AF4S11A - Accounting Research Management and Methods Coursework 1 ____________________________

Research Proposal on:

Identifying the most important risk factors and developing fraud prediction model in the perspective of financial statement frauds

GENERAL OVERVIEW OF TOPIC AREA Financial statements frauds include manipulation of expenses, revenues and accounts receivables and etc. It is observed that those highly-ranked personnel are the ones committing financial statement frauds for various reasons, such as securing the status as CEO, the performance-related bonuses or share options and etc. The impact of financial statement frauds is often greater in case of publicly listed companies and therefore needs to be more focused on.

Numerous studies have been carried out to look for an efficient conceptual model to explain fraud. According to the classic fraud triangle theory as developed by Cressey (1973), three elements are needed for fraud to take place, which consists of: Motivation, Opportunity and Rationalization. All of these elements must be presented in order for fraud to occur.

Motivation refers to an incentive or pressure to carry out fraud. It is also known as perceived non-sharable financial need by Cressey. The fraudster has some financial problem that cannot be solved legitimately. Hence, he considers no other alternative but committing frauds, like stealing cash or falsifying sales figures as a way to obtain financial means.

Opportunity refers to a situation that person finds that he could resolve the non-shareable financial problem by secretly violating the trust (Ventura and Daniel, 2010). It is believed
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that inadequate internal control over assets increases the susceptibility of assets misappropriation.

Rationalization refers to a situation where the potential trust violator justifies the relationship between the non-shareable problem and the illegal solution. Rationalization is to reduce the cognitive dissonance (Dorminey, et al. 2012) within the individual, as it was observed that individuals who commit fraud desire to remain within their moral comfort zone.

When all of three components exist, i.e. person has to have an opportunity to do something wrong combined with some sort of serious pressure along with a mindset to say that it is reasonable to do something wrong, it is highly likely that fraud will be committed.

The fraud triangle is being adopted as the framework for auditors to detect risk factors that increase the probability of fraud. It has been adopted by the American Institute of CPAs (AICPA) in Statement on Auditing Standards No. 99 (SAS) , Consideration of Fraud in a Financial Statement Audit, which requires auditors to evaluate the potential presence of fraudulent behavior by assessing factors related to pressure, opportunity and rationalization.

SAS has been adopted from Cresseys fraud triangle theory in a more prudent manner in which only one factor is needed to present in order for fraud to be committed. As a result, SAS requires the auditor to apply numerous new procedures aimed at examining the firm environment and to evaluate expansive amounts of new information in an effort to identify facts and circumstances that are indicative of the existence of the three elements.

The AICPA takes the view that only one element of the fraud triangle is needed to be present in order for committing fraud. As a result, SAS requires the auditor to apply numerous
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procedures to examine the firm environment and to evaluate extensive information for identifying facts and circumstances that are indicative of the existence of the three elements. The AICPA has listed out these elements in Table 1 of SAS and provides examples of situations and circumstances that are symptomatic of each fraud risk category. The SAS has been widely adopted for international accounting bodies to formulate their own auditing standards, including Hong Kong.

As discussed by Skousen and Wright (2008), empirical evidence proves that various corporate governance-related issues are related to the occurrence of financial statement fraud. However, most of the studies identify a number of factors related to fraud individually and there is no studies that identify an array of risk factors linked to financial statement fraud. Skousen and Wright therefore carried out such studies and based on the identified fraud risk factors to develop a robust fraud prediction model. Based on their study, this research tries to test whether the array of risk factors is still applicable to Hong Kong and the fraud prediction model could be functioned properly as designed.

IDENTIFICATION OF THE RELEVANT LITERATURE The research will be based on the one being done by Skousen and Wright (2008). The identification of the relevant literatures will be from two sources: The reference materials as suggested in the authors research paper. Search for other relevant articles, including e-journals, e-books through FINDit.

Systematically identify existing body of knowledge on the topic, as suggested by Ryan (2002): Search most recent high-quality academic journals for articles on topic. Identify key articles being cited by the authors. For example, look for those articles that
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are being referenced by the authors Compile time chart of key articles Repeat process back through time at, say, 5-yearly intervals

Some of the preliminary literature (in chronological order) being identified including: The study of Beasley (1996) predicts that the board of directors comprises larger proportions of external members significantly reduces the likelihood of financial statement fraud. The test is based on a sample size of 75 fraud and 75 no-fraud firms and using logit regression analysis. The results support Beasleys prediction, however, the presence of an audit committee does not significantly affect the likelihood of financial statement fraud.

Dechow et al. (1996) investigate firms subject to accounting enforcement actions by the Securities and Exchange Commission for alleged violations of Generally Accepted Accounting Principles. The authors find that an important motivation for earnings manipulation so as to attract external financing at low cost. They also find that firms manipulating earnings are: (i) more likely that management dominated the boards of directors; (ii) more likely to have a Chief Executive Officer (CEO) also serves as Chairman of the Board; (iii) more likely to have a CEO to be the firm's founder, (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder.

Summers and Sweeney (1996) investigates the relationship between insider trading and fraud. They measure each company's financial condition, financial performance, growth, inventory and insider trading variables. They find that in the presence of fraud, insiders reduce their shareholdings in the company through high levels of selling activity which is measured by the frequency of the transactions, the volume and the amount of shares sold.
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Abbott et al. (2000) examined whether two key audit committee characteristics combined, activity and independence, reduce likely fraud or aggressive financial statement actions. The study shows that firms with audit committees which are composed of independent directors and which meet at least twice per year are less likely to be sanctioned for fraudulent or misleading reporting. The independence of audit committees affects both companies earnings management and also investors perceptions.

Abbott et al. (2004) further find that the independence and activity level of the audit committee exhibit a significant and negative relationship with the occurrence of restatement. The authors identify a significant negative relationship between an audit committee that includes at least one member with financial expertise and restatement. A sample of 44 fraud and nofraud firms has been used to test the results and similar findings are noted. Their results imply that the audit committees help to strengthen the monitoring and overseeing role in the financial reporting process.

Dunn (2004) examines the relationship between top management team duality and the decision to release false financial information. Sample of 103 firms that were convicted of issuing fraudulent financial statements in the period from 1992 to 1996 has been used. The results show that when there is a concentration of power in the hands of insiders, such illegal corporate behavior is more likely to occur. Common characteristics are that insiders excise influential control over the top management team and the Board of Directors simultaneously by occupying the key managerial positions while also sitting on the Board (duality), and through their ownership interest in the firm.

Skousen and Wright (2008) notice that there is lack of research that examines a broad
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range of fraud risk factors by empirically testing. In their study, the authors make use of Cresseys (1953) fraud triangle theory in identifying and empirically examining a broad range of potential fraud risk factors for two objectives:

1.

The first objective is to identify a comprehensive set of firm-related factors that are empirically related to financial statement fraud. They develop fraud proxy variables representing various measures of pressure, opportunity and rationalization, based on the examples cited in SAS No. 99 and relying on prior fraud research. These variables are tested using a sample of fraud firms and a matched sample of no-fraud firms, and several significant factors related to pressure and opportunity are identified. These results indicate that (1) the proportion of independent audit committee members is inversely related to the incidence of fraud; (2) the probability of fraud increases when the proportion of ownership held by managers already holding more than 5 percent of the shareholdings; (3) the probability of fraud increases when the proportion of insider ownership (management and directors) decreases; (4) the occurrence of fraud is higher among firms that do not have an audit committee; and (5) the incidence of fraud is significantly higher when one individual holds both the CEO and Chairman of the Board positions as comparing with the situations when the two positions are held by different individuals.

2.

The second objective is to determine whether the fraud risk factor framework can be utilized to construct a fraud prediction model. The authors observe that other fraud prediction models have reported success rates of between 30 and 40 percent. The one that the authors construct is based on the above five significant fraud risk factors identified and using publicly available information for testing. The result indicates the success rate that such model correctly categorizes fraud and no-fraud
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firms substantially reach the level of nearly 70 percent.

KEY RESEARCH QUESTIONS IDENTIFIED AND EXPLAINED The primary research question is: Are those significant fraud risk factors identified by Skousen and Wright also the same when testing Hong Kong situations? If the result is similar to the authors, it means that those significant fraud risk factors can be use to test the accuracy of the predictability of the model. It also implies that the effect of the rationalization element and aspects such as different cultures remains minimal. If it shows dissimilar results, further studies can be conducted to investigate the differences.

Then, the secondary research question is: Can the fraud prediction model constructed by Skousen and Wright also be applied in Hong Kong and correctly classifying fraud and nonfraud firms?

METHODOLOGY

Proxy Variables Identification Based on the fraud risk factors identified by Skousen and Wright (2008), the proxy variables to measure pressure and opportunity are identified, which is relied on the Table 1 of SAS. The preliminary choice of proxy variables are described below:

A)

Fraud Risk Factor Proxies for Pressure According to SAS, four general types of pressure that may lead to financial statement fraud include financial stability, external pressure, managers personal financial situations, and meeting financial targets. The corresponding fraud risk factor proxies are listed below.
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Financial stability SAS suggests that managers face pressure to commit financial statement fraud when financial stability are threatened by economic, industry, or entity operating conditions. For example, where a company is experiencing below industry growth, management may manipulate financial statements for improving the firms outlook. Similarly, management may also manipulate financial statements for provide the appearance of stability instead of rapid growth. Accordingly, the proxy variables include growth in sales (Beasley 1996; Summers and Sweeney 1998) and growth in assets (Beneish 1997; Beasley et al. 2000) and are computed as: SGROW = Change in Sales Industry Average Change in Sales AGROW = Percent change in Assets for the two years prior to fraud.

SAS suggests that recurring negative cash flows from operations or an inability to generate positive operating cash flows in light of reported earnings growth amy affect financial stability. The following financial stability ratio (Albrecht 2002) to relate cash flows to earnings growth is used: NICFOTA = (Operating income Cash flow from operations)/Total assets

The sales to accounts receivable and sales to total assets are useful in fraud detection and therefore the following financial security proxies are used: SALAR = Sales / Accounts receivables SALTA = Sales / Total assets

External pressure It includes the ability to meet listing rules and requirements, repay debt or fulfill

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debt covenants. Vermeer (2003) reports that managers tends to make use of discretionary accruals when violations of debt covenants exist. Therefore, leverage is included as a proxy for external pressure: LEVERAGE = Total debt / Total assets

Dechow et al. (1996) note that managers are less likely to commit fraud when a firm has adequate internal funding. Hence, free cash flow is included as an additional measure of external pressure: FREEC = Net cash flow from operating activities cash dividends capital expenditures

Personal financial need Beasley (1996) and Dunn (2004) indicate that when executives have financial stake significantly in a firm, the firms financial performance may threaten their personal financial situation. Two proxies, OWNERSHIP and 5%OWN, for personal financial need as follows: OWNERSHIP = the cumulative percentage of ownership in the firm held by insiders. Shares owned by management divided by the common shares outstanding. 5%OWN = the cumulative percentage of ownership in the firm held by management who hold 5 percent of the outstanding shares or more divided by the common shares outstanding.

Financial targets The financial ratio of Return on total assets ( ROA) is used to measure how well assets have been employed. The ratio indicates the performance of managers, which

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may their performance-related bonus scheme. Summers and Sweeney (1998) report that ROA differs among fraud and no-fraud firms and therefore it is included as a financial target proxy. ROA = Net Income before extraordinary items t-1/Total Assets t

B)

Fraud Risk Factor Proxies for Opportunity SAS identifies four categories of opportunities that may lead to financial statement fraud, include: industry nature, monitoring effectiveness, organizational structure, and internal control. Based on these categories, the following proxies for opportunity are targeted.

Nature of industry SAS and Albrecht (2002) indicate that the opportunities for fraud rise when a firm has significant operations located in various jurisdictions. The proxy for opportunity resulting from significant foreign operations will be: FOROPS = Percent of foreign sales over total sales.

Ineffective monitoring Dunn (2004) and other previous studies observe that the board of directors of fraud firms consists of fewer outside members than no-fraud firms. The proxy for board composition is as follows: BOUTP = Percentage of board members who are outside members.

Beasley et al. (2000) observe a lower occurrence of fraud among those companies having an audit committee and the size of audit committees are negatively related to lower occurrence of fraud. Hence, the following measures related to audit committees are used: AUDCOMM = Indicator variable with the value of 1 if mention of oversight by
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an internal audit committee; and 0 otherwise. AUDCSIZE = The number of board members who are on the audit committee divided by the board size.

Abbott et al. (2000) and Beasley et al. (2000) recognize the relationship between the independence of audit committee members and the incidence of fraud. Therefore, we include IND as a proxy for ineffective monitoring. IND = The percentage of audit committee members who are independent of the company.

Additionally, we include AUDMEET as a measure the performance of audit committee by measure the number of meetings held. AUDMEET = The number of audit committee meetings held per year.

Organizational structure Beasley (1996) and Dunn (2004) conclude that as a CEO accumulates titles, domination in decision making is observed. As control of decision making may provide an opportunity to commit fraud, the following proxy is included: CEO = Indicator variable with a value of 1 if the chairperson of the board holds the managerial positions of CEO or president; and 0 otherwise.

Sample Selection Identifying Fraud Firms To evaluate the empirical prediction, a set of firms that had been accused of fraud by the Securities and Futures Commission (SFC) has to be identified. A fraud firm is defined as being those that were charged with violation of Section 298 of the Securities and Futures Ordinance (Cap. 571). The Enforcement Reporter issued by
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SFC issued between 2002 and 2011 will be examined.

Identifying Non-Fraud Firms To create a comparison group, non-fraud firms will be identified that are similar to the fraud firms in size, industry and stock exchange. Each fraud firm will be matched with a no-fraud firm based on the following requirements: The ordinary shares of a fraud firm and its matched non-fraud firm trade on the main board of Hong Kong Stock Exchange (HKSE). Firms are considered similar in firm size if the current market value of ordinary shares is within a range of 30 percent difference as comparing to the current market value of fraud firm in the year prior the year of the financial statement fraud. All firms identified are categorized within the same industry by HKSE as comparing to the fraud firm.

Testing Methods: To ensure whether the fraud and non-fraud firms should ideally be similar in the likelihood of a financial statement fraud occurrence, Paired t-tests for means and Wilcoxon matched-pair sign-rank test for medians will be performed. The tests help to ensure that samples of fraud and non-fraud firms are matched closely and do not differ significantly based on total assets, net sales and current market value of ordinary shares. A paired t-test is used to compare two population means where observations in one sample can be paired with observations in the other sample. The Wilcoxon matched-pairs sign-rank test is similar to a Paired t-test. However, the dependent variable is measured on an ordinal scale (ranked data). This test is used to test for significant differences between two conditions of an independent variable in an experiment where the matched participants are responding in both conditions of the study.
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Based on Beasley (1996) and Skousen and Wright (2004), logit regression will be used to test the proxy variables. As pointed out by the authors, the dependent variable, FRAUD, is dichotomous since the estimation is based on a choice-based sample in which 50 percent of the firms have experienced financial statement fraud while the remaining 50 percent have no frauds. However, as it is very likely that the actual rate of firms experiencing financial statement fraud within the total population of listed companies is less than 50 percent, the one-to-one matching process differs from a pure random sampling approach. Therefore the use of logit regression is justified.

(Word count, excluding the list of references: 3,145 words)

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LIST OF REFERENCES Abbott, L., Park, Y. and Parker, S. 2000. The effects of audit committee activity and independence on corporate fraud. Managerial Finance 26 (11): 55-67. Abbott, L., Parker, S., and Peters, G. F. 2004. Audit Committee Characteristics and Restatements. AUDITING: A Journal of Practice & Theory : March 2004, Vol. 23, No. 1, pp. 69-87. Albrecht, W. 2002. Fraud Examination. Mason, OH: Thomson-SouthWestern. Beasley, M. 1996. An empirical analysis of the relation between the board of director composition and financial statement fraud. The Accounting Review 71 (4): 443-465. Beasley, M., Carcello, J., Hermanson, D., and Lapides, P. D. 2000. Fraudulent financial reporting: Consideration of industry traits and corporate governance mechanisms. Accounting Horizons 14 (4): 441-454. Beneish, M. 1997. Detecting GAAP violation: Implications for assessing earnings management among firms with extreme financial performance. Journal of Accounting and Public Policy 16 (3): 271-309. Cressey, D. 1953. Other Peoples Money; a Study in the Social Psychology of Embezzlement. Glencoe, IL, Free Press. Dechow, P., R. Sloan, and A. Sweeney. 1996. Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research 13 (1): 1-36. Dorminey, J., Fleming ,A. S., Kranacher, M., and Riley, R. A. Jr. 2012, The Evolution of Fraud Theory, Issues in Accounting Education, Vol. 27, No. 2, pp. 555-579. Dunn, P. 2004. The impact of insider power on fraudulent financial reporting. Journal of Management, 30(3) 397-412. Ryan, B., Scapens, R. W. and Theobald, M. 2002. Research method & methodology in finance & accounting, 2 Ed., Thomsom. Skousen, C. J. and Wright, C. J.. 2008. Contemporaneous risk factors and the prediction of
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financial statement fraud. Journal of Forensic Accounting 9(1): 37-62. Summers, S. and J. Sweeney. 1998. Fraudulently misstated financial statements and insider trading: An empirical analysis. The Accounting Review 73 (1): 131-146. Ventura, M. and Daniel, S. J. 2010. Opportunities for Fraud and Embezzlement in Religious Organizations: An Exploratory Study, Journal of Forensic & Investigative Accounting Vol. 2, Issue 1. Vermeer, T. 2003. The impact of SAS No. 82 on an auditors tolerance of earnings management. Journal of Forensic Accounting 5: 21-34.

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