Corporate Governance Factors Associated with Financial Fraud

We identify a sample of 36 publicly-held companies with financial fraud in their 2003 financial statements. We use industry-specific summary corporate governance ratings (CGQ-Y) from RiskMetrics Group (formerly Institutional Investor Services), to select a sample of control firms with governance ratings similar to the fraud firms. We trace changes in CGQ-Y ratings as well as numerous governance mechanisms over the period of 2003-2006 to identify those with significant differences between the fraud firms and control firms. Specifically, we identify two corporate governance mechanisms with theoretical justification for their effects on differences due to fraud. The first is the extent of non-audit services, as proxied by the dollar magnitude of “audit-related” and “other” non-audit fees, provided by incumbent auditors. We hypothesize and find that significantly fewer fraud firms received substantial non-audit services compared to the control sample. The second governance variable is board election, where we hypothesize and find that fraud companies elect all directors annually, more often than control firms, which have more staggered terms for their directors. We used the Compustat data base to codify a number of control variables identified from prior literature as impacting governance and investigated differences by fraud and control firms. We do not find significant differences between fraud and control firms with respect to return on assets, the proportion of executive ownership of the firm, or firm size. However, we find that fraud firms have significantly more financial need, lower Z-scores, and more audit committee meetings in the fraud year than control firms. Finally, when compared with control firms, we find that fraud firms improve their overall governance rating in the year following the fraud, but revert to lower ratings in the following two years