Authors: Dimitrios Ntounis, Orestes Vlismas

Title: Exploring the predictive ability of asymmetric cost behavior on AAERs

Abstract

The current study examines the ability of cost asymmetry to predict cases of financial reporting misconduct. We argue that cost stickiness signifies the presence of various factors that may increase the likelihood a firm to commit financial reporting misconduct, such as increased managerial empire building behavior and managerial expectations for future performance. Using a sample of 41,061 firm-years observations over the period 1990-2020 and integrate them with instances of fraud disclosed in Securities and Exchange Commission (SEC) Accounting, Auditing and Enforcement Releases (AAERs), we provide evidence that the level of cost asymmetry contributes to the increased likelihood of financial reporting misconduct across different prediction periods. Additional analysis tests corroborate the important role of the primary drivers of cost asymmetry on the positive relation between cost asymmetry and the likelihood of firms receiving an AAER. Our empirical findings are robust against: (i) alternative measures of cost asymmetry, (ii) the effect of financial difficulties on the intensity of cost asymmetry and (iii) endogeneity concerns. Ultimately, the current study highlights an economically meaningful yet previously undocumented way in which managerial allocation decisions on the cost behavior may signal increased fraud risk.