Date of submission: September 17, 2021; date of acceptance: December 13, 2021. * Contact information: chaari_hela07@yahoo.fr, GEF2A Laboratory – Universi- ty of Tunis, Tunisia, phone: +1 514 779-7365; ORCID ID: https://orcid.org/0000-0002- 5998-1398. ** Contact information: amel_bns@yahoo.fr, Department of Finance and Econom- ics, College of Business, University of Jeddah, Jeddah, Saudi Arabia; GEF2A Labora- tory – University of Tunis, Tunisia, phone: +966563397927; ORCID ID: https://orcid. org/0000-0002-5745-0243. *** Contact information (corresponding author): azhaar.lajmi@isg.rnu.tn, Department of Finance, High Institute of Management, GEF2A Laboratory – University of Tunis, Tuni- sia, phone: +216-53958536; ORCID ID: https://orcid.org/0000-0003-2726-8341. Copernican Journal of Finance & Accounting e-ISSN 2300-3065 p-ISSN 2300-12402022, volume 11, issue 1 Chaari, H.F., Belanès, A., & Lajmi, A. (2022). Fraud Risk and Audit Quality: The Case of US Pub- lic Firms. Copernican Journal of Finance & Accounting, 11(1), 29–47. http://dx.doi.org/10.12775/ CJFA.2022.002 Hela friKHa cHaari* University of Tunis aMel belanès** University of Jeddah University of Tunis azHaar lajMi*** University of Tunis fraud risK and audit quality: tHe case of us public firMs Keywords: fraud risk, bankruptcy, audit quality, financial reporting, Beneish M-score model, Z-score model. J E L Classification: G32, M42, C23. Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi30 Abstract: The study raises questions about the fraud detection technique and the rel- evance of audit quality to mitigate fraud. The paper suggests a more comprehensive proxy for fraud risk that relies on the combination of Z-score and Beneish M-score. Bas- ing on Logit, regressions are applied to a sample of 5,613 US-listed public firms. The study reveals that the existence of an internal auditor and independent members with- in the audit committee would potentially reduce the fraud risk. Hiring a Big external auditor and paying it high fees is also helpful. Findings show that, unlike the firm lever- age, both firm profitability and growth opportunities have a negative effect of on fraud risk. Leverage provides a motivation for fraudulent financial reporting. It is important to note that this research underscores the audit’s monitoring role to mitigate fraud. Also, the adopted model helps regulators, bankers, managers and auditors to detect fraud at an early stage. So needed action can be taken at suitable time. Finally, in this study, we focus on financially distressed companies rather than those with financial re- statements. We suggest a collective tool to predict fraud risk; which is expected to offer a more reliable proxy for fraud risk than do binary models.  Introduction Fraud has become a challenge within the finance and accounting profession, and almost all companies and agencies are subject to fraud risks. Some renown companies are nowadays associated with fraud. Providing inaccurate and mis- leading financial information from those renowned companies has triggered an enduring crisis of confidence. These scandals have seriously impaired au- dit credibility and raised several questions about corporate governance quality and relevance of audit quality in fraud prevention and detection. New legislative reform known as the Sarbanes-Oxley Act (SOX) established new transparency standards for public companies. Besides, several anti-fraud measures and anti-false claims laws have been enacted worldwide, namely in the US, allowing public prosecutors to recover damages for fraud and false claims. Thanks to these measures, the number of frauds has decreased after 2002. Companies were also asked to set up a healthy system for control and au- dit to reduce the fraud occurrence, although the system’s weakness does not mean that the fraud could happen (Sanusi & Mohamed, 2015). According to the Financial Security Law, strengthening the governance mechanisms can help prevent fraudulent and manipulative practices; and reduce fraud. Based on the accounting literature, some studies recommend internal audit, audit commit- tee, and external audit as crucial pillars to better cope with frauds (Bajra & Ca- dez, 2018). However, the association between audit quality and financial state- ment fraud has been inconsistent in the extant literature. frAud risk And Audit QuAlity: the cAse of us Public firms 31 Therefore, “it is the management’s responsibility to design and implement programs and controls to prevent, deter and detect fraud” (AICPA, 2002). Man- agers must perform a detailed fraud assessment and identify its causes, although the process would be complicated and costly. Too little research has focused on the the usefulness of fraud detection techniques (Beneish, Lee & Nichols, 2012; Roshayani, Sharinah & Normahet, 2015). According to the fraud triangle theo- ry, there are three main elements of the fraud occurrence, the presence of pres- sure, opportunity and rationalization (Ozcelik, 2020). But risk of fraud is most attributed to the first factor, pressure or incentives. Past studies argue that fi- nancially distressed tend to manipulate their financial statements (Beneish et al., 2012; Roshayani et al., 2015). Particularly, failed firms which are financial- ly distressed tend to manipulate their financial statements and are more like- ly to be involved in fraudulent financial reporting (Altman, 1968; Roshayani et al., 2015). Consistent with these arguments, it is possible to detect fraud at an early stage and mitigate it at its inception by using some prediction tools such as Beneish model and Z-score model. The Altman’s Z-score model was accurate in predicting business failure and fraudulent financial reporting as well as the relationship between them (Roshayani et al., 2015). This model is believed to be the most thoroughly tested and broadly accepted distress prediction mod- el in the literature. The Beneish’s M-score had correctly revealed some of the most famous fraud cases that occurred later in a subsequent period (Beneish et al., 2012). In line with these arguments, this study argues that the combina- tion of the Z-score model and the Beneish M-score might enhance the predic- tion of fraud risk (Roshayani et al., 2015). Overall, according to the audit risk model, audit risk is a function of inherent risk, control risk and detection risk. Such a combination of scores would provide a more reliable proxy for fraud oc- currence than do previous binary models. This study has two main objectives. The first objective is to verify whether a collective prediction tool can be used to predict fraud risk. The second objec- tive is to examine the audit’s monitoring role through its three pillars, the audit committee, the internal audit and the external audit, while most previous re- search focused on them separately. The remainder of the paper is structured as follows. Section 2 reviews the related theoretical framework and develops the research hypotheses. Section 3 describes the research design and data. Section 4 reports and discusses the research findings, and section 5 concludes and suggests future research per- spectives. Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi32 Theoretical framework and research hypotheses We focus on three critical pillars of audit quality: internal audit, audit commit- tee, and external audit. Internal audit Several researchers highlight the relevant role of internal audits in prevent- ing fraud (Chen, Cumming, Hou & Lee, 2013). Companies with an internal au- dit are more likely to detect fraud. The latter can independently evaluate fraud risks and anti-fraud measures to implement by the executive board (Petrascu & Tieanu, 2014). Also, the results of Zeng, Yang and Shi (2020) reveal that in- ternal audit is significantly negatively correlated with the occurrence of cor- porate fraud. However, the internal auditor still needs to use its professional judgment and practical experience in assessing the likelihood of fraud (Sanusi & Mohamed, 2015). Given the above developments, we can formulate our first assumption as follows: H1: The existence of an internal audit is expected to reduce fraud risk. Audit committee The audit committee effectiveness can be assessed through multiple parame- ters (Neffati, Khiari & Lajmi, 2021), mainly independence and financial exper- tise of audit committee members (Lajmi & Gana, 2013; Lajmi & Yab, 2021). Independence of committee members Committees, most of whose members are independent, are argued to improve the quality and the transparency of financial reporting and hence to increase the credibility of disclosed financial information (Poretti, Schatt & Bruynseels, 2018). The quality of financial reporting is particularly relevant only in com- panies with audit committees with at least three members, most of whom are independent (Bajra & Cadez, 2018). Regarding frauds, some empirical studies show a negative and significant association between audit committee effective- ness and fraud occurrence (Chen et al., 2013). Improving audit quality through the audit committee might contribute to decreasing manipulative or fraudulent frAud risk And Audit QuAlity: the cAse of us Public firms 33 practices. In light of these developments, we suggest checking the second hy- pothesis below: H2: The existence of an audit committee, the majority of whose members are independent, is expected to decrease fraud. Expertise of committee members The existence of accounting or financial experts within committee members would help develop fair audit procedures and allow a thorough analysis. Be- sides, it helps reduce earnings management and thus the probability of fraud (Zalata, Tauringana & Tingbani, 2018). By the way, a positive relationship be- tween audit committee financial expertise and earnings quality is expected (Bilal, Chen & Komal, 2018). Besides, financial experts are more likely to de- tect any financial misstatements as they need to comply with their professional codes of ethics to preserve their reputation (Zalata et al., 2018). Consequently, including within the committee, core competences and skilled-experts would potentially help quite fair earnings management and limit fraudulent account- ing practices (Bajra & Cadez, 2018; Zalata et al., 2018). Grounded on the above developments, we state the following hypothesis as follows: H3: Audit committee members’ expertise is expected to contribute to fraud detection and would hence limit fraudulent practices. External audit Following the International Standards on Auditing, an external auditor is re- sponsible to ensure that financial statements mostly do not include any in- accuracies, due to either error or fraud. Therefore, external auditors have a significant role in providing reliable financial reporting. It follows that the existence of external auditors would hinder companies from engaging in fraudulent practices. Auditor’s relevance Big auditors are expected to provide better audit quality. This is thanks to the expertise knowledge and training that often only Big auditors can afford. Such advantages put external auditors in a great position to suggest useful perspec- Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi34 tives on best practices in financial reporting and controls, including the miti- gation of fraud risks (Zager, Malis & Novak, 2016). In addition, according to the study conducted by Lajmi, Khiari and Ouertani (2021), Big Four auditors reduce the risk of fraud in companies. Some non-Big Four auditors can afford the same quality of audit like their Big Four peers, though (Jacob, Desai & Agar- walla, 2018). The potential role that Big auditors may play to provide high audit quality motivates hence our fourth hypothesis: H4: Companies that are audited by Big auditors are less likely to commit fraud. Audit fees Given the agency theory, Jensen and Meckling (1976) note that shareholders support several monitoring costs including audit fees. Accordingly, external au- ditors must verify whether the company is managed in favor of the sharehold- er’s interest. Some empirical studies put in evidence the negative relationship between auditor’s fees and financial misstatements (Li & Ma, 2018), while oth- er studies report a positive association between non-audit fees and fraud risk (Mironiuc & Robu, 2012). For instance, Big auditors require relatively high fees for whom reputation represents a priority from which they will not be divert- ed (Li and Ma, 2018). Also, according to Saheed, Ajibola and Adedoyin (2021), Audit fees have a significant positive impact on audit quality. Therefore, an ad- equate level of audit fees will significantly contribute to decreasing fraud risk. These high fees can eventually reveal the thorough examination and the in- depth investigation carried out by the external auditor. It follows that audit fees are positively associated with audit quality (Bryan & Mason, 2016). Based on the above, we develop our fifth hypothesis as follows: H5: The higher external audit fees, the better audit quality, the less the fraud occurrence. Research Methodology The paper aims at analyzing the impact of audit quality on fraud risk. The fol- lowing sections present the sample, define the variables, and explain the esti- mation methodology. frAud risk And Audit QuAlity: the cAse of us Public firms 35 Sample selection The empirical study examines a sample of 5,613 publicly traded US companies for 11 years spanning from 2003 to 2013. Companies are listed on the three largest US and global stock markets, namely the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotations (NASDAQ), and the American Stock Exchange (NYSE Amex, often abbreviated as AMEX). The sample does include neither financial institution nor financial service company due to their specific regulatory requirements and accounting and reporting standards. Companies with missing or unavailable data are also excluded from the study sample. The sample companies operate in several sectors, including agriculture, forestry and fishing, construction, manufacturing, mining, retail trade, trans- portation services, communications, electricity, gas and sanitary services, and wholesale trade. The data regarding financial statements were extracted from Compustat. Measurement of variables Table 1 summarizes all the variables, whether dependent, independent, or con- trolled, and explains how they are estimated. Fraud risk (Fraud) represents the dependent variable. It is a binary variable. It takes the value one if there is a probability of fraud, and the value zero, otherwise. Fraud refers to the compa- nies’ attempt to deceive or mislead investors and creditors through misstate- ment in accounting statements (Rezaee, 2005). Based on previous literature, we contend that failed firms which are finan- cially distressed tend to manipulate their financial statements (Roshayani et al., 2015). Therefore, we suggest a collective tool based on a combination of the Altman’s Z-score (which predicts the likelihood of bankruptcy) and the Be- neish’s M-score (which predicts misstatements and earnings manipulation) to enhance the prediction of fraudulent practices. The model of Altman (1968) is considered by Iazzolino, Migliano and Gregorace (2013) as constituting the basis on which several new models were developed such as Altman (2002). In addition, Altman has developed other models from its initial model, but these have some particularities in their use which limit their relevance for our Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi36 research work. Thus, the other models have been modified to make them more efficient in certain contexts or specifically for certain types of companies. In fact, the Z-Score specifically for the private sector; Z-Score for emerging coun- tries and non-manufacturing firms and the Zeta score for SMEs (Altman, 2002). Altman’s (1968) model was originally created in a large business context. It therefore represents the one being the most appropriate in relation to our re- search. The Z-score model was developed by Altman (1968) to assess the bankrupt- cy risk. To avoid such a risk, executives may engage in aggressive accounting management practices or even fraudulent practices. Altman (1986) Z-score for- mula sets as follows: Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E (A; B; C; D and E are defined in table 1) A high score (Z-score> 2.99) ref lects the good health of the company and con- versely. The lower is the score (Z-score <1.81), the more likely the company is running the bankruptcy risk. Finally, if the Z-score is between these two limits (1.81 |r| under H0: Rho = 0 as well as the number of observations Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi42 LEV Q_Ratio ROA AUD_FEE CAU_IND AI_EXIS AUD_Big CAU_EXP AUD_Big: External Auditor’s Affiliation, AUD_FEE: Audit Fees, CAU_IND: Independence of Audit Committee, CAU_ EXP: Audit Committee Expertise, AI_EXIS: Existence of Internal Audit Service, Q _Tobin: Tobin Q, LEV: Corporate Debt, ROA: Profitability or Return on Assets. *, **, *** correspond to the statistics’ significance at the thresholds of 10%, 5%, 1%, respectively. S o u r c e : researcher’s computation. Multivariate analysis Table 5 summarizes the regression results related to the relationship between audit and fraud. The first hypothesis (H1) is confirmed, as there is a significant negative relationship between the internal audit and the fraud risk. Such a re- sult indicates that an internal audit cell within the firm would contribute to control fraudulent practices. Empirical findings highlight the key role of inter- nal audit to reduce fraud and prevent misappropriation and corruption. Such a result is in line with the findings of Gullkvist and Jokipii (2013). Table 5 also provides support to the second hypothesis (H2). This result suggests that au- dit committee members’ independence has a significant negative impact on the probability of fraud. Indeed, independence of audit committee directors allows them to control more efficiently the process of audit quality. Likewise, manag- ers are less eager to be involved in fraudulent behavior. These results converge with several previous studies that argue that the presence of audit committee, whose majority members are independent, helps reduce manipulative and non- complying practices (Rainsbury, Bradbury & Cahan, 2009). Table 5. Results of the impact of audit on fraud Variables DF Estimation Standard Error Wald Chi-deux Pr > Chi2 Constante 1 -0.2614 0.3503 0.5571 0.4554 LEV 1 1.9567 0.1209 261.9600 0.0001*** Q_Tobin 1 -0.2280 0.0266 73.6587 0.0001*** ROA 1 -0.4352 0.0859 25.6933 0.0001*** Table 4. Correlation… frAud risk And Audit QuAlity: the cAse of us Public firms 43 Variables DF Estimation Standard Error Wald Chi-deux Pr > Chi2 Constante 1 -0.2614 0.3503 0.5571 0.4554 LEV 1 1.9567 0.1209 261.9600 0.0001*** AI_EXIS 1 -0.3428 0.0647 28.0484 0.0001*** AUD_BIG 1 -0.1547 0.0671 5.3098 0.0212** AUD_FEE 1 -0.3238 0.0601 28.9807 0.0001*** CAU_EXP 1 0.0361 0.1358 0.0706 0.7905 CAU_IND 1 -0.0190 0.0908 0.0440 0.0833* Test of the null hypothesis: BETA=0 Test Chi-deux DF Pr > Chi2 Ratio of likelihood 660.0053 9 <.0001*** Fisher 702.2342 9 <.0001*** Wald 637.8153 9 <.0001*** AUD_Big: External Auditor’s Affiliation, AUD_FEE: Audit Fees, CAU_IND: Independence of Audit Committee, CAU_ EXP: Audit Committee Expertise, AI_EXIS: Existence of Internal Audit Service, Q _Tobin: Tobin Q, LEV: Corporate Debt, ROA: Profitability or Return on Assets. *, **, *** correspond to the statistics’ significance at the thresholds of 10%, 5%, 1%, respectively. S o u r c e : researcher’s computation. Table 5 does not provide support to the third hypothesis (H3). There is no sig- nificant relationship between the expertise of audit committee members and the fraud risk. In contrast, this study finds a significant negative relationship between the relevance of the external auditor and the fraud risk. It follows that the external auditor’s affiliation with an international network ref lects the audit quality and demonstrates its effectiveness in preventing and detecting fraud. Moreover, table 5 shows as well that the fifth hypothesis (H5) is con- firmed. This result suggests that there is a significant negative relationship be- tween the audit fee and the fraud occurrence. It seems that auditors with high fees are likely to meet the audit competency criterion. Therefore, they are likely to detect most accounting errors as well as significant anomalies either caused unintentionally or due to fraud, as argued by Bilal et al. (2018), among others. Table 5. Results… Hela Frikha Chaari, Amel Belanès, Azhaar Lajmi44 Finally, table 5 reports a significant positive relationship between leverage and fraud risk. Leverage provides a motivation to commit fraud (Ammar et al., 2018). On the other hand, table 5 shows a significant negative relationship between firm’s growth opportunities and fraud. There is also a similar relationship be- tween firm profitability and fraud. Firms with significant growth opportuni- ties are less eager to engage in fraudulent practices. These companies are often short of fund and look for external resources to finance their investment oppor- tunities. Similarly, profitable firms are not prone to manage their earnings and follow misstatement and fraudulent practices.  Conclusion This study raises questions about the fraud detection technique and the rel- evance of audit quality to mitigate fraud. This study has two main objectives. The first objective is to verify whether a collective prediction tool can be used to predict fraud risk. The second objective is to examine the audit’s monitor- ing role to mitigate fraud risk. Logit regressions are applied to a sample of 5,613 US-listed public firms during 2003–2013. The paper suggests a more comprehensive proxy for fraud risk that relies on the combination of Z-score and Beish M-score. The study reveals that the existence of an internal auditor and independent members within the audit committee would potentially reduce the fraud risk. Hiring a Big external auditor and paying it high fees is also helpful. Overall, con- trary to recent criticism, this paper provides compelling evidence that assuring high-quality information is consistently associated with a lower incidence of fraud. Our results underline the importance of several recommendations that have strengthened the monitoring and oversight role that audit plays in the fi- nancial reporting process through internal audit, audit committee, and exter- nal audit. Furthermore, the study puts in evidence that, unlike the firm lever- age, both firm profitability and growth opportunities have a negative effect on fraud risk. Leverage provides a motivation for fraudulent financial reporting. This study is related to several strands of existing research, namely the quality of audit, the effective use of financial information, fraud detection tech- niques. Several practical implications can be associated with this study. First, the research underscores the audit’s monitoring role to mitigate fraud. Second, frAud risk And Audit QuAlity: the cAse of us Public firms 45 the adopted model would help regulators, bankers, managers and auditors to detect fraud at an early stage. So needed action can be taken at suitable time. The study also offers two main contributions. Unlike most previous research, we focus on financially distressed companies rather than those with financial restatements. Besides, we suggest a collective tool to predict fraud risk; which is expected to offer a more reliable proxy for fraud risk than do binary models. Fraud is still a relevant theme for academic research. There are several fu- ture research perspectives for this research. Other factors of audit quality, such as internal audit effectiveness, external audit tenure, or audit committee dili- gence, are worth investigating and may lead to more interesting practical im- plications and recommendations. Besides, it would be better to estimate the fraud occurrence itself rather than the probability of fraud. An in-depth analy- sis is hence required.  References Altman, E.I. (1986). Handbook of corporate finance. New York: John Wiley and Sons. Altman, E.I. (1968). 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