Conservatism, SEC investigation, and fraud

We present evidence on the relationship between firms that have engaged in fraudulent financial reporting and accounting conservatism. We empirically investigate the extent to which US firms identified by the SEC in their Enforcement Releases demonstrate higher levels of conditional conservatism in order to mitigate information asymmetry and agency problems. Specifically, by assessing the timing of changes in the litigation risk environment for fraud firms, we document how differences in heightened legal liability guide changes in conservative accounting behavior. Compared to a matched non-fraud control sample, we document that fraud firms have significantly lower levels of accounting conservatism in the pre-fraud period. Consistent with changes in potential legal liability, we find an increase in accounting conservatism for fraud firms during the SEC investigation period. Subsequently, during the public discovery of fraud, any increases in accounting conservatism are marginal and appear to converge back to lower levels compared to the SEC investigation period. Overall, our findings suggest more temporary changes in conservative reporting in the short-term for fraud firms. We also document that increased levels of accounting conservatism for fraud firms are not due solely to the passage of the SOX Act. Our findings aid in explaining fraud firms’ incentives and opportunities for accounting conservatism and lend support for why standard setters, regulators and auditors should continue to monitor and re-evaluate conservatism’s short-term effects that are conditioned on changes in a firm’s risk environment.