Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions

Abstract

This study examines the impact of executives implicated in fraud on firms’ investment decisions using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC), aiming to address the underexplored aspect of rationalization within the fraud triangle. AAERs summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court. Executives implicated in fraud often display abnormal attitudes to justify accounting irregularities, prompting an investigation into how abnormal investment decisions are used for rationalizing fraud, given their critical role in a firm’s long-term sustainability. We utilize bootstrap analysis to address the non-normality of fraud firms in our sample, and to acquire multiple bootstrap samples that represent the fraud population, thereby bolstering the reliability of our statistical analysis. Analysis of AAERs spanning from 1981 to 2013 reveals that implicated executives, particularly CEOs and CFOs, tend to make abnormal investment decisions, and that collusive fraud exacerbates this behavior. Notably, such executives lean towards overinvestment, particularly in R&D expenditure, to hide or justify fraud; the duration of fraud amplifies its impact on investment decisions. By shedding light on the rationalization aspect of the fraud triangle, this research contributes valuable insights for investors, regulators, and academia, emphasizing the significance of public disclosure of fraud by regulators to enhance transparency in capital markets and to alert capital market participants. Furthermore, this study underscores the importance of ethics-focused education in accounting to prevent corporate fraud.