Date of Completion
Youli Zou; Alina Lerman
As with individuals, corporate entities are vulnerable to committing logical fallacies in the decision-making process. One such fallacy that has been observed across multiple disciplines is the phenomenon of guilt by association, here referred to as the “association fallacy.” In this study, I demonstrate the existence of the association fallacy within historical customer-supplier relationships, during which the supplier is named in an SEC Accounting and Auditing Enforcement Release (AAER). A panel regression is employed to track indicators of customer earnings management behavior in the years before, during, and after the supplier AAER. A cross-sectional analysis is also used to assess whether customer size, measured using the logarithm of total assets, corresponds with changes in customer earnings management behavior. Results indicate that customers’ financial reporting quality improved in the year during and after a supplier AAER relative to the year before, as indicated by lower levels of discretionary accruals. Further, smaller customers have a greater likelihood of exhibiting this behavior change than larger customers. These findings demonstrate that the fraudulent behavior of one entity has a measurable effect on other non-guilty but associated entities. Furthermore, the increased capital market scrutiny faced by a non-guilty entity following the publicized misconduct of a closely affiliated entity may incentivize the reduction of behaviors that are not explicitly illegal, but that are nonetheless detrimental to transparent financial reporting. Additional studies are indicated to further validate the association fallacy as a productive mechanism in the capital markets.
Willett, Nicholas, "The Association Fallacy – Fraud and Financial Reporting Quality in the Customer-Supplier Relationship" (2021). Honors Scholar Theses. 859.