Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures

Richard A. Price III Rice University Nathan Y. Sharp Texas A&M University 4353 TAMU College Station, Texas 77843-4353 Phone: 979-845-0338 Fax: 979-845-0028 nsharp@mays.tamu.edu David A. Wood Brigham Young University

June 2011 We are grateful for the comments and suggestions of two anonymous reviewers, Kris Allee, Andy Call, Michael Drake, Scott Emett, Tom Omer, Lynn Rees, Nate Stephens, and conference participants at the 2010 Lone Star Accounting Research Conference and the 2010 AAA Annual Meeting. We also thank Jonathan Karpoff, Scott Lee, and Jerry Martin for sharing their database of SEC enforcement actions, and Jack Zwingli and Audit Integrity for providing access to their Accounting and Governance Risk (AGR) and Accounting Risk (AR) ratings.

Electronic copy available at: http://ssrn.com/abstract=1546675

Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures

ABSTRACT Although a substantial body of academic research is devoted to developing and testing risk proxies that detect accounting irregularities, the academic literature has paid little attention to commercially developed risk measures. This is surprising given the general consensus that academic risk measures have relatively poor construct validity. We compare the commercially developed Accounting and Governance Risk (AGR) and Accounting Risk (AR) measures with academic risk measures to determine which best detects financial misstatements that result in Securities and Exchange Commission enforcement actions, egregious accounting restatements, and shareholder lawsuits related to accounting improprieties. We find that the commercially developed risk measures outperform the academic risk measures in all head-to-head tests for detecting misstatements. The commercial measures also perform as well as or better than the academic measures in new tests that predict future accounting irregularities using numbers reported one year before the misreporting even begins. Our results suggest commercially developed risk proxies may be useful to practitioners and academics trying to detect or predict accounting irregularities. Key Words: accounting irregularities; detecting fraud; predicting fraud; risk measures; commercial risk ratings JEL Descriptors: M41, G30, K22 Data Availability: Contact the authors.

Electronic copy available at: http://ssrn.com/abstract=1546675

INTRODUCTION Shareholders bear considerable costs when firms are accused of or admit to improper accounting; therefore, both academic researchers and commercial risk-rating services devote significant resources to detecting accounting irregularities. The objective of this paper is to compare several well-known academic risk measures with commercially developed risk proxies in terms of their ability to detect financial misstatements that result in: (i) Securities and Exchange Commission (SEC) Enforcement Actions; (ii) accounting restatements related to accounting irregularities (Hennes, Leone, and Miller 2008); and (iii) shareholder litigation related to accounting malfeasance.1 Ours is not the first study to compare the ability of risk measures to detect accounting irregularities; Jones et al. (2008) and Daines et al. (2010) also investigate this issue. Jones et al. (2008) compare only academic measures of accounting risk and find evidence that accrual estimation errors (Dechow and Dichev 2002; McNichols 2002) exhibit the strongest association with the existence and magnitude of fraud and nonfraud restatements. In contrast, Daines et al. (2010) focus exclusively on commercially developed measures of risk and conclude that commercial ratings substantially underperform relative to the claims made by the rating firms. Although Daines et al. (2010) provide useful insights, they do not compare the performance of the commercially developed risk proxies in their study with risk proxies developed and used frequently in the academic literature. Thus, even if these commercially developed measures perform less effectively than the rating firms claim, if they outperform academic measures of risk, academic researchers should be interested in using commercially developed metrics in certain research settings. For example, if commercial risk ratings are less noisy or possess greater construct validity than academic risk measures, the increase in statistical
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Throughout the paper, we refer to these types of misstatements collectively as accounting irregularities.

power may allow studies that incorporate commercial risk ratings to provide new evidence on the activities or characteristics of firms associated with accounting irregularities. Alternatively, if academic researchers have designed risk measures that are superior to commercially developed risk measures, this finding should interest practitioners, regulators, investors, auditors (internal and external), managers, and others who monitor firms financial reporting. Therefore, the purposes of this paper are first, to provide evidence concerning which metrics among the academic and commercial measures have the greatest ability to detect accounting irregularities and second, to provide insight on the attributes of superior risk metrics. In addition to the typical tests looking for the detection of misstatements during the period alleged to have been misstated (but generally preceding the announcement of the restatement or lawsuit), we conduct tests to see which measures can predict bad accounting outcomes even before the alleged misstatement period begins. These tests provide a sense of how useful the academic and commercial metrics are in identifying firms that are likely to begin manipulating their accounting in the future, and they represent another contribution of our paper. An additional contribution of this study is that we include relatively new academic risk measures that were unavailable for examination in prior comparative studies. Dechow et al. (2011) and Hribar et al. (2010) have each developed new risk proxies intended to predict bad accounting outcomes. Dechow et al. (2011), building on the Beneish (1997, 1999) model manipulation score (M-score), provide evidence that their measure, the F-score, has the ability to detect firms that are alleged to have misstated their quarterly or annual financial statements. Using a different approach, Hribar et al. (2010) measure accounting quality by estimating a firms unexplained audit fee. They find that the unexplained audit fee has incremental explanatory power relative to accruals-based risk measures for predicting fraud, restatements,

and SEC comment letters. We compare the detective and predictive validity of these and other academic measures relative to risk measures developed commercially by the risk rating firm Audit Integrity. We compare Audit Integritys Accounting and Governance Risk (AGR) and Accounting Risk (AR) measures2 with the following six academic measures: working capital accruals (Sloan 1996); Beneishs M-score (Beneish 1997, 1999); Dechow et al.s (2011) F-score; Dechow and Dichevs (2002) accruals quality measure; the modified-Jones model (Dechow, Sloan, and Sweeney 1995); and unexplained audit fees (Hribar et al. 2010).3 We compare the ability of these measures to detect (i.e., detect contemporaneously in originally reported financial statements) and to predict (i.e., predict future accounting irregularities using risk measurements one period before misreporting begins) misstatements from three different sources of accounting irregularities: SEC enforcement actions, restatements related to accounting irregularities, and shareholder litigation for accounting improprieties. The dependent variables in our detection tests capture the periods that were allegedly misstated, not the periods during which accounting irregularities were publicly announced or alleged. The dependent variables in the prediction tests capture the period prior to the alleged misstatement. To determine which measure has the greatest ability to detect and predict accounting irregularities, we perform a head-to-head comparison of each academic measure with the commercially developed measures. More specifically, we compare each academic risk measure with AGR or AR in analyses that include all of the observations for which we have data to compute the academic measure and for which we have AGR or AR scores. For each
We select Audit Integritys risk measures because Daines et al. (2010) find that AGR is superior to other commercially developed risk measures for predicting accounting irregularities. We have no affiliation with Audit Integrity and independently conducted this research for academic purposes only. 3 In cases where accounting irregularities resulted in restated financial statements, we use the Compustat As Originally Reported (unrestated) dataset to construct all academic risk measures during periods that were restated.
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comparison, we run two multivariate logistic regressions that vary only by whether we include the academic measure or the commercial measure as an explanatory variable. Thus, the sample composition is identical for each head-to-head comparison of the commercial risk measure with an academic risk measure. Our main tests result in two sets of 36 comparisons (six academic measures compared against each commercial risk measure for three dependent variables measured at two different periods of time). For each comparison, we use seemingly unrelated estimation (SUEST) to test coefficients across models to determine which risk measure has the highest coefficient (i.e., to determine whether the academic or commercial risk measure in each comparison best detects or predicts the accounting irregularity).4 In addition, we also report the following statistics for each model: the percentage change in the odds ratio for a one standard deviation change in the risk measure, the fully standardized coefficient estimates for each risk measure,5 the pseudo R-square, and the area under the ROC curve. Our results show that AGR outperforms the academic measures in all 18 comparisons for detecting accounting irregularities. AR similarly does very well, outperforming the academic measures in 16 of 18 comparisons (89 percent); in the remaining two comparisons, there is no statistical difference. When comparing AGR and AR against the academic measures in terms of predicting future irregularities, AGR performs significantly better in 10 out of 18 tests (56 percent) and AR outperforms the academic measures in 12 out of 18 tests (67 percent). There are no instances in which academic measures outperform the commercial measures.

Seemingly unrelated estimation (SUEST) was originally proposed by Zellner (1962) as an econometric technique for testing cross-model hypotheses. 5 We fully standardize the coefficient estimates to allow for a direct comparison of the coefficients in each pair of regressions.

Thus, our results suggest the commercial risk measures are dominant in terms of the ability to contemporaneously detect accounting irregularities, which are the typical tests conducted in the literature. The commercial risk measures are less dominant in terms of the ability to predict future irregularities. However, these new prediction tests demand more of the risk measures than any comparable tests we are aware of in the literature because they are measured one year before misreporting begins and predict future misreporting using data for which no irregularity is alleged. Taken together, commercial measures do as well as or better than the academic measures in every test conducted. This research makes an important contribution to the literature by providing evidence on the construct validity of risk measures that proxy for accounting irregularities. For academic researchers investigating fraud or aggressive financial reporting, the construct validity of risk measures is important for reaching appropriate conclusions and producing correct inferences particularly when investigating the ex-ante risk of accounting irregularities. Despite a general consensus that accruals-based measures are noisy proxies for aggressive financial reporting (Bernard and Skinner 1996; Guay, Kothari, and Watts 1996; McNichols 2000), researchers continue to rely on these measures. Our results suggest that commercially developed risk measures may be useful in future research. In addition, these findings demonstrate that bridging the gap between academic research and commercial practice may provide useful tools for research, potentially resulting in improved inferences and new insights.6 We do not intend to suggest with our paper that commercial risk measures like AGR or AR are preferable to academic risk measures in all research settings. A caveat to our findings is that, unlike commercially developed risk measures that are proprietary by nature, academic risk
For examples of recent academic studies that use Audit Integritys risk measures, see Bartov and Hayn (2007), Correia (2009), Charles et al. (2010), Daines et al. (2010), Dyreng et al. (2010), McGuire et al. (2010), Christ et al. (2011), and Prawitt et al. (2011).
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measures have the obvious advantage that researchers know all of the inputs to the measure. Further, even when some inputs to commercial risk measures are known, the inputs may include data that are not widely available to academics.7 Thus, researchers whose aim is to pinpoint specific types of reporting risks or specific firm characteristics that predict accounting irregularities may find a comprehensive risk measure like AGR or AR to be less useful than alternative risk measures from the academic literature. For example, the measure of unexplained audit fees derived by Hribar et al. (2010) demonstrates that audit fees can provide investors with information regarding misreporting that would otherwise not be known publicly. In addition, Brazel et al. (2009) show that nonfinancial measures can be used to assess fraud risk. The specific insights gained from papers like these may be difficult to glean from a study using AGR or AR. Despite these limitations, the results of our study suggest that comprehensive, commercial risk measures like AGR or AR are superior to academic risk measures in terms of an ex ante best estimate of the risk that financial statements have been intentionally misstated before the misreporting is revealed publicly. Studies that need an overall estimate of ex ante financial reporting risk or studies with small or limited sample sizes (i.e., where noise in academic risk measures or sample attrition associated with their computational requirements may be costly) are likely to benefit the most from using commercial risk measures like AGR or AR. In addition, we believe there is value in investigating how academic risk measures perform relative to these commercially produced risk metrics. Evidence that AGR and AR perform as well as or better than the academic measures suggests researchers using commercial risk measures will have improved statistical power in some research settings related to detecting and predicting accounting irregularities.
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The AGR and AR risk measures are easily available to academic researchers.

The paper proceeds as follows. In the next section we provide a detailed discussion of the measures we use for testing. We omit a section containing formal hypotheses and theoretical development as we offer no directional predictions in this paper but instead provide empirical evidence as to the best measure available for detecting or predicting accounting irregularities. The third and fourth sections discuss the data and the methodology we use for evaluating the measures. The fifth section contains our results, and the sixth section contains additional analyses, followed by the conclusion. MEASURES FOR TESTING In this section we describe the commercial and academic risk measures that we will compare in our testing.8 Our selection of these measures was guided by either prior literature providing evidence that these measures were correlated with accounting irregularities or by widespread use of the measures in the literature. The commercial risk measures we include are AGR and AR developed by Audit Integrity, LLP. The academic measures we include are working capital accruals (Sloan 1996), Beneishs M-score (Beneish 1997, 1999), Dechow et al.s (2011) F-score, Dechow and Dichevs (2002) accruals quality measure, the modified-Jones model (as presented in Dechow et al. 1995), and Hribar et als (2010) unexpected audit fee measure. We discuss each measure in turn. AGR Accounting and Governance Risk The Accounting and Governance Risk (AGR) measure is produced commercially by Audit Integrity, LLP. Audit Integrity uses publicly available accounting and governance data to estimate the likelihood that reported financial information includes elements that are misleading
We acknowledge that not each of the six academic risk measures we include in our study was designed specifically to maximize its detective or predictive ability as it relates to fraud or other egregious accounting irregularities. However, since all of these academic risk measures have been used in the literature to detect earnings management, they should be at least as effective in our setting as they would be with more subtle forms of earnings management. Collectively, these measures represent a reasonable set of risk measures developed in the accounting literature.
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or fraudulent.9 Audit Integritys Web site (April 2010) describes the AGR rating as a forensic assessment of the risk that financial results are misrepresented in public disclosures. It represents an independent, comprehensive measure of the overall risk of potentially fraudulent or misleading financial reporting at public companies. The AGR measure is available on the Bloomberg Professional service, and the AGR scores are typically released within two weeks of the publication of companies quarterly or annual financial statements. For researchers, one advantage of the AGR measure is that its coverage extends to over 7,000 public companies, permitting examination of financial reporting irregularities without the sample attrition associated with the computational requirements of some academic risk measures. The AGR rating is the output of a proprietary model that evaluates public companies financial reports and independently assesses the risk of misreporting by identifying suspicious patterns in accounting. To identify suspicious patterns in accounting, Audit Integrity examines the following five areas: (1) expense recognition, (2) revenue recognition, (3) high risk events, (4) governance, and (5) asset and liability valuation. Each risk category is assessed using multiple metrics that are examined along three dimensions: (i) the percentage change from the prior year, (ii) the number of standard deviations from an industry average, and (iii) volatility over an eight-quarter period. Audit Integrity combines these measures into a risk score for each company. Thus, AGR is an ex-ante estimate of the risk that companies are engaging in inappropriate or aggressive financial reporting. The AGR measure provided by Audit Integrity is a percentile ranking scaled from 0 to 100 and is decreasing in risk (a value of 100 suggests very low risk). For ease of interpretation and comparability with the academic measures, we invert the scale so it is increasing in risk (a value of 100 suggests very high risk). Audit Integrity produces AGR

Audit Integrity does not use any academic risk measure (e.g., F-Score, M-Score, etc.) as an input to its AGR or AR models. Market pricing data are also not used in the calculation of AGR or AR.

rankings quarterly, corresponding with the release of interim and annual financial statements. Our tests use the AGR ranking that corresponds to the annual financial statement or 10-K filing. AR Accounting Risk Accounting Risk (AR) is also produced commercially by Audit Integrity and is identical to AGR with the exception that AR does not include measures of governance.10 The same methodology is used to produce AR, except that AR is derived solely from financial accounting measures available in the financial statements and footnotes to the financial statements. For the sake of parsimony, we tabulate only the results for AGR because the AR results are very similar. We discuss AR results in the text where additional insights are provided. Working Capital Accruals A substantial body of literature uses accruals-based measures as proxies for earnings management (see Schipper 1989; Healy and Wahlen 1999; and Kothari 2001 for reviews of this literature). Although accruals-based measures are known to be noisy predictors of accounting irregularities (Bernard and Skinner 1996; Guay et al. 1996; McNichols 2000), we include a measure of working capital accruals based on its popularity in accounting research studies related to earnings management. We follow Sloan (1996) and compute our measure of working capital accruals as follows: WC_ACC = [(Current Assets Cash and Short-term Investments) (Current Liabilities Debt in Current Liabilities)] Taxes Payable Depreciation / Average Total Assets. Beneishs M-score Beneish (1997, 1999) develops a measure of the likelihood that a company has manipulated its reported financial statements by examining firms that were subject to SEC enforcement actions. Beneish (1997, 1999) uses the unweighted probit model listed below to
Papers that test the effects of different corporate governance choices on accounting risk are likely to prefer the AR measure because the governance component is taken out (e.g., see Christ et al. 2011; Prawitt et al. 2011).
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create a manipulation score. In his sample, Beneish (1997, 1999) finds that this model correctly classifies manipulators between 58 and 76 percent of the time. Higher values of the Mscore suggest greater likelihood of a company manipulating its financial statements. M-Score is computed as follows: MSCORE = -4.840 + 0.920DSRIit + 0.528GMIit + 0.404AQIit + 0.892SGIit + 0.115DEPIit 0.172SGAIit + 4.679TATAit 0.327LGVIit Where variables are defined as follows: DSRI GMI = Days sales receivable index (AR / REV) / (ARt 1 / REVt 1) = Gross Margin index [Revt 1 Cost of goods soldt 1 / REVt 1] / [REVt cost of goods soldt / REVt] AQI = Asset quality index (1 [Current assetst + PPEt] / ATt) / (1 - [Current assetst 1 + PPEt 1] / ATt 1) SGI = Sales growth index REVt / REVt 1 DEPI = Depreciation index (Depreciationt 1 / [Depreciationt 1 + PPEt 1]) / (Depreciationt / [Depreciation + PPE]) SGAI = Sales, general, and administrative expenses index (Sales, general, and administrative expenset / REVt) / (Sales, general, and administrative expenset 1 / REVt 1) TATA = Total accruals to total assets (Current assetst Casht Current liabilitiest Current maturities of long-term debtt Income tax payablet Depreciation and amortiazation) / ATt LGVI = Leverage index ([Long-term debtt + Current liabilitiest] / ATt) / ([Long-term debtt 1 + Current liabilitiest 1] / ATt 1)

Dechow et al.s F-score Dechow et al. (2011) follow a methodology similar to Beneish (1997, 1999) in developing a score to predict which companies have material accounting misstatements. Dechow et al. (2011) estimate a logistic regression with the dependent variable measuring whether a firm misstated earnings. The independent variables depend on which of the three models Dechow et al. (2011) estimate: Model 1 contains variables from the primary financial statements, Model 2 adds off-balance sheet and non-financial measures such as operating leases and abnormal changes in employees, and Model 3 adds market-related variables such as prior

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stock price performance and the book-to-market ratio. Dechow et al. (2011) find that their first model offers the bulk of the power (p. 5) in predicting material accounting misstatements. We therefore use this model to maximize sample size as it is the least restrictive model of the three proposed by Dechow et al. (2011).11 FSCORE is computed as follows: FSCORE = -6.789 + 0.817RSST + 3.230REC + 2.436 INV + 0.122 Cash Sales 0.992 Earnings + 0.972ACT Issuance Where: RSST = (WC+ NCO+ FIN)/Average total assets, where WC = [Current Assets Cash and Short-term Investments] [Current Liabilities Debt in Current Liabilities]; NCO = [Total Assets Current Assets Investments and Advances [Total Liabilities Current Liabilities Long-term Debt]; Fin = [Short-term Investments +Long-term Investments] [Long-term Debt + Debt in Current Liabilities + Preferred Stock; following Richardson et al. (2006). = Accounts Receivables / Average total assets = Inventory / Average total assets = Percentage change in cash sales [Sales Accounts Receivables]. = [Earningst / Average total assetst] [Earningst-1 / Average total assetst-1]. = An indicator variable coded 1 if the firm issued securities during year t.

REC INV CASH SALES EARNINGS ACT ISSUANCE

Accruals Quality (Accrual Estimation Errors) Dechow and Dichev (2002) develop a measure of accruals quality based on the realization of the prior year, current year, and future year cash flows. Accruals quality is said to be higher if the change in working capital accruals can be explained by past, present, and future realizations of cash flows. We note an important caveat in including this measure to detect and predict accounting irregularities: this measure contains future information (i.e., cash flows at time t+1), which creates a look-ahead bias. Although we include Dechow and Dichev (2002)
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We also estimate F-scores based on Model 2 and Model 3 in Dechow et al. (2011). Our inferences are unchanged if we use either of the other two F-score models. In our empirical tests, we convert the estimated F-score to a probability as follows: exp(F-score)/(1+exp(F-score)).

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accruals quality in our tests, we note that this look-ahead bias may give accruals quality an advantage over the other measures in our comparisonsparticularly when predicting irregularities in period t+1. Researchers using this measure must be careful to determine whether this measure is appropriate given the requirement for data in the year following an event. We estimate the following equation by two-digit SIC code: WCit = 0 + 1CFOit-1 + 2CFOit + 3CFOit+1 +it Where: WC CFO = = Change in working capital from year t-1 to year t scaled by average assets. Cash flows from operations for year t-1, t, or t+1 scaled by the respective average assets.

Dechow and Dichev (2002) compute their metric of accruals quality by taking the standard deviation of the residuals over a six-year window (estimation therefore requires eight years of data). Following Jones et al. (2008) and Dechow et al. (2011), we opt instead to estimate the formula cross-sectionally and use the residual from the cross-sectional estimation as our measure of accruals quality because many firms with accounting irregularities do not have sufficient data to estimate accruals quality over the six-year window. We label this measure DD in our tables. Modified Jones Model As our fifth academic measure, we estimate an abnormal accruals model. There are multiple variations of the original Jones (1991) model in the literature. We choose to test the one that has been most used in this line of research, the cross-sectional modified-Jones model (Defond and Jiambalvo 1994; Dechow et al. 1995). We estimate the following equation by twodigit SIC code and use the residual as the measure of discretionary accruals (labeled DSS in our tables):

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Acct = 0 + 1 (1/Assetst-1) + 2 (Sales Receivablest)/Assetst-1 + 3 PPEt/Assetst-1 + . Where: Acct Assetst-1 Salest Receivablest PPEt = ((Current Assetst Cash and Equivt) (Current Liabt Current LTDt Tax Payt))/Assetst-1 = Total assets at the beginning of the period = Change in sales revenue from the beginning of the period to the end of the period = Change in accounts receivable from the beginning of the period to the end of the period. = Change in property, plant, and equipment from the beginning of the period to the end of the period.

Unexplained Audit Fee Model As an alternative to using a companys financial statements to assess the quality of the companys reported numbers, Hribar et al. (2010) look to the external auditors fee to provide information about the risks a company faces. Hribar et al. (2010) argue that external audit fees incorporate the expected cost of poor quality earnings into the determination of the fee as external auditors face high litigation costs if a firm announces a bad accounting outcome. Because of this, the portion of the external audit fee that is not explained by known determinants should reflect, in part, the external auditors pricing of the expected cost of poor quality earnings. In computing the Hribar et al. (2010) measure, we omit four variables (the number of business segments, the percentage foreign sales, the governance index from Gompers et al. (2003), and the percentage of independent directors). We do this because our sample size is significantly reduced with the inclusion of these variables. In our tests, the exclusion of these variables has almost no effect on the explanatory power of the model and consequently is unlikely to affect our results.12 Unexplained audit fees are estimated as the residual of the following regression:

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We lose approximately 50 percent of our total sample observations for the AGR vs. UAF tests if we require the more restrictive model of audit fees. In sensitivity tests, we find our inferences related to detecting all types of

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LogFeest = Industry Indicators + 1 BigNt + 2 log(Assetst) + 3 Inventoryt/Avg Assetst + 4 Receivablest/Avg Assetst + 5 LTDt/Avg Assetst + 6 Earnt/Avg Assetst + 7 Losst + 8 Qualified + 9 Auditor Tenuret + Where: Industry Indicators: separate indicators for each two-digit SIC code LogFeest BigNt Earnt Losst Qualifiedt Auditor Tenure = Natural logarithm of total audit fees = Dichotomous variable equaling one of a Big N auditor is used and zero otherwise. = Operating income after depreciation = Dichotomous variable equaling one if a loss occurred within the current or previous two fiscal years and zero otherwise. = Dichotomous variable equaling one if the audit opinion was anything other than a standard unqualified opinion and zero if the opinon was a standard unqualified opinion. = Number of years the auditor has been auditing a company.

SAMPLE DATA Our sample is based on the set of firms in Compustat from 1995 to 2008. We obtain data from several additional sources, including the Center for Research on Security Prices (CRSP), Audit Analytics, and Audit Integrity. Because each measure of accounting risk requires different data inputs, the number of observations available for each measure varies. Therefore, for each head-to-head comparison, we attempt to increase the power of the test by using the largest subsample of observations that contains non-missing values for both risk measures being compared. The dependent variables in our tests capture the periods during which companies misstated their financial statementsnot the periods during which the misstatements were announced. Our sample of SEC enforcement actions is from the Karpoff et al. (2008a, 2008b) database. This hand-collected database consists of firms subject to SEC enforcement actions
accounting irregularities are unchanged if we use the more restrictive audit fee model to estimate unexpected audit fees. Inferences related to predicting irregularities (i.e., in the period before the misstatement begins) are not reliable because the reduced sample has so few irregularity observations.

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related to the following sections of the Foreign Corrupt Practices Act of 1977: Section 13(b)(2)(A), which requires firms to make and keep books and records that accurately and fairly reflect the transactions of the corporation; Section 13(b)(2)(B), which requires firms to devise and maintain an adequate system of internal accounting controls; and Section 13(b)(5), which establishes that no person shall knowingly circumvent or fail to implement a system of internal accounting controls or knowingly falsify any book, record, or account. Thus, this sample focuses exclusively on accounting-related enforcement actions.13 Our sample of egregious restatements is drawn from the Hennes et al. (2008) database, and our sample of shareholder lawsuits due to alleged accounting malfeasance comes from Audit Analytics. One concern with using Compustat annual data for our tests is that Standard and Poors backfills the Compustat database with the most recently reported data for each fiscal period (i.e., restated data replaces originally reported data). In the context of detecting accounting irregularities, our analyses and inferences could be called into question if restated financialstatement data were used to estimate the academic measures of accounting risk because the abnormalities that might indicate an accounting irregularity are likely to be removed when the data are restated. Thus, using restated data to estimate the accounting risk measures would lead to decreased power of the academic risk measures to detect irregularities. To mitigate this concern, we use the Compustat As Originally Reported unrestated database for all periods that are restated in our sample. Using the unrestated data allows us to compute the academic risk measures with the original data, which ensures that the tests are not biased against these measures.

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In 1982, the SEC began to assign a secondary designation, Accounting and Auditing Enforcement Release (AAER) to some, but not all, enforcement releases involving accountants or auditors. As discussed in Karpoff et al. (2008a), AAERs are not limited to financial misrepresentations and they do not cover all such actions; therefore, our sample of all accounting-related enforcement actions is more comprehensive than a sample of AAERs.

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The Compustat unrestated quarterly data includes the original quarterly amounts reported by firms. Since our analysis is conducted on an annual level, we extract the appropriate annual data from the unrestated data. Specifically, balance sheet data from the fourth quarter can directly be used as the annual measure without concern because it reflects the level of assets, liabilities, and equity at the end of each quarter as originally reported. Cash flow data from the fourth quarter can also be directly used because cash flow data in Compustat are cumulative (i.e., operating cash flows for the fourth fiscal quarter is a cumulative measure of quarters one through four). However, income statement data are not cumulative in Compustat and reflect only the amount related to each quarter. In general, to generate annual income-statement data from quarterly unrestated data, the sum of the four quarters is computed. However, if a firm restates quarterly earnings before the end of the fiscal year, then the sum of the four quarters unrestated earnings will not equal the unrestated annual earnings. The rule we adopt for the unrestated quarterly data is to use the sum of the four quarters when the restatement occurs after the end of the fiscal year. However, if a restatement occurs during the middle of a fiscal year, we use the income statement item from the Compustat annual file because the annual numbers were not restated.14 MODELS AND MEASURES FOR TESTING To test the detective and predictive ability of our measures, we run two sets of 36 multivariate regressions (i.e., 6 comparisons between each commercial measure (AGR and AR) and each academic measure for 3 different dependent variables measured at 2 different times). In order to maximize power in our tests and provide maximum external validity for each test, we conduct each comparison for all firm-year observations for which we have both the commercial and the academic measure. The models we use for comparison are as follows:
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In robustness tests, we find that our inferences are not sensitive to using the Compustat unrestated data.

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Dependent Variable = 0 + 1AGR + YearDummies + IndustryDummies + Dependent Variable = 0 + 1Academic Measure + YearDummies + IndustryDummies + Where the variables are defined as follows: Dependent Variable = One of six different dependent variables, SEC_ENFt, SEC_ENFt+1, IRREGt, IRREGt+1, LAWSUITt, or LAWSUITt+1. Each dependent variable is an indicator variable taking the value of 1 if the firmyears financial reporting period (or period t+1) was misstated according to an SEC enforcement action, restatement, or shareholder lawsuit. Audit Integritys Accounting and Governance Risk score. In untabulated analyses we also use Accounting Risk (AR). WC_ACC, MSCORE, FSCORE, DD, DSS, or UAF. Indicator variables for each fiscal year Indicator variables for the 17 industry groupings defined in Fama and French (1988).

AGR Academic Measures YearDummies IndustryDummies

= = = =

As measures of accounting irregularities, we use indicator variables for fiscal years that were misstated according to three different events: SEC enforcement actions, egregious accounting restatements, and shareholder lawsuits related to alleged accounting improprieties. For each event, if the irregularity spans multiple fiscal periods, we code the dependent variable as occurring (i.e., one), for every fiscal year affected by the irregularity. For egregious accounting restatements, we use the irregularity indicators from Hennes et al. (2008) to identify the subset of restatements that are related to intentional accounting malfeasance and exclude restatements related to simple clerical errors or changes in accounting rules. To test which measure best detects accounting irregularities, we measure the independent variables during the misstatement period. To test which measure best predicts accounting irregularities, we measure the independent variables one fiscal period before the misstatement period begins. The independent risk measures we use for testing (AGR, WC_ACC, MSCORE, FSCORE, DD, DSS, and UAF) are described in the previous section.

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We estimate the regressions for each comparison for the entire sample that has a value for both the AGR risk measure and the academic measure being tested. We use seemingly unrelated estimation (SUEST) to test (across the two models) whether the coefficients on the academic and commercial risk measures are statistically different. Specifically, we standardize the academic and commercial risk measures, then use SUEST to combine the parameter estimates and covariance matrices into one parameter vector and robust simultaneous covariance matrix. A chi-square test of the difference in the coefficients of the academic and commercial risk measures indicates which risk measure is most strongly associated with the accounting irregularity. In addition, we report the percent change in the odds ratio for a one standard deviation increase (from the mean) in the risk measures,15 the fully standardized coefficient, the pseudo R-square, and the area under the ROC curve for each pair of risk measures.16 TEST RESULTS Table 1 presents descriptive statistics related to the distribution of sample observations across industries and accounting irregularities across years. Panel A shows the distribution of our sample across each of the 17 industry groups and also shows the distribution of the Compustat universe during our sample period. Comparing our industry distribution with the distribution of the Compustat universe suggests the distributions are fairly similar, so our results should generalize reasonably well to the broad population of public companies in the Compustat
15

This statistic is useful because interpreting the performance of the risk measures is most intuitive in the context of comparing how a one standard deviation increase in the measure (from its mean) affects the odds ratio. 16 The fully standardized coefficient estimate is defined as , and can be interpreted as follows: for a one standard deviation increase in the risk measure xk , y is expected to change by standard deviations, holding all other variables constant (Long and Freese 2000). Although the interpretation of coefficient estimates in logit models is not intuitive, we include the fully standardized coefficient for comparative purposes. The Receiver Operating Characteristic (ROC) curve is a parametric plot of the probability of detection vs. the false positive rate. The area under the ROC curve is often used as a measure of diagnostic performance. Area under the ROC curve of 0.5 implies a random model, while area under the ROC curve of 1 indicates a model that forecasts perfectly. We note that although the area under the ROC curve discriminates well between good and bad models, it is not effective for discriminating between two good models (see Marzban 2004). Therefore, we do not use the area under the ROC curve as our primary basis for determining which risk measure performs best.

18

database. Panel B shows the distribution of misstated firm-year observations by each type of accounting irregularity across our sample period. Our sample of egregious restatements (IRREG) is based on the intersection of the restatement sample in Hennes et al. (2008) and the restatement sample from Audit Analytics, so there are several years at the beginning and ending of our sample period with no restatements for accounting irregularities. SEC enforcement actions and shareholder lawsuits are also less frequent in the first and last years of our sample than in the middle of the sample period.17 In total, our sample contains 1,826 firm-year observations that are identified as misstated in at least one type of accounting irregularity. Table 1, Panel C shows the distribution of all accounting irregularities across the deciles of each risk measure. Among all the risk measures, AGR has the highest percentage of accounting irregularities in its highest decile as well as the lowest percentage of irregularities in the lowest decile. (Insert Table 1 about here) Table 2, Panel A presents univariate statistics for each of our risk measures. Panel A reveals that our risk measures have considerable variation in their distributions, which is expected given the size of our sample. Table 2 Panel B displays the univariate correlations between our risk measures and the indicator variables for accounting irregularities. The relatively low correlations among the accounting irregularity indicator variables suggest that our three types of accounting irregularities are not merely three measurements of the same underlying misstatements. Instead, the correlations suggest they capture different events, or at

17

As discussed below in our robustness tests, our inferences remain the same if 2007 and 2008 are excluded from our sample.

19

least different dimensions of the same event.18 Five of the academic risk measures exhibit reasonably high correlations with each other: WC_ACC, MSCORE, FSCORE, DD, and DSS (Spearman correlations of at least 0.28). In contrast, AGR and UAF are not highly correlated with any of the other risk measures. Of the seven risk measures, only AGR and UAF are positively correlated with misstatements from all three samples of irregularities. (Insert Table 2 about here) Table 3, Panel A presents the comparisons of each pair of risk measures for detecting misstatements that result in SEC enforcement actions. In Panel A, the coefficient on AGR is significantly larger in all six comparisons. Overall, AGR performs well in terms of its ability to detect misreporting in originally reported financial statements. For example, in the head-to-head comparison between AGR and FSCORE, a one standard deviation increase in the FSCORE results in a 4.2 percent increase (p < 0.01) in the odds of an enforcement action; but a one standard deviation increase in the AGR measure results in a 50.5 percent increase (p < 0.01) in the odds of an enforcement action. The closest academic risk measure to AGR in terms of performance for detecting SEC enforcement actions is UAF. A one standard deviation increase in UAF results in a 36.0 percent increase in the odds of an enforcement action, and a one standard deviation increase in the AGR measure for the same sample results in a 61.9 percent increase in the odds of an enforcement action. Overall, the evidence suggests that AGR performs very well relative to the academic risk measures for detecting misreporting associated with SEC enforcement actions. In Panel B of Table 3, the risk measures are compared in terms of their ability to predict future misreporting associated with SEC enforcement actions. Recall that in these tests, we
18

The correlations also suggest that regulators and shareholders tend to respond to different accounting misstatements. For example, limited resources may prevent the SEC from investigating many misstatements that are targeted by shareholder lawsuits.

20

calculate the risk measures one period before the beginning of the misreporting targeted in the enforcement action. In head-to-head comparisons, AGR outperforms MSCORE; but there is no statistical difference between AGR and the other five academic risk measures. Although AGR does not outperform the other academic risk measures, no academic measure performs better than AGR. In addition, in all samples except one (the comparison with UAF), AGR significantly predicts future misreporting associated with SEC enforcement actions. Overall, while the AGR measure performs better than all academic risk measures for contemporaneously detecting misstatements that result in SEC enforcement actions, AGR is not statistically different from most academic risk measures for predicting these types of misstatements using risk measurements from the period before misreporting begins. (Insert Table 3 about here) Table 4 compares the ability of each risk measure to detect or predict misstatements that are associated with egregious restatements, as defined in Hennes et al. (2008). In Table 4, Panel A, AGR outperforms every academic risk measure in terms of its ability to contemporaneously detect egregious misstatements. In a head-to-head comparison with AGR, UAF performs the best relative to the other academic measures. A one standard deviation increase in AGR results in a 63.9 percent increase in the odds of an egregious restatement, while a one standard deviation increase in UAF results in an 29.5 percent increase in the odds ratio. In Table 4, Panel B, which compares the ability to predict egregious misstatements one period before misreporting begins, the coefficient of AGR is significantly larger in three out of six comparisons (WC_ACC, FSCORE, and DSS). Surprisingly, only one of the six academic risk measures (MSCORE) is statistically significant in the models predicting IRREGt+1, whereas AGR is significant in all six comparisons. In the comparison between AGR and UAF, a one

21

standard deviation increase in AGR results in a 43.9 percent increase in the odds of committing an egregious misstatement in the next period (IRREGt+1), but a one standard deviation increase in UAF is not significantly related to an increase in the odds of a misstatement. Overall, in Table 4, AGR performs better than most academic risk measures for detecting (6 out of 6 comparisons) and predicting irregular misstatements (3 out of 6 comparisons). (Insert Table 4 about here) Table 5 presents the results of our comparisons of the ability of the risk measures to detect or predict accounting misstatements that result in shareholder lawsuits related to accounting improprieties. In Panel A, the coefficient of AGR is significantly larger in all six comparisons. The closest comparison is with the risk measure based on unexplained audit fees (UAF). While a one standard deviation increase in UAF results in a 37.0 percent increase in the odds of a misstatement, a one standard deviation increase in the AGR measure results in a 77.6 percent increase in the odds of a misstatement. In Table 5 Panel B, looking at the prediction of future accounting irregularities related to shareholder lawsuits, the coefficient of AGR is significantly larger in six out of six comparisons. For these tests, the closest comparison is with accrual estimation errors (DD). In this case, a one standard deviation increase in accrual estimation errors results in a 16.2 percent increase in the odds of future misreporting that leads to a shareholder lawsuit, while a similar one standard deviation increase in AGR results in a 46.1 percent increase in the odds ratio. Importantly, we note again that the DD measure has a look-ahead bias that may make it easier to detect future events because DD uses future data in its construction. Overall, in Table 5 AGR performs better than academic risk measures for detecting and predicting misreporting associated with accounting litigation in all 12 comparisons.

22

(Insert Table 5 about here) When the results of Tables 3, 4, and 5 are considered together, there are 36 total comparisons (18 for contemporaneously detecting misstatements, and 18 for detecting future misstatements). AGR performs as well as or better than the academic risk measures in all 36 cases. Generally, AGRs relative advantage over the academic risk measures seems to be stronger for the typical contemporaneous detection tests that are conducted in the literature, where AGR statistically outperforms the academic measures in all 18 comparisons. Also relevant is the performance of AGR in the prediction of future accounting irregularities. In these new tests, we show that AGR is generally significant in the regression analyses (17 of 18 regressions), while the academic measures are only significant in half of the regressions (9 of 18). AGR statistically outperforms the academic measures in 10 of 18 comparisons, thus relative to the contemporaneous detection does not perform as well. Taken together, these results provide evidence that AGR performs well relative to academic risk measures and may be useful to practitioners and researchers in some settings. ADDITIONAL ANALYSES We conduct several additional analyses to test the robustness of our results. We rerun all 36 comparisons from Tables 3, 4, and 5 using AR in place of AGR. As mentioned previously, AR is commercially produced by Audit Integrity and is similar to AGR with the exception that it does not contain measures of governance. For parsimony, we do not tabulate the results of tests using AR in place of AGR. For the comparisons of AR and the academic risk measures, AR performs as well as or better than the academic measures in all tests. For the contemporaneous detection tests, AR has a statistically stronger association with accounting irregularities in 16 of 18 comparisons (89 percent). For the prediction tests, AR outperforms the academic measures in

23

12 of 18 comparisons (67 percent).19 These results suggest the relatively strong performance of AGR in our tests is not attributable to its incorporation of measures of governance and that AR is a legitimate alternative to academic measures of risk for research purposes.20 Table 6 presents the results of comparing each risk measure in terms of its association with the magnitude of misstatements. We use ordinary least squares (OLS) regression, with the impact of the restatement on earnings as the dependent variable (i.e., negative values indicate earnings were originally overstated during the misstatement period).21 Since each observation represents a firm-level misstatement, we average each risk measure over the entire misstatement period. We present the fully standardized coefficients on each risk measure, the results of a statistical test of the difference in the standardized coefficients using SUEST, the R-square values and the number of firm-misstatement observations in each comparison. Statistical tests across the models indicate that AGR has a stronger association with the magnitude of the misstatement than the academic risk measures in 4 out of 6 comparisons: AGRs coefficient is statistically higher than the coefficients for WC_ACC, FSCORE, DSS, and UAF. For the other comparisons, the coefficients are not statistically different. (Insert Table 6 about here) In Table 7, we present the results of tests that include all seven risk measures together in each logistic regression model that compares the ability of each risk measure to

19

In our prediction tests, no academic measure is ever statistically superior to AR. DD and UAF are statistically equivalent to AR in four comparisons, while WC_ACC and DSS are equivalent to AR in one comparison each. AR is statistically superior to MSCORE and FSCORE for all prediction tests. 20 When we directly compare AGR and AR in head-to-head tests using the accounting irregularities in our study, AGR outperforms AR in four out of six comparisons. 21 Data on the magnitude of misstatements are available for a limited sample of financial reporting irregularities from Audit Analytics, resulting in smaller sample sizes for the tests in Table 6.

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contemporaneously detect the three types of accounting irregularities.22 We tabulate the fully standardized coefficients on each risk measure to facilitate comparisons among the coefficients. Accrual estimation errors (DD), unexplained audit fees (UAF), and AGR have the highest coefficients in the models. The coefficient estimate for AGR is higher than the coefficient estimate for DD in the irregular restatements (p < 0.05) and lawsuit models (p < 0.01), while the coefficients on AGR and DD are statistically equivalent for the SEC enforcement action model. There is no statistical difference in the coefficient estimates for AGR and UAF in the SEC enforcement and lawsuit models; however, AGR has a higher fully standardized coefficient than UAF in the model of irregular restatements. Overall, only the coefficients on AGR and DD are positive and significant in all three models.23 Collectively, the results in Table 6 and Table 7 provide further evidence that AGR performs at least as well as academic risk measures as an effective proxy for the risk of accounting irregularities. (Insert Table 7 about here) In additional untabulated tests, we reestimate our 36 comparisons among the academic and commercial risk measures with additional control variables in the models for firm size, return on assets, leverage, book-to-market ratio, reporting losses, and Big N auditors. We note that the Jones et al. (2008) study controls for firm size, return on assets, leverage, and Big N auditors in its comparison of various academic risk measures. We include the same control variables in our models, and add the book-to-market ratio (Dechow et al. 2011) and a loss indicator variable (Hayn 1995). Similar to our primary tests, the commercial risk measures

22

We do not present a table for predicting the accounting irregularities because the sample size is too small for meaningful statistical comparisons (i.e., there are not enough irregularity observations for which we can compute all risk measures in the period before the misstatement begins). 23 Multicollinearity diagnostic tests indicate that, consistent with the low correlations among our risk measures discussed previously, multicollinearity is not a concern in these models (e.g., the variance inflation factors are all less than 2).

25

perform as well as or better than the academic risk measures in all comparisons that include these additional control variables. In detection tests, AGR outperforms the academic risk measures in 14 of 18 comparisons (78 percent), while AR outperforms in 11 of 18 comparisons (61 percent). In prediction tests, AGR outperforms the academic risk measures in 8 of 18 comparisons (44 percent), while AR outperforms in 9 of 18 comparisons (50 percent). In no case does an academic measure statistically outperform AGR or AR. In additional tests, we use the results of a likelihood ratio (LR) test to determine whether adding AGR to the regressions with the academic measures significantly improves the model fit. The LR test compares the log likelihood of two nested models: one that includes the academic risk measure and one that includes both the academic measure and the commercial measure. The model with the additional parameter will always fit as least as well as the model with only the academic risk measure (i.e., it will have a greater log likelihood); however, whether the difference in fit is statistically significant must be determined through the LR test. Chi-square test statistics from each LR test indicate that including the commercial risk measure significantly improves the model fit in 35 out of 36 models. These results provide additional evidence that AGR provides incremental detective and predictive power beyond what the academic risk measures provide. We next address the possibility that our commercially developed risk measures may be overfitted to our samples or may include hindsight bias. As discussed previously, Audit Integrity periodically updates the AGR model, primarily to incorporate newly available data sources in their risk scores. For example, since the company began publishing AGR risk scores in 2004, the model has been updated to incorporate new accounting standards and new disclosures requirements. While these updates to the AGR model allow Audit Integrity to incorporate recent

26

changes in generally accepted accounting principles (GAAP) or new sources of relevant data, they also result in a model that changes over time.24 To ensure that the performance of AGR is not attributable to changes in the AGR model over time, overfitting to our sample, or hindsight bias, we utilize the As Originally Published dataset of AGR risk scores from Audit Integrity for the 2004-2008 period.25 The ratings in this dataset include only the original AGR values published by Audit Integrity, which are ordinarily released within two weeks of when a company issues its quarterly or annual financial statements. In sensitivity tests, we find that the As Originally Published AGR scores are highly correlated with the AGR scores based on the current model (Pearson and Spearman correlations of approximately 0.80). Furthermore, in head-to-head tests using the reduced sample for which As Originally Published AGR scores are available and using only the 2004-2008 period, seemingly unrelated estimation indicates there are no statistical differences in the coefficient estimates for current AGR scores and original AGR scores (p > 0.30 for all comparisons). Our inferences are also robust to excluding 2007 and 2008 from our sample, and to dropping year and industry fixed effects from our models. Finally, because the AGR and AR models produce risk scores that are ranked to fall between 0 and 100, we similarly transform all of the academic risk measures in our study to rank between 0 and 100. In head-to-head comparisons between AGR and the ranked academic risk measures, we find that AGR outperforms the ranked academic risk measures in 22 out of 36 (61 percent) comparisons. Specifically, AGR outperforms the ranked academic risk measures in 16 out of 18 (89 percent) comparisons for detecting irregularities and in 6 out of 18 (33 percent) comparisons for

24

This ongoing development of the AGR model is not unlike the way academic researchers have continued to improve on the early models of discretionary accruals. 25 This dataset begins in 2004 because that is the year when Audit Integrity began publishing its risk ratings, so it is available for a substantially reduced sample relative to our main tests.

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predicting future irregularities. Because AGR outperformed the academic risk measures in 30 out of 36 comparisons when the academic risk measures were not ranked, the rank transformation appears to improve the performance of the academic measures. In particular, we note that AGR outperforms FSCORE in five out of six comparisons when we use the raw FSCORE; however, when using the ranked FSCORE, AGR outperforms FSCORE in only one out of six comparisons.

CONCLUSION The objective of this paper is to compare academic risk measures with the commercially developed AGR risk measure and AR risk measure in terms of their ability to detect and predict misreporting that results in: (i) SEC enforcement actions, (ii) accounting restatements related to accounting irregularities (Hennes et al. 2008), and (iii) shareholder litigation related to accounting malfeasance. With numerous risk measures available, determining which are best at detecting and predicting bad accounting outcomes should be useful to researchers, practitioners, regulators, investors, auditors (internal and external), managers, boards of directors, and analysts. Academic researchers who study fraud or aggressive financial reporting should also be interested in understanding which risk measures have the highest statistical power and construct validity. Our results provide evidence that commercially developed risk measures are useful as proxies for the risk of accounting irregularities. In comparisons between AGR and academic risk measures, we show that AGR performs well in all comparisons. In the typical contemporaneous detection tests, AGR statistically outperforms academic measures in every test. In new tests examining the ability of the risk measures to predict accounting irregularities before the misstatement has even begun, AGR outperforms the academic measures more than half of the time, and in the remaining cases there is no statistical difference in the predictive ability. Results 28

also show that AR, which is closely related to AGR but excludes the governance component, also performs well relative to the academic measures. Among the academic risk measures, accrual estimation errors (DD) and unexplained audit fees (UAF) appear to perform the best. Although it is beyond the scope of this paper to provide detailed evidence concerning why the AGR measure performs well relative to the academic risk measures we test, it is useful to point out some differences between AGR and the academic risk measures. AGR is the most comprehensive risk measure among those in our study because it incorporates the broadest set of inputs. As discussed previously, AGR includes a variety of financial and non-financial measures including information from footnotes to the financial statements, corporate governance inputs, and executive compensation. Prior research has shown that executive compensation (Efendi et al. 2007) and non-financial measures (Brazel et al. 2009) can provide important signals about the likelihood of managers intentionally misstating the financial statements; therefore, we believe the comprehensive nature of AGR contributes to its construct validity. Incorporating a broader set of financial and non-financial firm-specific information to create a comprehensive measure of the risk of intentional misstatements may be an interesting avenue for future academic research. In addition, AGR may weight its inputs more optimally than the academic risk measures for maximizing its ability to predict misreporting. One clear advantage of the academic risk measures we examine is that, unlike commercially developed risk measures that are proprietary by nature, researchers know all of the inputs to the academic measures. In addition, academic risk measures may be preferable for research that aims to pinpoint specific types of reporting risks or specific firm characteristics that predict accounting irregularities. On the other hand, studies that need an overall estimate of ex ante financial reporting risk or studies with small or limited sample sizes (i.e., where noise in

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academic risk measures or sample attrition associated with the computational requirements may be costly) are likely to benefit the most from using comprehensive, commercially developed risk measures like AGR or AR due to their improved statistical power. Finally, we note that it is important to consider the results of this study in light of the reality that the accounting irregularities we examine are relatively infrequent events. The probability that any individual firm commits intentional misstatements that result in the irregularities discussed in our study is quite small. Thus, although we discuss the percentage increase in the odds ratio for a one standard deviation increase in the risk measure, as with all studies that involve these types of infrequent events, it must be noted that the odds ratios themselves are modest. As discussed in the introduction to the paper, the considerable costs borne by shareholders when these infrequent events occur justify the efforts of numerous academic researchers and commercial firms to predict and detect these events.

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Jones, K. L., Krishnan, G. V., and Melendrez, K. D. 2008. Do models of discretionary accruals detect actual cases of fraudulent and restated earnings? An empirical analysis. Contemporary Accounting Research 25, 499-531. Karpoff, J. M., D. S. Lee, and G. S. Martin. 2008a. The consequences to managers for financial misrepresentation. Journal of Financial Economics 88 (2), 193-125. Karpoff, J. M., D. S. Lee, and G. S. Martin. 2008b. The cost to firms of cooking the books. Journal of Financial and Quantitative Analysis 43 (3), 581-612. Kothari, S. P. 2001. Capital market research in accounting. Journal of Accounting and Economics 31, 105-231. Long, J. S., and J. Freese. 2000. Listing and interpreting transformed coefficients from regression models for categorical and limited dependent variables. Stata Technical Bulletin. Marzban, C. 2004. A comment on the ROC curve and the area under it as performance measures. Working paper. The University of Washington. Available at http://faculty.washington.edu/marzban/roc.pdf. McGuire, S. T., T. C. Omer, and N. Y. Sharp. 2010. The impact of religion on financial reporting irregularities. Working Paper Texas A&M University. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1548154. McNichols, M. F. 2000. Research design issues in earnings management studies. Journal of Accounting and Public Policy 19, 313-345. McNichols, M. F. 2002. Discussion of the quality of accruals and earnings: the role of accrual estimation errors. The Accounting Review 77, 61-70. Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2011. Internal audit outsourcing and the risk of misleading or fraudulent financial reporting: did Sarbanes-Oxley get it wrong? Working Paper Brigham Young University, Texas A&M University, and Brigham Young University. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1333710. Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 3, 91-102. Sloan, R. G. 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315. Zellner, A. 1962. An efficient method of estimating seemingly unrelated regression equations and tests for aggregation bias. Journal of the American Statistical Association 57: 348368.

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TABLE 1 Distribution of Observations and Accounting Irregularities across Industries and Years Panel A: Industry Composition of Sample Industry Description Food Mining and Minerals Oil and Petro Products Textiles, Apparel & Footwear Consumer Durables Chemicals Drugs, Soap, Perfumes, Tobacco Construction Steel Fabricated Products Machinery and Business Equipment Automobiles Transportation Utilities Retail Stores Financial Institutions Other Observations 1,371 564 2,069 1,137 1,518 999 2,364 1,712 723 479 8,215 690 1,924 1,401 3,483 7,719 20,817 57,185 % of Sample 2.4 0.99 3.62 1.99 2.65 1.75 4.13 2.99 1.26 0.84 14.37 1.21 3.36 2.45 6.09 13.5 36.4 100% % of Compustat 19942008 2.17 3.26 4.66 1.26 2.15 1.39 3.19 2.51 1.13 0.61 9.63 1.07 2.87 2.89 4.34 23.85 33.01 100%

Panel B: Number of firm-year accounting irregularities observations by year SEC_ENF 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 6 26 32 67 90 150 140 121 96 74 41 17 5 1 866 IRREG 0 0 0 12 32 82 98 109 85 82 39 3 0 0 542 LAWSUIT 12 40 64 67 91 127 134 99 109 86 62 38 12 7 948

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(Table 1 continued) Panel C: Percentage of all accounting irregularities in each decile of each risk measure Decile 1 2 3 4 5 6 7 8 9 10 AGR 4.1% 5.2% 6.5% 8.1% 8.3% 10.5% 9.7% 13.4% 12.8% 21.4% WC_ACC 10.4% 9.2% 9.8% 9.6% 8.2% 10.0% 8.6% 11.1% 9.8% 13.3% MSCORE 8.6% 8.3% 8.0% 7.5% 6.9% 10.7% 10.1% 12.0% 14.0% 14.0% FSCORE 4.4% 8.7% 8.9% 8.5% 8.7% 8.6% 11.4% 12.1% 12.1% 16.7% DD 10.8% 8.0% 9.5% 9.0% 8.1% 8.4% 9.2% 12.3% 11.1% 13.7% DSS 11.9% 8.1% 8.9% 9.9% 8.5% 9.6% 8.5% 10.3% 11.9% 12.4% UAF 9.1% 7.7% 7.4% 6.5% 8.0% 10.5% 9.6% 10.1% 10.5% 20.6%

The statistics in this table are based on the 57,185 firm-year observations that are included at least once in our full set of tests. In Panel B, our sample of egregious restatements (IRREG) is based on the intersection of the restatement sample in Hennes et al. (2008) and the restatement sample from Audit Analytics, so there are several years at the beginning and ending of our sample period with no irregular restatements.

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TABLE 2 Descriptive Statistics Panel A: Univariate statistics Variable AGR WC_ACC MSCORE FSCORE DD DSS UAF Mean 50.051 -0.044 -2.168 0.004 0.004 -0.003 0.016 Std Dev 27.093 0.120 4.045 0.006 0.087 0.214 0.565 Median 49.000 -0.039 -2.563 0.003 0.000 -0.004 0.011 Min 1.000 -2.227 -32.859 0.000 -1.094 -3.744 -1.797 Q1 27.000 -0.085 -2.976 0.003 -0.027 -0.056 -0.356 Q3 73.000 0.002 -2.087 0.004 0.032 0.047 0.383 Max 99.000 1.070 50.112 0.220 0.623 1.967 1.633

Panel B: Pearson (above) and Spearman (below) correlations among irregularity events and risk measures Variable (1) SEC_ENFt (2) IRREGt (3) LAWSUITt (4) AGR (5) WC_ACC (6) MSCORE (7) FSCORE (8) DD (9) DSS (10) UAF 0.28 0.26 0.05 0.01 0.02 0.03 0.01 0.01 0.03 0.22 0.05 -0.01 0.00 0.01 0.00 0.00 0.02 0.06 0.02 0.04 0.05 0.03 0.01 0.04 0.05 0.08 0.08 0.05 0.03 0.09 0.55 0.42 0.49 0.68 -0.03 0.51 0.39 0.40 -0.07 0.28 0.31 -0.03 0.41 0.00 -0.05 (1) (2) 0.28 (3) 0.26 0.22 (4) 0.05 0.05 0.06 (5) 0.01 -0.01 0.02 0.03 (6) 0.01 0.00 0.01 0.05 0.19 (7) 0.01 0.01 0.03 0.07 0.14 0.19 (8) 0.00 0.00 0.03 0.04 0.49 0.13 0.11 (9) 0.00 0.00 0.00 0.01 0.52 0.08 0.07 0.30 (10) 0.03 0.03 0.04 0.09 -0.03 -0.07 -0.03 0.01 -0.03

Reported statistics in this table are based on all 57,185 firm-year observations that are included at least once in our full set of tests. In Panel B, all bolded correlations are statistically significant at the p-value < 0.05 level. Variable Descriptions: SEC_ENF is a dichotomous variable equal to one if the firm-year observation is associated with a financial misstatement that results in an SEC enforcement action. Our comprehensive database of SEC enforcement actions are from the Karpoff et al. (2008a, 2008b) database. IRREG is a dichotomous variable taking the value of one if the firm-year observation was misstated and subsequently restated due to accounting irregularities (Hennes et al. 2008). LAWSUIT is a dichotomous variable taking the value of one if the firm-year observation is associated with a financial misstatement alleged in a shareholder lawsuit related to accounting malfeasance. Lawsuit data is obtained from the Audit Analytics litigation database. AGR is the Accounting and Governance Risk measure produced by Audit Integrity, LLP. It ranges from 0 to 100, with higher numbers representing greater risk. WC_ACC are working capital accruals computed following Sloan (1996). MSCORE is the manipulation score created by Beneish (1997, 1999). FSCORE is the fraud score created by Dechow et al. (2011). DD is Dechow and Dichevs (2002) accrual quality measure. DSS is the modified-Jones model as computed by Dechow et al. (1995). UAF is unexplained audit fees computed similar to Hribar et al. (2010). All risk measures are winsorized at the top and bottom 1%.

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TABLE 3 Comparison of the Detective and Predictive Ability of AGR relative to Several Academic Risk Measures for SEC Enforcement Actions Panel A: Logistic Regression with SEC_ENFt as the dependent variable % in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # Fraud Obs # Control Obs AGR WC_ACC 49.8*** 11.8*** 0.185*** 0.052*** p < 0.01 0.0762 0.0629 0.7455 0.7236 738 738 48,082 48,082 AGR MSCORE 42.9*** 3.8 0.167*** 0.018 p < 0.01 0.0788 0.0676 0.7504 0.7324 392 392 27,014 27,014 AGR FSCORE 50.5*** 4.2*** 0.179*** 0.018*** p < 0.01 0.0785 0.0640 0.7467 0.7238 668 668 42,875 42,875 AGR DD 53.7*** 2.9 0.199*** 0.013 p < 0.01 0.0732 0.0569 0.7383 0.7094 780 780 45,903 45,903 AGR DSS 49.7*** 4.0 0.184*** 0.018 p < 0.01 0.0777 0.0633 0.7477 0.7232 744 744 48,453 48,453 AGR UAF 61.9*** 36.0*** 0.200*** 0.130*** p < 0.08 0.1028 0.0922 0.7794 0.7581 537 537 33,393 33,393

Panel B: Logistic Regression with SEC_ENFt+1 as the dependent variable AGR WC_ACC 19.9** 31.7*** 0.082** 0.124*** p < 0.34 0.0677 0.0710 0.7524 0.7631 161 161 41,098 41,098 AGR MSCORE 6.7 38.3*** 0.142*** 0.029 p < 0.04 0.0944 0.0875 0.7981 0.7914 73 73 22,609 22,609 AGR FSCORE 23.6*** 9.4*** 0.079*** 0.033*** p < 0.14 0.0812 0.0790 0.7723 0.7684 136 136 36,468 36,468 AGR DD 27.6*** 16.3* 0.098*** 0.061* p < 0.44 0.0831 0.0805 0.7757 0.7710 169 169 45,729 45,729 AGR DSS 20.1** 22.1* 0.082** 0.090* p < 0.77 0.0683 0.0687 0.7536 0.7574 162 162 41,403 41,403 AGR UAF 21.9 41.9** 0.085 0.148** p < 0.51 0.1087 0.1142 0.8349 0.8338 53 53 27,918 27,918

% in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # Fraud Obs # Control Obs

Notes: ***, **, * represent statistical significance at the p-value < 0.01, 0.05, and 0.10 levels, respectively. See Table 2 for variable descriptions. Table 3 presents comparisons of the AGR risk measure to 6 academic risk measures using the following unconditional models with standard errors clustered at the firm level: Dependent Variable = 0 + 1AGR + YearDummies + IndustryDummies + Dependent Variable = 0 + 1Academic Measure + YearDummies + IndustryDummies + Although we report several relevant statistics for each model, we use seemingly unrelated estimation (SUEST) to test across models for significant differences between the coefficients on AGR and the academic risk measure in each comparison (reported p-value labeled Sig. Difference). % in odds ratio is the percent change in the odds ratio for a one standard deviation increase in the risk measure (from the mean), and FS Coefficient is the fully standardized coefficient.

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TABLE 4 Comparison of the Detective and Predictive Ability of AGR relative to Several Academic Risk Measures for Irregular Restatements Panel A: Logistic Regression with IRREGt as the dependent variable % in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # of Irreg. Obs # Control Obs AGR WC_ACC 59.4*** -0.3 0.142*** -0.001 p < 0.01 0.1268 0.1095 0.8132 0.7850 444 444 48,376 48,376 AGR MSCORE 63.8*** 1.1 0.158*** 0.004 p < 0.01 0.1330 0.1143 0.8265 0.7968 212 212 27,194 27,194 AGR FSCORE 60.6*** 4.3** 0.148*** 0.013** p < 0.01 0.1209 0.1034 0.8060 0.7760 409 409 43,134 43,134 AGR DD 61.5*** 2.9 0.215*** 0.013 p < 0.01 0.1030 0.0845 0.7898 0.7569 505 505 46,178 46,178 AGR DSS 56.9*** -0.7 0.175*** -0.003 p < 0.01 0.1218 0.1055 0.8108 0.7819 457 457 48,740 48,740 AGR UAF 63.9*** 29.5*** 0.174*** 0.092*** p < 0.03 0.1114 0.0978 0.7868 0.7560 439 439 33,491 33,491

Panel B: Logistic Regression with IRREGt+1 as the dependent variable % in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # of Irreg. Obs # Control Obs AGR WC_ACC 30.0*** 0.7 0.120*** 0.003 p < 0.03 0.0687 0.0637 0.7597 0.7466 150 150 41,364 41,364 AGR MSCORE 25.5* 10.2** 0.100* 0.043** p < 0.35 0.0910 0.0890 0.7915 0.7958 63 63 22,705 22,705 AGR FSCORE 29.3*** 5.8 0.118*** 0.026 p < 0.05 0.0637 0.0594 0.7488 0.7363 133 133 36,693 36,693 AGR DD 24.7*** 7.6 0.102*** 0.034 p < 0.19 0.0664 0.0633 0.7575 0.7480 158 158 46,015 46,015 AGR DSS 28.1*** -3.4 0.123*** -0.017 p < 0.03 0.0526 0.0482 0.7275 0.7169 152 152 41,661 41,661 AGR UAF 43.9*** 17.0 0.163*** 0.071 p < 0.21 0.0928 0.0855 0.7959 0.7813 83 83 27,960 27,960

Notes: ***, **, * represent statistical significance at the p-value < 0.01, 0.05, and 0.10 levels, respectively. See Table 2 for variable descriptions. Table 4 presents comparisons of the AGR risk measure to 6 academic risk measures using the following unconditional models with standard errors clustered at the firm level. Dependent Variable = 0 + 1AGR + YearDummies + IndustryDummies + Dependent Variable = 0 + 1Academic Measure + YearDummies + IndustryDummies + Although we report several relevant statistics for each model, we use seemingly unrelated estimation (SUEST) to test across models for significant differences between the coefficients on AGR and the academic risk measure in each comparison (reported p-value labeled Sig. Difference). % in odds ratio is the percent change in the odds ratio for a one standard deviation increase in the risk measure (from the mean), and FS Coefficient is the fully standardized coefficient.

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TABLE 5 Comparison of the Detective and Predictive Ability of AGR relative to Several Academic Risk Measures for Accounting-Related Lawsuits Panel A: Logistic Regression with LAWSUITt as the dependent variable % in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # Lawsuit Obs. # Control Obs AGR WC_ACC 58.7*** 19.4*** 0.218*** 0.085*** p < 0.01 0.0671 0.0515 0.7282 0.6949 747 747 48,073 48,073 AGR MSCORE 70.4*** 6.4** 0.245*** 0.030** p < 0.01 0.0871 0.0636 0.7592 0.7258 363 363 27,043 27,043 AGR FSCORE 58.5*** 7.9*** 0.217*** 0.037*** p < 0.01 0.0669 0.0499 0.7280 0.6956 673 673 42,870 42,870 AGR DD 61.9*** 24.1*** 0.227*** 0.104*** p < 0.01 0.0671 0.0514 0.7236 0.6967 841 841 45,842 45,842 AGR DSS 59.7*** 4.1 0.219*** 0.019 p < 0.01 0.0684 0.0493 0.7301 0.6924 748 748 48,449 48,449 AGR UAF 77.6*** 37.0*** 0.257*** 0.145*** p < 0.01 0.0965 0.0787 0.7680 0.7398 595 595 33,335 33,335

Panel B: Logistic Regression with LAWSUITt+1 as the dependent variable % in odds ratio FS Coefficient Sig. Difference Pseudo R2 ROC Curve # Lawsuit Obs # Control Obs AGR WC_ACC 34.9*** 6.6 0.141*** 0.030 p < 0.01 0.0503 0.0434 0.7092 0.6933 292 292 40,964 40,964 AGR MSCORE 54.5*** 11.2*** 0.201*** 0.050*** p < 0.01 0.0654 0.0526 0.7441 0.7172 138 138 22,500 22,500 AGR FSCORE 40.3*** 9.2*** 0.161*** 0.043*** p < 0.01 0.0480 0.0406 0.7040 0.6904 260 260 36,343 36,343 AGR DD 46.1*** 16.2*** 0.179*** 0.072*** p < 0.01 0.0522 0.0427 0.7114 0.6901 339 339 45,498 45,498 AGR DSS 34.5*** -3.6 0.140*** -0.018 p < 0.01 0.0507 0.0437 0.7100 0.6958 293 293 41,272 41,272 AGR UAF 42.0*** 4.5 0.163*** 0.021 p < 0.01 0.0606 0.0514 0.7342 0.7181 161 161 27,754 27,754

Notes: ***, **, * represent statistical significance at the p-value < 0.01, 0.05, and 0.10 levels, respectively. See Table 2 for variable descriptions. Table 5 presents comparisons of the AGR risk measure to 6 academic risk measures using the following unconditional models with standard errors clustered at the firm level. Dependent Variable = 0 + 1AGR + YearDummies + IndustryDummies + Dependent Variable = 0 + 1Academic Measure + YearDummies + IndustryDummies + Although we report several relevant statistics for each model, we use seemingly unrelated estimation (SUEST) to test across models for significant differences between the coefficients on AGR and the academic risk measure in each comparison (reported p-value labeled Sig. Difference). % in odds ratio is the percent change in the odds ratio for a one standard deviation increase in the risk measure (from the mean), and FS Coefficient is the fully standardized coefficient.

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TABLE 6 Comparison of the Association of Risk Measures with the Magnitude of Misstatements AGR WC_ACC -0.089*** 0.068 p < 0.02 0.0079 0.0046 1,411 1,411 AGR MSCORE -0.069** -0.168* p < 0.25 0.0047 0.0283 976 976 AGR FSCORE -0.096*** -0.172*** p < 0.03 0.0093 0.0297 1,289 1,289 AGR DD -0.082*** -0.046 p < 0.32 0.0068 0.0022 1,509 1,509 AGR DSS -0.085*** 0.062 p < 0.01 0.0073 0.0039 1,433 1,433 AGR UAF -0.082*** 0.022 p < 0.01 0.0068 0.0005 1,493 1,493

FS Coefficient Sig. Difference R-Square N

Notes: ***, **, * represent statistical significance at the p-value < 0.01, 0.05, and 0.10 levels, respectively. See Table 2 for variable descriptions. Table 6 presents pair wise comparisons of the fully standardized coefficient estimates for each risk measure from an OLS regression with the magnitude of each misstatement as the dependent variable. We use seemingly unrelated estimation (SUEST) to test across models for significant differences between the coefficients on AGR and the academic risk measure in each comparison (reported p-value labeled Sig. Difference). The misstatement values are scaled by average total assets, and risk measures are averaged over the misstatement period. Thus, each observation in the model represents a unique firm-misstatement observation, and standard errors are clustered at the firm level. CHG_INCOME = 0 + 1M_AGR + YearDummies + IndustryDummies + CHG_INCOME = 0 + 1M_Academic Measure + YearDummies + IndustryDummies +

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TABLE 7 Comparison of the Detective Ability of Risk Measures with All Risk Measures Included Together

AGR WC_ACC MSCORE FSCORE DD DSS UAF Pseudo R-Square Area under ROC curve No. of Fraud Obs No. of Control Obs

SEC_ENFt 0.132*** -0.043 -0.003 0.021** 0.062** -0.037 0.100* 0.0831 0.7459 221 12,820

IRREGt 0.230*** -0.101 -0.005 0.016 0.079** -0.020 0.091 0.0890 0.7694 151 12,890

LAWSUITt 0.201*** 0.030 -0.003 0.042*** 0.063** -0.071 0.152*** 0.1143 0.7890 215 12,826

Notes: ***, **, * represent statistical significance at the p-value < 0.01, 0.05, and 0.10 levels, respectively. See Table 2 for variable descriptions. Table 7 presents fully standardized coefficients from models that compare the detective ability of the AGR risk measure and 6 academic risk measures using the following logistic regression model with standard errors clustered at the firm level: Dependent Variable = 0 + 1AGR + 2WC_ACC + 3MSCORE + 4FSCORE + 5DD + 6DSS + 7UAF + YearDummies + IndustryDummies +

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