ABSTRACT This paper examines the Hennes indicator to determine the effectiveness of the indicator in separating financial reporting fraud from errors in.

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ABSTRACT This paper examines the Hennes indicator to determine the effectiveness of the indicator in separating financial reporting fraud from errors in a group of 598 restatement observations. The paper extends the Hennes et al study by increasing the validation period and using a more robust analysis. The study provides alternative indicators to the Hennes indicator.

BACKGROUND The Hennes indicator (Hennes, Leone, & Miller, 2008) was developed based on the assumptions that firms and regulators would respond to financial reporting fraud. Recent studies contradict this assumption- Financial reporting fraud involves high level executives (COSO 2010) Management turnover following fraud is not a given (Collins et al. 2008) CEO has influence in board decisions (Paredes 2004; Ramirez 2004) Disclosure affects stock price (value) (Feroz et al. 1991; Palmrose et al. 2004; Hribar and Jenkins 2004)

PURPOSE OF STUDY To evaluate the effectiveness of the indicator using two measures of fraud evidence-class action lawsuits and AAER filings. To determine if there are characteristics from firms that do not respond that may be helpful in developing better indicators. To develop indicators that properly classify more restatement observations with higher explained variance.

DIFFERENT APPROACHS THIS STUDY Analysis based on Type I and Type II errors. Validation period much longer (4 years). Two measures of fraud evidence (class action and AAER filings). HENNES et al Logistic regressions Short validation period. Class action lawsuits.

RESULTS Classification Outcomes: FraudNo FraudTotal Hennes Predictions: Fraud % 71.09% % 15.22% % 28.09% No Fraud % 28.99% % 84.78% % 71.91% % % % % % Frequency Tables of Outcome Measures With Calculated Hennes Indicator Values Using the class action lawsuit measure, approximately 29% of frauds are missed. The overall accuracy of the indicator is 82%. These results are similar using AAER filings: 41% frauds missed and 80% correct.

Research Questions Answered Research Question : Are frauds missed due to failure of firms to respond? Response: Yes. Only 20% of frauds are disclosed by firms. Research Question: Can the indicator be improved by finding characteristics associated with failure to disclose (such as accruals or financial distress)? (H3) Response: The indicator can be improved using accrual measures but not by using measures of financial distress.

Comparison of Indicators Fraud Evidence Measures Indicators: Using AAER filings:Using Class Action Lawsuits: Explained Variance (R 2 ) Percentage Correctly Identified Explained Variance (R 2 ) Percentage Correctly Identified Hennes (Hennes et al. 2008) n/a 80%.34 82% Files (Files et al. 2009)Not given.33 90% Accrual model (this study).51 86%.40 79% Market model (this study).41 85%.37 77% The NEW indicators either outperform (or perform similarly to) the Hennes (or Files model) indicator dependent on the evidence of fraud, AAER (class action lawsuits). This study suggests the proper measure of fraud evidence should be AAERs due to the self-selecting nature of class action lawsuits.

STUDY CONTRIBUTIONS Development of indicators that either perform as well (or performs better than) existing indicators in separating frauds from errors in a group of restatements. Determination that indicators should not be used to develop fraud samples unless specificity (ability to properly recognize frauds) can be assured. Providing supporting evidence of firms failure to disclose following financial reporting fraud. Providing evidence of the shortcomings of fraud evidence measures, including documentation of the self-selecting nature of class action lawsuits.

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