in each field reviewed. James Cox thus provides his perspective on the
law literature on financial reporting misconduct in Section 2. Richard Sloan does so for
accounting in Section 3, and Jonathan Karpoff for finance in Section 4. Given this
structure, the survey proceeds as follows. Section 2 provides a review of legal issues
involving financial reporting misconduct, highlighting relevant case law, the elements
necessary to establish fraud, and several stylized institutional details that impede
empirical work in this domain. Section 3 provides a review of the accounting literature
on financial reporting misconduct, emphasizing research into the motivations for
engaging in financial reporting misconduct and the characteristics that facilitate it.
Section 4 provides a review of the finance research on financial misconduct, empha-
sizing how misconduct erodes the trust that underlies much contracting, exchange, and
production activity. In Section 5 we identify questions and opportunities for future
research into financial misconduct, and Section 6 concludes.
2 The legal perspective
2.1 Overview of the legal perspective
Because the mission of the federal securities laws is the protection of investors and
facilitation of the efficient allocation of capital, financial reporting misconduct is an
important focus within the legal community. This is most visible in the data that reports
slightly more than 200 securities fraud class actions are filed each year and about half
this number of suits are settled each year for an average of about $10 million (Comolli
and Starykh 2015). Adding to these statistics are enforcement actions filed by the
Securities Exchange Commission. Such private and public enforcement actions reflect
the U.S. commitment to truthful reporting of financial information by public compa-
nies. Nonetheless, what does and does not constitute a material misstatement,
misreporting, or omission is very much underexplored by legal scholars.
United States v. Simon, decided nearly half a century ago, remains among legal
academics the most important financial reporting fraud case.6 In that case, the Second
Circuit upheld the criminal conviction of Continental Vending’s auditor. The focus of
the auditor’s defense was the testimony of representatives from seven of the then Big 8
accounting firms. (Simon worked for the eighth firm.) Those representatives each
testified that Simon’s conduct complied with both generally accepted accounting
principles (GAAP) and generally accepted auditing standards (GAAS). The particular
issue that won Simon (and his associates on the engagement) not only a place in legal
history but a criminal fine was the failure of the audited financial statements to disclose
that money lent by one corporation to another, each of which was controlled by the
same person, Harold Roth, was re-lent to Roth. The footnote disclosure that was made
of the transaction was minimal and, in addition to failing to disclose the second firm
had re-lent to Roth the money it had borrowed from the first firm, did not also disclose
that repayment of the loan by Roth was highly questionable. Moreover, the auditor,
though aware that the loan amounts had increased after the close of the fiscal year when
the audit was on-going, did not use this post-statement period information to qualify
what was reported; in so acting, Simon complied literally with GAAS, which then did
not require post-statement information to be considered by the auditor. Simon was
widely commented on in the legal community when it was decided and continues to be
much discussed today. The ensuing commentary’s focus is not on Continental
Vending’s chicanery but instead on the doctrine Simon established: notwithstanding
6
425 F.2d 796 (2d Cir. 1969).
technical compliance with GAAP and GAAS, financial statements are materially
misleading if they do not conform with the statements in the auditor’s short-form
opinion that they Bfairly present^ the financial position and performance of the firm. As
a consequence of the auditor’s failure to meet the Bfairly presents^ standard, each were
subject to a criminal fine.
The overarching significance of Simon is not why the financial statements failed to
Bfairly present^ Continental Vending’s financial position, nor in identifying any partic-
ular deficiency in either GAAP or GAAS. Simon’s enduring significance is that the
Bfairly presents^ standard is an overarching requirement that drives the accounting
professional to exceed technical compliance with industry-developed norms. Contrary
to the approach taken in other areas (medical malpractice, for example), where com-
pliance with customary practice and industry standards insulate the professional from
tort or criminal responsibility, Simon finds such conformance is not itself sufficient if
the financial statements do not fairly report the firm’s performance and position.
The bankruptcy of Continental Vending was important in its day, but its failure is
dwarfed by that of Enron, WorldCom, and Lehman Brothers—each of which concealed
their vulnerabilities by the artful use of accounting. Nonetheless, little legal scholarship
resulted from their collapse, since none established any new legal doctrine. This section
seeks to both explain what attracts scholarly attention in the legal academy and provide
an overview of legal scholars’ foci on financial reporting misconduct.
Before reviewing the legal academic literature on financial reporting misconduct, it
is useful to better understand the forces that shape this literature. Scholars within any
discipline are shaped by their training and years of experience. Most legal scholars
endured three years of law school, often followed by a few years of practice that can
include clerking for a judge, private practice, or government service. Throughout this
period, they focus on statutes, administrative regulations, and judicial decisions but
invariably with a heavy emphasis on their policy implications. Such a focus springs
from the case method that is the steady fare in American law schools, where policy is
the currency of the realm. Thus the facts of a case are relevant not to themselves but as a
means for shaping the matter in dispute and highlighting the policy that underlies a
legislative, agency, or court action. Law students are indoctrinated into the importance
of not just logical thinking but, more emphatically, with the value of orderly process
and procedures. Above all, lawyers are proceduralists. Legal academics thus have not
only a deep interest in the wisdom of a statute, regulation, or case holding but also have
an unqualified interest in the process by which issues are resolved under a rule of law.
To be sure, the above is qualified by fairly recent shifts in hiring practices in elite law
schools; faculty members with JD-PhDs made up 67% of the law hires in 2014 and
2015 at the top 26 law schools. However, faculty members with JD-PhDs constitute
only 29% of the faculty of those schools (LoPucki 2016). Another study reports that, of
the 1374 PhDs on the faculty of the top 34 law schools, only 135, or about 10%, earned
PhDs in fields likely to engage in empirical research focused on financial reporting
misconduct (i.e., economics, business, finance, or statistics) (McCrary et al. 2016).
Thus the trend line for the prevalence of PhDs in the legal academy is definitely
upward; nonetheless, the bulk of legal academics, even at top law schools, do not hold
PhDs. Law professors who do not have a PhD but who wish to engage in empirical
work—a focus that increasingly is the currency within the legal academy—either must
engage in the substantial effort to Btech up^ or, more frequently, partner with an
academic who has the training and experience to conduct empirical research into legal
issues. Nonetheless, the bulk of legal scholarship, even that in the financial area, is
doctrinal and not empirical.
A further force shaping legal scholarship is the nature of law. For example, as noted
in the introduction, what constitutes Bfraud^ is not a simple concept. This is because
law is situational. Statutes and case law define fraud variously. And when defining it,
they share a common feature, namely that fraud is viewed as a combination of multiple
elements. The most basic elements are that (i) there must be a misrepresentation in the
form a misstatement or omission; (ii) the misrepresentation must be material; (iii) the
person making the misrepresentation must have done so with some fault, in the sense
that the material misrepresentation was committed negligently, recklessly, or with
knowledge of its falsity 7; and (iv) in private suits, the misrepresentation is causally
related to a loss suffered by the suit’s plaintiff. There are many more elements that are
common to such matters, and the elements vary depending on the particular type of
transaction, such as securities or consumer products.
2.2 State of the law literature on financial misconduct
2.2.1 Inquiring into the meaning of fraud?
Rarely does legal scholarship provide a close analysis of particular instances of

fraudulent financial reporting. Even in the highly significant Simon, legal scholarship
was focused on the broader question of the appropriateness of the Bfairly presents^
standard trumping compliance with GAAP and GAAS. As observed earlier, scholar-
ship discussing Simon did not focus on the misrepresentation committed by Continental
Vending but on the policy and implications for which the case is celebrated. A rare
exception to discussing fraud in the specific context is Bratton’s (2002) insightful
account of how Enron overstepped accounting principles in its reporting of forward
contracts and how doing so contributed to the false image of Enron’s operations and
financial position. Bratton suggests that, in an environment in which wealth
maximization drives managers to pursue the greater rewards that may
accompany risky choices, investor protection is more likely to be achieved by strong
initiatives to improve the professional detachment of auditors than by sweeping
changes in the mechanisms of corporate governance. Moreover, Coffee (2002)
7
While the term Bscienter^ is casually used at times in the popular press and some literatures, we do not
employ this term because the factors used to determine scienter vary across the 12 circuit courts of appeal.
That is, scienter does not require that the defendant intended or desired to mislead anyone; it is sufficient that
the misleading nature and consequences of words or actions are such that a reasonable person would be aware
they are inaccurate. [See SEC v. Falstaff Brewing Co., 629 F.2d 62, 76 (D.C. Cir. 1980).] Recklessness is also
a means to satisfy the courts’ requirement for scienter. The courts are divided on whether it is judged by an
objective standard, akin to a gross negligence approach, in which the defendant has made an extreme departure
from what would be reasonable under the circumstances (Buell 2011). However, most courts believe
recklessness is judged subjectively, where not just an extreme departure from what the reasonable person
would have done but taking that action or made statements that the defendant knew or must have known had a
danger of misleading investors. [See Broad v. Rockwell Int’l Corp., 642 F.2d 929, 961–62 (5th Cir. 1981).] In
addition to slight variations in how courts define recklessness, the appellate courts vary widely in their
approaches to applying the heightened pleading requirement private litigants must meet when alleging scienter
(Cox et al. 2009).
makes the case that Enron and similar financial frauds stem from the failure of
gatekeepers, most significantly auditors, whose independence and concern for reputa-
tion had robbed their profession of the ability to protect investor interests.
The doctrinal focus of legal scholarship on the meaning of fraud is rich with
complaints about the absence of an overarching objective for deeming conduct fraud-
ulent. Within the federal securities laws, conduct can be criminally prosecuted for the
same level of fault, for example, reckless disregard of the accuracy of a statement, as
required for private suits under the antifraud provisions. This raises an important
jurisprudential question, as criminal prosecutions involving incarceration in other areas
of the law are traditionally reserved for offenses believed to be morally blameworthy.
However, courts and the legislative history of the antifraud rule largely duck the
question of why a reckless misrepresentation merits a criminal sanction or why a
reckless misrepresentation committed by the CFO merits a large private recovery by
investors against her employer (Buell 2011).
In grappling with what prosecutors and investors must prove to recover for securities
fraud, federal courts frequently seek guidance from the common law principles for
deceit and misrepresentation. This seems to be a sensible approach, given that, over
centuries, courts have developed highly textured body of law to grapple with misrep-
resentations, albeit usually in face-to-face consumer or commercial transactions. None-
theless, scholars have repeatedly shown that federal courts’ attempts to divine the
meaning of fraud in the context of financial reporting by extrapolating insights from
the common law have frequently distorted the result (e.g., Goldberg and Zipursky
2013). This may suggest that policy perspectives the courts hold regarding a belief that
private fraud securities suits may be socially harmful impacts the results reached by the
courts. For example, the Supreme Court erred in its interpretation of the common law in
conditioning any securities class suits on the plaintiff establishing that there was a
material correction in the affected security’s price upon a public announcement that an
earlier misrepresentation had occurred.8 In the context of litigation, what is fraud in the
particular case is ultimately decided by the presiding court. Though precedent
established by the weight of case law built upon legislative enactments establish the
elements for fraud, those elements are applied to the facts of the particular dispute that
is before the court.
A central inquiry in the litigation is whether the defendant acted with knowledge,
recklessness, or negligence in making the statement the plaintiff claims was materially
misleading. In this context, there is a substantial risk of Bhindsight bias,^ meaning that
the court’s awareness of a bad outcome, for example, a substantial asset write-off,
biases the judgment in concluding that fraud had occurred, even if it had not (Gulati
et al. 2004). Comparing reported securities litigation from 1978 to 2004 where courts
invoked the phrase Bfraud by hindsight^ with decisions not using this expression,
Gulati et al. (2004) observe the expression served like a heightened pleading standard;
it was not code for overcoming possible bias so as to reach a fair result but instead was
used strategically in the early stages of litigation. Their analysis supports the view that
courts are not reluctant to use hindsight evidence to dismiss a case and do so with
statistically observable regularity when making a judgement on the pleadings respect-
ing whether the defendant acted with knowledge, recklessness, or negligence.
8
Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005)
2.2.2 Assessments of the efficacy of SEC and private enforcement9
Because attorneys involved in financial reporting misconduct suits by investors cus-

tomarily proceed on a contingency fee basis and most investor losses are not sufficient
in themselves to attract the interest of a contingency fee attorney, nearly all private
securities fraud litigation proceeds as a class action where investors’ claims are
aggregated. The suits invariably are so-called open-market fraud suits that allege
members of the class traded securities at a price that was impacted by a material
misrepresentation committed by the company, such as in a financial report or other
announcement that was materially misleading. Such suits have been extensively studied
by legal academics. The focus of this robust area of empirical work is not the meaning
of fraud; it has instead been how well class actions and even parallel government
enforcement actions likely fulfill a compensatory or deterrent function.
Central questions in securities fraud suits are whether the alleged misrepresen-
tation actually injured members of the class. In individual cases, plaintiffs and
defendants rely on event studies that examine not only the misrepresentation’s
impact, if any, on the security’s price but also whether the security’s price changed
upon a public announcement that the earlier announcement was materially mis-
leading. Brav and Heaton (2016) examine multiple problems with event studies
that focus on the stock price behavior of a single firm. Their analysis does not
reject the use of event studies, but it heavily caveats the use of event studies on a
single-firm basis in probing an announcement’s impact.
Related to event studies is the question of which metric should be used to measure
the benefits of securities fraud litigation. The conventional focus of this inquiry is
settlements that are reached between the parties (e.g., Cox et al. 2008). In this context,
investigators use event studies, albeit across a portfolio of securities class-action
settlements, to compare settlement amounts with estimates of the loss suffered by the
class. This comparison regularly reflects that recoveries, when measured against the
amount of estimated provable losses, are small and that statistically greater recoveries
(both in terms of absolute amount and relative to estimated provable losses) occur when
the lead plaintiff for the class action is a financial institution, especially if that financial
institution is a pension or labor fund (Choi et al. 2005; Cox et al. 2006).
What is not known is whether financial institutions achieve better results than when
individuals or a group of individuals are the lead plaintiffs, and whether the financial
institutions systematically cherry-pick the suits in which they petition to serve as lead
council. Such a self-selection bias is very much possible under procedures introduced
in 1995 by the Private Securities Litigation Reform Act (PSLRA). In a securities class
action, the presiding court circulates notice to all possible investors whereby any class
member can request to be appointed the lead plaintiff. The PSLRA provides that the
petitioner with the largest financial loss is presumptively the lead plaintiff. A compre-
hensive study found that there was competition to be the lead plaintiff in 71% of the
cases studied (Baker et al. 2015).
Because an institutional investor can be expected to suffer larger total losses than an
individual investor, this presumption favors large traders and hence financial
9
For earlier and more inclusive reviews of the empirical studies of securities fraud, see Choi (2004) and Cox
and Thomas (2009).
institutions. Moreover, because the PSLRA also places restrictions on the number of
suits during any five-year period in which the same individual or entity can serve as a
lead plaintiff, it provides an incentive for the institution to pick wisely in deciding in
which suits to involve itself. Cox et al. (2008) disaggregate settlements by their size as
well as type of lead plaintiff. Among the findings is that claims and settlements below
$2 million have a very different profile than larger settlements: the lead plaintiffs in
such suits are individuals not institutions, the suits’ claims are settled more quickly,
there is much less evidence of provable loss, and they are generally focused on a single
misrepresentation event.
As can be seen from the above, the type of plaintiff selected as the lead plaintiff
provides an important signal about the quality of the suit and its likely settlement value.
An additional consideration is how the PSLRA’s lead plaintiff provision changed the
competitive structure of the plaintiffs’ bar that prosecutes such suits. The lead plaintiff
is the class’ representative and the PSLRA assigns to the lead plaintiff the role of
selecting counsel for the suit. This necessarily means that law firms that wish to be
retained in large class-action suits must establish a stable of institutional clients that will
select that firm to be the class counsel for suits in which the institution petitions to be a
lead plaintiff and whose loss dwarfs that of other petitioners. Thus, post PSLRA,
plaintiff-oriented firms engaged in a number of practices to nurture relationships with
institutional investors, primarily public and labor pension funds. Indeed, the evidence
presented by Choi et al. (2011) demonstrates a link between political contributions by
plaintiff law firms and their selection as securities fraud class-action counsel.
Competition among plaintiff-oriented firms courting institutional clients should
produce evidence of lower fees. Studies of whether this is the case support the
conjecture, but the benefits of competition may be marginal. For example, one study
found that in only 11% of the examined settlements did the court approving the
settlement discuss the existence of an ex ante fee agreement. Fees tend to be lower in
federal courts that handle a high volume of securities class actions. They are also lower
(as a percentage of the settlement) when there was an ex ante fee agreement between
the lead plaintiff and class counsel. And public pension funds are more likely to
negotiate ex ante fee agreements with counsel (27% of the time for public pension
funds versus 13% for other types of lead plaintiff) (Baker et al. 2015).
There is a robust literature questioning the overall efficacy of private suits’ impact on
either deterring financial fraud or providing meaningful compensation. The leading
critic of private litigation is Joseph Grundfest, a former SEC Commissioner, who
reasons that overall the suits negatively impact capital formation and reward the bar
(Grundfest 1995). Echoing these concerns, Bratton and Wachter (2011) conclude that
the SEC, with an increased enforcement budget, would be more efficient than the
current approach. An intermediate approach is to not only increase the SEC’s enforce-
ment budget but to condition the initiation of securities class-action suits on case-by-
case approval of the SEC (Rose 2008).
The critics of private suits do not overcome the empirical evidence. Cox et al. (2003)
find that SEC enforcement actions accompanied settlements of securities class actions
in only 15% of the cases; thus many more investor successes occur without a parallel
SEC enforcement action. Moreover, the SEC targeted smaller firms than were targeted
in private suits and the firms targeted by the SEC were more likely to be suffering
financial distress. Even more flattering to private securities class actions are the findings
of Choi and Pritchard (2016) that disclosure violations are more precisely identified in
private suits than in SEC actions and that private suits yield more resignations of senior
officers than occurs when there is only an SEC enforcement action. The findings of
Choi and Pritchard (2016) that the private suits produced greater consequential effects
on managers than SEC enforcement actions is significant in light of the research
showing significant negative consequences to managers and the firm in government
enforcement actions (Karpoff et al. 2008a, b) (discussed in section 4.2).
There has been little work on the impact of private suits against firms that commit
open-market fraud. The leading work is that of Bai et al. (2010). They find that
defendant firms suffered negative changes in certain metrics bearing on their operating
efficiency (EBIT/total assets, current ratio, Altman Z-scores, and market-to-book ratio)
versus their cohort of firms not subject to fraud allegations during the pendency of the
suit. Following the settlement, defendant firms experience noticeable liquidity prob-
lems, including worsening Altman Z-scores. Their work therefore offers evidence that
litigation is not a zero-sum game for the firm, as would be the case were the settlement
only borne by the defendant firm’s insurer. On this point, it is notable that 43 of the 480
defendant firms in the study entered bankruptcy in the period beginning with com-
mencement of the suit and ending three years after the suit’s settlement.
Despite glowing reports on the efficacy of securities class actions vis-à-vis the SEC,
the image of the securities class action is tempered by two studies that raise a central
complaint: the securities class action may not serve a compensatory objective expected
of private suits. Cox and Thomas (2005) examine 118 securities class-action settle-
ments to determine whether institutional investors that had claims covered by a
settlement in fact pursued their share of the settlement the class had wrested from the
defendants in the action. They report that only 28% of the institutions entitled to
payment submitted claims; thus the institutions collectively left millions on the table.10
The compensatory mission of the securities class action is seriously challenged by
the so-called circularity problem. These suits involve open-market fraud, where a
publicly traded company commits a materially misleading misrepresentation that
impacts the price of its publicly traded stock. For example, if the company overstates
earnings for the fiscal year, a class action could maintain that the false information
inflated the stock’s price by, say, $1. Assume that a class action involving this act was
settled with the defendant corporation agreeing to pay each class member $1 for the
shares purchased during the period between the release of the deceptive statement and
announcement of the truth. With the simplifying assumptions that investors overall hold
a portfolio of securities, are frequent traders, or both, securities class actions can be seen
as reaping no net gain over their lifetime investment horizon. The purchasers in this
hypothetical who continue to hold their shares when the settlement is reached are
indirectly paying themselves. Also, over their investment horizon, the gains garnered
by firms that cook their books (sellers in this example) will be offset when they are the
victims of the firm’s misrepresentation. Only one unpublished empirical study has
explored whether such circularity exists; it finds that at least financial institutions break
even with respect to their trading in stocks of firms that settle securities class actions
(Thakor et al. 2005). A major data challenge in testing the circularity problem is
10
The study’s findings are nearly identical to the authors’ earlier pilot study of 53 settlements. See Cox and
Thomas (2002).
identifying not just institutional traders (whose identities can be and frequently are
masked in SEC filings) but the larger number of individual traders for whom the
portfolio and frequency of trading assumptions may less easily apply. The circulatory
problem is also relevant in the case of fines and other payments made by the firm as a
result of a fraud judgment or settlement in SEC or DOJ actions. This problem and
findings related to this problem are discussed in section 4.2.2 below.
2.2.3 Slippage within the regulatory net
Congress has mandated that, in promulgating rules, the SEC must consider whether the
rule is necessary and appropriate for the Bpublic interest^ as well as whether the rule
Bwill promote efficiency, competition and capital formation.^ 11 Many of the rules
adopted by the SEC are justified as necessary to protect investors from possible fraud.
A good deal of empirical analysis by legal academics is focused on whether well-
intentioned objectives of SEC rules are systematically eviscerated by artful strategies.
The best evidence on this topic is the rich body of research documenting that trading on
inside information is pervasive. Mergers and takeovers are particularly rife with insider
trading abuses in the pre-announcement period. Because these transactions customarily
involve significant market premiums to the acquired firm and because their planning
and execution involve many individuals, each faces the temptations of certain gains and
uncertain detection if he or she trades on secret knowledge. For example, Keown and
Pinkerton (1981) find significant evidence of insider trading 12 days before the first
public announcement of a merger. Moreover, about 40% to 50% of the price gain
experienced by the targets of takeovers occurs before the actual takeover announce-
ment. The stock market is not the only venue where the insiders reap the rewards; data
confirms that put and call options are also used by insiders to reap gains in the pre-
takeover period (Arnold et al. 2006).
An interesting example of how a regulatory safe harbor against charges of insider
trading is the study of Rule 10b5–1 plans.12 This regulation provides that employees
whose trades occur pursuant to a written trading plan that was entered into before the
employee was in possession of confidential material information does not constitute
illegal inside trading. Among the abuses that occur with these plans is that a single
executive can have co-existing buy and sell instructions, whereby the termination of the
sell plan, for example upon secret knowledge of a wealth increasing event, would
enable the executive to reap a gain upon the automatic purchase with the nonterminated
buy plan. Henderson (2011) documents that executives’ trading freedom increased
using Rule 10b5–1 in tandem with reductions in other forms of pay, suggesting that
those reductions occurred to offset the potential gains from trading on inside informa-
tion. Thus the specter that boards negotiate overall executive pay with an understanding
that some of the compensation will be reaped from the market as a consequence of the
executive’s informational advantage vis-à-vis outside investors.
Relatedly, Bozanic et al. (2012) examine the setting of insider trading and SEC
requests for comment. In an SEC request for comment, similar to a FASB request for
11
Securities Act Section 2(b), 15 U.S.C. §77(b).
12
Rule 10b5–1, Regulation Selective Disclosure and Insider Trading, prohibits company officers from trading
in their company’s stock while in Bknowing possession^ of material, nonpublic information.
comment, the SEC proposes new regulations and, before finalizing them, seeks input
from those outside of the SEC (e.g., investors, associations, individuals, etc.) on the
potential merits and consequences of the proposed regulation. Drawing on institutional
theory, the authors’ central premise revolves around the notion of regulatory capture. A
regulatory agency is said to be Bcaptured^ when it advocates for the interests of those it
regulates, especially large commercial enterprises with considerable resources to shape
policy outcomes, instead of acting in the public’s interest. Their findings suggest that the
SEC was more responsive to those to be regulated by the new insider trading regulation
than to those to whom this regulation was intended to protect from trading abuse. Namely,
those regulated by Rule 10b5–1 effectively influenced this regulation by way of success-
fully advocating for an affirmative defense provided for so-called Bplanned trades.^
Further evidence of perversion of SEC rules involves mandatory disclosure com-
pelled by Form 8-K. Historically, SEC-mandated disclosure has been periodic in the
sense that reporting companies must release detailed information annually and quarterly
on Form 10-K and 10-Q, respectively. Mandated disclosure is increasingly ongoing, as
the SEC has greatly expanded the range of items reporting companies must disclose
and that disclosure must occur for most items within four days of their occurrence.
Cohen et al. (2015) report that company insiders consistently reap abnormal returns by
trading with the four-day trading gap. The message here is that knowledge of informa-
tion that will not be released until a future date may well be a time of laissez faire for
company insiders.
Laxity in SEC enforcement of the agency’s own rules has also been explored. A
recent example is the poor oversight the SEC has accorded its path-breaking anti-
bundling rules adopted in 1992, which prohibit in a single proxy resolution the joinder
of multiple unconnected items. The rules serve the valuable purpose of preventing
public companies from combining in a single resolution something managers want but
shareholders generally may abhor, such as a classified board, with something that
shareholders may favor, such as a majority vote provision. A joinder such as this
presents shareholders with a distorted choice and undercuts the value of the shareholder
vote. Cox et al. (2016) find that, among about 1,300 proxy resolutions, disconnected
items were joined in roughly 30% of the resolutions, and more than 20% of the bundled
items involved instances of a material negative value resolution coupled with a material
positive value resolution.
Many mandatory disclosure requirements are designed to work prophylactically.
Specific directives regarding mandated disclosure can therefore be understood as the
first line of defense for investors and the integrity of capital markets. With so much
slippage around the SEC’s mandatory disclosure requirements, as illustrated by just the
few of many studies reviewed here, the future of securities fraud enforcement suits
appear well secured.
3 The accounting perspective
3.1 Overview of the accounting perspective
Many of the most infamous cases of corporate misconduct involve accounting misrep-
resentations. Enron and WorldCom are two classic examples from the recent past, with
the former ultimately leading to the downfall of Arthur Andersen, a once venerable
‘Big 5’ accounting firm. It is therefore not surprising that accounting researchers have
devoted considerable attention to the study of financial reporting misconduct. In this
section of the paper, we summarize financial reporting misconduct research from an
accounting perspective.
Recall the common features of fraud discussed previously: (i) there must be a
misrepresentation in the form a misstatement, misreporting, or an omission; (ii) that
misrepresentation must be material; (iii) the person making the misrepresentation must
have done so with some fault in the sense that the material misrepresentation was
committed negligently, recklessly, or with knowledge of its falsity (a crucial part here is
that errors without intent cannot be considered fraud); and (iv) in private suits the
misrepresentation is causally related to a loss suffered by the suit’s plaintiff.
Financial statements are obviously an important source of information for investors,
creditors, and other stakeholders and are thus a frequently alleged source of material
false statements that are relied upon by plaintiffs. While charges of securities fraud are
generally brought under Section 10(b) of the Exchange Act or Section 17(a)(1) of the
Securities Act, charges involving financial statement misrepresentations typically in-
clude violations of Section 13(b) of the Exchange Act. Section 13(b)(2)(A) requires that
SEC registrants Bmake and keep books, records, and accounts, which in reasonable
detail, accurately and fairly reflect the transactions. .. of the issuer.^ Heavy reliance is
placed on GAAP in determining whether the accounts fairly reflect the transactions of
the issuer. Nevertheless, as discussed in section 2.1 above, the U.S. vs. Simon ruling
shows that financial reporting fraud can be alleged in a criminal case and a conviction
secured even if in full compliance with GAAP.
There are three important definitional issues that are frequently overlooked in
accounting studies of financial reporting misconduct. First, studies of financial
reporting misconduct often employ a sample of companies subject to securities class-
action lawsuits. While such lawsuits frequently allege financial misrepresentations,
allegations of GAAP violations are less common. For example, Cornerstone Research
(2016) reports that, in 2015, 99% of securities class-action filings involved financial
misrepresentations, with 49% involving false forward-looking statements and only
35% involving GAAP violations. Thus many of these lawsuits do not involve specific
allegations of accounting misconduct. A good example of such a lawsuit is City of St.
Clair Shores Police and Fire Retirement System vs. Volkswagen AG, 15–01228, U.S.
District Court, E.D. Va. This securities class-action lawsuit alleges that Volkswagen
made materially false and misleading statements and omissions to investors concerning
company operations, financial condition, and outlook by failing to disclose that it had
used a Bdefeat device^ in certain diesel cars. Note that this case does not involve
specific allegations of GAAP violations.
The second important definitional issue relating to studies of financial reporting
misconduct involves the use of Accounting and Auditing Enforcement Releases
(AAERs) as a source of financial reporting frauds per se. Numerous studies employ
samples derived from AAERs, typically focusing on the subset of AAERs that make
allegations of violations of Section 13(b) of the Securities Exchange Act.13 The advantage
13
As further discussed in section 4.1, Karpoff et al. (2008a) find that 75% of these actions include allegation
of fraud.
of such an approach is that these cases are more likely to focus on GAAP violations and
other cases of accounting misrepresentations. However, civil enforcement and adminis-
trative actions brought by the SEC for violations of Section 13(b) do not have to prove
intent and hence do not necessarily constitute fraud.14
Third, accounting fraud lies at the far right of a spectrum of opportunistic accounting
choices, with legally acceptable earnings management that complies with the provi-
sions of GAAP on the far left. There is a significant gray area in the middle, which
includes other financial reporting misconduct, such as misrepresentation and
misreporting. Both class-action lawsuits and AAERs frequently lie in this gray area
as well. The vast majority of class-action lawsuits result in either dismissal or settlement
(Cornerstone Research 2015), and most AAERs are settled via consent decree, in which
a defendant accepts monetary and injunctive penalties without admitting to or denying
the allegations (Kaul 2015). Thus any research on financial reporting fraud based on
either a sample of securities class-action lawsuits or a sample of AAERs is more
correctly characterized as research involving allegations of misconduct, rather than
research involving established cases of misconduct.
We also note that the studies reviewed below typically rely, in whole or in part, on
the ability of AAER to discriminate between Bmisconduct^ and Bnonmisconduct^
firms, which, as discussed by Dechow et al. (2010), is problematic insofar as B… the
SEC has limited resources that constrain its ability to detect and prosecute
misstatements. Thus, the SEC may not pursue cases that involve ambiguity and
that it does not expect to win. As a result, the AAER sample is likely to contain
the most egregious misstatements and exclude firms that are aggressive but
manage earnings within GAAP.^
With these definitional issues in mind, we next turn to a summary and evalu-
ation of the primary findings of research on financial reporting fraud and other
misconduct. We note at the outset that there is a large body of related literature
that examines legally acceptable earnings management. Since the focus of this
study is financial reporting misconduct, we do not attempt to cover the volumi-
nous literature on earnings management but instead focus on studies that involve
allegations of misconduct.
3.2 State of the accounting literature on financial reporting misconduct
There is a large literature in accounting that examines financial reporting miscon-

duct. Within this literature, we focus on what we see as the four most important
strands of research. The first strand of research focuses on the motivations for
engaging in financial reporting misconduct. Self-enrichment is an obvious goal,
but the mechanism through which this is achieved (e.g., insider trading or incen-
tive compensation) is less clear. The second strand of research focuses on the
institutional characteristics that facilitate misconduct, such as weak governance
structures. The third strand identifies other variables associated with financial
reporting misconduct and that can be used to identify it. Finally, the fourth strand
focuses on the traits of executives who commit misconduct.
14
See Evans (2015) and SEC vs. World-Wide Coin Investments, 567 F. Supp. 724, 749–51 (N.D. Ga. 1983).
3.2.1 Motivations for engaging in financial reporting misconduct
Motivations for financial reporting misconduct fall into two broad categories. The first
category encompasses capital market incentives, including boosting the value of stock-
based compensation, obtaining new corporate financing on favorable terms, and
generating gains from insider trading. The second category encompasses contracting
incentives, including gaming accounting-based bonus contracts and avoiding
accounting-based debt covenants. We cover each in more detail below.
Capital market motivations This category of motivations centers on financial bene-

fits that can be derived from increasing the price of the company’s common stock. It
also applies to other securities that trade in capital markets, including debt and preferred
stock, and to derivative instruments that are tied to stock price, including employee
stock options, restricted stock, and stock appreciation rights. Perhaps the most often
cited motivation in this category is the desire to increase the value of stock-based
compensation. Top executives are frequently compensated with stock options, restrict-
ed stock, and stock appreciation rights. To the extent that these executives can increase
the price of the company’s stock by overstating earnings and other measures of
financial performance, the value of their stock-based compensation will also increase.
One of the earliest studies to examine whether stock-based compensation incentiv-
izes earnings management was by Beneish (1999b). This study examines a sample of
earnings overstatements in firms subject to AAERs. It finds that managers are more
likely to sell their holdings and exercise stock appreciation rights in earnings
overstatement periods. A subsequent paper by Burns and Kedia (2006) studies a sample
of restatements that arise from GAAP violations. This study finds that the sensitivity of
the CEO’s option portfolio to stock price is significantly positively related to misstate-
ments but that other stock-based components of compensation have no significant
relation with restatements. The authors attribute their results to the strong incentives
provided by the convex relation between option values and stock prices. In contrast to
the first two studies, Erickson et al. (2006) examine a sample of AAERs in which the
SEC makes explicit allegations of fraud and find no consistent evidence that executive
equity incentives are linked to fraud.
These early studies paint a mixed picture, and subsequent research has been unable
to conclusively resolve this question. Efendi et al. (2007) find that the likelihood of a
restatement increases significantly when the CEO has sizeable holdings of in-the-
money stock options. Peng and Röell (2008) find that employee stock options increase
the probability of securities class-action litigation. Johnson et al. (2009) find that
misconduct firms’ executives have greater incentives from unrestricted stock holdings.
Spurred by this mixed evidence, Armstrong et al. (2010) re-examine the link between
equity incentives and accounting irregularities using propensity-score matching to
control for omitted variable bias. This study finds no evidence of a positive association
between CEO equity incentives and accounting irregularities. Thus, while stock-based
compensation is a very frequently cited and highly researched motivation for financial
reporting misconduct, the evidence supporting it is mixed.
More recently, Call et al. (2016) make a novel contribution to research in this area. In
contrast to the prior research that concentrates on executive stock-based compensation,
Call et al. (2016) focus on the use of stock-based compensation for rank-and-file
employees. They find that firms involved in class-action securities litigation grant
more stock options to rank-and-file employees. They conclude that granting stock
options to these employees encourages them to facilitate misreporting and dis-
courages whistle blowing.
A second capital market-based motivation for financial reporting misconduct is to
raise new financing on more favorable terms. For example, a firm may overstate
earnings to obtain a higher price for a new equity issuance or a lower interest rate for
a new debt issuance. In extreme cases, a company could use financial reporting
misconduct to conceal financial distress, the disclosure of which could threaten the
company’s survival, let alone its ability to raise new capital. Dechow et al. (1996)
provide evidence on this issue. They examine a sample of firms subject to AAERs
and find that the firms are in need of external financing in the periods during
which they engage in misreporting. In a follow-up study, Beneish (1999b) does
not find firms in need of external financing engage in more misreporting, which he
attributes the difference in results to his use of age matching. Similarly, Burns and
Kedia (2006) and Erickson et al. (2006) find that the need for external financing is
significant in univariate tests but becomes insignificant after including other
controls.
A third capital-market-based motivation for financial reporting misconduct is to
generate profits from insider trading on the knowledge that the stock price is tempo-
rarily boosted due to the financial reporting misconduct. This motivation relates closely
to the previous two motivations. With respect to the stock-based compensation moti-
vation, employees are likely to have greater stockholdings with which to engage in
insider trading if they receive stock as a form of compensation. With respect to the
external financing motivation, we can view that motivation as a form of insider trading
on behalf of the firm, rather than on behalf of the individual. Early research by Dechow
et al. (1996) did not find a significant relation between AAERs and the level of insider
sales. Beneish (1999b) extends the work of Dechow et al. (1996) by using a more
comprehensive measure of net insider sales and includes a dummy variable for the
exercise of stock appreciation rights. Beneish (1999b) finds that both net insider selling
and the exercise of stock appreciation rights are greater in periods of earnings
overstatements. Peng and Röell (2008) provide confirmatory evidence of heightened
insider selling for a sample of firm-years subject to securities class-action lawsuits.
Contracting motivations This category of motivations involves the commission of

financial reporting misconduct with the goal of exploiting contracts that are based on
accounting numbers. There are two primary contracting motivations. The first is
earnings-based compensation contracts. The most common type of earnings-based
compensation contract is the annual bonus plan. Since these plans are usually tied
directly to earnings and have lower bounds that make them susceptible to gaming
(Healy 1985), they seem like natural catalysts for financial reporting misconduct. Yet
the evidence linking them to misconduct is both sparse and unsupportive. Dechow et al.
(1995) study the frequency with which an earnings-based bonus plan is identified in the
proxy statement. They find that bonus plans appear in about 40% of proxy statements
for both AAER firms and a sample of control firms, and conclude that bonus plans do
not appear to be a significant determinant of earnings manipulation. Beneish (1999b)
finds similar results. The weak results for earnings-based bonus plans seem surprising.
A possible explanation is that executive compensation is tied to earnings through other

explicit or implicit mechanisms, so tests focusing on formal bonus plans specified in
proxy statements lack power.
The second contracting motivation is to avoid the violation of covenants in debt
contracts that are based on accounting numbers. Dechow et al. (1996) study the
frequency of technical violations of debt covenants for a sample of AAERs from the
beginning of the manipulation period until two years after. They reason that the
discovery of earnings manipulation will lead to a restatement that will cause the
technical violation. Their results indicate that technical violations are twice as likely
in AAER firms, providing support for the debt contracting incentive. Beneish (1999b),
however, does not find evidence of a greater frequency of technical defaults in AAER
firms. Beneish attributes the different result to his use of an age-based control sample,
versus the size-based control sample used by Dechow et al. (1996). Burns and Kedia
(2006) use leverage as a proxy for closeness to covenants, finding that a sample of
restatement firms has higher leverage than a sample of nonrestating years. The authors
conclude that there is some evidence that firms might adopt aggressive accounting
practices to reduce the costs of financial distress.
3.2.2 Institutional features facilitating financial reporting misconduct
The previous section finds mixed and conflicting evidence for the various motivations
for financial reporting misconduct. This evidence makes it clear that the existence of
motive alone is not sufficient for financial reporting misconduct. A large body of
research examines institutional features that may facilitate financial reporting miscon-
duct. Foremost among these are various features of corporate governance.
The two early studies on the link between governance structures and financial
reporting misconduct are by Beasley (1996) and Dechow et al. (1996). Both studies
use AAERs for their misconduct sample, with Beasley (1996) adding some additional
cases of white-collar crime identified in the Wall Street Journal Index. Both studies find
that financial reporting misconduct is higher at firms with a greater proportion of
insiders on the board of directors. Dechow et al. (1996) also find that misconduct is
more likely when the CEO simultaneously serves as chairman of the board, when the
CEO is also the firm’s founder, when the board does not have an audit committee, and
when the firm does not have a significant outside blockholder.
Beasley (1996), in contrast, does not find that the lack of an audit committee
increases the likelihood of misconduct. In a follow-up study, however, Beasley et al.
(2000) do find evidence that misconduct firms in certain industries are less likely to
have audit committees. This matter is now somewhat moot, as the major U.S. stock
exchanges and the SEC now require firms to have audit committees. Beasley (1996)
also analyzes how outside director characteristics influence misconduct and finds that
misconduct decreases with director stock ownership and director tenure but increases
with the number of outside directorships held. Follow-up research by Fich and
Shivdasani (2007) and Zhao and Chen (2008) provides further evidence that good
governance practices help reduce financial reporting misconduct, though Larcker et al.
(2007) find that key dimensions of corporate governance have little relation to a sample
of accounting restatements.
Some studies further explore the role of internal controls on the incidence of
financial reporting misconduct. Beasley et al. (2000) find that misconduct is lower in
firms with a formal internal audit function. Coram et al. (2008) provide similar
evidence from Australia and New Zealand. Farber (2005) finds that misconduct firms
have fewer audit committee meetings leading up to financial reporting misconduct but
that audit committee meetings increase substantially afterward.
3.2.3 Other variables associated with financial reporting misconduct
A large body of research finds that various financial characteristics are systematically
associated with financial reporting misconduct. In some cases, the financial character-
istic is thought to reflect the mechanism through which the financial reporting miscon-
duct is perpetrated (e.g., abnormal accruals models), while in other cases, it is hypoth-
esized to reflect a circumstance that provides an incentive to commit misconduct (e.g.,
slowing sales growth). We consider each in turn.
The foundational studies on the mechanisms through which financial reporting
misconduct is perpetrated are by Dechow et al. (1995) and Beneish (1997, 1999a).
Dechow et al. use a sample of AAERs containing allegations of earnings overstate-
ments to evaluate alternative models for detecting earnings management. They consider
a variety of models based on working capital accruals. Their results indicate that
earnings manipulators tend to have larger working capital accruals. Moreover, they
note that many of the AAERs involve allegations of overstated sales revenue and that
this is reflected by increases in accounts receivable. An important implication of this
finding is that the popular Jones (1991) model of discretionary accruals can fail to
detect misconduct resulting from manipulation of sales revenue, because that model
directly controls for the change in sales.
Beneish (1997) builds on the work of Dechow et al. (1995) by showing that
both lagged accruals and an index of the days’ sales in receivables aid in the
identification of earnings manipulations. High lagged accruals are thought to
indicate that managers have exhausted legitimate techniques for earnings
management and so must resort to more questionable techniques. Beneish
(1999a) shows that an asset quality index helps to further predict manipulations.
This index comprises the ratio of noncurrent assets, other than property, plant, and
equipment, to total assets and measures the proportion of total assets for which
future benefits are potentially less certain. As such, the index builds on prior
research by considering accruals that extend beyond working capital.
Richardson et al. (2006) build on previous findings by showing that a compre-
hensive measure of accruals that incorporates both working capital accruals and
accruals relating to noncurrent assets and liabilities provides additional explana-
tory power for alleged earnings overstatements. They further show that cases of
alleged earnings overstatements relate negatively to subsequent accruals. This
result highlights the fact that alleged cases of earnings overstatements are charac-
terized by extreme accrual reversals in the aftermath of the overstatement. These
reversals are concentrated in the second and third years following the alleged
overstatements.
Dechow et al. (2011) provide a comprehensive model for predicting earnings
misstatements. Their results generally corroborate the accruals results from earlier
research. They also report some additional variables that help detect earnings manip-
ulations. They find that the percentage change in the number of employees, relative to
the percentage change in total assets, relates negatively to earnings overstatements.
They argue that the discrepancy between real growth and accounting measures of
growth helps flag accounting misstatements. They also find two footnote disclosures
that help identify earnings misstatements: firms with earnings misstatements have both
more operating leases and higher expected return assumptions for pension plan assets.
They interpret these results as indicating that earnings misstatement firms are more
likely to have exhausted Blegitimate^ techniques for earnings management before
resorting to more questionable misstatements.
The foundational study on financial characteristics reflecting incentives to commit
misconduct is by Beneish (1999a). Beneish (1999a) finds that earnings manipulators
have both deteriorating gross margins and high sales growth. He interprets the gross
margin result as suggesting that firms with deteriorating prospects are more likely to
engage in earnings manipulation. Beneish offers several explanations for the positive
relation between sales growth and earnings manipulations. First, the financial positions
and capital needs of growth firms put pressure on managers to meet earnings targets.
Second, the quality of internal controls and financial reporting systems tends to lag
operations in times of high growth. Third, if growth companies face large stock price
losses at the first indication of an earnings slowdown, they may have greater incentives
to manipulate earnings.
Subsequent research corroborates and extends the findings of Beneish (1999a)
in several respects. Johnson et al. (2009) find that misconduct firms experience
decelerating growth in earnings per share before the misconduct begins, suggest-
ing that they are facing negative shocks to financial performance. Dechow et al.
(2011) find that misstating firms have deteriorating return on assets. They also
find that misstating firms have high valuation multiples and larger stock-price run-
ups ahead of the manipulations. Finally, Chu et al. (2016) find that earnings
manipulators are firms that have had consecutive strings of positive earnings
surprises that appear to have contributed to their higher valuation multiples. The
combined evidence suggests that manipulators tend to be firms that have experi-
enced strong past operating performance that is beginning to wane. The strong
operating performance has led to elevated stock prices, and managers manipulate
earnings in an effort to preserve their high stock prices.
3.2.4 Recent methodological advances in misconduct prediction
There have been significant recent advances in methodologies to predict misconduct.

Brazel et al. (2009) assess misconduct risk using nonfinancial measures (NFM), such as
operating capacity (e.g., manufacturing space) or retail footprint (e.g., number of
outlets). They find that the difference between growth in either revenue or employee
count and NFMs is greater for misconduct firms as compared to their nonmisconduct
counterparts. Another recent and novel approach to the detection of financial miscon-
duct can be found in the work of Amiram et al. (2015), who apply Benford’s Law to
firms’ publicly reported financial statements. They show that (i) deviations from
Benford’s Law are positively correlated with accounting quality and earnings manage-
ment measures, (ii) firms that just beat zero earnings have higher deviation from
Benford’s Law than those that just miss, (iii) the restated financial statement numbers
firms report more closely conform to Benford’s Law, and (iv) divergence from
Benford’s Law is negatively associated with earnings persistence. In contrast to prior
related research, this approach does not rely on predicting model residuals, time-series
data, cross-sectional data, forward-looking information, or the identification of mana-
gerial incentives, and so forth.
Another statistics-based method can be found in the work of Cecchini et al.
(2010), who apply machine learning (i.e., support vector machines or SVM) to
financial statement data to classify misconduct firms. They show that their
technique can substantially improve upon the error rates documented in prior
research (e.g., Beneish 1999a; Dechow et al. 2011) by correctly labeling 80%
(90%) of misconduct (nonmisconduct) firms. Hoberg and Lewis (2015) employ
a linguistic approach by examining the text of the management discussion and
analysis (MD&A) section of firms’ 10-Ks. Specifically, they model the topics
found within the MD&A using Latent Dirichlet Allocation (Blei et al. 2003) to
shed light on the topics misconduct firms are more or less likely to disclose
(e.g., instances of omitting quantitative detail, over explaining to ex-post ratio-
nalize, or both).
Whereas Hoberg and Lewis (2015) employ a linguistic approach, Hobson et al.
(2012) examine whether vocal markers of cognitive dissonance help detect financial
misreporting. They use speech samples of CEOs during earnings conference calls and
generate vocal dissonance markers using automated vocal emotion analysis software.
They find that vocal dissonance markers are positively associated with the likelihood of
irregularity restatements. The diagnostic accuracy levels are 11% better than chance
and are of similar magnitudes to models based solely on financial accounting
information.
In the spirit of the work of both Cecchini et al. (2010) and Hoberg and Lewis (2015),
Purda and Skillicorn (2015) apply SVM techniques but, instead of using financial
statement data, classify misconduct firms using the individual words (i.e., instead of
topics) contained within firms’ MD&A. Thus their technique does not rely on a pre-
defined Bbag of words^ approach. They find that their SVM-derived, word-based
classifier outperforms other approaches in the literature (e.g., Brazel et al. 2009;
Dechow et al. 2011).
3.2.5 Executive traits
The discussion above highlights the incentives for engaging in financial reporting
misconduct and characteristics related to it. Yet it also appears that only a small fraction
of managers facing these incentives and characteristics seem to actually engage in
misconduct. Recent research has therefore focused on trying to understand why certain
managers engage in misconduct and which managerial traits are more likely to result in
misconduct.
Schrand and Zechman (2012) conduct a detailed analysis of 49 AAERs involving
financial misstatements. Their analysis indicates that most misstatements begin with
optimistic bias that is not clearly intentional fraud. Executives, however, feel compelled
to make increasingly optimistic statements to cover up the initial bias. This initial
overconfidence therefore leads to what they term the ‘slippery slope’ to financial
misreporting. Based on an analysis of executive compensation structure, they conclude

that overstating executives are more likely to exhibit characteristics of overconfidence
and narcissism.
Davidson et al. (2015) conduct a more detailed analysis of how executive
behaviors and personal traits influence corporate culture and financial
reporting risk. They find that CEOs and CFOs with more prior legal infrac-
tions are more likely to perpetrate financial reporting misconduct. They find
no direct link between executives’ conspicuous consumption patterns and
financial reporting misconduct. They, however, do find that less frugal CEOs
oversee a looser control environment that is more likely to result in financial
reporting errors.
Studies have also examined which executives are instrumental in the decision
to perpetrate financial reporting misconduct. Dechow et al. (1996) find that CEOs
who are company founders and CEOs who also serve as chair of the board of
directors are more likely to misstate earnings. These two results highlight the role
of the powerful, entrenched CEO in driving misconduct. Feng et al. (2011)
examine the importance of CFO involvement in accounting manipulations. They
find no evidence that higher CFO equity incentives lead to more manipulations,
but they do find that higher CEO equity incentives and power lead to more
manipulations. They conclude that CFOs succumb to CEO pressure, rather than
trying to seek personal financial benefit.
4 The finance perspective
4.1 Overview of the finance perspective
Financial reporting misconduct is an important problem in finance because it

undermines investors’ trust. Without trust, investors are less willing to partici-
pate in financial markets (Giannetti and Wang 2016). Without trust, large-scale
enterprise via the corporate form also would break down, as investors would be
unwilling to invest in activities over which managers have day-to-day control
(Mayer 2008). In theory, truthful financial reporting helps build investors’ trust
(e.g., Alchian and Demsetz 1972). Empirical research on financial misconduct
therefore can yield insights about whether financial reporting and investors’
trust are indeed of first-order importance for the corporate form of organization,
and through which channels they operate.
Dupont and Karpoff (2017) propose that trust is the foundation of most
exchange and production activity. The Btrust triangle,^ which is illustrated in
Fig. 2, provides a way to conceptualize the major threads in the finance
literature that examines financial misconduct. The left corner of the triangle
represents the role of third-party enforcement through legal institutions, as
explored in the law and finance literature (e.g., La Porta et al. 1998). The
right corner represents the role of culture, social norms, and personal values as
a foundation of trust. Recent literature has generated new insights about the
influence of culture and managerial traits on the incidence and impact of
financial misconduct. For example, Liu (2016) examines how a CEO’s ancestry
Fig. 2 This figure illustrates three main pathways by which counterparty trust is formed and enforced in
economic exchange and production activities. The lower left leg of the triangle refers to third-party enforce-
ment via the legal and regulatory system, including SEC enforcement of securities laws and private lawsuits.
The lower right leg of the triangle refers to cultural influences on the propensity to maintain trust, including
personal values and social norms. The upper leg of the triangle refers to related-party enforcement via markets
and reputation
affects the likelihood of financial misconduct, and Parsons et al. (2017) examine the
influence of geography-based social norms on misconduct. 15 The upper corner of the
trust triangle represents the role of markets and reputation in encouraging trust. Market
discipline for misconduct has been examined theoretically by Klein and Leffler (1981)
and Shapiro (1983), and Karpoff and Lott Jr. (1993) use the term Breputational loss^ to
refer to the present value of a firm’s losses from lower future sales and higher future
costs when it is revealed to have engaged in misconduct.16
As pointed out in the introduction to this survey, terminology can be important for
describing and interpreting the results of empirical tests in this literature. For example,
many papers use the term Bfraud^ in a colloquial sense to denote potentially misleading
reporting. Others reserve the term for intentional acts of financial deception. This latter
approach is consistent with the Public Company Accounting Oversight Board, which
argues that BThe primary factor that distinguishes fraud from error is whether the
underlying action that results in the misstatement of the financial statements is inten-
tional or unintentional.^ (AS § 2401.05) These definitional issues presumably arise
because, as discussed in section 2.1, the relevant statutes and case law are complex and
situation-specific and define fraud differently. Karpoff et al. (2017a) propose that U.S.
securities law provides a screen that can be useful in helping to identify financial
reporting fraud as opposed to other types of misconduct. In particular, the 1933
Securities Act identifies several categories of fraud for misleading representations in
connection with the offer or sale of a security, and the 1934 Securities Exchange Act
15
This literature has advanced as researchers have developed ways to measure culture that are tractable in
large samples. Many measures of cultural influence or social norms focus on (1) managers’ personal
backgrounds, behavior, and values (e.g., Cline et al. 2017), (2) religion (e.g., Stulz and Williamson 2003),
(3) geographic commonalities (e.g., Parsons et al. 2017), (4) political affiliations (e.g., Hutton et al. 2015), (5)
networks (e.g., Khanna et al. 2015), and (6) surveys and rankings (e.g., Bargeron et al. 2015). See also
Section 3.2.
16
Akerlof’s (1970) market for lemons characterizes the potential breakdown in trust when counterparties have
private information about their contractual performance. For additional theoretical models of reputation and
trust that overcome the lemons problem, see the work of Kreps and Wilson (1982), Diamond (1989), and
Tirole (1996).
has five statutory and seven regulatory fraud-related provisions that relate to deceptive
practices that affect the trading of a security that has already been issued.17,18
As an illustration of the potential relevance of a regulator-based definition of fraud,
Karpoff et al. (2008a) construct a sample based on violations of Section 13(b) of the
1934 Securities Exchange Act. The language in Section 13(b) requires firms to keep
accurate books and records and mandates a system of internal controls to assure
accurate reporting. So Karpoff et al. (2008a) refer to their sample as cases of Bfinancial
misrepresentation.^ In this case, Bfraud^ would be an inaccurate characterization of the
sample because only 75% of these cases included charges of financial fraud under the
1933 or 1934 Acts.
Some papers use samples of violations of Section 13(a) of the 1934 Securities
Exchange Act (e.g., Dechow et al. 1996). Section 13(a) requires the timely filing with
the SEC of certain financial reports, including 10-K and 10-Q reports. So, hypotheti-
cally, a firm could file accurate financial reports and thereby not violate the 13(b)
requirements for accurate books and records. But if the reports were filed late, the firm
could face charges for a 13(a) violation. To distinguish 13(a) from 13(b) violations, one
might use Bfinancial misreporting^ to refer to 13(a) violations and Bfinancial
misrepresentation^ to refer to 13(b) violations. As discussed in the introduction of this
survey, as an umbrella term that captures instances of financial misreporting, financial
misrepresentation, and financial fraud, we use the term Bfinancial misconduct.^ Finan-
cial misconduct also is sometimes used to describe instances of potential problems
identified by restatement announcements. However, Hennes et al. (2008) point out that
many restatement announcements are better characterized as errors than as irregulari-
ties, and so, in most applications, the term Bfinancial misconduct^ better describes the
events that Hennes et al. (2008) call irregularities.19
4.2 State of the finance literature on financial reporting misconduct
4.2.1 The consequences to firms of the discovery of financial misconduct
Trust, reputation, and financial reporting misconduct Economists have long real-
ized the importance of trust as a foundation for contracting, exchange, and production.
Klein and Leffler (1981) and Shapiro (1983) develop models in which reputation—and
reputation alone—encourages good behavior and disciplines bad behavior. In these
17
For example, Section 77q(a) of Title 15, Chapter 2A, Subchapter 1 prohibits any person B… 1) to employ
any device, scheme, or artifice to defraud, or 2) to obtain money or property by means of any untrue statement
of a material fact or any omission to state a material fact necessary in order to make the statements made ... not
misleading^ during the offer or sale of any security. Section 77q(b) prohibits a person from giving publicity to,
or disseminating information about, a security without fully disclosing the presence and amount of any
consideration received from an issuer, underwriter, or dealer (commonly known as an Banti-touting^ statute),
and Rule 230.463 requires new issuers to report on the uses of their issuance proceeds within the entity’s first
annual report filed with the SEC. Specifically, see Sections 77.17(a), 77.17(b), and 15.77q and Rule 230.463.
18
See sections 78.15(c), 78.10A, 78.10(b), 78.10(a), and 15.78j(b) and Rules 240.15c1–2, 240.10b-9,
240.10b5–1, 240.10b-5, 240.10b-3, 240.10b-10, and 240.10b. http://law.justia.com/cfr/title17/17-
3.0.1.1.1.1.58.75.html
19
Our proposed umbrella term, Bfinancial misconduct,^ differs from the term Bfinancial market misconduct,^
which Cumming et al. (2015) use to characterize a large class of illegal activities involving insider trading,
market manipulation, and broker-agency problems.
models, individuals or firms develop reputations for honest dealing. Good reputations
are valuable because they yield favorable terms of contract with customers, employees,
suppliers, and investors. As a consequence, firms can invest in reputation, just as they
might invest in machinery, R&D, or human capital. Reputational capital is the present
value of the improvement in net cash flow and lower cost of capital that arises when the
firm’s counterparties trust that the firm will uphold its explicit and implicit contracts
and will not act opportunistically to their counterparties’ detriment.
Despite the importance of trust and reputation in economic theory, there is relatively
little empirical research on whether reputation matters in financial contracting. As
examples of empirical research on reputation, Beatty et al. (1998) and Fang (2005)
find that investment banks with better reputations obtain higher fees for their services,
and Atanasov et al. (2012) find that venture capitalists who are sued by their
counterparties experience severe business cutbacks. The primary challenge for empir-
ical research in this area is that it is difficult to measure a firm’s reputational capital, and
we have little evidence on its size or value for most firms. 20 Financial misconduct
allows researchers to finesse the measurement problem by examining the counterex-
amples in which trust is broken and the value of a firm’s reputational capital changes,
that is, when firms and managers lie, cheat, and steal. While this approach does not
yield direct measures of a firm’s reputational capital, it allows us to infer whether,
where, and to what extent reputation works to enforce explicit and implicit contracts.
Market value losses when financial misconduct is revealed Many papers report that
share values decrease, on average, upon news that suggests the possibility of financial
misconduct, including earnings restatements, securities-related lawsuits, and regulatory
enforcement actions for financial misrepresentation.21 The point estimates of the loss in
share values, however, vary widely. On the high end, Karpoff et al. (2008a) report a
one-day average abnormal return of −25.2% for firms subject to SEC and Department
of Justice enforcement for financial misrepresentation, and Beneish (1999b) finds a
total cumulative loss of over 20% during a three-day window around announcements of
GAAP violations (SEC AAERs and news media revelations). Other samples yield
smaller estimates of loss. For example, Gande and Lewis (2009) report an average
three-day abnormal return of −4.7% for firms targeted in securities class-action law-
suits. Dechow et al. (1996) find an average one-day abnormal stock return of −8.8% for
firms subject to an SEC Accounting and Auditing Enforcement Release (AAER), and
20
Attempts to measure a firm’s reputation frequently are based on surveys (e.g., Pevzner et al. 2015), CSR-
based rankings (Sadok et al. 2011), or firms’ written materials (e.g., Guiso et al. 2015), although many
researchers define Breputation^ as a general opinion about the firm, rather than as a capital asset, as the term is
used in this paper. There also is overlap between measures of a firm’s reputation and measures of culture, as
summarized in footnote 10.
21
Studies that find share value losses associated with earnings restatements include those by Anderson and
Yohn (2002); Hribar and Jenkins (2004); Palmrose et al. 2004); Agrawal and Chadha (2005); Akhigbe et al.
(2005); Burns and Kedia (2006); Desai et al. (2006); Hennes et al. (2008); Kravet and Shevlin (2010); and
Chava et al. (2010). For share price reactions to securities-related lawsuits, see Kellogg (1984); Bohn and Choi
(1996); Francis et al. (1994); Ferris and Pritchard (2001); Griffin et al. (2004); Romano (1991); Bhagat et al.
(1998); and Gande and Lewis (2009). For share price reactions to regulatory enforcement actions for financial
misconduct, see Feroz et al. (1991); Dechow et al. (1996); Beneish (1999b); Ozbas (2008); Karpoff et al.
(2008a); and Karpoff and Lou (2010). Some papers use news stories or key word searches to identify samples
of financial misconduct, e.g., Karpoff and Lott Jr. (1993); Davidson et al. (1994); Bernile and Jarrell (2009);
and Tanimura and Okamoto (2013).
Burns and Kedia (2006) report an average three-day abnormal stock return of −8.8%
for a sample of financial restatement announcements.
Section 4.2.4 below argues that the wide variation in point estimates results in
part from the fact that different studies use different proxies and data sources to
compile samples of financial misconduct. These samples also differ by the extent
to which their events reflect relatively benign errors or more serious frauds. For
example, Hennes et al. (2008) calculate that the average abnormal stock return for
a subset of reporting errors in the GAO database is −1.93%, compared to −13.64%
for a subset of restatements in the GAO database that represent more serious
irregularities. Karpoff et al.(2017a) show that the events in several popular
databases that are associated with fraud charges, as brought by the SEC or
Department of Justice, have much more negative average stock returns than the
events unassociated with fraud charges.
Reputational losses for financial misconduct Despite heterogeneity in the samples

and point estimates, nearly all the available evidence indicates that share values fall, on
average, upon news of financial misconduct. In reasonably efficient markets, share
prices reflect investors’ expected values of future cash flows to equity, changing when
expectations change. This implies that changes in share values upon the revelation of
the firm’s misconduct provide a measure of investors’ expectations of the losses faced
by the firm. The losses can include direct costs, such as regulatory fines, class-action
settlements, and increased legal expenses. They also likely include a decline in share
value as investors realize they had been relying on incorrect financial information to
forecast the firm’s future cash flows, that is, a reversal of the share price inflation
attributable to the incorrect financials. The losses can also include lost reputation, that
is, the loss in value if the firm faces a higher cost of capital, lower sales, or higher
operating costs as the revelation of misconduct changes the terms by which
counterparties are willing to do business with the firm.
Several papers have attempted to isolate the portion of the total loss in share values
that is attributable to each of these types of penalties. In samples that include both
financial and other types of misconduct, Karpoff and Lott Jr. (1993) and Alexander
(1999) estimate that very little of firms’ total losses in share values—as little as 7%—is
attributable to direct costs such as fines and legal settlements, and that most of the loss
in share values represents lost reputation. In a sample consisting only of financial
statement misconduct, Karpoff et al. (2008a) estimate that 25% of the loss in share
values represents the reversal of the artificial price inflation that accompanies such
misconduct. Another 9% represents such direct costs as legal fines and penalties, and
the remaining 66% represents lost reputational capital. Consistent with this view,
Beneish (1999b) finds that only a small portion of firms’ losses around the announce-
ments of GAAP violations is attributable to settlement costs.
Information about financial misconduct and its consequences typically is conveyed
to investors via a long sequence of events that can stretch out over multiple years.
Karpoff et al. (2008a), for example, report that the average time from the initial
announcement of financial misconduct in their sample to the last SEC enforcement
activity related to the misconduct exceeds 50 months. It therefore can be challenging to
identify the value impact of news of the misconduct and to partition this impact into
direct costs and reputational losses.
Armour et al. (2016) exploit a setting that addresses this concern. In the United
Kingdom, enforcement activities for possible violations of financial regulation and
listing rules undertaken by the Financial Services Authority (FSA) and the London
Stock Exchange (LSE) involve only one public announcement. News about an inves-
tigation is announced only after misconduct has been established, and the announce-
ment includes complete information on any legal penalties. Furthermore, private
securities class-action lawsuits are virtually non-existent in the United Kingdom, so
the sole announcement contains complete information about the firm’s legal penalties.
This setting facilitates a precise breakdown of the loss in share value from news of
regulatory enforcement into the portion that represents legal penalties. Armour et al.
(2016) find relatively small total losses to firms when their misconduct is revealed
(−1.68%). Still, they find that reputational losses average nine times the losses that are
attributable to legal penalties.
Overall, the evidence indicates that firms can temporarily inflate their share values by
misrepresenting their earnings and assets. When the misrepresentation is detected,
however, firm value decreases by much more than the original share price inflation.
Some of the additional decline is due to legal penalties and other direct costs when the
misconduct is uncovered. The largest decline, however, is due to lost reputational capital.
Direct measures of lost reputational capital The measures of reputational loss

summarized above are estimates of the residual market value loss after tallying the
other sources of lost value. A problem with this approach is that the other sources of
loss may be poorly measured. Karpoff et al. (2008a) report, for example, that different
methods to measure the artificial share price inflation all generate large estimates of
reputational loss but the point estimates vary.
An alternative approach is to examine directly whether the revelation of financial
misconduct is associated with an increase in firm costs or a decrease in firm revenues.
Hribar and Jenkins (2004) and Kravet and Shevlin (2010), for example, find that the
cost of equity capital increases for firms that misrepresent earnings, and Chava et al.
(2010) find that the cost of equity capital increases following a securities class-action
lawsuit. Graham et al. (2008) and Chava et al. (2017) find that restating firms face
higher borrowing costs and tighter nonprice terms of their loan contracts, especially for
firms that restate due to fraud. Yuan and Zhang (2015) estimate that interest rate spreads
increase 19% for firms targeted by class-action lawsuits and that lenders also tighten
nonprice terms of these loans.
The increase in firms’ cost of capital appears to affect real investment activity, as
Autore et al. (2014) and Yuan and Zhang (2016) find that firms that are targets of
securities-related lawsuits subsequently reduce their external financing and investment
activity. The revelation of misconduct may also affect firms’ current operations, as
Palmrose et al. (2004) show that analysts forecast lower future earnings for restating
companies, and Murphy et al. (2009) find that misconduct firms experience both a
higher cost of capital and a decrease in cash flows from operations. Barber and
Darrough (1996); Karpoff et al. 1999 and Johnson et al. (2014) document wide-
ranging operational losses for firms targeted by lawsuits related to product market
frauds, as these firms experience higher operating costs and lower sales to large
customers. It is not clear, however, whether these results would extend to samples that
contain only financial misconduct.
Another open question is whether the residual and direct approaches to

measuring reputational loss yield similar measures of reputational loss for
individual firms, in addition to yielding similar inferences from sample
averages. Two papers make headway on this question. For product market
frauds, Johnson et al. (2014) show that their measures of reputational loss using
stock price reactions to news of misconduct and changes in subsequent operating
performance are positively correlated. Haslem et al. (2016) use both the residual
and direct approaches to support their inference that reputational losses are
significant for securities-related lawsuits but not for several other types of law-
suits. Nonetheless, the exact pathways by which misconduct firms suffer reputa-
tional losses are only partly understood.
Do misconduct firms always lose reputational capital? A central feature of models

of reputational capital is that firms lose reputation only if the firm’s counterparties
change the terms with which they are willing to do business with the firm. It is unlikely
that investors and firm counterparties intend to impose penalties on the offending firm.
Rather, they are simply protecting their own interests by requiring a premium to do
business with firms that are less trustworthy than previously believed. Firms that
defraud customers, for example, experience large reputational losses because they lose
sales. Similarly, firms that lose investors’ trust by misreporting their financials face a
higher cost of capital.
This raises an important question: do the firm’s counterparties care about and react to
any indication of firm misconduct, even if it does not affect them directly? Or do they
care only about misconduct that affects them directly? For example, suppose a firm is
caught dumping toxic waste into a river. We would expect firm value to decline to
reflect any expected legal consequences such as EPA fines. But does the firm’s
pollution directly affect its contracting with investors and customers? That is, does
the firm’s willingness to push social norms and violate the law with regard to environ-
mental safety cause investors to believe the firm’s financial statements are more likely
to be in error or cause customers to believe the firm is more likely to cheat them?
Some researchers argue that firm or managerial misconduct of any kind
reflects a culture of corruption that affects all of the firm’s counterparties. For
example, Porter and Van der Linde (1995) argue that environmental polluters
will suffer bad reputations that lead to lower sales, even if the pollution does
not directly affect the firm’s customers. Davidson et al. (2015) and Griffin et al.
(2017) show that, when managers act illegally or unethically in their personal
affairs, there is an increased chance the firm is cheating in its financial
reporting as well. These findings suggest that any indication of illegal or
unethical behavior can motivate a firm’s counterparties to change the terms of
their contracting with the firm, even if the misconduct does not directly affect
them.
A preponderance of available evidence, however, argues that such a view is
simplistic. Karpoff and Lott Jr. (1993); Alexander (1999); Karpoff et al. (2005);
Murphy et al. (2009); and Karpoff et al. (2017b) show that losses in
reputational capital are negligible for misconduct that affects third parties, such as
environmental violations, foreign bribery, and third-party regulatory violations. Exam-
ining a large sample of lawsuits related to several types of corporate misconduct,
Haslem et al. (2016) find evidence of reputational losses for securities-related lawsuits
but not for lawsuits related to such other types of misconduct as civil rights, personal
injury, or intellectual property violations.
Cline et al. (2017) report evidence that points to a specific channel by which
reputational penalties are imposed. Like Davidson et al. (2015) and Griffin et al. (2017),
they show that there is a positive relation between a manager’s personal indiscretions
and the likelihood of misconduct at the firm level. They show, however, that managerial
indiscretions affect firm value and operations only when they directly influence the
firm’s contracting with counterparties, for example, only when the manager’s behavior
increases a strategic partner’s concern that the manager will cheat on the strategic
partner relationship. These empirical results indicate that the role of reputation is more
complex than a bland admonition that firms should Bfollow the Golden Rule^ or Bdo
well by doing right.^ Reputational capital appears to discipline misconduct that directly
affects a firm’s counterparties but not other types of misconduct. This, in turn, implies
that firm culture matters for firm value and operations primarily when it facilitates low-
cost contracting with the firm’s counterparties, including investors, employees, sup-
pliers, and customers.
Rebuilding reputational capital If reputation is an asset, firms can invest in it.

Researchers have documented changes consistent with the notion that some firms
reinvest in reputational capital when it is diminished following financial miscon-
duct. Farber (2005) reports that firms change the composition of their boards
following a restatement, and Wilson (2008) shows that restating firms that change
their CEO or auditor recover their reporting credibility more quickly than firms
that do not make these changes. Marciukaityte et al. (2006) find that firms
increase the fraction of outside directors on their boards and on their audit,
compensation, and nominating committees following a broad range of
misconduct events. Chakravarthy et al. (2014) and Chava et al. (2017) find that
firms that restate their financials pursue a wide variety of reputation-rebuilding
investments that target both financial and nonfinancial stakeholders. Activities that
target investors include improving governance and internal control systems,
changing executives, increasing board independence, reorganizing the firm, and
repurchasing stock. Most of these papers also find that firms’ reputation-
rebuilding activities are associated with improvements in firm value or perfor-
mance, consistent with the view that firms make reputation-rebuilding investments
when they have positive net present value. Chava et al. (2010), however, find that
reputational damage can be long-lasting and not easily reversed, as restating firms
experience higher bank loan rates for at least six years after their restatements,
even if they invest in reputation rebuilding activities.
Although reputational investments can have positive NPV, we would not expect
them always to. For example, Klein and Leffler (1981) examine theoretically the
conditions under which reputational investments will not arise to assure perfor-
mance quality. An underexplored question in the literature is whether and under
what conditions firms that lose reputation optimally choose not to reinvest in it,
and whether such firms optimally liquidate or settle into a new market niche in
which they offer low quality assurance in their contracting with investors, sup-
pliers, and customers.
4.2.2 Should shareholders pay? Do managers pay?
La Porta et al. (2006) examine securities law enforcement around the world and
conclude that private enforcement, for example, via securities class-action lawsuits, is
associated with financial market development.22 Nonetheless, critics of securities class-
action lawsuits argue that a firm’s shareholders should not be held financially respon-
sible for financial misconduct that is perpetrated by managers (Arlen and Carney 1992).
This argument can be extended to all penalties imposed on a firm for financial
misconduct, including those imposed by regulators. Shareholders, according to this
argument, are victimized twice—once by the cheating mangers and again when the
firm suffers direct or reputational penalties when the misconduct is revealed.23
This criticism raises three related questions. First, do firm-level penalties victimize
shareholders twice? Second, does this imply that firm-level penalties are inefficient?
Third, do the individual perpetrators suffer personal consequences for financial mis-
conduct, or do they tend to get off without penalty?
Do shareholders pay twice? Regarding the first question, it is useful to use Jensen and
Meckling’s (1976) characterization of the firm as a nexus of contracts. The firm does
not make decisions, but rather people do. And while we talk as if the firm suffers a
penalty, the incidence of the penalty falls upon specific individuals. This perspective is
the basis for the argument that firms should not be penalized for misconduct, as the firm
does not commit misconduct. Rather, individual managers engage in the misconduct.
Viewed this way, it might seem that at least some shareholders are victimized
twice. Anyone who purchases stock before the misconduct is revealed pays
inflated prices, and all shareholders pay when the firm has to make legal payments
or suffers reputational losses. A further complication is that the extent to which
any individual shareholder pays depends on when she buys or sells shares.
Shareholders who pay the most are those who buy while the stock price is
artificially inflated by the false financial reports and who continue to hold until
the misconduct is revealed and penalized. Shareholders who sell while the firm’s
price is inflated by the misconduct, in contrast, can benefit.
The argument that a firm’s misconduct victimizes shareholders twice implies that
assessing penalties on the firm, rather than solely on managers, can exacerbate the
agency problem and provide too little misconduct deterrence. This is because the costs
of getting caught are diffused among the firm’s many stakeholders, rather than con-
centrated on the managers who are responsible for the misconduct.
Are firm-level penalties efficient? Might firm-level penalties nonetheless be an

efficient form of deterrence? The answer is yes, provided that the firm has a compar-
ative advantage in monitoring and disciplining managers. Suppose, for example, it is
very costly for an outside monitor, such as the SEC, to detect misconduct but relatively
22
For a counterargument and evidence that public enforcement via agencies such as the SEC are important for
financial market development, see Jackson and Roe (2009).
23
The legal perspective of this criticism, specifically whether penalties and class actions’ monetary outcomes
serve their compensatory role, is discussed in section 2.2.2.
easy to construct internal reporting and monitoring systems to do so. It could then be
efficient to expend resources internally to monitor managers and deter misconduct.24
This is how the prospect of penalties at the firm level can induce an efficient
investment of resources to monitor and deter misconduct. Since shareholders bear the
direct and reputational costs that are imposed on the firm, they have incentive to invest
optimally in internal monitoring and detection. So while shareholders are victimized
when managers engage in misconduct and the firm pays a penalty, the expected costs of
any potential misconduct are priced into the shares they purchase, and shareholders are
incentivized to invest optimally in monitoring and governance processes to deter
misconduct. As observed by Demsetz (1983) when discussing agency costs, the value
of the firm is net of the expected costs from monitoring and penalties, just like it is net
of the expected costs of labor and utilities. Indeed, the value of any idea that grows into
a firm is net of all such expected costs.
Consequences for managers and directors This efficiency argument for firm-level
penalties requires that managers internalize the expected costs of their misconduct. One
potentially important consequence is that a manager who engages in misconduct loses
his or her job. Indeed, it is reasonable to conjecture that the threat of job loss is a
primary avenue by which the firm’s internal governance deters managers from engag-
ing in misconduct that could be costly for shareholders. Despite such conjectures, early
research yielded mixed results on whether managers who were caught in misconduct
lost their jobs. While most findings suggested that they do (e.g., Feroz et al. 1991;
Alexander 1999; Desai et al. 2006; Arthaud-Day et al. 2006; Agrawal and Cooper
2016), others implied they do not (e.g., Beneish 1999b; Agrawal et al. 1999).
Karpoff et al. (2008b) argue that previous findings were mixed because the tests
were poorly specified for reasons discussed in more detail in Section 4.3 below. For
example, the Agrawal et al. (1999) sample is based on events that typically post-date
the actual revelation of misconduct. As a result, many actual forced CEO turnovers are
inaccurately categorized as occurring before the misconduct was uncovered and thus
are not counted as forced turnovers in their tests. Karpoff et al. (2008b) use detailed
case histories of financial misrepresentation prosecuted by the SEC to pinpoint when
the misconduct was uncovered and find that more than 90% of the managers who are
named as culpable are replaced. Further evidence indicates that sizable minorities of
these managers face criminal charges and jail sentences. These results indicate that
internal governance processes do, in fact, frequently discipline managers who are
caught engaging in financial misconduct. Consistent with this interpretation, Hazarika
et al. (2012) find that managers who aggressively manage earnings are significantly
more likely to be forced out of the firm, even if their earnings management does not
trigger regulatory enforcement.25
24
For an overview of the debate over the optimal mix of individual and firm-level penalties, see Arlen and Carney
(1992), Polinsky and Shavell (1993), Arlen and Kraakman (1997), Arlen (2007), and Jackson and Roe (2009).
25
Griffin et al. (2017) document a seeming counterexample to these results, as they find that many bank
managers who were associated with fraudulent residential mortgage-backed security offerings did not suffer
large career consequences. It is possible, however, that the RMBS-related frauds examined in this study did
not impose large reputational costs on the issuing banks. Cline et al. (2017) find that, in general, managerial
indiscretions are associated with large consequences only when they disrupt the firm’s relationships with
important counterparties.
The personal consequences to directors who serve on the boards of firms that
experience financial misconduct, in contrast, are less clear. Individual directors fre-
quently are named as defendants in securities-related lawsuits (Brochet and Srinivasan
2014). But Black et al. (2006) show that independent directors rarely are held person-
ally responsible for misconduct in such lawsuits and argue that directors’ major threat is
B… the time, aggravation, and potential harm to reputation that a lawsuit can entail, not
direct financial loss^ (p. 1056). Agrawal et al. (1999) find that directors do not
experience a high rate of turnover following the revelation of misconduct at their
companies, and Helland (2006) does not detect a decrease in these directors’ other
board seats. Srinivasan (2005), however, finds that outside directors, particularly those
serving on the audit committee, experience high turnover rates when their firms restate
earnings. Fich and Shivdasani (2007) find that outside directors do not experience high
turnover rates at firms that are targeted by class-action lawsuits for financial miscon-
duct, but they lose board seats in other companies.
Cai et al. (2009) find that directors of firms facing lawsuits receive slightly lower
support in subsequent director elections, but the effect is very small and has no
significant effect on directors’ reelection or compensation. Brochet and Srinivasan
(2014), however, find that the individual directors who are named as defendants in
securities-related lawsuits receive significantly more negative votes in director elections
and are more likely to leave the sued firms.
Some of these tests regarding directors may suffer from specification problems
similar to those discussed above regarding managerial turnover. Our interpretation is
that managers frequently experience significant personal costs when caught engaging in
financial misconduct but the personal costs to directors are smaller and less clear. An
important caveat to this literature, however, is that it does not establish whether the
penalties imposed on managers and directors are socially optimal. Optimality depends
not only on the size and cost of the penalty but also the social cost of the misconduct
and the probability of detection.
4.2.3 Why do managers do it? Motives and constraints
The evidence summarized in Section 4.2.1 indicates financial misconduct can result in
large share value and reputational losses. Section 4.2.2 indicates that managers caught
committing misconduct frequently risk job dismissal, civil penalties, and even jail time.
Given the risks, why do managers sometimes engage in misconduct?
We would expect managers to misrepresent their companies’ financial statements
when their expected private benefits exceed their expected private costs. Researchers
have examined four broad areas of potential benefit, including managers’ desire to (1)
increase their own compensation, (2) attract new external financing, (3) meet certain
earnings thresholds, and (4) relieve financial distress. The expected costs are affected
by how managers are monitored and constrained in their decision-making. These
constraints are determined by the firm’s governance, ownership structure, transparency,
and external monitoring.26
26
Section 3.2, which partly overlaps with this section, points out another consideration in managers’ motives
to engage in misconduct: overconfidence and personal attitudes toward social norms.
Motives for financial misconduct Compensation: There is some support for the
notion that managers manipulate earnings to boost their compensation. Bergstresser
and Philippon (2006) find that the use of discretionary accruals to manage earnings
increases with the CEO’s stock-based compensation. Burns and Kedia (2006) find that
the likelihood of an earnings restatement increases with the sensitivity of the CEO’s
option portfolio to the firm’s stock price. Denis et al. (2006) detect a positive relation
between option intensity and fraud allegations for firms facing class-action suits. Other
compensation-related motives that are correlated with financial misconduct include
stock appreciation rights (Beneish 1999b) and tournament-related CEO pay (Haß et al.
2015). Wang et al. (2010) find that misconduct increases with executives’ short-term
compensation incentives, particularly when investors expect high performance.
Not all findings, however, indicate that managers’ compensation drives their deci-
sions to cook the books. As one example, Erickson et al. (2006) report evidence
inconsistent with an association between misconduct and executive equity incentives
in their sample of AAERs. Johnson et al. (2009) conclude that the likelihood of
misconduct in their sample of AAERs is positively related to managers’ unrestricted
stock holdings but unrelated to managers’ holdings of restricted stock, vested stock
options, and unvested options. Armstrong et al. (2013) propose that prior findings are
mixed because financial misreporting affects both a manager’s wealth and her portfolio
risk. Consistent with this argument, they find that misreporting is most strongly
associated with the sensitivity of the manager’s wealth to portfolio risk. Complicating
this line of inquiry is that researchers have used a wide variety of equity incentive
measures. We are not aware of a systematic examination of whether misconduct is
associated with a broad-based measure of equity incentives, or with only some such
measures.
New financing: Another motive for financial misconduct is to inflate a firm’s
earnings and asset values to gain new external financing at favorable terms.
Consistent with this hypothesis, Dechow et al. (1996) and Dechow et al. (2011) find
that the violation periods referenced in AAERs frequently cover periods during which
firms issue new securities. 27 Efendi et al. (2007) find that earnings restatements also
frequently cover periods during which firms issue new securities. Richardson et al.
(2003) find that restating firms have high debt levels and are subject to abnormally high
earnings growth expectations and infer that managers’ prime motive to manipulate
earnings is to attract low cost external financing.
Earnings thresholds: Managers also may manipulate earnings when they have
pressure to meet earnings thresholds, such as analysts’ earnings forecasts. For example,
Schilit (2010) warns that managers are tempted to manipulate earnings especially
during the inevitable decline in growth that all fast-growth firms experience. Consistent
with this view, Richardson et al. (2003) show that earnings restatements are often filed
by firms that had recorded a consecutive string of abnormal earnings increases before
engaging in the aggressive accounting policies that resulted in the restatement.
Robb (1998) finds that managers of financial institutions increasingly manipulate
earnings through loan loss reserves as analysts’ earnings forecasts converge, suggesting
27
Beneish (1999b), however, does not find evidence that AAERs are associated with periods with external
financing.
that managers work to meet analysts’ forecasts particularly when analysts agree.
Degeorge et al. (1999) consider three behavioral thresholds of earnings management:
reporting positive profits, sustaining recent performance, and meeting analyst expecta-
tions. They conclude that the predominant goal of managers who manipulate the books
is to report positive earnings. This conclusion is supported by Payne and Robb (2000),
who report that managers use discretionary accruals to meet analysts’ expectations
when expected performance is below market expectations with a goal of preventing
negative earnings surprises. Similar to Robb (1998), they also find that the tendency to
use discretionary accruals increases as the dispersion of analysts’ forecasts decreases.
Financial distress: Maksimovic and Titman (1991) construct a model in which
managers’ incentives to engage in misconduct increase as the firm’s expected
performance declines. The core idea is that poorly performing firms and
managers have less to lose from the risk of getting caught, that is, they have
less reputational capital. This idea has been applied to managers’ decisions to
misrepresent their financial statements as well. Loebbecke et al. (1989) find that
19% of their sample of firms that engaged in misconduct were experiencing
solvency problems. Beneish (1999b), however, does not find evidence that
misconduct that prompts AAERs is motivated by a desire to avoid debt
covenant violations.
Constraints on financial misconduct Firm governance: Several papers find that the
likelihood of financial misrepresentation is affected by the quality of firm governance.
The exact features that matter, however, remain unsettled. For example, Beasley (1996)
finds that firms cited in AAERs have significantly lower percentages of independent
board members, and Klein (2002) finds a negative relation between board indepen-
dence and the size of firms’ abnormal accruals. Uzun et al. (2004) find that financial
and nonfinancial misconduct relates negatively to the number of independent directors
on the board as well as on the audit and compensation committees. Gerety and Lehn
(1997), in contrast, find that the incidence of disclosure violations is unrelated to board
independence—as well as to board size, the presence of an audit committee, a classified
board, the existence of an accounting-based incentive plan, and whether the auditor was
one of the Big 8 auditing firms. Agrawal and Chadha (2005) also find that the
probability of earnings restatements is unrelated to overall board independence but
the probability is lower in companies whose boards or audit committees have an
independent director with financial expertise.
Ownership structure: The incidence of misrepresentation also can be affected by the
firm’s ownership structure. Alexander and Cohen (1999), for example, find that
corporate crime is less frequent when managers have large shareholdings. Gerety and
Lehn (1997) find that misconduct relates negatively to board ownership, and Cornett
et al. (2008) find that institutional ownership and institutional investor
representation on the board reduce the use of discretionary accruals in
earnings management. However, Denis et al. (2006) conclude that institutional and
block ownership also exacerbates the option-based incentive to engage in misconduct.
The most striking finding related to ownership structure is Anderson et al. (2015)
discovery that financial misconduct is much more likely in firms controlled by the
founders’ family members. Agrawal and Chadha (2005) also find that restatements are
more likely among companies in which the CEO belongs to the founding family.
Transparency: Financial misconduct is more likely when it is costly for outsiders to

monitor the firm’s operations and managers. Kedia and Philippon (2009) show theo-
retically that imperfect information creates incentives for low-productivity firms to
over-invest, which leads to an increased likelihood of financial reporting violations.
Povel et al. (2007) develop a model in which financial misrepresentation peaks toward
the end of a boom period, particularly when monitoring costs decrease, only to be
revealed during the following bust.28 Wang et al. (2010) find that misconduct relates to
investors’ expectations and monitoring costs in a sample of IPO firms. Gerety and Lehn
(1997) find that the incidence of disclosure violations relates positively to a proxy for
the cost of valuing the firm’s assets, and Dechow et al. (2011) find that the likelihood
that a firm will have a material earnings misstatement increases with its accruals and its
use of off-balance-sheet financing such as operating leases. All of these findings are
consistent with the view that financial transparency relates negatively to the incidence
of financial misconduct.
External monitoring: The incidence of misrepresentation can vary over time because
laws and regulations change. Since 1990, the U.S. Congress has enacted or authorized
five major changes in the regulation of financial misconduct. These include the
Securities Enforcement and Penny Stock Reform Act of 1990, the implementation of
the U.S. Sentencing Commission Guidelines for crimes by organizations in November
1991, the Private Securities Litigation Reform Act of 1995, the Sarbanes-Oxley Act of
2002, and the Dodd-Frank Act of 2010. To the extent that these laws have changed the
penalties or regulatory oversight for financial misrepresentation, they could also change
the incidence of such misrepresentation. Cohen et al. (2008) report that earnings
management rose steadily in the years preceding Sarbanes-Oxley’s passage, primarily
in poorly performing industries, and significantly immediately afterwards.
Misconduct, or its discovery and punishment, also can be affected by the nature and
intensity of regulatory oversight. For example, Choi et al. (2017) find that SEC
enforcement actions for financial misrepresentation follow industry-specific enforce-
ment waves that are partly explained by the SEC’s enforcement budget. Yu and Yu
(2011) find that firms with high political lobbying expenses are less likely to face
charges for financial misconduct. Kedia and Rajgopal (2011) find that firms are less
likely to announce financial restatements if they are located close to an SEC office or in
areas that have attracted past SEC enforcement activity. They also suggest that firms
located close to an SEC regional office are more likely to be targeted by an SEC
enforcement action, but Parsons et al. (2017) find that this result disappears when
controlling for other geographic characteristics.
4.2.4 Proxies and databases used to identify samples of financial statement misconduct
Researchers use different proxies and data sources to collect samples to study financial
misconduct. Early researchers compiled samples of financial statement misconduct
28
In the Povel et al. (2007) model, the combination of managers’ incentives to commit fraud and investors’
incentives to monitor yields nonmonotonic relations between fraud, investor beliefs, and monitoring costs. See
also Hertzberg (2017), who develops a model in which positive investor beliefs generate greater managerial
incentives to commit fraud.
from primary sources, such as keyword searches of financial press databases (e.g.,
Davidson et al. 1994) or SEC filings (e.g., Palmrose et al. 2004). Over the past 10 years,
however, the large majority of papers that examine financial misconduct are based on
samples drawn from one or more of four electronically available databases: the
Government Accountability Office (GAO) and Audit Analytics (AA) databases of
restatement announcements, the Stanford Securities Class Action Clearinghouse
(SCAC) database of securities class-action lawsuits, and the Securities and Exchange
Commission’s (SEC’s) Accounting and Auditing Enforcement Releases, most recently
as compiled by the University of California-Berkeley’s Center for Financial Reporting
and Management (CFRM).
Karpoff et al. (2017a) examine the GAO, AA, SCAC, and CFRM data sources and
demonstrate that empirical results frequently are sensitive to the choice of proxy and
database. In simple tests that examine changes in such outcome variables as return on
assets and equity issues around the revelation of misconduct, they show that the
replication rate is only 42% when the misconduct events from one randomly chosen
alternative database are replaced by the misconduct events identified by randomly
chosen alternative database. These results suggest that a researcher’s choice of a proxy
and database to identify a sample of financial statement misconduct events can affect
the empirical inferences.
The main reason different databases yield different results is that each captures a
different subset of information about an instance of misconduct. A firm’s financial
misconduct typically is revealed to the public via a complex sequence of announce-
ments that spread out over multiple years. Some instances of misconduct involve one or
more earnings restatements, others involve class action lawsuits, others involve various
regulatory actions, and still others have various combinations of these types of events.
Each database captures only one of these many types of announcements. So samples
constructed from restatement announcements do not have large overlap with samples
constructed from, say, class-action lawsuits.
As an analogy, suppose the sequence of announcements by which investors learn
about each instance of misconduct is like a novel. Class-action lawsuits sample from
the front chapters, restatement announcements sample from the middle chapters, and
regulatory actions (such as AAERs) sample from the end of the book. Researchers
drawing a sample of, say, restatement announcements will compile a sample of middle
chapters and ignore the beginnings and ends of the novels in their samples. This poses
no problem if each chapter contains a fairly complete narrative of the whole story or if
the research question pertains only to a specific part of the narrative. As Karpoff et al.
(2017a) show, however, each of the various announcements pertaining to an instance of
misconduct contains information that is important for many research questions and that
is not available in the other announcements related to the misconduct. Using stock price
reactions to measure information content, they show that the events identified by any
one of these popular databases capture only a small portion of the value-relevant
information that informs how a researcher classifies and interprets the results from
empirical tests. Because each database focuses on a different subset of information
events that convey information about financial misconduct, each database tends to
identify different dates upon which investors learn of misconduct. Karpoff et al. (2017a)
show that the differences can be substantial, thus having large impacts on inferences
from event studies or studies that examine changes in firm characteristics around the
revelation of misconduct. To return to the novel analogy, each chapter does not contain a
fairly complete narrative of the whole story, and most research questions do not pertain only
to a specific part of the narrative.
Researchers work to offset the gaps in their data, sometimes by combining events
from multiple data sources, running separate tests using samples from different data-
bases, or hand-collecting data to expand the scope and inclusiveness of their data (e.g.,
Beneish et al. 2017). Future researchers using these databases will need to continue to
such efforts. The most important single lesson is that each proxy and database used to
identify misconduct events represents only a small part of the total sequence of events
by which investors learn about the full scale of the misconduct, the periods over which
it occurred, and its consequences. For many research questions about financial
misconduct, this partial coverage of each database will be an important characteristic
to manage. Karpoff et al. (2017a) include a list of specific suggestions for researchers
seeking to use these databases.
5 Direction for future research on financial reporting misconduct
This section offers several avenues for future research. Answers to the ten questions
below can further our understanding of financial misconduct and how it shapes firms’
reputations, investors’ trust in financial markets, and the value created by the corporate
form of organization.
(i) Given the pervasiveness of partial observability and database problems in

conducting research on financial reporting misconduct, how robust are the extant
results and inferences?
Partial observability is endemic to research on financial reporting misconduct; that

is, most studies are conducted on samples of firms that are caught, as we typically do
not observe the firms that commit misconduct and are not caught. As an analogy, while
many drivers (firms) may speed (engage in misconduct), we as empiricists typically
only observe ex-post those that receive speeding tickets (e.g., AAERs or securities class
action lawsuits), who may very well be the group that is less successful at avoiding
traffic officers (the DOJ or SEC). This observational bias imposes severe limitations on
our ability to address key questions. For example, what are the differences between
firms that engage in misconduct and are caught versus those that engage in misconduct
but are not caught? Is the latter group simply more successful at concealing misconduct,
and are the penalties optimally large to deter such conduct? What is the ex-ante value of
misconduct for managers and firms? Is misconduct an example of an agency problem
or an example of profit maximization? Under what conditions is it appropriate to
generalize inferences based on results from a sample of only firms that were caught?
To answer such questions requires estimates of the probability that a firm engages in
misconduct, a nontrivial task that is further complicated by the issues highlighted by
Karpoff et al. (2017a) regarding the conventional databases used in financial reporting
misconduct research.
Several papers attempt to make progress on these challenging issues. Beneish
(1999a) and Beneish et al. (2013) develop an empirical model that uses financial
statement variables to predict earnings manipulation. Dechow et al. (2011) use a similar
approach to develop the F-score, a summary measure to predict the likelihood that a
firm is committing fraud. Relatedly, Amiram et al. (2015), relying on Benford’s Law,
develop the Financial Statement Divergence (FSD) Score and show that it can be used
as a leading indicator to identify material misstatements. Wang (2013) and Wang et al.
(2010) use bivariate probit models to simultaneously estimate the likelihood a firm
commits fraud and the likelihood that a fraud firm is caught. Hahn et al. (2016) extend
Wang (2013) to model a Bayesian specification in estimating the relative likelihoods.
Zakolyukina (2017) constructs a structural model of a CEO’s decision to manipulate
earnings and estimates that 60% of CEOs manipulate earnings at least once, with a
probability of detection of 14% over a five-year horizon. Dyck et al. (2017) use the
demise of Arthur Andersen to identify a calibration exercise and infer that the proba-
bility a firm engages in financial misconduct in any given year is 15%. Karpoff et al.
(2017b) calibrate a model of foreign bribery that can be adapted to financial miscon-
duct. Their base case calibration implies that 23% of firms with foreign sales engaged
in a sustained program of foreign bribery sometime during their 36-year sample period,
of which 6.4% were caught. Despite this progress, more work is needed to answer the
key questions noted above.
(ii) Why do managers engage in financial reporting misconduct?
Sections 3.1 and 4.2 summarize a number of papers that seek to identify managers’
incentives to misreport and organizational constraints on misreporting. But researchers
have yet to identify a comprehensive answer to the question: why, given the large
consequences of getting caught, do managers engage in financial misreporting?
If most financial reporting misconduct is detected, then expected penalties would
appear to be large, and it becomes more difficult to rationalize misreporting. Perhaps
behavioral theories based on executive overconfidence, narcissism, and greed are at
work. Recent evidence suggests that overconfident executives are more likely to get
promoted to CEO (Banerjee et al. 2015). If this is the case, then CEOs are more likely
to exhibit exactly the behavioral biases leading to Schrand and Zechman’s (2012)
slippery slope to financial reporting misconduct.
Another possibility is that detected misconduct is just the tip of the iceberg and
that undetected misconduct is pervasive. If so, managers’ expected penalties may
be small, thus justifying such benefits as a reduction in the cost of capital or an
increase in stock price and managerial wealth. In this respect, note that financial
reporting misconduct may never be detected if it is used to smooth earnings. For
example, assume that a firm has positive growth opportunities but is unable to
credibly convey the value of these growth opportunities to investors. Financial
reporting misconduct could allow such a firm to access funding for growth
opportunities that would otherwise be foregone. Alternatively, financial reporting
misconduct could be masked by issuing new capital at inflated prices and using
the proceeds to cover up the misconduct.
Further research is needed to untangle these competing explanations. Such research
could enable additional safeguards to mitigate misconduct. But as with many other
forms of criminal activity, the elimination of financial reporting misconduct is unlikely
to be feasible. Not only would the costs of detection be prohibitive, but doing so could
have negative real effects. For example, executive overconfidence has also been shown
to enhance innovation (Hirshleifer et al. 2012) and performance (Kaplan et al. 2012). It
therefore seems that some financial reporting misconduct is an inevitable side effect of
the capital market system.
Relatedly, most papers examine only one or two possible motives or constraints—
compensation, for example—in isolation. To the extent that the other various motives
and constraints examined in Section 3.1 and 4.2 are at work, any test that excludes them
is potentially mis-specified.
(iii) How is financial misconduct disciplined and deterred around the world?
What combination of third-party enforcement, culture, and reputation works to

discipline and deter misconduct? Evidence from U.S. and U.K. firms indicates a large
role for reputational enforcement, as firms caught committing financial misconduct
experience significant losses in reputational capital that dwarf their direct penalties
(e.g., Karpoff et al. 2008a; Armour et al. 2016). As illustrated in Fig. 2, however, the
equilibrium reliance on reputation in any given market will depend also on the
enforcement provided by legal and cultural institutions. Where legal contracting pro-
tections are weak, for example, we might expect that buyers and sellers rely more on
the informal protection provided by reputational guarantees and greater reputational
penalties for misconduct. Or, where cultural norms mitigate against misconduct, we
would see more or less reliance on reputational and legal enforcement depending on
whether these mechanisms are complements or substitutes.
(iv) How do reputational and cultural enforcement interact with public and private
enforcement?
An important special case of question (iii) is raised by the nascent literature on the
relative importance of public and private enforcement of securities laws. La Porta et al.
(2006) argue that private enforcement, including the threat of lawsuits, is much more
important than public enforcement for financial market development. Jackson and Roe
(2009) conclude the opposite. Previous work that investigates public and private
enforcement, however, ignores the role of reputation and culture in disciplining finan-
cial misconduct and promoting financial market development. These results imply that
a properly specified test of the effects of public and private enforcement must include
reputational and cultural enforcement as well.
(v) How does culture play into financial reporting misconduct?
Cultural influences on misconduct may have received relatively little attention in the
finance literature because it is even more difficult to measure culture in large sample
research than to measure legal or reputational penalties. Recent advances in this area
use measures that capture some aspect of a firm’s culture based on individual mana-
gerial characteristics, regional or firm-related religious affiliations, geographic effects
on social norms, political affiliations, and networks. Graham et al. (2016) survey
managers’ attitudes toward corporate culture and propose several new measures of
culture. Researchers are likely to continue to explore these and other measures to gain
additional insights into the influence of culture—and thereby also legal and reputational
deterrence—on financial misconduct.
(vi) How significant are measurement errors in financial reporting misconduct

research?
Measurement is a fundamental aspect of financial misconduct research. Legal

penalties for misconduct can include a wide range of monetary fines imposed by
regulators, class-action lawsuit settlements, legal costs, post-misconduct compliance
expenditures, prohibitions on certain activities, and debarment from government
contracting. Firms incur other direct costs through internal reviews, legal expenses,
and lost management time. Previous findings provide only preliminary evidence about
the sizes and costs of such penalties and whether firms’ penalties are associated with the
severity of the misconduct.
Reputational penalties are even more difficult to measure, using either the
residual approach discussed in Section 4.2.1.3 or the direct approach discussed
in Section 4.2.1.4. The residual approach to measuring reputation loss depends on
one’s estimate of the amount by which share prices were artificially inflated before
the misconduct was revealed—yet another measurement problem. There also is
only limited evidence on whether the residual and direct approaches to measuring
reputational losses yield similar results in the cross-section (Johnson et al. 2014;
Haslem et al. 2016).
(vii) To what extent does our current system in both public and private enforcement
systematically commit more Type I than Type II errors?
As reviewed in section 2.2, the data focused on by legal academics are various
aspects of completed lawsuits, such as dismissal rates of private suits, amounts
recovered in private settlements, and how these results are impacted by the type of
plaintiff. Since very few cases, whether they be government or private enforcement
matters, go to trial, there is no clear evidence in much of this work that a material
misrepresentation in fact occurred and that it was committed with the level of culpa-
bility to merit being characterized as fraudulent. As seen earlier, settlements below $2
million bear distinctive differences from larger settlements. Does this suggest the
impact of fraud was small or that defendants calculated that a small settlement was
an efficient way to dispose of a nuisance suit?
Thus the overall unexplored question is to what extent does our current system in
both government and private suits systematically commit more Type I than Type II
errors? This concern is especially high in private suits where the PSLRA, discussed
above, mandates that suits must, upon filing, set forth specific facts that establish a
Bstrong inference^ that the misrepresentation was knowingly or recklessly committed.29
Failing to meet this high pleading requirement, the suit will be dismissed before any
further factual inquiry into the claim of fraud. What invites error is that, until the court
decides that a strong inference that the alleged misrepresentation was committed with
knowledge of its falsity or reckless disregard of its truth, the plaintiff is barred from
29
For further detail on this debate, see generally Choi (2007) and Issacharoff and Miller (2013).
accessing the records of the defendant or deposing its officers. Thus the heightened
pleading requirement and a bar to discovery likely biases outcomes toward false
negatives. At the same time, court rulings that the heightened pleading requirement
occur without a robust probing of the underlying facts so that there may well be false
negatives as well. These concerns, when coupled with there being hardly any trials but
only settlements in government and private enforcement actions, raise nontrivial
concerns regarding the error rate.
(viii) What is the relation between macroeconomic conditions and financial reporting
misconduct?
Povel et al. (2007) model the relation between macroeconomic booms, busts,
and misconduct. They argue that misconduct is most likely to occur in relatively
good times, and the link between fraud and good times becomes stronger as
monitoring costs decrease. Their model explains why misconduct peaks toward
the end of a boom and is then revealed in the ensuing bust. The relation between
macroeconomic conditions and financial reporting misconduct can have
significant implications, ranging from a link between the probability of
misconduct and expected returns to the ability to use insights from misconduct
research to predict busts in real time. Despite the importance of this question, very
few published empirical studies address it. Davidson (2015) finds that the inci-
dence of observed financial reporting misconduct increases with GDP and is at its
highest in the periods leading up to an economic peak, and that the incidence of
observed financial reporting misconduct decreases with the average correlation
between firm and market returns.
To the extent that misconduct behavior increases toward the end of a boom period,
models that predict such behavior could be useful in predicting the timing of a bust.
Predicting busts in real time has proven to be an elusive task for economists. The idea is
that misconduct behavior may reveal mangers’ private information that has not yet been
publicly released to the markets.
(ix) Is there a relation between expected returns and the probability of financial
reporting misconduct?
To the extent that financial reporting misconduct is an idiosyncratic behavior, tradi-

tional asset pricing models predict no relation between its probability and expected
returns. Nevertheless, the discussion above suggests a relation between macroeconomic
conditions and misconduct detection. As misconduct detection is associated with negative
returns, and is more likely to be detected during a macroeconomic bust, these patterns
create a positive correlation between misconduct detection and macroeconomic condi-
tions. This correlation should result in higher expected returns under traditional asset
pricing theories.
There is very little work in the literature that examines this relation, though an
exception is by Beneish et al. (2013), who show that an accounting-based model has
strong out-of-sample power not only for detect misconducting but also for predicting
cross-sectional returns. Surprisingly, and in contrast to the predictions of traditional
asset pricing theories, they find that firms with a higher probability of manipulation
earn lower returns. Their result is consistent with managers being able to mislead the
markets and with fundamental analysis investment theories.
(x) What is the role of gatekeepers (e.g., lawyers, auditors, and media) in detecting
misconduct?
Dyck et al. (2010) document that only 7% of the misconduct cases they study
were detected by the SEC, 10% by the auditors, and 3% via private litigation;
analysts were not found to be important detectors of misconduct.30 Interestingly,
they find that actors who do not own any residual claim in the firms involved (and
are often not considered important players in the corporate governance arena) play
a key role in misconduct detection: employees (17%), nonfinancial market regu-
lators (13%), and the media (13%). They conclude that that this result is consistent
with the incentive structure of identifying misconduct. These findings call for
further research to better understand the incentives of traditional versus nontradi-
tional gatekeepers in exposing financial reporting misconduct.
One group of investors who stand to gain from the revelation of misconduct is short
sellers. Karpoff and Lou (2010) find that short sellers are good at identifying miscon-
duct before it is publicly revealed. Their short selling offsets and limits the miscon-
duct’s ability to artificially inflate share prices, and accelerates the time to publicly
uncover the misconduct. Fang et al. (2016) find that short selling increases the
probability that firms misreporting their financials are caught, and that managers react
to the mere prospect of short selling by decreasing their earnings management and
misreporting behavior. These results suggest that market participants play a significant
role in detecting and deterring misconduct.
Miller (2006) examines the role of the media as firm monitor and, in addition
to documenting that the media redistributes information on accounting fraud to
the public in a timely manner, provides evidence suggesting that the media
serves a watchdog role through its investigative reporting by synthesizing public
information in bringing its allegations to bear. Some studies examine the role of
internal legal counsel as another potential gatekeeper. For example, Kwak et al.
(2012) find the presence of internal legal expertise is associated with better
financial reporting quality (e.g., more accurate management forecasts), whereas
Hopkins et al. (2015) find the opposite (e.g., greater discretionary accruals). In
contrast, Bozanic et al. (2017) examine the role of external legal counsel in
financial reporting. They find that the role of external counsel as a potential
gatekeeper depends in part on whether managers’ incentives appear to be aligned
with those of investors. Given the difficulties in distinguishing between redistri-
bution of knowledge and its cultivation as well as the direct role of either
internal or external counsel, future research could explore better identification
mechanisms to overcome some of the measurement limitations in this
stream of the literature.
30
For a discussion of the Bexpectations gap^ between what external stakeholders typically expect of auditors
in a standard financial statement audit versus what is required of auditors by GAAS, see Albrecht and Hoopes
(2014). As they discuss, given the scope of a financial statement audit as dictated by GAAS and, in contrast to
a fraud audit, it is unclear whether auditors should be expected to detect misconduct in the course of a financial
statement audit.
6 Conclusions
This survey reviews the literature on financial reporting misconduct from the perspec-
tives of law, accounting, and finance. We first discuss the problems with defining and
identifying types of financial reporting misconduct, such as fraud, misrepresentation,
misreporting, and irregularities. Thus the first task we address is to establish a common
framework for these types of events. We then turn to review the literature on financial
reporting misconduct across the disciplines.
The review presents a wide spectrum of opportunistic financial reporting behavior
where financial reporting misconduct lies at the far right and legally acceptable
earnings management to convey private information that complies with the provisions
of GAAP on the far left. We discuss several established factors, such as discretionary
accruals and proxies for earnings management, that have been found to be significant
predictors of misconduct behavior, and augment that discussion by highlighting some
of the newer methodologies that show promise in predicting misconduct, such as
linguistic and vocal analysis.
While there is strong evidence showing that financial reporting misconduct is
associated with an array of negative consequences, there is mixed evidence on what
causes this misconduct. There is also conflicting evidence on whether internal moni-
toring and governance limit financial misconduct behavior. There is a large literature
that examines the effectiveness of public enforcement via agencies such as the SEC
versus the effectiveness of private enforcement such as class-action lawsuits though we
know little about the objective function of regulatory agencies in detecting financial
reporting misconduct. We also discuss the debate in the literature on whether the
monetary payments by the firm that committed the misconduct to regulators and
plaintiffs are either fair or efficient.
In terms of personal deterrents, the evidence in the literature suggests that executives
who engage in financial reporting misconduct are severely punished yet the costs for
directors are smaller and less clear. Given the punishments and negative consequences
consequent to financial reporting misconduct, it is a puzzle as to why it exists and
persists. We review several advances toward better understanding this puzzle, notably
recent evidence on the relations between personal traits of executives, social norms, and
financial reporting misconduct.
We conclude by discussing the significant challenges that the literature on
financial reporting misconduct faces. These challenges include finding common
ground in identifying financial reporting misconduct, the unobservability of firms
that engage in misconduct but are not caught, the simultaneity of misconduct
behavior with other factors, and that different datasets of financial misconduct
yield different results. With those challenges in mind, the literature on miscon-
duct offers significant opportunities for future research, as many questions
remain open.
Acknowledgements We thank Peter Easton (the editor), Daniel Beneish (the referee), Allison Koester,
Gerald Martin, and Ethan Rouen for valuable comments. We would also like to thank Diana Choi, Margaret
Fong, and Aaron Nelson for their research assistance. We are also grateful to the Center for Accounting
Research and Education (CARE) at Notre Dame for its 2016 Perspectives on Fraud conference, which served
as the guiding force behind this paper’s inception.
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Financial Reporting Fraud and Other Forms of Misconduct: A Multidisciplinary Review of The Literature

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Rev Account Stud (2018) 23:732–783

Financial reporting fraud and other forms of misconduct:

Dan Amiram 1 & Zahn Bozanic 2 & James D. Cox 3 &

Published online: 25 January 2018

Keywords Financial reporting . Fraud . Misconduct . Irregularities . Misreporting .

increases in the cost of capital, and—perhaps most important—the loss of reputation

2 The legal perspective

2.1 Overview of the legal perspective

2.2 State of the law literature on financial misconduct

2.2.1 Inquiring into the meaning of fraud?

Rarely does legal scholarship provide a close analysis of particular instances of

2.2.2 Assessments of the efficacy of SEC and private enforcement9

Because attorneys involved in financial reporting misconduct suits by investors cus-

2.2.3 Slippage within the regulatory net

3 The accounting perspective

3.1 Overview of the accounting perspective

3.2 State of the accounting literature on financial reporting misconduct

There is a large literature in accounting that examines financial reporting miscon-

3.2.1 Motivations for engaging in financial reporting misconduct

Capital market motivations This category of motivations centers on financial bene-

Contracting motivations This category of motivations involves the commission of

A possible explanation is that executive compensation is tied to earnings through other

3.2.2 Institutional features facilitating financial reporting misconduct

3.2.3 Other variables associated with financial reporting misconduct

3.2.4 Recent methodological advances in misconduct prediction

There have been significant recent advances in methodologies to predict misconduct.

3.2.5 Executive traits

misreporting. Based on an analysis of executive compensation structure, they conclude

4 The finance perspective

4.1 Overview of the finance perspective

Financial reporting misconduct is an important problem in finance because it

4.2 State of the finance literature on financial reporting misconduct

4.2.1 The consequences to firms of the discovery of financial misconduct

Reputational losses for financial misconduct Despite heterogeneity in the samples

Direct measures of lost reputational capital The measures of reputational loss

Another open question is whether the residual and direct approaches to

Do misconduct firms always lose reputational capital? A central feature of models

Rebuilding reputational capital If reputation is an asset, firms can invest in it.

4.2.2 Should shareholders pay? Do managers pay?

Are firm-level penalties efficient? Might firm-level penalties nonetheless be an

4.2.3 Why do managers do it? Motives and constraints

Transparency: Financial misconduct is more likely when it is costly for outsiders to

5 Direction for future research on financial reporting misconduct

(i) Given the pervasiveness of partial observability and database problems in

Partial observability is endemic to research on financial reporting misconduct; that

(ii) Why do managers engage in financial reporting misconduct?

What combination of third-party enforcement, culture, and reputation works to

(v) How does culture play into financial reporting misconduct?

(vi) How significant are measurement errors in financial reporting misconduct

Measurement is a fundamental aspect of financial misconduct research. Legal

To the extent that financial reporting misconduct is an idiosyncratic behavior, tradi-

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