Do Analysts Anticipate Accounting Fraud?

Abstract (Via SSRN)

We examine whether analysts anticipate the public disclosure of accounting frauds by studying a sample of companies that have committed fraud as evidenced by the Security and Exchange Commission (SEC) issuance of an Accounting and Auditing Enforcement Release (AAER). We use survival analysis to determine when analysts drop coverage and revise their recommendations down prior to the public disclosure of fraud. Our analyses indicate some evidence that analysts anticipate fraud and use different signals to inform investors about different fraud types. For example, firms that commit larger frauds are significantly more likely to have analysts drop coverage earlier in the period preceding the public announcement, but are not significantly more likely to show downward revisions in recommendations. We also find that analysts appear to be fooled by fictitious frauds – they are no more likely to drop coverage or revise down earlier prior to public disclosure for firms that commit these frauds versus firms that do not commit fictitious frauds. Finally, our results show that the decision and timing of dropping coverage is not correlated with revision of forecasts, indicating that analysts consider different variables for the two decisions.

Additional Excerpts (Via SSRN)

Analysts are considered important information intermediaries between management and investors (Schipper 1991). In this paper, we examine a situation where the contribution of analysts for investors would be considered particularly important. Westudy whether sell-side equity analysts anticipate accounting fraud and reveal this negative information by revising their recommendations down or dropping coverage of the firm prior to the public disclosure of the fraud. The results of our analyses indicate some evidence that analysts anticipate fraud and use different signals to inform investors about different fraud types. However, these results also point to the possibility that analysts’ decisions may be more closely aligned with their own economic incentives and reputation concerns than client protection.

We find that firms that commit larger frauds are significantly more likely to have analysts drop coverage earlier in the period preceding the public announcement, but are not significantly more likely to show downward revisions in recommendations. We also find that analysts are more likely to drop coverage of firms who commit frauds involving overvalued assets and less likely to revise their recommendations down for these same firms prior to the disclosure of the fraud. We also show that analysts appear to be fooled by fictitious frauds – they are no more likely to drop coverage or revise down prior to disclosure for firms that commit these frauds versus non-fictitious frauds. However, analysts are more likely to both revise recommendations down and to drop coverage of firms whose fraud moves them from a loss to profit position than for firms whose frauds do not change their loss/profit position. Interestingly, we find that for firms that commit revenue frauds, whether fictitious or premature, analysts are no more likely to drop coverage or revise recommendations downward prior to public disclosure despite the fact that these frauds have been found to be the most commonly occurring frauds both in our sample and in prior literature (Bonner et al. 1998). In addition, we find no evidence that analyst experience is related to coverage and recommendation choices.

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03. December 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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