Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions

Round 1

Reviewer 1 Report

Comments and Suggestions for Authors

The article is well written and compiled.

However, I have reasonable remarks on two important parts of this article.

1.      Introductory part. It should be slightly replaced and expanded. The following parts given there should have been added to other parts of the article.

 

This study examines the impact of executives implicated in financial reporting fraud (hereafter fraud) on firms' investment decisions. Also, it investigates how colluded executives in fraud influence investment decisions. We use hand-collected data of fraud cases in which executives are implicated or colluded using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC).-  THERE IS ALREADY IN ABSIRACT. THIS IS REPETITION. THIS IS HOW THE INTRODUCTORY PART OF THE ARTICLE CANNOT BE STARTED.

Prior studies suggested that more than half of executives are implicated in fraud, and of these cases, over 60% involve at least two executives [1, 2, 3].-  LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Prior studies primarily focused on examining factors related to opportunity and incentives that reflect circumstances [e.g., 7-12].  -  LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

This study examines the distinct behaviors of executives implicated in or colluded in fraud. Moreover, we focus on internal investment decision-making in firms to explore the fraud rationalization process. To date, there is little research that deals with the relationship between fraud and its effect on internal decision-making. This study fills the void by examining how executives use abnormal investment decisions as a means of rationalizing fraud.-  GIVE THIS AT THE END OF THE INTRODUCTORY PART OF THE ARTICLE.

This study relies on AAERs from 1981 to 2013 to create a sample of fraud firms with available investment data. These releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court whether a firm's financial statements were materially misstated; the charges brought against named executives; the year fraud began; the year fraud detected; and the amount of civil penalty if applicable. - LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.  

Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [3, 11, 12]. -  LET IT BE GIVEN IN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

We utilize bootstrap analysis to address the non- normality of fraud firms in our sample by estimating the resampling distributions. We thus acquire multiple bootstrap samples that represent the fraud population. By employing bootstrap analysis, we expand the sample size from 151 to 1,510 firm-level observations, thereby bolstering the reliability of our statistical analysis without relying on strict assumptions about the underlying distribution of the data.- LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.  

The first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [13].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decisionmaking. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [3] documented that the interconnectedness among top management team members fosters 'groupthink', consequently elevating the risk of accounting fraud. Building on Li's findings [3], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and find that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects… ………. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.-  LET IT BE GIVEN IN CONCLUSION

This study underscores the importance of public disclosure of fraud by regulators to alert capital market participants.-  IT SHOULD BE GIVEN IN ABSTRACT.

 

2.         Conclusion and discussion the part must be completely redesigned.

It is recommended that you refer to literature summaries and articles of MDPI journals in discussion.

Author Response

Reply to Reviewer 1 Comments

Manuscript ID sustainability-2992918

“Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions”

 

Dear Reviewer 1,

We thank you for your dedicated comments. We greatly value the opportunity to revise our manuscript based on your insightful suggestions. We have done our best to address your suggestions in a conscientious manner and hope that we have revised the manuscript appropriately. We highlighted the revised part in green in the revised text.

Below, your original comments are in boxes, followed by our responses.

Comment 1: The article is well written and compiled. However, I have reasonable remarks on two important parts of this article. Introductory part. It should be slightly replaced and expanded. The following parts given there should have been added to other parts of the article. This study examines the impact of executives implicated in financial reporting fraud (hereafter fraud) on firms' investment decisions. Also, it investigates how colluded executives in fraud influence investment decisions. We use hand collected data of fraud cases in which executives are implicated or colluded using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC). -  THERE IS ALREADY IN ABSIRACT. THIS IS REPETITION. THIS IS HOW THE INTRODUCTORY PART OF THE ARTICLE CANNOT BE STARTED.

Response: We thank the reviewer for having raised this issue. We agree that the first paragraph in the introduction needs to clearly elaborate the motivation of conducting this study and the importance of using the U.S. context to examine the research question. Therefore, as you suggested, we deleted the first paragraph.

Comment 2: Prior studies suggested that more than half of executives are implicated in fraud, and of  these cases, over 60% involve at least two executives [1, 2, 3] -LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you suggested, we have included the sentence, “Prior studies suggested that more than half of executives are implicated in fraud, and of these cases, over 60% involve at least two executives [1,2,3]” as part of the first paragraph in Section 2.2. Collusive Fraud and Investment Decision-making in the revised text.

Page 4: Collusion involving two or more executives undermines the effectiveness of corporate governance and internal control systems, which serve as vital monitoring mechanisms for firms [25,26]. Financial reporting is a multifaceted process involving multiple parties, and collusive accounting fraud occurs more frequently than solo fraud [27-29]. In the study of Khanna et al. [28], on average, litigation or SEC enforcement actions implicated 4.8 individuals for the period of 1996 and 2006. Prior studies suggested that more than half of executives are implicated in fraud, and of these cases, over 60% involve at least two executives [7,27,30]. However, studies investigating fraud cases involving colluding executives have been limited. A few studies show that the executives’ connections with audit committee members, CEOs, and CFOs elevate the likelihood of financial reporting fraud [28,31,32].

Comment 3: Prior studies primarily focused on examining factors related to opportunity and incentives that reflect circumstances [e.g., 7-12].  -  LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you suggested, we moved the respective sentence from the introduction to section 2. Literature Review and Hypothesis Development. Thank you for your insightful comment. Please refer to the first paragraph in section 2. 1. Financial Reporting Fraud and Investment Decision-Making in green highlighted part.

Page 2: Prior papers presented evidence that fraud occurs in the presence of a fraud triangle –opportunities, incentives, and rationalization [6,8,9]. To date, research has predominantly focused on determinants of opportunity and incentives that reflect circumstances [7-12]. Several studies have found a relationship between equity incentives and the probability of financial reporting fraud [10,11,12]. Others identified fraud incentive-related red flags evident in a firm’s financial statements [13]. Fraud opportunity-related studies presented evidence that weak corporate governance, including weak internal controls, unethical tone at the top, and inadequate internal policies and procedures, provide ideal circumstances for management to commit fraud [14-16,17]. Another primary research focus has been market reactions following fraud detection [e.g., 18,19]. Prior studies showed that firms accused of fraud by the SEC experience a decline in firm value and a significant increase in the cost of capital.

Comment 4: This study examines the distinct behaviors of executives implicated in or colluded in fraud. Moreover, we focus on internal investment decision- making in firms to explore the fraud rationalization process. To date, there is little research that deals with the relationship between fraud and its effect on internal decision making. This study fills the void by examining how executives use abnormal investment decisions as a means of rationalizing fraud.-  GIVE THIS AT THE END OF THE INTRODUCTORY PART OF THE ARTICLE

Response: Thank you for your constructive suggestion. According to your suggestion, we moved the respective sentences from the beginning of the introduction to the end of the introduction as an extension of contributions of this study. Please refer to the second to the last paragraph in 1. Introduction in green highlighted part.

Page 2: This study contributes to the literature as follows. Firstly, by examining fraud cases involving implicated or colluding executives, this study provides insights into the rationalization element of the fraud triangle, an area that remains relatively unexplored. This study examines the distinct behaviors of executives implicated in or colluded in fraud. Moreover, we focus on internal investment decision-making in firms to explore the fraud rationalization process. To date, there is little research that deals with the relationship between fraud and its effect on internal decision-making. This study fills the void by examining how executives use abnormal investment decisions as a means of rationalizing fraud. Secondly, this study offers supplementary empirical evidence to enhance the understanding of the relationship between fraud and investment decision-making initially provided by McNichols and Stubben [4]. They anticipated that executives' awareness of fraud may impact decision-making processes, but their analysis was not differentiated based on this awareness. We verify that executives' awareness of fraud has a detrimental impact on investment decisions. Thirdly, this study expands the findings of Li [7], who illustrated how groupthink negatively influences internal decision-making in firms. Executives who collude in fraud, especially CEOs and CFOs, make abnormal investment decisions through group thinking to conceal their wrongdoing. Fourthly, we discuss the usefulness of public disclosure of executive involvement or collusion via AAERs in the U.S. In firms where executives are implicated or colluded in fraud, there is an increased probability of making inefficient investment decisions, ultimately leading to a decline in the firm's sustainability. Investors can evaluate a firm's sustainability by analyzing the detailed fraud information provided in AAERs.

Comment 5: This study relies on AAERs from 1981 to 2013 to create a sample of fraud firms with available investment data. These releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court whether a firm's financial statements were materially misstated; the charges brought against named executives; the year fraud began; the year fraud detected; and the amount of civil penalty if applicable. - LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.

Response: We agree with your suggestion. In response to your comment, we moved the sample description from 1. Introduction to 3. Sample Selection and Research Design. Please refer to the first paragraph of section 3.1 Sample Selection in green highlighted part.

Page 5: This study relies on AAERs from 1981 to 2013 to create a sample of fraud firms with available investment data. These releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court whether a firm’s financial statements were materially misstated; the charges brought against named executives; the year fraud began; the year fraud detected; and the amount of civil penalty if applicable. Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [7, 11, 12].

Comment 6: Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [3, 11, 12]. -  LET IT BE GIVEN IN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you advised, we moved the sentence, “ Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [3, 11, 12]” from 1. Introduction to the third from the last paragraph in section 2.1 Financial Reporting Fraud and Investment Decision-Making as follows. Please see the green highlighted part in the revised text as well.

Page 3: Due to available data limitations, few empirical studies on executives implicated in fraud cases have been conducted. However, recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [7,11,12]. For example, Davidson [12] noted that executives implicated in fraud have stronger equity incentives than executives who are not implicated in fraud. That study demonstrated that decision-making varies across executive positions, and its fraud analysis at the executive level provided robust empirical results regarding fraud incentives for executives. Davidson [12] also shed light on the personal incentives of executives' involvement in fraud, examining the impact of such incentives on firms’ internal decision-making processes.

Comment 7: We utilize bootstrap analysis to address the non- normality of fraud firms in our sample by estimating the resampling distributions. We thus acquire multiple bootstrap samples that represent the fraud population. By employing bootstrap analysis, we expand the sample size from 151 to 1,510 firm-level observations, thereby bolstering the reliability of our statistical analysis without relying on strict assumptions about the underlying distribution of the data.- LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.

Response: In response to your comment, we moved the detailed sample selection process and research methodology from 1. Introduction to Section 3. The Sample Selection Process and Research Methodology in the revised text. Please see the green highlighted part in the last paragraph in section 3.1. Sample Selection as follow:

Page 6: We utilize bootstrap analysis to address the non-normality of fraud firms in our sample by estimating the resampling distributions. We thus acquire multiple bootstrap samples that represent the fraud population. By employing bootstrap analysis, we expand the sample size from 151 to 1,510 firm-level observations, thereby bolstering the reliability of our statistical analysis without relying on strict assumptions about the underlying distribution of the data.

Comment 8: The first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments.Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [13].The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [3] documented that the interconnectedness among top management team members fosters 'groupthink', consequently elevating the risk of accounting fraud. Building on Li's findings [3], this study offers additional evidence thatgroupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making. Further analysis disaggregates investment by level (overinvestment, underinvestment) and find that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects… ………. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.-  LET IT BE GIVEN IN CONCLUSION

Response: Thank you for your constructive comments. As suggested, we moved two paragraphs in section 1. Introduction to section 6. Discussion and Conclusion. Please refer to the green highlighted second, third, and fourth paragraph of 6. Discussion and Conclusion in the revised text.

Page 23-24: In details, the first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [4].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [7] documented that the interconnectedness among top management team members fosters ‘groupthink’, consequently elevating the risk of accounting fraud. Building on Li's findings [7], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and finds that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects. In the next analysis, we disaggregate investment by type (capital expenditures, R&D expenditures, and acquisition expenditures); the results are qualitatively similar to the main results. This shows the robustness of our findings. Among the three investment types, all implicated executives in our sample invested in R&D inefficiently to hide or rationalize fraud. Inefficient investment of the other two investment types (capital expenditure and acquisition expenditures) occurred only when the CEO or CFO was involved. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.

Comment 9: This study underscores the importance of public disclosure of fraud by regulators to alert capital market participants.-  IT SHOULD BE GIVEN IN ABSTRACT.

Response: In response to your comment, we moved the sentence, “This study underscores the importance of public disclosure of fraud by regulators to alert capital market participants from 1. Introduction to Abstract in the revised text. Please refer to the green highlighted part in the revised text.

Page 1: This study examines the impact of executives implicated in fraud on firms' investment decisions using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC), aiming to address the underexplored aspect of rationalization within the fraud triangle. AAERs releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court. Executives implicated in fraud often display abnormal attitudes to justify accounting irregularities, prompting an investigation into how abnormal investment decisions are used for rationalizing fraud, given their critical role in a firm's long-term sustainability. We utilize bootstrap analysis to address the non-normality of fraud firms in our sample, and to acquire multiple bootstrap samples that represent the fraud population, thereby bolstering the reliability of our statistical analysis. Analysis of AAERs spanning from 1981 to 2013 reveals that implicated executives, particularly CEOs and CFOs, tend to make abnormal investment decisions, and that collusive fraud exacerbates this behavior. Notably, such executives lean towards overinvestment, particularly in R&D expenditures, to hide or justify fraud; the duration of fraud amplifies its impact on investment decisions. By shedding light on the rationalization aspect of the fraud triangle, this research contributes valuable insights for investors, regulators, and academia emphasizing the significance of public disclosure of fraud by regulators to enhance transparency in capital markets and to alert capital market participants. Furthermore, this study underscores the importance of ethics-focused education in accounting to prevent corporate fraud.

Comment 10: 2.  Conclusion and discussion the part must be completely redesigned. It is recommended that you refer to literature summaries and articles of MDPI journals in discussion.

Response: Thank you for providing constructive suggestions. As you suggested, section 6. Discussion and Conclusion have been completely reconstructed. In addition, we included articles of MDPI journals [46-48] to increase contributions of current research. Please refer to 6. Discussion and Conclusion in green highlighted part of the revised text.

Page 23-24: This study investigates the impact of executives involved in fraud on firms' investment decisions utilizing AAERs in the U.S. While previous studies primarily examined factors related to opportunity and incentives within the fraud triangle [5,43-45], rationalization has received limited attention due to data constraints. Executives implicated in fraud often show aberrant attitudes to rationalize accounting irregularities. This study fills the gap by exploring how executives use abnormal investment decisions as a means of rationalizing fraud in light of the critical role of investment decisions in a firm's long-term sustainability. Analysis of AAERs from 1981 to 2013 reveals that executives implicated in fraud cases tend to make abnormal investment decisions, particularly CEOs and CFOs. Collusive fraud among executives exacerbates abnormal investment decision-making. The results also indicate that such executives generally tend to overinvest rather than underinvest, particularly in R&D expenditures, to conceal or rationalize fraud. The duration of fraud further amplifies the impact of implicated executives on abnormal investment.

In details, the first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [4].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [7] documented that the interconnectedness among top management team members fosters ‘groupthink’, consequently elevating the risk of accounting fraud. Building on Li's findings [7], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and finds that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects. In the next analysis, we disaggregate investment by type (capital expenditures, R&D expenditures, and acquisition expenditures); the results are qualitatively similar to the main results. This shows the robustness of our findings. Among the three investment types, all implicated executives in our sample invested in R&D inefficiently to hide or rationalize fraud. Inefficient investment of the other two investment types (capital expenditure and acquisition expenditures) occurred only when the CEO or CFO was involved. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.

By shedding light on the rationalization element of the fraud triangle and offering insights into the detrimental impact of fraud on investment decisions, this research can help investors, regulators, and academics. This study extends prior fraud research, which used novel methodologies such as network analysis or text analysis in international contexts [46-48], by utilizing bootstrap analysis to increase statistical reliability in identified fraud samples and to magnify the fraud rationalization behaviors of executives (particularly, CEOs and CFOs) in relation to abnormal investment decisions in the U.S. market. Investors may be able to evaluate a firm's sustainability by analyzing the detailed fraud information available in AAERs, in which information about fraud cases is continuously updated. Furthermore, this study underscores the importance and urgency of public disclosure of fraud by regulators to alert capital market participants. Lastly, academics interested in ethics-focused education in accounting departments will find this study useful. When students recognize how abnormal investment decisions can be made at the expense of curtailed growth or innovation due to fraud, increased awareness of ethical decision-making will be a preventive control over corporate fraud.

Additional references from those published by MDPI journals have been included in the revised text.

Jan, C. L. Detection of financial statement fraud using deep learning for sustainable development of capital markets under information asymmetry. Sustainability 2021, 13(17), 9879. Sustainability | Free Full-Text | Detection of Financial Statement Fraud Using Deep Learning for Sustainable Development of Capital Markets under Information Asymmetry (mdpi.com)

Yao, J., Pan, Y.;Yang, S., Chen, Y.; Li, Y.  Detecting fraudulent financial statements for the sustainable development of the socio-economy in China: a multi-analytic approach. Sustainability 2019, 11(6), 1579. Sustainability | Free Full-Text | Detecting Fraudulent Financial Statements for the Sustainable Development of the Socio-Economy in China: A Multi-Analytic Approach (mdpi.com).

Yu, S. J.; Rha, J. S. Research trends in accounting fraud using network analysis. Sustainability 2021, 13(10), 5579; Sustainability | Free Full-Text | Research Trends in Accounting Fraud Using Network Analysis (mdpi.com).

The paper has benefited from your insightful suggestions, and we are grateful for that. We have done our best to address your comments and hope that we have responded in a satisfactory fashion.

The revised paper is attached as a file.

Author Response File: Author Response.pdf

Reviewer 2 Report

Comments and Suggestions for Authors

Thanks to the editors for this opportunity related to reviewing this paper concerned with examining the impact of executives implicated in fraud on firms' investment 8 decisions using AAERs in the US. The paper has a potential for publication in Sustainability Journal after considering these comments:

-       The used methodology is not clear in the abstract

-          The use of AAERs for the first time in the abstract should be defined.

 -          The motivation for conducting this study, and why it is important to focus on the US context is not clear in the introduction section.

 -          The last section (discussion and conclusion) is very thin. The discussion of the findings regarding the literature is absent. This section should clearly discusses the study findings concerning the literature.

 

Author Response

Please see the attachment.

Author Response File: Author Response.pdf

Reviewer 3 Report

Comments and Suggestions for Authors

Conclusion. Author should mention in what areas this study could be developed taking into consideration another aspects: psychological, if it applies in same way to all industries, if culture factors are determinant and if lack of clear governance culture influence it. 

Author Response

Rely to Editor Comments

Manuscript ID sustainability-2992918

“Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions”

Dear Mr. Natatsawas Soonthornwiphat,

We thank you and the two anonymous reviewers for your dedicated and constructive comments. We greatly value the opportunity to revise our manuscript. We have done our best to address your suggestions rigorously and hope that we have revised the manuscript appropriately. We have checked that all references are relevant to the contents of the revised manuscript and have highlighted any changes in green. This way, you and the referees can easily identify the changes made in the revised text. Please see the following, which explains, point by point, the details of the revisions made to the manuscript in response to the referees.

 

Sincerely,

 

Reply to Reviewer 1 Comments

Manuscript ID sustainability-2992918

“Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions”

 

Dear Reviewer 1,

We thank you for your dedicated comments. We greatly value the opportunity to revise our manuscript based on your insightful suggestions. We have done our best to address your suggestions in a conscientious manner and hope that we have revised the manuscript appropriately. We highlighted the revised part in green in the revised text.

Below, your original comments are in boxes, followed by our responses.

Comment 1: The article is well written and compiled. However, I have reasonable remarks on two important parts of this article. Introductory part. It should be slightly replaced and expanded. The following parts given there should have been added to other parts of the article. This study examines the impact of executives implicated in financial reporting fraud (hereafter fraud) on firms' investment decisions. Also, it investigates how colluded executives in fraud influence investment decisions. We use hand collected data of fraud cases in which executives are implicated or colluded using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC). -  THERE IS ALREADY IN ABSIRACT. THIS IS REPETITION. THIS IS HOW THE INTRODUCTORY PART OF THE ARTICLE CANNOT BE STARTED.

Response: We thank the reviewer for having raised this issue. We agree that the first paragraph in the introduction needs to clearly elaborate the motivation of conducting this study and the importance of using the U.S. context to examine the research question. Therefore, as you suggested, we deleted the first paragraph.

Comment 2: Prior studies suggested that more than half of executives are implicated in fraud, and of  these cases, over 60% involve at least two executives [1, 2, 3] -LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you suggested, we have included the sentence, “Prior studies suggested that more than half of executives are implicated in fraud, and of these cases, over 60% involve at least two executives [1,2,3]” as part of the first paragraph in Section 2.2. Collusive Fraud and Investment Decision-making in the revised text.

Page 4: Collusion involving two or more executives undermines the effectiveness of corporate governance and internal control systems, which serve as vital monitoring mechanisms for firms [25,26]. Financial reporting is a multifaceted process involving multiple parties, and collusive accounting fraud occurs more frequently than solo fraud [27-29]. In the study of Khanna et al. [28], on average, litigation or SEC enforcement actions implicated 4.8 individuals for the period of 1996 and 2006. Prior studies suggested that more than half of executives are implicated in fraud, and of these cases, over 60% involve at least two executives [7,27,30]. However, studies investigating fraud cases involving colluding executives have been limited. A few studies show that the executives’ connections with audit committee members, CEOs, and CFOs elevate the likelihood of financial reporting fraud [28,31,32].

Comment 3: Prior studies primarily focused on examining factors related to opportunity and incentives that reflect circumstances [e.g., 7-12].  -  LET IT BE GIVEN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you suggested, we moved the respective sentence from the introduction to section 2. Literature Review and Hypothesis Development. Thank you for your insightful comment. Please refer to the first paragraph in section 2. 1. Financial Reporting Fraud and Investment Decision-Making in green highlighted part.

Page 2: Prior papers presented evidence that fraud occurs in the presence of a fraud triangle –opportunities, incentives, and rationalization [6,8,9]. To date, research has predominantly focused on determinants of opportunity and incentives that reflect circumstances [7-12]. Several studies have found a relationship between equity incentives and the probability of financial reporting fraud [10,11,12]. Others identified fraud incentive-related red flags evident in a firm’s financial statements [13]. Fraud opportunity-related studies presented evidence that weak corporate governance, including weak internal controls, unethical tone at the top, and inadequate internal policies and procedures, provide ideal circumstances for management to commit fraud [14-16,17]. Another primary research focus has been market reactions following fraud detection [e.g., 18,19]. Prior studies showed that firms accused of fraud by the SEC experience a decline in firm value and a significant increase in the cost of capital.

Comment 4: This study examines the distinct behaviors of executives implicated in or colluded in fraud. Moreover, we focus on internal investment decision- making in firms to explore the fraud rationalization process. To date, there is little research that deals with the relationship between fraud and its effect on internal decision making. This study fills the void by examining how executives use abnormal investment decisions as a means of rationalizing fraud.-  GIVE THIS AT THE END OF THE INTRODUCTORY PART OF THE ARTICLE

Response: Thank you for your constructive suggestion. According to your suggestion, we moved the respective sentences from the beginning of the introduction to the end of the introduction as an extension of contributions of this study. Please refer to the second to the last paragraph in 1. Introduction in green highlighted part.

Page 2: This study contributes to the literature as follows. Firstly, by examining fraud cases involving implicated or colluding executives, this study provides insights into the rationalization element of the fraud triangle, an area that remains relatively unexplored. This study examines the distinct behaviors of executives implicated in or colluded in fraud. Moreover, we focus on internal investment decision-making in firms to explore the fraud rationalization process. To date, there is little research that deals with the relationship between fraud and its effect on internal decision-making. This study fills the void by examining how executives use abnormal investment decisions as a means of rationalizing fraud. Secondly, this study offers supplementary empirical evidence to enhance the understanding of the relationship between fraud and investment decision-making initially provided by McNichols and Stubben [4]. They anticipated that executives' awareness of fraud may impact decision-making processes, but their analysis was not differentiated based on this awareness. We verify that executives' awareness of fraud has a detrimental impact on investment decisions. Thirdly, this study expands the findings of Li [7], who illustrated how groupthink negatively influences internal decision-making in firms. Executives who collude in fraud, especially CEOs and CFOs, make abnormal investment decisions through group thinking to conceal their wrongdoing. Fourthly, we discuss the usefulness of public disclosure of executive involvement or collusion via AAERs in the U.S. In firms where executives are implicated or colluded in fraud, there is an increased probability of making inefficient investment decisions, ultimately leading to a decline in the firm's sustainability. Investors can evaluate a firm's sustainability by analyzing the detailed fraud information provided in AAERs.

Comment 5: This study relies on AAERs from 1981 to 2013 to create a sample of fraud firms with available investment data. These releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court whether a firm's financial statements were materially misstated; the charges brought against named executives; the year fraud began; the year fraud detected; and the amount of civil penalty if applicable. - LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.

Response: We agree with your suggestion. In response to your comment, we moved the sample description from 1. Introduction to 3. Sample Selection and Research Design. Please refer to the first paragraph of section 3.1 Sample Selection in green highlighted part.

Page 5: This study relies on AAERs from 1981 to 2013 to create a sample of fraud firms with available investment data. These releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court whether a firm’s financial statements were materially misstated; the charges brought against named executives; the year fraud began; the year fraud detected; and the amount of civil penalty if applicable. Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [7, 11, 12].

Comment 6: Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [3, 11, 12]. -  LET IT BE GIVEN IN SECTION 2. PRIOR LITERATURE AND ESTABLISHES THE RATIONALE BEHIND THE HYPOTHESES.

Response: As you advised, we moved the sentence, “ Recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [3, 11, 12]” from 1. Introduction to the third from the last paragraph in section 2.1 Financial Reporting Fraud and Investment Decision-Making as follows. Please see the green highlighted part in the revised text as well.

Page 3: Due to available data limitations, few empirical studies on executives implicated in fraud cases have been conducted. However, recent fraud studies documented that use of AAERs decreases the likelihood of type I errors given that firms undergoing SEC investigations are subject to the most egregious manipulations [7,11,12]. For example, Davidson [12] noted that executives implicated in fraud have stronger equity incentives than executives who are not implicated in fraud. That study demonstrated that decision-making varies across executive positions, and its fraud analysis at the executive level provided robust empirical results regarding fraud incentives for executives. Davidson [12] also shed light on the personal incentives of executives' involvement in fraud, examining the impact of such incentives on firms’ internal decision-making processes.

Comment 7: We utilize bootstrap analysis to address the non- normality of fraud firms in our sample by estimating the resampling distributions. We thus acquire multiple bootstrap samples that represent the fraud population. By employing bootstrap analysis, we expand the sample size from 151 to 1,510 firm-level observations, thereby bolstering the reliability of our statistical analysis without relying on strict assumptions about the underlying distribution of the data.- LET IT BE GIVEN IN SECTION 3.  THE SAMPLE SELECTION PROCESS AND RESEARCH METHODOLOGY.

Response: In response to your comment, we moved the detailed sample selection process and research methodology from 1. Introduction to Section 3. The Sample Selection Process and Research Methodology in the revised text. Please see the green highlighted part in the last paragraph in section 3.1. Sample Selection as follow:

Page 6: We utilize bootstrap analysis to address the non-normality of fraud firms in our sample by estimating the resampling distributions. We thus acquire multiple bootstrap samples that represent the fraud population. By employing bootstrap analysis, we expand the sample size from 151 to 1,510 firm-level observations, thereby bolstering the reliability of our statistical analysis without relying on strict assumptions about the underlying distribution of the data.

Comment 8: The first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments.Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [13].The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [3] documented that the interconnectedness among top management team members fosters 'groupthink', consequently elevating the risk of accounting fraud. Building on Li's findings [3], this study offers additional evidence thatgroupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making. Further analysis disaggregates investment by level (overinvestment, underinvestment) and find that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects… ………. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.-  LET IT BE GIVEN IN CONCLUSION

Response: Thank you for your constructive comments. As suggested, we moved two paragraphs in section 1. Introduction to section 6. Discussion and Conclusion. Please refer to the green highlighted second, third, and fourth paragraph of 6. Discussion and Conclusion in the revised text.

Page 23-24: In details, the first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [4].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [7] documented that the interconnectedness among top management team members fosters ‘groupthink’, consequently elevating the risk of accounting fraud. Building on Li's findings [7], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and finds that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects. In the next analysis, we disaggregate investment by type (capital expenditures, R&D expenditures, and acquisition expenditures); the results are qualitatively similar to the main results. This shows the robustness of our findings. Among the three investment types, all implicated executives in our sample invested in R&D inefficiently to hide or rationalize fraud. Inefficient investment of the other two investment types (capital expenditure and acquisition expenditures) occurred only when the CEO or CFO was involved. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.

Comment 9: This study underscores the importance of public disclosure of fraud by regulators to alert capital market participants.-  IT SHOULD BE GIVEN IN ABSTRACT.

Response: In response to your comment, we moved the sentence, “This study underscores the importance of public disclosure of fraud by regulators to alert capital market participants from 1. Introduction to Abstract in the revised text. Please refer to the green highlighted part in the revised text.

Page 1: This study examines the impact of executives implicated in fraud on firms' investment decisions using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC), aiming to address the underexplored aspect of rationalization within the fraud triangle. AAERs releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court. Executives implicated in fraud often display abnormal attitudes to justify accounting irregularities, prompting an investigation into how abnormal investment decisions are used for rationalizing fraud, given their critical role in a firm's long-term sustainability. We utilize bootstrap analysis to address the non-normality of fraud firms in our sample, and to acquire multiple bootstrap samples that represent the fraud population, thereby bolstering the reliability of our statistical analysis. Analysis of AAERs spanning from 1981 to 2013 reveals that implicated executives, particularly CEOs and CFOs, tend to make abnormal investment decisions, and that collusive fraud exacerbates this behavior. Notably, such executives lean towards overinvestment, particularly in R&D expenditures, to hide or justify fraud; the duration of fraud amplifies its impact on investment decisions. By shedding light on the rationalization aspect of the fraud triangle, this research contributes valuable insights for investors, regulators, and academia emphasizing the significance of public disclosure of fraud by regulators to enhance transparency in capital markets and to alert capital market participants. Furthermore, this study underscores the importance of ethics-focused education in accounting to prevent corporate fraud.

Comment 10: 2.  Conclusion and discussion the part must be completely redesigned. It is recommended that you refer to literature summaries and articles of MDPI journals in discussion.

Response: Thank you for providing constructive suggestions. As you suggested, section 6. Discussion and Conclusion have been completely reconstructed. In addition, we included articles of MDPI journals [46-48] to increase contributions of current research. Please refer to 6. Discussion and Conclusion in green highlighted part of the revised text.

Page 23-24: This study investigates the impact of executives involved in fraud on firms' investment decisions utilizing AAERs in the U.S. While previous studies primarily examined factors related to opportunity and incentives within the fraud triangle [5,43-45], rationalization has received limited attention due to data constraints. Executives implicated in fraud often show aberrant attitudes to rationalize accounting irregularities. This study fills the gap by exploring how executives use abnormal investment decisions as a means of rationalizing fraud in light of the critical role of investment decisions in a firm's long-term sustainability. Analysis of AAERs from 1981 to 2013 reveals that executives implicated in fraud cases tend to make abnormal investment decisions, particularly CEOs and CFOs. Collusive fraud among executives exacerbates abnormal investment decision-making. The results also indicate that such executives generally tend to overinvest rather than underinvest, particularly in R&D expenditures, to conceal or rationalize fraud. The duration of fraud further amplifies the impact of implicated executives on abnormal investment.

In details, the first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [4].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [7] documented that the interconnectedness among top management team members fosters ‘groupthink’, consequently elevating the risk of accounting fraud. Building on Li's findings [7], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and finds that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects. In the next analysis, we disaggregate investment by type (capital expenditures, R&D expenditures, and acquisition expenditures); the results are qualitatively similar to the main results. This shows the robustness of our findings. Among the three investment types, all implicated executives in our sample invested in R&D inefficiently to hide or rationalize fraud. Inefficient investment of the other two investment types (capital expenditure and acquisition expenditures) occurred only when the CEO or CFO was involved. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.

By shedding light on the rationalization element of the fraud triangle and offering insights into the detrimental impact of fraud on investment decisions, this research can help investors, regulators, and academics. This study extends prior fraud research, which used novel methodologies such as network analysis or text analysis in international contexts [46-48], by utilizing bootstrap analysis to increase statistical reliability in identified fraud samples and to magnify the fraud rationalization behaviors of executives (particularly, CEOs and CFOs) in relation to abnormal investment decisions in the U.S. market. Investors may be able to evaluate a firm's sustainability by analyzing the detailed fraud information available in AAERs, in which information about fraud cases is continuously updated. Furthermore, this study underscores the importance and urgency of public disclosure of fraud by regulators to alert capital market participants. Lastly, academics interested in ethics-focused education in accounting departments will find this study useful. When students recognize how abnormal investment decisions can be made at the expense of curtailed growth or innovation due to fraud, increased awareness of ethical decision-making will be a preventive control over corporate fraud.

Additional references from those published by MDPI journals have been included in the revised text.

Jan, C. L. Detection of financial statement fraud using deep learning for sustainable development of capital markets under information asymmetry. Sustainability 2021, 13(17), 9879. Sustainability | Free Full-Text | Detection of Financial Statement Fraud Using Deep Learning for Sustainable Development of Capital Markets under Information Asymmetry (mdpi.com)

Yao, J., Pan, Y.;Yang, S., Chen, Y.; Li, Y.  Detecting fraudulent financial statements for the sustainable development of the socio-economy in China: a multi-analytic approach. Sustainability 2019, 11(6), 1579. Sustainability | Free Full-Text | Detecting Fraudulent Financial Statements for the Sustainable Development of the Socio-Economy in China: A Multi-Analytic Approach (mdpi.com).

Yu, S. J.; Rha, J. S. Research trends in accounting fraud using network analysis. Sustainability 2021, 13(10), 5579; Sustainability | Free Full-Text | Research Trends in Accounting Fraud Using Network Analysis (mdpi.com).

The paper has benefited from your insightful suggestions, and we are grateful for that. We have done our best to address your comments and hope that we have responded in a satisfactory fashion.

 

Reply to Reviewer 2 Comments

Manuscript ID sustainability-2992918

“Executives Implicated in Financial Reporting Fraud and Firms’ Investment Decisions”

 

Dear Reviewer 2,

Thank you for providing constructive suggestions. We greatly value the opportunity to revise our manuscript. We have done our best to address your suggestions, and hope that we have revised the manuscript according to your suggestion appropriately. We highlighted the revised part in green in the revised text.

Below, your original comments are in boxes, followed by our responses.

Comment 1: -       The used methodology is not clear in the abstract

Response: We thank the reviewer for having raised this issue. As you suggested, we included the used methodology in the abstract. In addition, we also addressed the use of AAERs for the first time, and its definition in the Abstract as well. Please refer to the green highlighted portion of the Abstract in the revised text. (pages 1 in the revised version).

Page 1: This study examines the impact of executives implicated in fraud on firms' investment decisions using publicly disclosed Accounting and Auditing Enforcement Releases (AAERs) of the U.S. Securities and Exchange Commission (SEC), aiming to address the underexplored aspect of rationalization within the fraud triangle. AAERs releases summarize enforcement actions subject to civil lawsuits brought by the SEC in federal court. Executives implicated in fraud often display abnormal attitudes to justify accounting irregularities, prompting an investigation into how abnormal investment decisions are used for rationalizing fraud, given their critical role in a firm's long-term sustainability. We utilize bootstrap analysis to address the non-normality of fraud firms in our sample, and to acquire multiple bootstrap samples that represent the fraud population, thereby bolstering the reliability of our statistical analysis. Analysis of AAERs spanning from 1981 to 2013 reveals that implicated executives, particularly CEOs and CFOs, tend to make abnormal investment decisions, and that collusive fraud exacerbates this behavior. Notably, such executives lean towards overinvestment, particularly in R&D expenditures, to hide or justify fraud; the duration of fraud amplifies its impact on investment decisions. By shedding light on the rationalization aspect of the fraud triangle, this research contributes valuable insights for investors, regulators, and academia emphasizing the significance of public disclosure of fraud by regulators to enhance transparency in capital markets and to alert capital market participants. Furthermore, this study underscores the importance of ethics-focused education in accounting to prevent corporate fraud.

Comment 2: -   The use of AAERs for the first time in the abstract should be defined.

Response: We thank you for having raised this issue. Please refer to our response in Comment 1.

Comment 3:  -    The motivation for conducting this study, and why it is important to focus on the US context is not clear in the introduction section.

Response: Thank you for providing insightful and constructive comments. We agree that the first paragraph in 1. Introduction needs to clearly elaborate the motivation of conducting this study and the importance of using the US context to examine the research question. Therefore, as you suggested, we revised the paragraph as follows. Please refer to the paragraph highlighted in green in the revised text as well.

Page 1-2: The financial reporting fraud (hereafter fraud) triangle consists of three elements that underlie a fraudster’s decision to commit fraud: opportunities, incentives, and rationalization [1-3]. Rationalization is an internal process within firms, and mainly observable at the individual level analysis. Due to the constraints of generalizable empirical data, research on rationalization in fraud has been limited. Executives implicated in fraud may display aberrant attitudes to justify obscure accounting irregularities and hide them from investors, regulators, external auditors, and other stakeholders [4]. In this study, we pay attention to the rationalization of executives who are implicated in (or collude in) fraud and examine how their internal decision-making based on rationalization leads them to make abnormal investment decisions.

Studies investigating fraud cases where executives are implicated in (or collude in) fraud have been limited, mainly due to the challenges of identifying executive involvement in fraud. In this regard, publicly disclosed AAERs of the SEC in the U.S. provide an optimal institutional context to examine the impact of executives who are implicated in (or collude in) fraud on firms’ investment decisions. A fraud analysis allows representation of fraud firms free from hidden bias. AAERs clearly identify fraud firms, names and roles of specific management team members, and what charges were laid against them, which is the core of identification methodology utilized in this study. However, the small sample size resulting from use of AAERs increases the probability of Type II errors, reducing the power of empirical tests and decreasing the generalizability of the results [5, 6].

 

Comment 4: -    The last section (discussion and conclusion) is very thin. The discussion of the findings regarding the literature is absent. This section should clearly discusses the study findings concerning the literature.

Response: We admit that the last section (6. Discussion and Conclusion) needs to be expanded and include findings regarding the literature. Therefore, as you suggested, we reconstructed the conclusion in the revised text as follows. Please refer to the green highlighted part in the conclusion section of the revised text.

Page 23-24: This study investigates the impact of executives involved in fraud on firms' investment decisions utilizing AAERs in the U.S. While previous studies primarily examined factors related to opportunity and incentives within the fraud triangle [5,43-45], rationalization has received limited attention due to data constraints. Executives implicated in fraud often show aberrant attitudes to rationalize accounting irregularities. This study fills the gap by exploring how executives use abnormal investment decisions as a means of rationalizing fraud in light of the critical role of investment decisions in a firm's long-term sustainability. Analysis of AAERs from 1981 to 2013 reveals that executives implicated in fraud cases tend to make abnormal investment decisions, particularly CEOs and CFOs. Collusive fraud among executives exacerbates abnormal investment decision-making. The results also indicate that such executives generally tend to overinvest rather than underinvest, particularly in R&D expenditures, to conceal or rationalize fraud. The duration of fraud further amplifies the impact of implicated executives on abnormal investment.

In details, the first analysis shows that when executives are implicated in fraud cases, it results in abnormal investment decisions. Analyzing Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other executives separately, we find that abnormal investment decisions are more prevalent when the CEO or CFO is implicated. The findings indicate that executives implicated in fraud cases are more likely to rationalize their misconduct through over- or underinvestment than those unnamed in fraud cases. We speculate that named executives might perceive that they can compensate for distorted financial information through inappropriate investments. Moreover, to mask their own misdeeds, they may strategically choose to overinvest or underinvest [4].

The second analysis presents evidence that collusive fraud among executives leads to abnormal investment decisions. Analysis according to executive roles indicates that CEO or CFO involvement in collusive fraud intensifies abnormal investment decision-making. Conversely, collusion among other executives than the CEO or CFO has no incremental impact on investment decisions. Li [7] documented that the interconnectedness among top management team members fosters ‘groupthink’, consequently elevating the risk of accounting fraud. Building on Li's findings [7], this study offers additional evidence that groupthink involving high-level C-suite positions in collusive fraud detrimentally influences investment decision-making.

Further analysis disaggregates investment by level (overinvestment, underinvestment) and finds that executives involved in fraud generally overinvest rather than underinvest. However, if CEOs or CFOs are implicated or colluding in fraud, they tend to underinvest by not investing in profitable projects. In the next analysis, we disaggregate investment by type (capital expenditures, R&D expenditures, and acquisition expenditures); the results are qualitatively similar to the main results. This shows the robustness of our findings. Among the three investment types, all implicated executives in our sample invested in R&D inefficiently to hide or rationalize fraud. Inefficient investment of the other two investment types (capital expenditure and acquisition expenditures) occurred only when the CEO or CFO was involved. This indirectly suggests that R&D is an easier channel through which to disguise fraud than other investment types. Additionally, our results reveal that the duration of fraud influences the impact of implicated and colluded executives on abnormal investment, with longer durations showing increased impact.

By shedding light on the rationalization element of the fraud triangle and offering insights into the detrimental impact of fraud on investment decisions, this research can help investors, regulators, and academics. This study extends prior fraud research, which used novel methodologies such as network analysis or text analysis in international contexts [46-48], by utilizing bootstrap analysis to increase statistical reliability in identified fraud samples and to magnify the fraud rationalization behaviors of executives (particularly, CEOs and CFOs) in relation to abnormal investment decisions in the U.S. market. Investors may be able to evaluate a firm's sustainability by analyzing the detailed fraud information available in AAERs, in which information about fraud cases is continuously updated. Furthermore, this study underscores the importance and urgency of public disclosure of fraud by regulators to alert capital market participants. Lastly, academics interested in ethics-focused education in accounting departments will find this study useful. When students recognize how abnormal investment decisions can be made at the expense of curtailed growth or innovation due to fraud, increased awareness of ethical decision-making will be a preventive control over corporate fraud.

We are grateful to you for providing constructive suggestions. We have done our best to address your comments and hope that we have responded in a satisfactory fashion.

 The revised paper is attached as a file. 

 

 

Author Response File: Author Response.pdf