Signaling via earnings downgrades: How reputational concerns shape analyst responses to corporate fraud?

• Date: 01 July 2020
• Published date: 01 July 2020
• DOI: http://doi.org/10.1111/corg.12322

ORIGINAL ARTICLE

Signaling via earnings downgrades: How reputational concerns

shape analyst responses to corporate fraud?

Lerong He

1

| Martin J. Conyon

2

| Jing Chen

3

1

School of Business and Management, State

University of New York at Brockport,

Brockport, New York, USA

2

Bentley University, Waltham, Massachusetts,

USA

3

School of Management, Fudan University,

Shanghai, China

Correspondence

Dr. Lerong He, School of Business and

Management, State University of New York at

Brockport, Brockport, NY 14420, USA.

Email: lhe@brockport.edu

Funding information

National Natural Science Foundation of China,

Grant/Award Numbers: 71673048, 71872048

Abstract

Research Question/Issue: This study examines reactions of financial analysts to the

disclosure of corporate fraud. We posit that analysts downgrade earnings forecasts

of fraudulent firms after fraud disclosure to signal their quality and integrity. We

explore how internal and external contingencies shape analysts' reputational con-

cerns, influence their motivation to signal via earnings downgrades, and consequently

affect their responses to corporate fraud.

Research Findings/Insights: Using longitudinal data on Chinese publicly traded firms

between 2002 and 2013 and employing a difference-in-differences design, this study

documents that financial analysts significantly lower their earnings estimates of

fraudulent firms after fraud disclosure compared with the control group of non-

fraudulent firms. In addition, post-disclosure earnings downgrades are larger for more

experienced analysts, for analysts following firms with stronger analyst coverage, and

after the revision of the professional ethics code for analysts.

Theoretical/Academic Implications: This study provides empirical support to signal-

ing theory. We show that earnings downgrades of fraudulent firms may serve as a

signal for financial analysts to indicate their quality and integrity. We document that

analysts' motivation to signal via earnings downgrades is influenced by their reputa-

tional concerns, which are moderated by their career experience, peer pressure, pro-

fessional norm, and social expectations.

Practitioner/Policy Implications: This study offers insights to policy makers on how a

professional labor market and codes of ethics could serve as disciplinary mechanisms

to strengthen the external governance role of financial analysts.

KEYWORDS

China, corporate fraud, financial analyst, reputation, signaling

1|INTRODUCTION

Corporate fraud, defined succinctly by Zahra et al. (2005, p. 804) as

the “deliberate actions taken by management at any level to deceive,

con, swindle, or cheat investors or other key stakeholders,”under-

mines trust of stakeholders on corporate managers, weakens investor

confidence on the integrity of the capital market, and causes

significant financial loss for firms and the global economy. Examining

causes, processes, and consequences of corporate fraud thus has

attracted considerable attention from scholars in corporate

governance, corporate finance, accounting, management, and

other related fields (Cumming, Dannhauser, & Johan, 2015; Greve,

Palmer, & Pozner, 2010; Trompeter, Carpenter, Desai, Jones, &

Riley, 2013, 2014). As an infamous event, corporate fraud creates a

Received: 21 February 2019 Revised: 4 April 2020 Accepted: 6 April 2020

DOI: 10.1111/corg.12322

240 © 2020 John Wiley & Sons Ltd Corp Govern Int Rev. 2020;28:240–263.wileyonlinelibrary.com/journal/corg

stain that not only impairs trustworthiness of the fraudulent firm but

also spreads to individuals and other organizations associated with

the focal firm, whose reputations are also discounted, discredited, or

tainted owing to their relationships with the fraudulent firm, so called

stigma by association (Devers, Dewett, Mishina, & Belsito, 2009; Sut-

ton & Callahan, 1987). Therefore, an important stream of corporate

fraud literature is to examine actions taken by fraudulent firms and

related parties to repair their tarnished reputations after the exposure

of corporate misconduct. For example, fraudulent firms have been

found to replace CEOs and CFOs, lower executive compensation,

experience more board member and auditor turnovers, and implement

more stringent internal control mechanisms in the aftermath of

wrongdoing (e.g., Agrawal & Cooper, 2016; Agrawal, Jaffe, &

Karpoff, 1999; Conyon & He, 2016; Gangloff, Connelly, &

Shook, 2016; Gomulya & Boeker, 2016).

Following this line of study, our paper investigates responses of

financial analysts to the disclosure of corporate fraud. Because the

revelation of corporate fraud influences perceptions of investors on

quality and integrity of financial analysts as a valuable and trustworthy

market intermediary, financial analysts may react to fraud disclosure

by lowering earnings estimates of these fraudulent firms to signal

their professional competency and objectivity. We posit that earnings

downgrades convey observable, credible, and verifiable information to

signal quality and intent of analysts (Spence, 2002). We further theo-

rize that analysts' motivation to signal via earnings downgrades is

influenced by their reputational concerns. The greater the reputational

concerns, the more likely analysts will downgrade earnings of their

covered firms after fraud disclosure. Analysts' earnings downgrade

thus produces a separating mechanism to distinguish high-quality ana-

lysts and those intent to remain impartial from low-quality and less

willing ones.

We then integrate arguments of signaling theory (Spence, 2002)

with reputational research (Boivie, Graffin, & Gentry, 2016; Kreps &

Wilson, 1982) to examine how internal and external contingencies

affect analysts' reputational concerns and consequently influence

their incentives to signal via earnings downgrades. Professional repu-

tation has long been recognized as an effective disciplinary mecha-

nism in the labor market (Fama, 1980). Because a damaged reputation

causes long-term losses of career prospects and economic benefits,

business professionals may refrain from engaging in opportunistic

behaviors that generate short-term gains (Kreps & Wilson, 1982). Per-

tinent to the financial analyst profession, prior literature indicates that

analysts' reputational concerns motivate them to provide higher qual-

ity and less optimistic earnings forecasts, thus mitigate conflicts of

interest arising from their employers' investment banking businesses

and trade commissions (Bradley, Clarke, & Cooney, 2012; Fang &

Yasuda, 2009; Hong & Kubik, 2003; Jackson, 2005). Reputational

effects are only sustainable to the extent that individuals care about

them and are willing to maintain them, thus they vary by individuals

and are also subject to the influence of peer and social expectations

(Harrison, Boivie, Sharp, & Gentry, 2018). We thus expect that the

disciplinary power of reputations differs between analysts and varies

with institutional conditions that analysts are facing. By incorporating

variations in analysts' reputational concerns in the empirical design,

our study augments reputational research and signaling theory to

explain why and explore how analysts may respond to threats to their

professional reputations induced by the disclosure of corporate fraud.

We also identify internal and external contingences affecting analysts'

reputational stakes and motivation to signal. Therefore, our study

answers the call of Connelly, Certo, Iremand, and Reutzel (2011) to

investigate the influence of signaler heterogeneity on their signaling

intent, an understudied feature that broadens applications of signaling

theory.

Different from prior literature examining analysts' external moni-

toring role to deter or expose corporate fraud ex ante (e.g., Chen,

Cumming, Hou, & Lee, 2016; Dyck, Morse, & Zingales, 2010; Yu,

2008), this study focuses on analysts' ex post responses to the disclo-

sure of corporate fraud. Although a few papers have studied how firm

characteristics and fraud types affect analyst responses to fraud dis-

closure (e.g., Griffin, 2003; Palmrose, Richardson, & Scholz, 2004;

Young & Peng, 2013), they have largely neglected variations in analyst

characteristics and have yet to explore the influence of reputational

concerns on analyst behavior. In contrast, we switch the research foci

from examining firm and fraud characteristics to recognizing analyst

heterogeneity and investigating how analyst characteristics, peer, and

social expectations may affect analysts' motive to preserve profes-

sional reputations and shape their responses to corporate fraud dis-

closure. Applying this novel research angle, our study provides

additional empirical evidence on the disciplinary role of reputations in

alleviating financial analysts' opportunism and enhancing their

accountability in safeguarding shareholder interest. It thus contributes

to corporate governance and fraud literature by revealing conditions

strengthening the effectiveness of financial analysts as a “socially pro-

ductive”external corporate governance mechanism in reducing

agency costs and constraining corporate fraud (Jensen &

Meckling, 1976).

2|INSTITUTIONAL CONTEXT

Our study is positioned in China. Because of the relative infancy of

Chinese capital markets and difficulties in implementing binding legal

structures over a short period, investor protection is rather weak in

comparison with more mature markets such as the United States. As a

result, corporate fraud is widespread among Chinese listed firms

(Conyon & He, 2016; Ding, Jia, Li, & Wu, 2010). The China Securities

Regulatory Commission (CSRC) is the major enforcement institution

for detecting and sanctioning corporate fraud in listed Chinese firms.

CSRC discovers fraud by conducting regular reviews and random

inspections as well as responding to alleged fraud complaints raised

by whistleblowers (Chen et al., 2016). The CSRC's enforcement

actions range from official warning, fines, return of illegally raised pro-

ceeds, confiscation of illegal income, to termination of securities trad-

ing qualifications (Jia, Ding, Li, & Wu, 2009). Apart from CSRC, stock

exchanges also issue warnings and condemnations on corporate fraud,

although typically on minor and less severe violations. Owing to

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