Restoring Trust after Fraud: Does Corporate Governance Matter?

Abstract

In this study, I examine the association between the credibility of the financial reporting system and the quality of governance mechanisms. I use a sample of 87 firms identified by the SEC as fraudulently manipulating their financial statements. Consistent with prior research, results indicate that fraud firms have poor governance relative to a control sample in the year prior to fraud detection. Specifically, fraud firms have fewer numbers and percentages of outside board members, fewer audit committee meetings, fewer financial experts on the audit committee, a smaller percentage of Big 4 auditing firms, and a higher percentage of CEOs who are also chairmen of the board of directors. However, the results indicate that fraud firms take actions to mprove their governance, and three years after fraud detection these firms have governance characteristics similar to the control firms in terms of the numbers and percentages of outside members on the board, but exceed the control firms in the number of audit committee meetings. I also investigate whether the improved governance influences informed capital market participants. The results indicate that analyst following and institutional holdings do not increase in fraud firms, suggesting that credibility was still a problem for these firms. However, the results also indicate that firms that take actions to improve governance have superior stock price performance, even after controlling for earnings performance. This suggests that investors appear to value governance improvements. Keywords: fraud; corporate governance; credible financial reporting; investor trust; agency costs; independent directors; audit committee. Data Availability: The data used in this study are available from public sources identified in the text. This paper is based on my dissertation completed at Cornell University. I thank my dissertation committee chairperson, Julia D’Souza, for her unwavering support and guidance in the development of this paper. I also thank my other committee members Charles Lee, Tim Mount, and Bhaskaran Swaminathan, as well as Daniel Beneish, Walt Blacconiere, Tom Dyckman, John Elliott, Sue Haka, Marilyn Johnson, Kathy Petroni, and workshop participants at the University of California at Berkeley, Cornell University, Georgia State University, Indiana University, Michigan State University, University of Nebraska, New York University, and Syracuse University for their suggestions and comments. I appreciate the valuable comments I received at the 2002 AAA Annual Meeting. I thank Mark Beasley for sharing his sample of fraud firms. I am also grateful to the librarians at Cornell University and the University of Rochester for their invaluable assistance, with special thanks to Don Schnedeker. I thank I/B/E/S for analyst data. I thank the editor (Patricia Dechow) and two anonymous referees for helpful suggestions that have greatly improved this paper. Finally, I acknowledge the financial support of the Johnson Graduate School of Management. All errors are my own.