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Are positive reactions to bad news plausible? the consideration of fraud detection in audit and reporting delays

Yim, Andrew (2011): Are positive reactions to bad news plausible? the consideration of fraud detection in audit and reporting delays.

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Abstract

I formulate a model to emphasize the fraud detection role of auditors in the financial market and relate the role to audit and financial reporting delays. The model focuses on asset misappropriation fraud, which is one of the two types of fraud US and international auditing standards require auditors to consider. In the model, an auditor considers whether to perform extended audit procedures after observing a red flag generated from regular audit procedures. An audit delay is represented by the event of extending audit procedures and manifested as a financial reporting delay observed by the market. I derive a simple closed-form condition characterizing when a positive market reaction to a delay is possible. The condition provides a theoretical basis for formulating empirically testable hypotheses. I discuss why the fundamental logic behind the counter-intuitive positive-reaction condition also applies to accounting fraud, as well as other contexts (e.g., internal control weakness disclosure). Documented evidence in the literature suggests that “positive reactions to bad news” (PR2BN) is a general phenomenon. Other empirical implications of the model, with suggestions for regression equation specifications, are also discussed.

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