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Accounting Conservatism in Fraud Firms: An Empirical Investigation*

Keith Jones Assistant Professor George Mason University kjonesm@gmu.edu

Gopal Krishnan Professor Lehigh University gkrishn1@gmu.edu

Mikhail Pevzner** Assistant Professor George Mason University mpevzner@gmu.edu

Partha Sengupta Associate Professor George Mason University psengupt@gmu.edu

We examine whether Ball and Shivakumar (2006) and Basu (1997) models of conservatism identify fraud firms as anti-conservative. We show that both models do so to some extent, but Ball and Shivakumar model results are stronger. We further show that these results are driven by firms committing largest frauds as a percentage of firms’ assets. Our results are important to academics who use conservatism measures in their studies, and to policy makers who seek to assess usefulness of conservatism to capital markets.

**Corresponding Author, 4400 University Drive, MS5F4, Fairfax, VA 22030

Accounting Conservatism in Fraud Firms: An Empirical Investigation*

We examine whether Ball and Shivakumar (2006) and Basu (1997) models of conservatism identify fraud firms as anti-conservative. We show that both models do so to some extent, but Ball and Shivakumar model results are stronger. We further show that these results are driven by firms committing largest frauds as a percentage of firms’ assets. Our results are important to academics who use conservatism measures in their studies, and to policy makers who seek to assess usefulness of conservatism to capital markets.

Key Words: Conservatism, Basu Model, Ball and Shivakumar Model, Fraud

Data Availability: All data employed in this study are commercially available from sources described in the text.

1. Introduction In this study, we examine whether 1) two popular conditional conservatism models, namely the Basu (1997) and the Ball and Shivakumar (2006) models correctly identify a lack of conservatism among firms known to have committed financial statement fraud, and 2) whether these models indicate changes in fraud firms’ conservatism policies in the years following the discovery of the fraud. These research questions are important for several reasons. First, the debate on whether accounting conservatism is important is still very much ongoing (Watts (2003)). In light of FASB’s continued orientation towards further expansion of the role of fair value, potentially at the expense of reducing levels of firms’ accounting conservatism, it is important to once again identify whether the stock market participants view conservatism as an important aspect of financial statement quality. Our paper addresses this concern by investigating whether fraud firms change their conservatism policies, in the years following the fraud’s discovery. Second, within academic literature, we have seen a lively debate on how to measure accounting conservatism correctly. Here the debate centers primarily on whether the Basu (1997) model (hereafter the Basu model) indeed measures firms’ conservatism. Opponents of the Basu model argue that it is econometrically biased and is also unstable in time-series estimations (e.g. Givoly et al., 2007, and Deitrich et al, 2007). Proponents of the Basu model argue that the Basu model has a good economic motivation and exhibits theoretically expected properties, such as a positive correlation with market-to-book ratio over longer time horizons (e.g. Roychowdhury and Watts, 2007, and, Ball and Kothari, 2008). We contribute to this debate by examining whether the Basu model and its recent counterpart, Ball and Shivakumar (2006) model (hereafter the Ball and Shivakumar model), correctly identify a lack of conservatism among fraud firms in years when

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the fraud was committed. Firms that commit fraud are by definition taking actions to boost earnings and assets aggressively and therefore we would expect these firms to be less conservative over the fraud period. A good model of conservatism should...
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