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    Restoring Trust after Fraud: Does Corporate Governance...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight 
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    Title:
    Restoring Trust after Fraud: Does Corporate Governance Matter?
    Practical Implications:

    The results of this study suggests that the economic costs firms incur to improve their governance environment are effective in helping to restore some of the firm’s credibility after a fraudulent reporting event.  The study supports prior research that associates weak governance structures with fraudulent financial reporting.  Just as important, the results indicate that fraud firms receive some positive economic benefits from this recovery strategy, at least in terms of abnormal market returns. 

    Citation:

    Farber, D. 2005. Restoring Trust after Fraud: Does Corporate Governance Matter? The Accounting Review 80 (2): 539-561.

    Keywords:
    fraud; corporate governance; credible financial reporting; investor trust; agency costs; independent directors; audit committee
    Purpose of the Study:

    Given the fraud-related scandals of the early 2000’s, regulators recognized the impact that a high quality corporate governance environment can have on firms’ financial reporting quality and enacted several provisions to strengthen or enhance firms’ governance structures.  Academic studies support this perception and show an association between weak corporate governance structures and fraudulent financial reporting.  However, while the academic evidence supports regulators’ belief that strong corporate governance helps prevent fraudulent financial reporting, there is little evidence regarding what steps are actually taken by firms to improve their governance environments after these firms have committed acts of fraudulent financial reporting.  In addition, there is little evidence regarding the effectiveness of these acts in restoring the firm’s credibility with capital market participants.  Therefore, this paper addresses these concerns through the following two specific objectives:

    • Examine whether an association exists between the revelation of fraudulent financial reporting and subsequent steps taken to improve the firm’s corporate governance environment.  The corporate governance steps examined in this paper relate to the characteristics of the board of directors and audit committee, as well as other governance mechanisms such as a Big 4/non Big 4 auditor as the external audit provider and the CEO serving the dual role of Chairman of the Board.
    • Examine whether the firm’s improvements in corporate governance are rewarded by informed capital market participants.  The informed capital market participants examined in this study include analysts, institutional owners, and short-sellers.
    Design/Method/ Approach:

    The author examines a sample of U.S. publicly traded firms cited by the SEC in Accounting and Auditing Enforcement Releases (AAERs) for SEC Rule 10b-5 of the Exchange Act of 1934 violations during the period of 1982 - 1997.  The author further limits his sample to financial statement-related fraud violations.

    The author tests changes in corporate governance by matching fraud firms with a control firm based upon industry, stock exchange listing and comparable sales.  Using the combined sample of fraudulent and control firms, the author examines the stated objectives using changes in univariate statistics for up to three years subsequent to the fraud revelation and regression analysis methods.

    Findings:
    • In the year prior to fraud detection, the author finds that fraud firms have a weaker governance environment as measured by outside director percentage, the number of outside directors, the number of audit committee meetings, the number of financial experts on the audit committee, the quality of the external audit firm, the proportion of firms with the combined CEO/Chairman position, and the percentage of blockholder ownership.
    • Fraud firms, at the end of three years following the fraud detection, are statistically similar to the control firms on many governance characteristics, including outsider director percentage and the proportion with the combined CEO/Chairman position.  Fraud firms even appear to exceed the control firms in terms of the number of audit committee meetings, although control firms have a larger number of financial experts and are more likely audited by Big 4 auditors.
    • Although the author finds that analyst following and institutional ownership do not increase in fraud firms, increasing the board’s independence does appear associated with long-run buy-and-hold abnormal returns.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight
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