Restoring Trust after Fraud: Does Corporate Governance Matter?

TLDR

The study examines how the credibility of financial reporting relates to governance quality and whether post‑fraud governance improvements affect informed market participants. The authors analyze a sample of 87 SEC‑identified fraud‑prone firms. Fraud firms initially exhibit weaker governance than controls, but three years after detection their governance aligns with or surpasses controls, while analyst following and institutional holdings remain unchanged, yet firms that enhance governance achieve better stock‑price performance, suggesting investors reward governance improvements.

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 improve 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.