What factors might indicate a likelihood of financial misreporting? There might be markers in companies’ financial statements, for example, with respect to reserving practices or practices with respect to other estimated items. There may be more general indicators as well, as, for example where companies reliably hit their revenue estimates due to a rush of end of reporting period sales. According to a recent academic study, attitudes in the community where businesses are located may also affect companies’ propensity for financial misreporting.
In a May 30, 2017 paper entitled “Gambling Attitudes and Financial Misreporting” (here), Dale Christensen of the University of Oregon, Keith Jones of the University of Kansas, and David Kenchington of Arizona State University, companies headquartered in areas where residents hold gambling-friendly attitudes are more likely to intentionally misreport financial information. The authors findings were summarized in an August 14, 2017 Wall Street Journal article entitled “A Roll of the Dice on Financial Misreporting” (here).
In order to measure gambling attitudes and gambling activity, the authors used state-lottery data from the U.S. census bureau and county-level religious views on gambling. Views on gambling vary by locality. For example, while New York and San Francisco are more accepting of gambling, other cities such as Seattle and Phoenix are less accepting.
To determine possible links to financial reporting, the authors analyzed data from 1994 to 2008 on public company financial disclosures where companies needed to re-release financial results and were determined to have intentionally misreported financial results.
The authors found that restatements due to intentional misreporting are more common in areas where gambling is socially acceptable. Specifically, they found that intentional financial misreporting rates were 50% higher in areas where gambling is more accepted by a majority of residents. Business leaders were more likely to misreport when close to meeting a performance benchmark, when announcing a firm’s poor financial results, when a firm was under investment-related pressure or when engaged in risky investments.
The authors analyzed their results as consistent with the proposition that some financial reporting choices involve taking deliberate, speculative risks. Their results are consistent with their hypothesis that in places where gambling is more socially acceptable, managers will be more likely to take financial reporting risks that increase the likelihood that financial statements will be restated.
Financial misreporting is rare, but prosecution for financial misrepresentation is rarer. Even if the risks involved in financial misreporting are substantial, the likelihood of facing penalties may be a matter of calculation for some business managers. Because of the risk calculation involved, the authors sought to make the comparison to gambling attitudes, as a way to measure general acceptance of calculated risk taking.
These observations may be useful for financial analysts considering the reliability of published financial reports. The observations may also be useful for D&O underwriters. Underwriters are well accustomed to segmenting public company risk in a number of ways, for example by industry. The authors’ analysis suggests that it may be possible to segment risk in other ways as well, for example by location, as a proxy for a propensity to engage in financial misreporting. Underwriters interested in selecting away from kinds of companies that are likeliest to have problems may well be able to shape their portfolio away from geographic regions that are more accepting of gambling.