Tone at the top's role in the detection and prevention of financial statement manipulation in South africa.

Abstract

Corporate frauds destroy wealth, undermining investor confidence. Given the severity of corporate fraud, regulators have enhanced monitoring mechanisms designed to prevent and detect financial statement manipulation. Despite these efforts, financial statement manipulation continues to occur, and academic research has found mixed results regarding the effectiveness of interventions. An identified reason is that a company’s overall culture, as set by the tone at the top, may undermine the effectiveness of monitoring mechanisms. Consequently, this study investigated the role of tone at the top in detecting and preventing financial statement manipulation. The study adopted a quantitative methodology, analysing data from non-financial firms on the JSE, to estimate how tone at the top moderates the effectiveness of three fundamental monitoring mechanisms: the audit committee, the external auditor and the market reaction. The study’s first paper found that commonly used financial statement manipulation detection models (the Beneish M-score and Dechow et al. F-score) are unsuitable in South Africa. Consequently, the study used two measures to proxy for financial statement manipulation: financial statement fraud and accruals-based earnings management. Tone at the top was measured by analysing CEO statements in the annual report using the DICTION software’s five master variables. Principal component analysis was used to reduce these five themes into two primary tones: autocratic and pragmatic. Principal component analysis was also used to develop five audit committee (activity, diversity, financial expertise, governance expertise and independence) and two external auditor proxies (competence and independence). The market reaction was measured using cumulative abnormal returns. The relationships between these variables were estimated using panel data regression methods. Overall, the study found that tone at the top is not directly related to financial statement manipulation. Considering tone at the top’s moderating effect, the findings suggested that an autocratic tone undermines the effectiveness of audit committees’ activity and diversity. However, the autocratic tone can enhance the committees’ financial expertise and independence, the external auditors’ competence, and result in a more negative market reaction to financial statement manipulation. In contrast, the pragmatic tone can inhibit the audit committees’ financial expertise, but enhance its activity and diversity. The pragmatic tone does not impact the external auditor or the market reaction. These findings would interest regulators, investors, audit committee members, external auditors and market analysts as they show the importance of understanding how tone at the top either undermines or supports these monitoring mechanisms. Consequently, careful attention must be paid to the individuals appointed to key monitoring positions to ensure they will be effective rather than ceremonial.