MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 18: 587 599 (1997)

The Causes and Consequences of Accounting

Fraud
Mason Geretya,* and Kenneth Lehnb
a

Department of Finance, Northern Arizona Uni6ersity, Flagstaff, AZ USA

Katz School of Business, Uni6ersity of Pittsburgh, Pittsburgh, PA USA

One of the fundamental purposes of corporate accounting is to facilitate the monitoring of

managers. Since managers are instrumental in the production of accounting numbers, and
since it is costly to monitor their behavior in this regard, firms sometimes report fraudulent
accounting numbers. This paper tests several hypotheses concerning why some firms, and not
others, commit accounting fraud. This is accomplished through examination of a sample of
62 firms charged with disclosure violations by the Securities and Exchange Commission
(SEC) during the period 19811987. We also examine whether directors of companies that
commit accounting fraud are disciplined in the managerial labor market.
We adopt the perspective that the decision to commit fraud is governed by the expected
costs and benefits of this behavior (This approach to the study of fraud has been used
elsewhere, e.g. Darby and Karni (1973) Michael R. Darby and Edi Karni, Free Competition and the Optimal Amount of Fraud, Journal of Law and Economics 16 (April 1973),
6888. For a brief discussion of the economics of fraud, see Edi Karni (1989) Fraud in
The New Palgra7e: Allocation, Information, and Markets, edited by John Earwell, Murray
Milgate, and Peter Newman, New York: W.W. Norton, 117 119). Accordingly, a theory of
accounting fraud requires an understanding of how these costs and benefits vary across firms.
Those costs and benefits can be varied by external forces, through institutions such as equity
markets and independent auditors, or internally through the design of monitoring and reward
systems. We will divide our attention between the external and internal forces that change
the costs and benefits of accounting fraud. 1997 John Wiley & Sons, Ltd.

INTRODUCTION
Discussions of the efficient structure of a corporation date at least from Berle and Means (1933).
Their focus was the supposed inefficiency of the
separation of ownership and control. Empirical
investigation of the efficient corporate structure
has become prominent recently. For example,
Demsetz and Lehn (1985) find that ownership
structure varies based on firm size, profit instability, regulation, and amenity potential. They propose that external forces are the determinants of
corporate structure. In a very real way, corporate
ownership structure is a response to market
forces. We adopt that perspective here. We control for firm size and industry and test whether
* Correspondence to: Department of Finance, Northern Arizona University, Flagstaff, AZ. Tel.: + 1 520 5237355.

CCC 01436570/97/070587-13$17.50
1997 John Wiley & Sons, Ltd.

anything else matters in the frequency of accounting fraud. We separate our investigation into external (market determined) and internal
(endogenous responses to the market) forces that
could vary between those firms accused of fraud
and those not accused. Our results support the
concept that market forces shape corporate activities more that internal structures.
In a window around the commencement of
accounting fraud, we find evidence that stock
performance increases relative to an industry
match firm. Fraud seems to fool the market, at
least in the short term. We also find that the
announcement of SEC charges of accounting
fraud result in statistically significant average cumulative abnormal returns of 3.05% during a 3
day window surrounding these announcements.
These results document that SEC charges impose

588

M. GERETY AND K. LEHN

costs on firms (or revise investor expectations

regarding true asset value). The frequency of BigEight versus non-Big-Eight auditors does not
differ significantly across the two samples, suggesting that auditor reputation does not effect the
likelihood of committing accounting fraud. We
find that a significant direct relationship exists
between R&D expenditures and the frequency of
accounting fraud across 256 industry groups. This
result suggests that the more costly it is to value
assets, the more likely is accounting fraud. Another proxy for the ease of valuing assets, intangible assets, is positively, although not significantly,
related to the frequency of accounting fraud.
We find that several classic corporate governance variables do not differ significantly across
the sample of offenders and a sample of control
firms in the same industries. For example, none of
the following variables differ significantly across
the two samples: The mix of outside and inside
directors, the presence or absence of audit committees, or the presence or absence of classified
boards. We do find that while aggregate stock
ownership by the board of directors has a weak,
and statically insignificant influence over the
probability of fraud, concentration of ownership
in one individual on the board significantly reduces the probability of fraud. The frequency of
accounting based executive compensation packages is slightly, but not significantly, higher for
the sample of offenders than for the control sample. This suggests that the reliance on accounting
based managerial compensation incentives does
not increase the likelihood of accounting fraud.
Some of these results, especially those involving
the mix of inside and outside directors, are at
odds with other research investigating the role of
directors in the incidence of accounting fraud. For
example, Beasley (1996) finds that firms with a
greater proportion of outside directors are less
likely to commit accounting fraud. In a multivariate logit design, he finds robust results that indicate that holding many other firm characteristics
constant, the percentage of outside board members matters. The multivariate logit design of his
work has some advantages over our research design, as he can hold constant other influences. On
the other hand, while Beasley includes in his
sample firms matched by size and industry, he
cant control specifically for the match. He can
only balance his sample with offender and non-offender firms. Our methodology, described later,
1997 John Wiley & Sons, Ltd.

does not allow for ceterus paribus tests, but does

allow for direct matching of the same industry,
same size offenders and non-offenders. This difference in test design may account for the different results.
We also find evidence of Famas (Fama, 1980)
managerial labor market at work within the market for corporate directors. The number of other
directorships held by the directors of firms
charged with accounting fraud declines significantly compared with the corresponding number
of directorships for directors of the control firms.
This evidence is consistent with the argument that
the managerial labor market penalizes directors
who serve on boards of firms charged with accounting fraud.
In short, we find that the decision to commit
fraud seems to be governed by the cost of valuing
its assets. Corporate governance structures, the
reputation of the auditor, and its reliance on
accounting-based executive compensation plans
do not appear to significantly affect the likelihood
of accounting fraud, while there appears to be
evidence that concentration of stock ownership
matters. Consistent with Fama (1980), there appears to be some ex post settling up in the labor
market for directors of firms committing accounting fraud. We will divide this work into four
sections. The first describes the sample, a few of
the cases of accounting fraud, and outlines the
types of fraud committed. The second examines
and tests hypotheses regarding the external forces
that determine the costs and benefits of accounting fraud. The third does the same for the internal
forces. Finally, we turn our attention to the evidence regarding ex-post settling up.

EXAMPLES OF ACCOUNTING FRAUD

In some ways, the term accounting fraud is misleading. A more generic term, disclosure 6iolation,
might be more appropriate for our purposes. Our
original dataset contained violations that run the
gamut from failure to file appropriate and required financial statements with the Securities and
Exchange Commission to internal fraud that
shows lack of proper internal controls to clear
and willful misrepresentation of the financial
health of the firm. There are also some notable
outliers, including a set of banks that were
charged with improper accounting for loan loss
Manage. Decis. Econ. 18: 587599 (1997)

CAUSES AND CONSEQUENCES OF ACCOUNTING FRAUD

reserves and one case of a violation of the Foreign

Corrupt Practices Act. All the results reported in
the paper were replicated dropping the banks
from the sample, and there were no noticeable
changes in the results. Splitting the sample into
types of fraud was considered. There are many
specific types of fraud, and splitting to a fine level
of distinction produces too few observations to
make the results meaningful. Grouping to alleviate the problem of limited observations becomes
ad hoc. We maintained the dataset in its entirety,
only eliminating firms due to lack of data. We
now give an overview of some representative, and
entertaining, cases from the sample.
Many of the firms that started in our sample
were dropped because they had failed to file any
documents at all with the SEC, and as a result we
were unable to find any relevant information regarding their corporate structure. Our original
sample was quickly whittled to 62 firms. There
still remained seven firms charged with a failure to
file some document. Typical in this regard is the
SEC v. Permeator Corporation. On March 29,
1983 the SEC filed for civil injunctive action
against Permeator alleging that they failed to file
their 1982 10-K report, and filed various other
reports late. Other firms in the sample filed late,
or failed to file one or more reports. To be
included in the sample they must have filed at
least some reports with the SEC at some time.
A more common violation was the inflation of
revenue and/or earnings, or the shifting of revenue and/or earnings. Two cases that describe the
typical violation are SEC v. McCormick & Company and SEC v. Tandem Computers Incorporated et al. In the case of McCormick & Co., the
firm and the general manager of a division were
accused of inflating revenues. This was accomplished by (1) the systematic deferral of the
recognition of substantial amounts of promotional and advertising expense; and (2) the recognition of sales revenue in a fiscal period for goods
that were prepared for shipment in that period
but not shipped until a later period1. The accused general manager was also a member of the
Board of Directors. Because the manager had
incentive clauses based on bottom line accounting
numbers in his contract, he was shifting his bonus
forward one period, increasing its present value.
The case of Tandem Computers et al. was similar.
In this case, the CEO, COO, and controller were
also named in the case. Tandem was alleged to be
1997 John Wiley & Sons, Ltd.

589

involved in a concerted effort to lie about the

financial health of the firm. This was allegedly
accomplished by shifting sales revenue, recognizing a contingent order as a sale, and recognizing
revenue on goods not yet shipped. The allegations
of shifting revenue or income, or inflating revenue
or income, comprise 18 of our final 62 firms.
Another common allegation involved firms who
made false or misleading statements about the
financial prospects of the firm. Two classic cases
are SEC v. Equity Gold et al. and SEC v. Zoe
Products. Equity Gold was a firm that claimed to
be in the gold mining business, and also reclaimed
old mines. It is alleged that from its inception the
firm and the directors engaged in systematic false
statements regarding the amount of gold in reserves and the amount of drilling done in testing
for gold, in an attempt to increase the price of the
stock selling on the OTC. At one point they
claimed to possess more gold at one mine than
had been taken from any gold district up to and
including the year 1959 (i.e. this mine had more
gold in it than the entire California district during
the California Gold Rush). The statements made
by Zoe Products are, in retrospect, just as ludicrous. Zoe Products was in the business of producing and marketing natural vitamins, and in an
8-K report they claimed to have found a product
that they marketed as Sober-Aid. This product
would return an intoxicated person to sobriety. It
is easy to dismiss these kinds of cases based on
materiality, but in this regard the case of Zoe
Products is illuminating. Zoe traded on the OTC,
and as of 1982 (the year of the announcement of
Sober-Aid) had the following financial information: book assets of $1 387 000; long term debt of
$26 000 (much of this was a car loan and some
revolving credit card debt used to buy an office
copier); one employee; 6059 shareholders, and a
maximum market value of $45 221 498. It would
appear that someone believed the claims made by
Zoe.
The allegation of inadequate internal controls
constitutes another type of disclosure violation
found in our dataset. The case of Tonka Corporation is one situation where there were not only
inadequate internal controls, but perhaps none.
Tonka makes toys, and before 1981 made a profit
doing this. Prior to 1981, they had no cash management plan to speak of, and their short term
cash was held exclusively in certificates of deposit
and commercial paper. They had no short term or
Manage. Decis. Econ. 18: 587599 (1997)

590

M. GERETY AND K. LEHN

long term investment policy. Indeed, they had no

Chief Financial Officer. In 1981 a CFO was hired,
in the main to provide a short and long term
investment strategy. Unbeknownst to Tonka, the
CFO set up a shell company in Iowa and issued
14% preferred stock, which the CFO purchased
using Tonkas money. The CFO and his partner
in the Iowa firm then used the cash proceeds to
write covered call options. In a matter of 2 years
the CFO had lost over $3 000 000. The disclosure
violation alleged that no one on the Board of
Directors of Tonka ever asked for any information about the firm in Iowa, although they authorized all purchases of the preferred stock. There
were no internal controls that mitigated this type
of fraud.
The last obvious grouping of firms was a set of
five banks that were alleged to have improperly
accounted for loan loss reserves. Typical of this
type of allegation was the matter of Texas Commerce Bankshares. The allegation in this case
revolved around the lack of an adequate system
to identify problem credits. The Commission argued that when the bank grew, it did not add
sufficient staff to review the growing portfolio. In
an ex-post fashion, the SEC looked at the bank
after it got into trouble, and alleged that the
bank, if it had examined the portfolio with due
diligence, would have written down some of the
loans prior to their becoming insolvent.
There were many variations on these themes
present in the data, and some that were one-of-akind accusations. In this vein is the violation of
the Foreign Corrupt Practices Act by Ashland
Oil. We argue that because these violations have
many dimensions, finding a consistent theme in
the data will strengthen the work, not detract. We
now outline the market forces that influence the
decision to commit accounting fraud. This will be
followed by a discussion of the internal corporate
structures that either enhance or mitigate the
probability of a firm committing accounting
fraud.

As a general proposition, the prevalence of fraud

is expected to be higher in markets where it is
costly to verify the quality of the transacted good.
In a discussion of fraud in The New Palgrave,
Karni2 discusses this phenomenon: Fraud is as
prevalent and as persistent as the asymmetrical
information necessary to support it. The fraud
may occur whenever the cost of verification of the
producers claims to the actual purchase of the
good or service is prohibitively high. In short,
the probability of detecting fraudulent behavior,
and hence the expected costs of fraud, varies
inversely with the costs of verifying product quality.
Following this reasoning the probability of detecting accounting fraud is likely to be related
inversely to the costs of valuing a firms assets.
For example, outsiders presumably have more
difficulty detecting accounting malfeasance in
firms with high research and development (R&D)
expenditures or substantial intangible assets than
in firms with hard assets that are more easily
valued. Since the probability of detection varies
directly with the expected cost of committing
fraud, accounting fraud should be more likely in
firms with assets that are difficult to value.
Another external force to be examined is the
effect of conscientious independent auditing. The
role of the independent auditor is to provide
outside verification of the veracity of accounting
numbers. Arguably, the major asset of auditors is
their reputation for verifying the quality of accounting numbers produced by corporate managers. Watts and Zimmerman (1986) describe the
importance of an auditors reputation:

EXTERNAL FORCES THAT EFFECT THE

COSTS AND BENEFITS OF ACCOUNTING
FRAUD

To the extent that the more reputable auditors are

more likely to detect accounting fraud, it can be
argued that firms with such auditors are less likely
to commit accounting fraud. Assuming that Big
Eight (now Big Six)3 auditors have the most
reputational capital, we examine the prevalence of
the use of Big Eight auditors in the sample.

One major external force that drives the choice to

commit accounting fraud may be the inherent
difficulty the market has for valuing some assets.
1997 John Wiley & Sons, Ltd.

Reputation gives auditors incentives to be independent. It is costly to establish a track record and
reputation for discovering and reporting contract
breaches, but once established, reputation increases the demand for the auditors services and
fees If found to have been less independent than
expected, the auditors reputation is damaged and
the present value of the auditors services is reduced. He bears the cost. Thus the auditors reputation (a valuable asset) serves as a collateral bond
for independence.

Manage. Decis. Econ. 18: 587599 (1997)

CAUSES AND CONSEQUENCES OF ACCOUNTING FRAUD

Table 1.

591

Summary Statisticsa

Firm characteristic

Accused firm

Control firm

p-Value on difference

Total assets
R&D expense
Big 8 auditor (proportion)
Classified board (proportion)
Number of directors
% Directors insider
% Directors outsiders
Audit committee (proportion)
Compensation committee (proportion)
Nomination committee (proportion)
ESOP (proportion)
Accounting bonus plan (proportion)
Stockholdings, largest board holding
Total board holdings
Number of 5% stockholdings
Age of directors
Dispersion of age (S.D.)
Tenure on board
Dispersion of tenure (S.D.)

$3980.28 (mil)
$19.42 (mil)
0.803
0.158
10.05
0.566
0.395
0.667
0.579
0.228
0.089
0.446
14.30
24.39
1.38
53.88
7.79
7.02
5.07

$2592.12 (mil)
$22.56 (mil)
0.831
0.121
9.67
0.576
0.373
0.569
0.466
0.293
0.121
0.310
17.46
27.65
1.30
53.77
8.69
8.22
5.91

0.423
0.874
0.681
0.564
0.760
0.910
0.809
0.278
0.220
0.426
0.584
0.131
0.289
0.420
0.722
0.929
0.789
0.120
0.870

The means here are of all firms for which data was available. Means will differ in matched pairs tests
performed later due to the necessity that both the accused and control firms must have the relevant data
available.

SAMPLE AND EVIDENCE

Our final sample consists of 62 firms charged with
financial disclosure violations by the Securities
and Exchange Commission (SEC) during the
fiscal years 1981 1987. The sample was collected
by inspecting the SEC annual reports during this
period. Firms were eliminated from the sample
either because (a) their returns were not contained
on the Center for Research on Security Prices
(CRSP) daily or NASDAQ tapes; or (b) because
they are not covered by the Moodys Industrials,
OTC, Public Utility, Bank and Finance, or Transportation manuals in the fiscal year immediately
preceding the SEC charges.
For each of the 62 firms we selected a control
firm that was not charged with accounting fraud
by the SEC. The control sample consists of the
firm in the same 4-digit Standard Industrial Classification (SIC) code that was nearest in size, as
measured by total book value of assets, to the
corresponding offender in the fiscal year preceding the SEC charges. To avoid matching firms
with divergent asset mixes, the ratio of current
assets to total assets was compared for each of the
pair of firms. When the ratio of current assets to
total assets diverged by an order of magnitude
and an alternative match was available, the alternative was chosen. This only happened twice in
1997 John Wiley & Sons, Ltd.

the sample. Additional requirements for inclusion

in the control sample are that: (a) the firms had
not been previously or subsequently charged with
accounting violations by the SEC; (b) financial
data on the firms are contained on the Compustat
tape; (c) the firms are listed in the Moodys manuals in the fiscal year preceding the SEC charges;
and (d) SEC proxy filings for the firm are available in the fiscal year preceding the SEC charges.4
Table 1 provides summary statistics on the
accused firms and their controls. Presented are the
mean (or percentage or standard deviation if appropriate) of the accused sample, the same relevant statistic for the control sample, and the
p-value from the test of the hypothesis (nonpaired) that the statistics are equal. As can be seen
from the univariate statistics presented for the
entire sample, the two samples are not significantly different at a reasonable level of significance. This lack of significant difference will
continue in most dimensions when we examine
the sample in a series of matched-pair tests.
Despite our attempts to match on size, the
average difference in the total assets of offenders
versus the control sample ($1.38 million) is statistically significant from zero (Wilcoxon (paired)
t-statistic of 2.5) in the year preceding the SEC
charges. When ten banks are excluded from the
sample, however, this difference ($400 000) is not
Manage. Decis. Econ. 18: 587599 (1997)

592

M. GERETY AND K. LEHN

statistically different from zero (Wilcoxon t-statistic of 1.34). The average difference in the ratio of
current to total assets is not statistically different
from zero (Wilcoxon t-statistic) for the sample of
non-banks.5
A fraud is not material if there is no reliance
upon the information by an unsophisticated investor. We examine materiality by looking at
stock price performance near the beginning of the
fraudulent period as well as stock price performance upon the announcement of the fraud. We
find that, on average, the cases in the sample were
material.
To examine materiality, we examined a window
surrounding the beginning of the firms accounting fraud. The choice of a date for the commencement of fraud was somewhat tenuous, but we
chose the release date of the first 10-K or 10-Q
that the SEC claimed was fraudulent. We found
for a sample of 23 matched pairs of firms for
which data existed, in the 150 trading days prior
to the commencement of fraud the accused firms
performed 7.4% worse6 than their industry match
firm. In the 150 trading days following the commencement fraud, the offender did as well as the
industry match (difference in CARs 0.004). It
seems that the market was fooled by the fraud, at
least in the short run.
To verify that SEC charges of accounting fraud
actually impose costs on firms, we estimated the
average effect that the announcements of these
charges had on the stock prices of firms in our
sample. Various editions of the Wall Street Journal Index (WSJI) were used to identify the first
public announcement of the SEC charges. If no
announcement was contained in the WSJI, the
date on which the SEC announced the charges
was used. These announcement ranged from rumors of SEC charges to definitive announcements
of SEC charges. Conventional event study
methodology is used to estimate the stock price
effects of these announcements over a three day
period: the day before through the day after the
announcements. Sufficient stock return data for
the event study are available for only 37 of the 62
companies. This sample of 37 firms contains 18
NYSE and AMEX firms and 19 NASDAQ firms.
The average cumulative abnormal return for
the 37 firms over the 3 day window surrounding
these announcements is 3.05%, which is statistically different from zero (t-statistic = 1.89).
The 3 day CARs ranged from 34.39% (Flo 1997 John Wiley & Sons, Ltd.

rafax International) to 18.7% (Charter Company).

The average CAR is less negative for NYSE and
AMEX firms ( 2.15%, with a t-statistic of
1.79) than for firms that trade on the NASDAQ
system ( 3.91%, with a t-statistic of 2.02).
This difference may result from the fact that
compared with NASDAQ companies, the event
dates for NYSE and AMEX companies are more
likely to be rumors, rather than definitive SEC
charges. Alternatively, this evidence may suggest
that charges of accounting misdeeds convey more
information about lesser known firms (i.e. NASDAQ) than the do about better known firms (i.e.
NYSE).
Next we turn to an examination of the cost of
valuing assets. Assuming that the costs of valuing
assets varies systematically across industries, we
expect the distribution of firms committing accounting fraud to be clustered in industries in
which these costs are especially high. To test
whether the sample of offenders is distributed
randomly across industries, we compare the actual and expected number of offenders in each
3-digit SIC code. We had definitive 3-digit SIC
classifications for 55 of our original 62 firms. The
other seven were spread across more than one
3-digit SIC code. The expected number of offenders in each industry was computed by multiplying
the sample size by the proportion of the full
COMPUSTAT sample that fell in the corresponding industry. For example, SIC code 738, miscellaneous office products, had 166 firms in the
COMPUSTAT sample, or about 1.5% of the total. To find the expected number of offenders in
this industry, 1.5% is multiplied by the total number of firms in our sample, 55, to generate an
expected number of 0.83. The Chi-square statistic
corresponding to the absolute value of the difference between the actual and the expected number
of offenders by industry is 28 717, which reveals
rather decisively that the offenders are not distributed randomly across industries.7
The difference between the actual and expected
number of offenders for the top 20 and bottom 20
SIC codes is listed in Table 2. The incidence of
offenders (i.e. the difference between the actual
and expected number of offenders) is highest
among office computing and accounting machines
(SIC code 357), commercial and stock savings
banks (SIC code 602), drugs (SIC code 283),
computer programming and data processing services (SIC code 737), and electric lighting and
Manage. Decis. Econ. 18: 587599 (1997)

CAUSES AND CONSEQUENCES OF ACCOUNTING FRAUD

Table 2.

593

Twenty 3-digit SIC Codes with Smallest and Largest Difference between Actual and Expected
Number of Fraud Cases

3-Digit SIC codes

Actualexpected
number of cases

Description

Panel A: Industries most underrepresented

679
2.73578
131
2.26885
367
1.31257
581
1.15667
481
0.92533
308
0.72920
492
0.63868
541
0.59845
873
0.58336
421
0.56324
781
0.51295
451
0.46769
284
0.43752
331
0.43752
344
0.42746
230
0.41740
506
0.41237
358
0.40735
799
0.40735
353
0.39226

Miscellaneous investing
Crude petroleum and natural gas
Electronic components
Eating and drinking places
Telephone communications
Misc plastic products
Gas production and distribution
Grocery stores
Resh, development, testing services
Trucking
Motion picture production
Scheduled air transportation
Soap, detergent, toilet preps
Steel work, roll & finish mill
Fabricated structural metal
Apparel, other finished products
Electrical goods-wholesale
Refrig & service ind machines
Misc amusement & rec svcs
Constr, mining, matl handling eq

Panel B: Industries most over-represented

206
0.844100
209
0.849129
517
0.879303
511
0.889361
808
0.889361
152
0.924564
733
0.929593
286
0.934622
609
0.939651
162
0.959767
379
0.959767
639
0.989941
738
1.165183
621
1.532301
641
1.753578
364
1.763636
737
1.827466
283
1.908704
602
4.838297
357
8.149323

Sugar & confectionery prods

Misc food preps
Petroleum & pete prod, wholesale
Paper & paper prod, wholesale
Home health care svcs
Gen bldg contractors-res
Mailing, repo, comml art Svcs
Industrial org chem
Functions rel to deposit banking
Hvy Constr, ex highway
Misc transportation equip
Insurance Carriers, nec
Misc business services
Security brokers and dealers
Ins agents, brokers & service
Electric lighting, wiring
Comp programming, data proc
Drugs
Commercial banks
Computer & office equip

wiring equipment (SIC code 364). Industries with

the lowest incidence of offenders are miscellaneous investing (SIC code 679), crude petroleum
and natural gas (SIC code 131), electronic components and accessories (SIC code 367), eating and
drinking places (SIC code 581) and telephone
communications (SIC code 481).
To test whether the distribution of accounting
fraud cases across industries varies according to
the cost of valuing assets in industries, we regress
the difference between the actual and expected
number of fraud cases by industry on proxies for
the cost of valuing industry assets. One proxy is
1997 John Wiley & Sons, Ltd.

the ratio of aggregate R&D expenditure in each

3-digit SIC industry to the sum of the aggregate
cost of goods sold and general administrative
costs in the industry. We expect that as R&D
increases relative to other costs, the difficulty of
monitoring asset values increases. The second
proxy is the ratio of aggregate intangible to aggregate total assets in each 3-digit SIC industry,
which also is expected to vary directly with the
costs of valuing assets.
The regression of the frequency of fraud on the
R&D variable yields the most favorable results.
The frequency of fraud varies directly, and signifiManage. Decis. Econ. 18: 587599 (1997)

594

Table 3.

M. GERETY AND K. LEHN

Summary of Results

Panel A: Evidence on Big-Eight auditors

N

% Both

% Neither

% Off only

% Control only

Big 8 auditors

70.9

4.8

11.3

12.9

% Off only

% Control only

10.6
13.4

8.5
7.7

62

Panel B: Evidence on determinants of accounting fraud

Corporate governance variablesmatched pairs t-tests
N
Offender-Control
Percentage outside directors
Percentage inside directors
Percentage professional directors
Accounting based compensation
Ownership by largest board
member

52
52
52
52
52

Corporate governance variablespercentages

N
Audit committees
Classified boards

47
52

Panel C: Evidence on ex-post settling up

Percentage change in number of directorships
Years after
Excess lost by
offenders
+1 Year
+2 Years
+3 Years

t-Test

0.016
0.038
0.021
0.096
4.512

0.431
0.917
1.211
0.689
1.793

% Both

% Neither

53.2
3.8

26.7
75.0

Z-score

5.7%
6.2%
5.7%

2.54
2.14
1.78

1 Year later

2 Years later

3 Years later

0.1623
0.1720
0.1007
0.198

0.2312
0.2696
0.1740
0.663

0.2587
0.3444
0.2320
1.401

Panel D
Not bad performing accused
Poor Performing accused
Control Sample
Z-statistic (null is not bad
performing equals poor
performing)

cantly at the 0.01 level (t-statistic of 3.02), with

R&D expenditures. The regression in which the
ratio of intangible to total assets serves as the
independent variable also yields a positive relationship, but is insignificant (t-statistic of 1.38).
Although this evidence is mixed, it is generally
consistent with the argument that the more
costly it is to value assets, the more likely is
accounting fraud.
Is the likelihood of committing accounting
fraud lower for firms audited by major accounting firms? To test this, we recorded whether
each offender and control firm had a Big Eight
auditor in the year preceding the SEC charges.
Data on auditors were obtained from SEC
proxy statements in the year preceding the SEC
charges for 62 matched pairs. The results on
auditor reputations are shown in Table 3, panel
A. Both the offender and the control firm had a
1997 John Wiley & Sons, Ltd.

Big Eight auditor in 70.9% of the pairs, and

neither firm had a Big Eight auditor in 4.8% of
the pairs. In 11.3% of the pairs only the offender had a Big Eight auditor, and in 12.9% of
the cases only the control firm had a Big Eight
auditor. The frequency of Big Eight auditors is
slightly higher among the control firms, although this difference is not statistically significant.

INTERNAL DETERMINANTS OF
ACCOUNTING FRAUD
We turn our attention to an evaluation of the
effects of the structure of internal monitoring and
reward systems on the probability of a firm committing accounting fraud. The governance structure of firms has been suggested as a variable that
Manage. Decis. Econ. 18: 587599 (1997)

CAUSES AND CONSEQUENCES OF ACCOUNTING FRAUD

affects the likelihood of committing accounting

fraud. For example, much of the debate in the
1970s over corporate governance centered on the
role of boards of directors in mitigating accounting
fraud. Outside directors, some argued, have
stronger incentives than inside directors to monitor
the activities of managers, including the managers
production of accounting numbers. In the late
1970s and the early 1980s there was a substantial
increase in the ratio of outside to inside directors
of publicly traded companies, perhaps due in part
to this public policy controversy.8
In addition, the New York Stock Exchange
(NYSE) adopted a listing standard in 1978 that
requires NYSE-listed companies to have audit
committees made up of directors who are independent of management. The purported role of the
audit committee in mitigating fraud was summarized in 1977 by Harold Williams, then-Chairman
of the SEC:
It should be evident, but perhaps bears repeating,
that integrity in reporting financial data is vital
both to an efficient and effective securities market
and to capital formation. One key to increasing
public confidence in that data long advocated by
many segments of the financial community, including public accounting firms, is more direct
involvement by boards of directors in the auditing
process and the integrity of reported financial
information. The vehicle, which the Securities and
Exchange Commission, the New York Stock Exchange and an increasing number of public corporations have turned to, has been the independent
audit committee. (Williams, 1977)

Some legal scholars and regulators have applauded the proliferation of outside directors and
audit committees, on the grounds that they raise the
probability of detecting, and hence increase the
expected cost of accounting fraud. Alternatively,
others argue that outside directors and audit committees are largely perfunctory and have little or no
effect on corporate governance.
An additional part of a firms governance structure that is thought to affect the incentives of
directors to monitor managers is whether or not the
board is classified. Boards of directors are classified
(sometimes referred to as staggered) if in any year
only a subset of directors stand for election or
reelection. Usually, with classified boards, onethird of the directors stand for election or reelection
to a 3 year term every year. Consequently, classified
boards impede quick transfers of control, and are
frequently viewed as anti-takeover devices.
1997 John Wiley & Sons, Ltd.

595

Two competing views of the effect of classified

boards on accounting fraud exist. Viewed as an
anti-takeover device, classified boards may dull
incentives of board members to monitor managers,
and therefore increase the likelihood of accounting
fraud. However, as Weston, Chung, and Hoag
point out, (Weston et al., 1990) managements
purported rationale in proposing a staggered board
is to assure continuity and experience, which
suggests that classified boards might mitigate accounting fraud.
The final variable of interest is the extent to
which a firm uses accounting based incentives in
management compensation plans. It is commonly
acknowledged that accounting choices are governed in part by contractual considerations.9 In
particular, the frequent use of accounting based
incentives in executive compensation plans are
often thought to be important factors affecting
accounting choices (See, e.g. Healy, 1985). We test
the hypothesis that the presence or absence of
accounting based executive compensation plans
has no effect on the likelihood that a firm will
commit accounting fraud.
To test whether the structure of boards of
directors affects the likelihood of committing accounting fraud, we collected various data on the
offenders boards and those of their corresponding
controls in the year immediately preceding the SEC
charges. The source for these data are various
proxy statements filed with the SEC. The number
and identity of board members is listed in the proxy
statements for 52 pairs of offenders and control
firms. Offenders had slightly larger board sizes, but
this average difference (0.403) is not statistically
different from zero (Wilcoxon t-statistic of 0.56).
To examine the extent to which the mix of
outside to inside directors, or the number of professionals on a board affects the likelihood of
committing accounting fraud, we classified each
board member of all 52 offenders and their control
firms. Inside directors include present or former
employees of the firm, founders of the firm and
their families, representatives of suppliers to the
firm including the firms lawyers, and representatives of the firms customers. Professional directors
include representatives of the firms commercial or
investment bankers, and outside directors as all
others.
This categorization of directors is somewhat
arbitrary, but generally consistent with other studies. Hermalin and Weisbach (1988) and Weisbach
Manage. Decis. Econ. 18: 587599 (1997)

596

M. GERETY AND K. LEHN

(1988) define full time employees and ex-employees as insiders, those with business dealings as
grays and others as outsiders. Rosenstein and
Wyatt (1990) define outsiders as those not
presently or formerly employed. Bryd and Hickman (1990) as well as Baysinger and Butler (1985)
define employees and ex-employees as executives,
investment bankers and bankers as instrumental
directors, and all others as monitoring directors.
We adopt the convention that those with monetary gains at stake are insiders, those with possible
outside business-oriented brand names (e.g.
bankers and investment bankers) are professionals, and those with no contractual relationship
other than their membership are outsiders.
The data, shown in Table 3, panel B, reveal no
significant difference in the mix of outside and
inside directors for the offenders and their corresponding controls. The average differences in the
number of inside directors, expressed as a percentage of all directors, is negative (meaning that
there are fewer inside directors on the boards of
offenders), although this difference is not significantly different from zero (Wilcoxon t-statistic of
0.43). Similarly, the average difference in the
number of outside directors, expressed in the
same way, is positive (more outside directors on
boards of offenders), but this difference is not
statistically significant (Wilcoxon t-statistic of
0.917). The null hypothesis that the likelihood of
accounting fraud is not related to the mix of
outside to inside directors cannot be rejected.
Next we turn to the question of whether the
presence of audit committees affects the likelihood of committing accounting fraud. We examined the proportion of offenders that had audit
committees in the year before the SEC charges, to
see if that proportion was lower than the corresponding proportion for the control firms. Since
the NYSE mandates audit committees, we excluded five matched pairs from this analysis because one of the two firms traded on the NYSE
while the other did not. This leaves 47 matched
pairs for this analysis.
Table 3, panel B, contains the empirical results
on audit committees. In 53.2% of the matched
pairs both firms had an audit committee, and in
27.6% of the matched pairs neither firm had an
audit committee. For more than 80% of the
matched pairs, the presence or absence of an audit
committee was identical for both the offenders
and the control firms. In 10.6% of the matched
1997 John Wiley & Sons, Ltd.

pairs only the offender has an audit committee,

and in 8.5% of the sample only the control firm
had an audit committee. The presence of audit
committees was actually higher for the offenders
than the control firms, although this difference is
not statistically significant. The results fail to reject the null hypothesis that the presence of an
audit committee has no effect on the likelihood of
committing accounting fraud.
We also tested the null hypothesis that the
likelihood of committing accounting fraud is not
affected by whether a firm has a classified board
of directors. Data on how directors were elected
in the year before the SEC charges are available
in SEC proxy filings for 52 matched pairs. Neither
the control firm nor the offender had a classified
board in 75% of the matched pairs, both firms
had classified boards in 3.8% of the pairs (see
Table 3, panel B). In almost 80% of the pairs,
there was no difference in the frequency of
classified boards. In 13.4% of the pairs only the
offender had a classified board and in the remaining 7.7% of the pairs, only the control firm had a
classified board. The frequency of classified
boards is slightly higher among offenders than
control firms, although this difference is not
statistically significant. This result fails to reject
the null hypothesis that the likelihood of accounting fraud does not depend on whether or not a
firm has a classified board.
Our results regarding board ownership of equity suggests that ownership of equity matters:
with higher board ownership the likelihood of a
firm committing accounting fraud falls. It is interesting that the ownership that matters is not
aggregate board holdings, but the holdings of the
largest stockholder on the board. In the control
sample, the largest shareholder held on average
4.51% more equity than on the offender sample
(t= 1.793). Having a large shareholder on the
board reduces the probability of accounting
fraud. These results are also summarized in Table
3, panel B.
To examine whether the presence of accounting-based management compensation plans affects the likelihood of committing accounting
fraud, we collected compensation data for the
chief executive officer of each offender and control firm in the year before the SEC charges.
These data were collected from the relevant SEC
proxy filing for each firm. We identified compensation plans as having accounting-based incenManage. Decis. Econ. 18: 587599 (1997)

CAUSES AND CONSEQUENCES OF ACCOUNTING FRAUD

tives if they contained bonus plans, profit sharing

plans, or incentive stock options that were triggered by achieving some level of accounting performance. The number of these types of plans
was then contrasted across the samples. These
results are contained in Table 3, panel B. The
mean difference is 0.096 plans, which is consistent
with the argument that accounting-based compensation plans increase the likelihood of accounting fraud. However, this difference is not
statistically significant (Wilcoxon t-statistic of
0.689).
In summary, most forces that are internally
determined by the structure of the monitoring
and reward systems of the firm have no bearing
on the probability of accounting fraud, holding
constant firm size and industry. The only effect
that was marginally significant was equity ownership by the largest shareholder on the board. We
find that large single shareholders impede accounting fraud.

EVIDENCE OF EX-POST SETTLING UP

In addition to probing why some firms and not
others commit accounting fraud, we examine
whether or not directors of firms that commit
accounting fraud are disciplined in the market for
corporate directors. Fama (1980) argues that the
managerial labor market disciplines corporate
managers who deviate from profit maximization.
The ex-post settling up imposed by this market
serves to mitigate agency problems that purportedly arise from diffuse structures of equity ownership. In a recent paper, Kaplan and Reishus
(1990) find that directors of companies that cut
dividends are less likely to serve on boards of
directors in the future, a result that is consistent
with Fama.
To test whether directors of companies charged
with disclosure violations are disciplined in the
labor market, we examine the number of boards
on which directors of offenders served, before and
after the SEC charges. To control for normal
changes in the number of board seats held by
directors over comparable periods, we also examine this change for the directors of the corresponding control firms. Data on other board seats
held by directors of 62 matched pairs of offenders
and control firms are collected from various SEC
proxy statements. These results are also contained
1997 John Wiley & Sons, Ltd.

597

in Table 3, panel C. In the year before the SEC

charges, 523 directors of the 62 offenders held 724
other board seats and 543 directors of the corresponding 62 control firms held 660 other board
seats listed in proxy statements. Those other
boards were listed on the proxy statements, and
of those other boards, 57% of the companies were
listed in Moodys. We tracked these directors on
other boards for three years after the SEC announcement of fraud using the Moodys manuals.
One year following the SEC charges, the number of other board seats held by directors of the
offenders declined by 15.7%. The corresponding
decline for directors of the control firms was only
10%; the difference is statically significant (zstatistic of 2.54). Two years following the SEC
charges, directors of the offenders were on 23.6%
fewer boards, while those of the control firms
were on 17.4% fewer boards. This difference is
statistically significant (z-statistic of 2.14). Finally, 3 years after the SEC charges, the number
of other directorships held by directors of the
control firms had fallen by 28.9%, while those of
the control firms had fallen by only 23.2%. This
difference is also statistically significant (z-statistic of 1.78) at the 0.1 level.
These results reject the null hypothesis that the
number of directorships held by directors of companies charged with accounting fraud does not
change relative to the control group following
these charges. This evidence is consistent with the
argument that directors of companies charged
with accounting fraud suffer a reputational loss in
the market for corporate directors. This reputational loss, which serves as a form of ex-post
settling up, is similar to that found by Kaplan
and Reishus (1990) for a sample of companies
that cut dividends during the early 1980s.
An alternative hypothesis is that directors of
poorly performing firms are disciplined by the
managerial labor market. Because we know that
the accused sample performed abnormally poorly,
this is an hypothesis that deserves examination.
We divided the accused sample of directors in
half based on stock price performance in the 250
trading days prior to the SEC announcement of
the charges. The results are summarized in Panel
D of Table 3. We find that directors of poorly
performing accused firms do lose more directorships than those of the relatively well performing
accused firms, but both sub-samples have more
losses than the directors of the control sample.
Manage. Decis. Econ. 18: 587599 (1997)

598

M. GERETY AND K. LEHN

CONCLUSION
This paper empirically investigates the causes and
consequences of accounting fraud. Adopting the
perspective that the commission of accounting
fraud is governed by rational choice, several hypotheses are tested. We divide these hypotheses
broadly into external and internal forces that
effect the choice to commit accounting fraud. We
find evidence suggesting that the cost of valuing
assets influences the choice to commit accounting
fraud. Furthermore, evidence suggests that the
immediate effect of the instigation of accounting
fraud does increase stock prices, while the announcement of charges by the SEC significantly
lowers stock prices. Corporate governance structures, auditor reputation, and the use of accounting based executive compensation schemes appear
unimportant in affecting the decision to commit
this type of fraud. We do, however, find that the
concentration of ownership in a single individual
mitigates the probability of accounting fraud. Finally, directors of firms committing accounting
fraud appear to be punished in the managerial
labor market.
In general, we find significant effects from external forces, and minimal effects from internal
forces. Given that internal compensation and
monitoring plans are choice variables for equity
owners, while external forces are market determined, it is not surprising that in equilibrium the
choice variables would have little influence while
external forces would drive the choice to commit
accounting fraud.

2. Karni, supra note 1, at 117.

3. The following auditors are considered Big Eight:
Arthur Andersen, Aurthur Young, Coopers and Lybrand, Deloitte Haskins & Sells, Ernst & Whinney,
Peat Marwick Mitchell, Price Waterhouse, and
Touche Ross. Our sample predates the subsequent
mergers of Deloitte Haskins & Sells and Touche
Ross, and Aurthur Young and Ernst & Whinney.
For our purposes the term Big Eight retains meaning.
4. One possible problem arises from matching NYSE
firms with non-NYSE firms. NYSE firms arguably
have more stringent reporting requirements. This
type of match occurred with only five firms. Where
this is most important, for the presence of independent audit committees, those firms were dropped
from the sample.
5. There existed a tradeoff in the choice of control
firms. By expanding the industry classification to the
three digit level we would have had more match
candidates, and could have controlled more exactly
for firm size. Because we had a prior belief that the
type of business a firm did was more important than
firm size in determining the proclivity to commit
accounting fraud, we felt it better to err on the side
of size than on line of business.
6. These numbers are average comulative abnormal
returns (CARs).
7. It is possible that three digit classifications are too
narrow to examine this question. Data was aggregated to the two digit level and the test statistic was
recalculated. The resulting Chi-squared statistic was
957.24.
8. For a sample of 142 New York Stock Exchange
companies, Hermalin and Weisbach find that the
average percentage of directors who were outside
directors increased from 37.6% in 1971 to 53.9% in
1983. The corresponding percentage for inside directors fell from 49.1% in 1971 to 34.3%. (See Hermalin
and Weisbach, 1988).
9. For a rich discussion of this literature, see Watts and
Zimmerman (1986), supra note 5.

Acknowledgements
The majority of this work was done while both authors were
in the Office of Economic Analysis, Securities and Exchange
Commission. This work does not express the views of either
the Commission or the authors colleagues at the commission.
The authors wish to thank D.B. Johnson, C.M. Lindsay, M.T.
Maloney, L. Morweis, J.H. Mulherin, S. Rosenstein, K. Scott,
an anonymous referee, and seminar participants at Clemson
University and the Arizona Finance Symposium for comments
on earlier drafts.

NOTES
1. Litigation Release No. 9842/December 21, 1982, Securities and Exchange Commission v. McCormick &
Company, Incorporated, et al. (United States District Court for the District of Columbia, Civil Action No. 82-3614).

1997 John Wiley & Sons, Ltd.

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