Investor Reaction to Disclosures of Employee Fraud
James M. Lukawitz, Paul John Steinbart · Journal of managerial issues · 1995
Employee fraud is a serious problem for American businesses. Estimates of annual losses due to employee theft and embezzlement across all industries exceed $100 billion (Lary, 1989; Wells, 1994). It has been argued that disclosure and subsequent prosecution of all cases of discovered fraud might serve as a deterrent (Albrecht et al., 1994; Dycus, 1991; Richards and Knotts, 1989; but for an opposing view see Wells, 1990). Management has been criticized, however, for not adequately responding to discovered cases of employee fraud (Dycus, 1991). For example, studies (O'Donoghue, 1987; Richards and Knotts, 1989; Straub and Nance, 1990) have found that less than one-half of the discovered cases of computer-related frauds are ever reported to the authorities. Indeed, it is estimated that less than 20% of all discovered frauds are ever reported (Cushing and Romney, 1993). A common rationale for management's failure to report discovered cases of fraud is fear of adverse publicity (Richards and Knotts, 1989; Gerlin, 1995). The objective of this paper is to test the validity of that belief. To do so, the reactions of one important segment of the public, investors, are examined. Focusing on investor reactions provides a powerful test of whether any embarrassment or reputational damage to the company arising from disclosure of employee fraud has economic consequences. If disclosure of employee frauds is indeed bad news, such disclosures should be associated with a negative stock price reaction. The lack of negative market reaction to disclosures of employee frauds would indicate that investors did not perceive any significant long-term financial repercussions arising from the incident. BACKGROUND AND HYPOTHESES The word fraud encompasses many types of acts; hence, it is important to carefully define how it is used in this study. The authoritative auditing literature distinguishes two types of irregularities: management fraud and employee frauds (AICPA, 1988). Management fraud refers to such things as fraudulent financial reporting that results in misleading financial statements. The term employee frauds refers to the misappropriation of assets, thus including such acts as theft and embezzlement. This study focuses on the effect of disclosing discovered cases of frauds committed by employees. A recent study by Karpoff and Lott (1993) examined investors' reactions to disclosures of management fraud. They found that the stock market did react negatively to disclosures of management fraud, including such acts as defrauding the government, consumers, and other stakeholders. Karpoff and Lott did not, however, include incidences of fraud by employees in their sample. Therefore, this study extends their research by examining the stock market's reaction to disclosures of employee fraud. Although Karpoff and Lott found that investors reacted negatively to disclosures of management fraud, there are several reasons to question whether investors react similarly to disclosures of employee fraud. First, the authoritative auditing literature (AICPA, 1988) states that employee frauds are often immaterial in amount. This means that the amounts are too small to seriously affect the company's financial position. Consequently, investors may not react to such disclosures. Second, the disclosure itself indicates that the fraud has been detected and stopped. Therefore, there may be no effect on the company's future performance. Stock prices reflect investors' perceptions of future events; therefore, investors may not react negatively to news of employee fraud that has been detected and stopped. Third, it has been argued that companies publicly disclose cases of employee fraud only when they feel they can recover most or all of the loss (Pae, 1989). If that argument is correct, then any stigma attached to the fraud may be offset by the public's expectation that the loss will be recovered. On the other hand, the concept of materiality can also be used to support the possibility that there will be a negative stock price reaction to disclosures of employee frauds. …