HKUST Business Review

S&P Fraud Detection Performance Before and After the 2008 Financial Crisis Insights to Mitigate Fraud Risk and Enhance Performance As a result, CRAs like S&P can often offer valuable, otherwise hidden insight into potential fraud. So, what does this mean for investors, companies, and regulators? Below, we walk through key takeaways for each of these three groups, shedding light on how these stakeholders can leverage our findings to reduce the risk of fraud and boost performance. Takeaways for Investors 1. Integrating Rating Changes into Investment Screening First and foremost, our research demonstrates that S&P’s negative rating actions serve as early and reliable indicators of accounting fraud, making them a valuable tool for investors to identify high-risk firms before fraud is revealed publicly. As such, investors should integrate S&P rating changes into their investment screening and review processes (and, to ensure consistent implementation, they should provide training programs to educate their teams about the effectiveness of this approach). 2. Flagging Downgraded Firms for Divestment Particularly when rating changes are misaligned with market trends or economic conditions, investors can proactively flag downgraded firms for potential divestment or further due diligence. Divestment can take the form of selling equity or debt securities, shorting stocks, or purchasing credit default swaps to hedge against potential fraud- related declines in firm value, while enhanced due diligence may include reviewing SEC filings, engaging forensic accountants, or analysing management communications (e.g., earnings calls) for signs of deception. 3. Engaging CRAs for Rating Actions Insights Our research also suggests that investors may benefit from engaging directly with CRAs to gain additional context on their rating actions, particularly for high-risk firms. While confidentiality requirements prohibit CRAs from explicitly sharing private information, analysts may highlight red flags or nuances based in public information that external investors might have overlooked, but whose importance the CRA has confirmed using private data. Takeaways for Rated Companies Of course, fraud isn’t just bad for investors—it’s also bad for the firms that get caught committing it. That means visibility into early warning signs of potential fraud can be highly valuable not only to investors, but also to the companies that CRAs rate. 1. Monitor Rating Actions and Rectify Potential Issues Specifically, firms should monitor their own S&P rating actions in real time, and whenever a downgrade occurs, they should proactively conduct a thorough internal review to identify and rectify the accounting irregularities or operational issues that triggered it before the problem escalates further. Firms should also develop a communication strategy to address negative rating actions promptly, maintaining trust and minimizing adverse market reactions by transparently explaining the reasons behind the downgrade (and the steps being taken to address them) to lenders, investors, and other stakeholders. 2. Detecting Fraud Proactively to Avoid Downgrades At the same time, especially as more investors incorporate S&P rating changes into their analyses, it will become increasingly important for rated companies to take steps to avoid being downgraded. On the one hand, this means developing internal mechanisms to detect and prevent fraud before it triggers CRA rating changes. For instance, firms may consider investing in advanced data analytics and fraud detection tools to monitor their financial reporting for anomalies, implementing robust internal audits and engaging external auditors to regularly review financial statements, and establishing whistleblower programs and internal reporting channels to encourage early identification of potential fraud rather than waiting until it is detected externally by CRAs or regulators. Insight 42 HKUST Business Review