Fraud Allegations and Government Contracting

• DOI: http://doi.org/10.1111/1475-679X.12258
• Author: JONAS HEESE,GERARDO PÉREZ‐CAVAZOS
• Date: 01 June 2019
• Published date: 01 June 2019

DOI: 10.1111/1475-679X.12258

Journal of Accounting Research

Vol. 57 No. 3 June 2019

Printed in U.S.A.

Fraud Allegations and Government

Contracting

JONAS HEESE

∗AND GERARDO P´

EREZ-CAVAZOS

∗

Received 13 August 2017; accepted 29 November 2018

ABSTRACT

This paper examines whether fraud allegations affect firms’ contracting with

the government. Using a data set of whistleblower allegations brought under

the False Claims Act against firms accused of defrauding the government, we

find that federal agencies do not reduce the total dollar volume of contracts

with accused firms; however,they substitute approximately 14% of the harder-

to-monitor cost-plus contracts for fixed-price contracts. This effect is concen-

trated in the procurement of services and explained by contract and service

substitution. Finally, we find that after the conclusion of the investigation, the

government reduces the contract dollar volume by approximately 15% for

cases that resulted in a settlement. Our findings indicate that contract-design

changes are used to mitigate uncertainty in suppliers’ reputation.

JEL codes: D82; G18; M41

Keywords: whistleblower; fraud allegations; False Claims Act; government

contracting; risk allocation

∗Harvard Business School.

Accepted by Christian Leuz. We appreciate helpful comments from two anonymous ref-

erees, Rand Allen, Terrence Blackburne, Bryant Demere (discussant), Srikant Datar, Stuart

Gerson, David Gragan, Paul Healy,Steven Kelman, Heidi Packard (discussant), Andreya Perez,

Delphine Samuels, Steven Schooner, Eugene Soltes, Gwen Yu, and workshop participants at

Harvard Business School, University of British Columbia, the 2018 AAA and EAA Annual Meet-

ings, and the 2017 Cherry Blossom Conference at George Washington University School of

Business. We thank David Engstrom for sharing his data on FCA whistleblower allegations. We

thank Botir Kobilov for excellent research assistance.

675

CUniversity of Chicago on behalf of the Accounting Research Center,2019

676 J.HEESE AND G.P´

EREZ-CAVAZOS

1. Introduction

In this paper, we examine whether fraud allegations affect firms’ contract-

ing relationships with the U.S. government, which is the single largest buyer

of goods and services in the country, with contract awards of over $400 bil-

lion annually.1Despite frequent assertions that firms’ customer relation-

ships tend to break up after fraud allegations, with the explanation that

allegations can shake customers’ trust in the accused firm and depress de-

mand for its goods and services (e.g., Karpoff, Lee, and Martin [2008b]),

the validity of such assertions has rarely been tested. To examine these ef-

fects, we focus on whistleblower lawsuits brought under the False Claims

Act (FCA) against firms accused of defrauding the government.2

From a research-design perspective, our setting has three strengths. First,

while prior studies typically include only a fraction of fraud allegations (e.g.,

those reported in the press or those disclosed by the regulator), we use

a novel data set that includes all FCA whistleblower fraud allegations ob-

tained directly from court filings via Freedom of Information Act (FOIA)

requests.3Second, in our setting, the information content of the allega-

tion is new to the government, and the court filing of the allegation is also

unexpected. Consequently, we can examine the government’s response to

a fraud allegation before and after an investigation establishes case merit.4

Finally, the government discloses detailed information about all its procure-

ment contracts. Thus, we have access to granular data on firms’ contracts

with federal agencies.

Theoretical studies predict that fraud allegations can damage firms’ rep-

utation, leading to negative consequences in the context of the product

market (e.g., Klein and Leffler [1981]). Empirically, Johnson, Xie, and Yi

[2014] document that trading relationships are more likely to break up af-

ter the detection of financial fraud. Similarly, government contractors often

highlight the potential consequences of fraud allegations as a risk factor in

their financial statements. For example, Boeing, the second largest govern-

ment contractor,describes this risk in its 10-Ks as follows: “Any inadequacies

in our systems and policies could result in withholds on billed receivables,

1For a list of total government contract awards by fiscal year, visit www.USAspending.gov.

2The FCA includes provisions that allow whistleblowers to initiate a lawsuit on behalf of

the government and earn a bounty of up to 30% of the recovered amounts. Institutionally,

the FCA whistleblower regime is the government’s main instrument to combat government

procurement fraud, with over 5,000 lawsuits and roughly $24 billion in recoveries between

2009 and 2016 alone (DOJ [2016]).

3A potential concern with samples based on press reports or regulators’ announcements

is that they could suffer from selection biases, potentially biasing the conclusions on the ef-

fect of fraud allegations. For example, the media typically covers more visible, important, or

sensational allegations (Miller [2006]).

4The FCA contains several provisions, which we describe in subsection 2.3, to ensure that

the lawsuit provides new information to the government. Empirical tests, described in subsec-

tion 5.1, support this conjecture.

FRAUD ALLEGATIONS AND CONTRACTING 677

penalties and reduced future business. [...] We also could suffer reputational

harm if allegations of impropriety were made against us, even if such alle-

gations are later determined to be false.” [Emphasis added throughout.] Under

this hypothesis, we would expect a reduction in contract dollar volume be-

tween the federal agency and the accused firm following an allegation.

Alternatively, the agency may choose not to reduce contract dollar vol-

ume because the allegation could be perceived as frivolous or misleading

(e.g., Miceli and Near [1992], Bowen, Call, and Rajgopal [2010]). In the

context of the FCA, agencies ultimately decide not to prosecute the major-

ity of cases after the conclusion of an investigation. Under this alternative,

the federal agency does not perceive the allegations are credible, and thus

we would not expect to find a reduction in contract dollar volume.

Another possibility is that the agency mitigates the uncertainty about

the accused firm’s reputation by changing the contracting terms. Theoret-

ical (e.g., Akerlof [1970], Holmstrom [1979], Titman [1984]) and empir-

ical (e.g., Costello [2013]) studies show that uncertainty can be mitigated

through contract-design changes. In the government-procurement setting,

the main contract-design feature is whether pricing is fixed-price or cost-

plus. According to the Federal Acquisition Regulations (FARs), the objec-

tive of contract negotiation is to achieve “reasonable contractor risk and

provide the contractor with the greatest incentive for efficient and econom-

ical performance” (FAR 16.103(a)). In fixed-price contracts, the contractor

provides a product or service to the government at a fixed price, and thus

bears all risks associated with cost overruns. In cost-plus contracts, revenue

equals the reported production cost and a profit margin, making it prone to

manipulation (e.g., Williamson [1971], Rogerson [1992], Chen and Gunny

[2014]).5Thus, cost-plus contracts allocate most of the risks to the federal

agency. If fraud allegations increase uncertainty, the agency could be less

willing to bear these risks. Under this hypothesis, we would expect a reduc-

tion in cost-plus contracts following an allegation. In sum, whether and how

fraud allegations influence federal agencies’ contract-granting behavior are

ultimately empirical questions.

To answer these questions, we use a difference-in-differences methodol-

ogy, exploiting the fact that firms are subject to whistleblower allegations at

staggered points in time. Specifically, we analyze the four-year window sur-

rounding the court filing date of 296 FCA whistleblower fraud allegations

between 2000 and 2012. The FCA whistleblower data set contains the date

of the initial court filing, the name of the defendant (the accused firm),

and the allegedly defrauded federal agency. After matching accused firms

to Compustat and government-procurement data, we examine agencies’

5Under these contracts, contractors are often required to comply with Cost Accounting

Standards (CAS), a set of 19 government-specific accounting rules designed to achieve unifor-

mity and consistency in contractors’ cost-accounting practices (Samuels [2017]). These stan-

dards control how costs are measured, accumulated, and allocated to a final cost objective,

and are far more detailed than cost-accounting guidance provided by GAAP.