Abstract
This study examines voluntary ethics disclosure among public companies that were investigated by the Securities Exchange Commission for fraudulent financial reporting, and whose first year of fraud was before the effective date of the Sarbanes–Oxley Act (SOX) and the New York Stock Exchange's (NYSE) ethics rule. The research question is that of whether investors could assess the likelihood of a firm's involvement in fraudulent financial reporting by reading its publicly available reports for voluntary ethics disclosure. The extent of ethics disclosure was measured by 18 aspects using a point system. The sample includes 111 fraud firms and 111 matched no-fraud firms. The three important findings are as follows. First, only 11.7 per cent of fraud firms and 19.8 per cent of no-fraud firms had ethics disclosure in their proxy statements and/or 10-K reports in the first year of fraud. Second, the extent of ethics disclosure was lower among fraud firms than no-fraud firms. Third, ethics disclosure was negatively related to the likelihood of fraudulent financial reporting based on a logit regression analysis that controls for five explanatory variables. These findings suggest that investors could use the extent of voluntary ethics disclosure to assess fraud likelihood. Therefore, these findings support the requirement of the SOX and the NYSE that listed firms must disclose their code of ethics. Given that many countries currently do not require ethics code and disclosure, two major implications are that (1) global investors could use the extent of voluntary ethics disclosure as a screening criterion for stock investments in these countries, and (2) policy makers in these countries may want to consider requiring their public companies to adopt and disclose an ethics code.
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Notes
These SEC-investigated companies are referred to as fraud firms because earlier studies (Feroz et al, 1991 and Persons, 2005) either use this term or suggest that it is reasonable to assume that these firms were involved in fraudulent financial reporting. On the other hand, no-fraud firms were not investigated and accused by the SEC of fraudulent financial reporting. Details about the definition of no-fraud firms can be found in the Data Collection section.
The effective date of Section 406 of the Act (requiring code of ethics disclosure) is fiscal years ending on or after 15 July 2003 for all listed firms except small business issuers. This date precedes the NYSE compliance date which is the earlier of the company's first annual meeting after 15 January 2004 and 31 October 2004.
Premiums averaged 12–14 per cent in North America and Western Europe, 20–25 per cent in Asia and Latin America, and 30 per cent in Eastern Europe and Africa.
Data collection started with AAERs issued in June 1999 because they were the earliest AAERs available on the SEC website at the time this study retrieved the data. These electronic copies of AAERs are much easier to access than the paper copies available at only certain college libraries.
If there is no potential control firm with the closest net sales in the same four-digit-SIC-code industry, the search for such a firm will be expanded to the three-digit SIC code and the two-digit SIC code, respectively.
A publicly traded company has three options to make their code of ethics publicly available: (1) filing a copy of the code as part of the SEC Form 10-K or 20-F; (2) posting the code on the firm's website as well as stating in the annual report and Form 10-K or 20-F that the code of ethics is available on the website; and (3) stating in the annual report and Form 10-K or 20-F that a free copy of the code will be provided upon request.
Insiders are major stockholders and all employees including directors and top executives. These individuals have access to inside nonpublic information that provides them an unfair advantage in terms of stock trading.
This study uses a dichotomous measure for INDAUD because, per the SOX, all public companies are now required to have an entirely independent audit committee. This requirement implies that it is also desirable to have an entirely independent audit committee during the pre-SOX period. Using a percentage of independent directors does not change any inferences.
The t-test is not significant because no-fraud firms have much higher standard error than fraud firms owing to one no-fraud company (Berkshire Hathaway) that had an extremely high earnings per share of 971. The EPS t-test becomes significant after excluding Berkshire Hathaway and its paired fraud company. All other inferences remain the same.
Correlations of the six explanatory variables are relatively low, ranging from −0.093 to 0.287. Such low correlations suggest that collinearity is not likely to be a problem in the regression analysis.
After excluding Berkshire Hathaway (with an extremely high EPS) and its paired fraud company, the logit regression also indicates EPS as a significant variable. All inferences about the other variables remain the same.
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Persons, O. Could investors use voluntary ethics disclosure to assess the likelihood of fraudulent financial reporting?. Int J Discl Gov 7, 153–166 (2010). https://doi.org/10.1057/jdg.2009.24
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DOI: https://doi.org/10.1057/jdg.2009.24