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Factors Eliciting Corporate Fraud in Emerging Markets: Case of Firms Subject to Enforcement Actions in Malaysia

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Abstract

This study investigates the key factors that elicit financial reporting fraud among companies in Malaysia. Using enforcement action releases issued by the Security Commission of Malaysia (SC) and Bursa Malaysia, we identify a sample of 76 firms that had committed financial reporting fraud during the period of 1996–2016. We use the fraud triangle framework and the Malaysian International Standards on Auditing 240 to identify the factors. Since the simple probit model fails to address the identification problem (partial observability), we estimate our results using a bivariate probit model. The new model estimates the effects of pressure, opportunity, and rationalization on the probability of fraud likelihood by disentangling the detection probability of fraud. Among several proxies used for pressure, our results suggest that aggressive tax reporting and financial difficulties increase the likelihood of fraud commission. In regard to opportunity, we find that dedicated institutional investors, independence of the board, effective audit committee, and the presence of a female on the board provide active monitoring and oversight in reducing fraud occurrence. Results for rationalization suggest that prior violations and frequent changes of external auditors increase the chances of fraud occurrence. This research offers possible insights to auditors, managers, and regulators to prevent, detect, and react to fraud. Specifically, it highlights the specific factors that may exacerbate the fraudulent intentions of firms.

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Notes

  1. Post-Asian Financial Crisis, the Malaysian government introduced key corporate governance reforms which include, Capital Market Master Plan (CMMP), initiation of the Malaysian Code of Corporate Governance, demutualization of Bursa Malaysia, the Malaysian Institute of Corporate Governance and the Minority Shareholders Watchdog Group, and changes in the composition and role of Boards of Directors. Related measures covered the disclosure rules, strengthening of whistleblowing and restructuring of the government linked corporations (GLCs) in 2005 (World Bank, 2005).

  2. Please refer to https://assets.kpmg.com/content/dam/kpmg/pdf/2016/03/fraud-survey-report.pdf for the detailed discussion of situation of fraud in Malaysia.

  3. Ernst & Young Fraud Investigation and Dispute Services Asia–Pacific 2013 reports that reported fraud cases in Malaysia are double the Asia pacific average of 27%.

  4. Studies on risk assessment of financial reporting fraud have mainly focused on examining risk red flags (Pincus 1989; Wang 2010; Zimbelman 1997; Nieschwietz et al. 2000; Hegazy and Kassem 2010). However, several related red flags involve a great level of subjective judgment and nonpublic information that is only available to insiders and auditors of the firms (Persons 1995; Hackenbrack 1993). Owusu-Ansah et al. (2002) and Hackenbrack (1993) report that fraud red flags are subjective, general and less practical. Moreover, Eining et al. (1997) document that auditors using logit model performed better than those using only checklist or risk red flags.

  5. See e.g., (Abbott et al. 2000; Beasley 1996; Beasley et al. 2000; Crutchley et al. 2007; Johnson et al. 2012).

  6. They estimate that the cost of fraud to the median fraudulent firm is 22% of enterprise value. This estimate includes both the fraud that are normally detected and those that are not. Since the average fraud lasts 1.67 years, the annual cost of fraud among large US corporations is $380 billion.

  7. According to Karpoff et al. (2008), firms subject to enforcement actions lose on an average of $381 million. They find that such firms incur $0.36 as a legal penalty and $ 2.71 as reputational penalty for every one dollar of earnings manipulated. Further, Dechow et al. (1996) report that fraudulent firms experience a decline of 9 percent in the share price, reduced analysts’ coverage and liquidity.

  8. The selected period 1996–2016 is chosen based on the availability of the reported cases in security commission of Malaysia website. The available and valid sources of information for fraud cases are security commission and Bursa Malaysia. That is why we followed maximum data availability period on these sources.

  9. Practice Note (PN4, 2001) represents the conditions, where a company fails to meets the listing requirement of Bursa Malaysia or facing financial difficulties. These companies are also called financial distressed firms.

  10. In year 2005, Practice Note 4 (PN4) was replace by PN 17 to deal with financial distressed firms.

  11. To conserve space, we do not provide correlation results in our study.

  12. Please refer Trompeter et al. (2012) for the detailed discussion on areas of future research on fraud.

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Authors and Affiliations

  1. Department of Finance and Banking, Faculty of Business and Accountancy, University of Malaya, Kuala Lumpur, Malaysia

    Abdul Ghafoor, Rozaimah Zainudin & Nurul Shahnaz Mahdzan

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  1. Abdul Ghafoor
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  2. Rozaimah Zainudin
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  3. Nurul Shahnaz Mahdzan
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Correspondence to Abdul Ghafoor.

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Appendix

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Table 7 Variable measurement
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Ghafoor, A., Zainudin, R. & Mahdzan, N.S. Factors Eliciting Corporate Fraud in Emerging Markets: Case of Firms Subject to Enforcement Actions in Malaysia. J Bus Ethics 160, 587–608 (2019). https://doi.org/10.1007/s10551-018-3877-3

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