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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

Corporate Governance and Non-Financial Reporting Fraud

Obeua S. Persons, Rider University

Abstract

This study uses logit regression analysis to identify corporate governance characteristics which can potentially reduce the likelihood of non-financial reporting fraud. Results indicate that the likelihood of non-financial reporting fraud is lower if: (1) the Board of D irectors (BOD) has a larger proportion of outside independent directors, (2) the chief executive officer (CEO) and the BOD chairman are not the same person, (3) the BOD size is smaller, (4) the CEO tenure on the BOD is long, and (5) the profitability is high. These findings not only support the recent corporate governance reform which requires a majority of independent directors on the board, but also suggest alternatives for further improvement in corporate governance. In particular, the corporate governance could be further improved by disallowing a person to serve as both the CEO and the BOD chairman and reducing the BOD size. Results also suggest that fraud firms do not necessarily implement nor enforce ethical standards even when they so stated in writing.

INTRODUCTION

Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment (Shleifer and Vishny 1997). In the U.S., stockholders play a major role of supplying finance to corporations. One scenario, which greatly casts doubt on whether stockholders will be able to receive reasonable return, is when a corporation is engaged in fraudulent conduct. Karpoff and Lott (1993) report that initial press reports of allegations or investigations of corporate fraud are associated with substantial decrease in the values of the common stock of affected companies. Such decrease in stock value has direct adverse impact on the stockholders wealth, and hence, the return on their investment. Therefore, it is of great interest to stockholders to know which corporate governance features are effective in deterring corporate fraud. Recent studies (Beasley, 1996 and Dechow et al, 1996) have examined corporate governance features which are associated with the likelihood of financial reporting fraud. 1 There is, however, no study which examines the relation of corporate governance characteristics and non-financial reporting fraud.

This study attempts to fill this void by identifying specific characteristics of corporate governance which could help reduce the probability of non-financial reporting fraud. Examples of non-financial reporting fraud are fraud against customers and governments, and violations of regulations other than financial reporting. Although both financial reporting fraud and non- financial reporting fraud are driven by the greed and unethical conduct of the firm s officers, there are two major distinctions between them. First, unlike financial reporting fraud, non- financial reporting fraud does not involve the use of accounting methods or estimates to misrepresent the firm s financial condition. Second, victims of financial reporting fraud are mainly stockholders who were misled by the false financial reports, whereas the main victims of non-financial reporting fraud are not only stockholders but also customers/consumers and

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

governments. Because more parties are adversely affected, the seriousness of non-financial reporting fraud rivals that of financial reporting fraud.

The characteristics of corporate governance examined in this study pertain mainly to the level of independence and effectiveness of the board of directors. Fama and Jensen (1983) state that the board of directors (BOD) is the most important mechanism responsible for monitoring the actions of top management. They argue that the BOD which is more independent from top management is better at monitoring top management. This study employs four measures of BOD independence. They are the percentage of outside independent directors, whether the chief executive officer (CEO) is also the BOD chairman, the tenure of the CEO on the BOD and the percentage of common shares owned by outside directors relative to total shares owned by all directors. The BOD independence is likely compromised if the BOD is composed of a low proportion of outside independent directors, the CEO also serves as the BOD chairman, CEO tenure on the BOD is long, and the percentage of common shares owned by outside directors is small. Another important aspect of the BOD is its effectiveness. The effectiveness of the BOD is measured by the BOD size and the number of its meetings. The effectiveness is compromised if the BOD size is large and the number of its meetings is small. This study also includes another three variables which could potentially affect occurrences of non-financial reporting fraud. They are the company s profitability, the corporate ethical standards, and the percentage of common shares held by outside blockholders who own at least 5% of such shares and are not affiliated with management. Non-financial reporting fraud is more likely to occur if the profitability is low, a firm has no ethical standard disclosure, and the percentage of common shares owned by outside blockholders is small.

The results indicate that lower likelihood of non-financial reporting fraud is associated with smaller BOD size, larger percentage of outside independent directors, the CEO not serving as the BOD chairman, longer CEO tenure on the BOD, higher profitability and surprisingly, no ethical-standard disclosure. In the wake of recent corporate governance reform, these results are highly relevant to both stockholders and regulators who contemplate further improvement of the BOD independence and effectiveness, and the ethical-standard supervision.

HYPOTHESIS DEVELOPMENT

Recent accounting scandals among U.S. firms have focused much of our attention on financial reporting fraud. However, Karpoff and Lott (1993) find that companies stockholders also suffer significant losses in the values of their common stock upon the disclosure of non- financial reporting fraud. The losses in common stock values amount to an average of $60.8 million for fraud against private parties and $40 million for fraud against government agencies. This section discusses the importance of the BOD and the expected relationship between the likelihood of non-financial reporting fraud and the specific BOD characteristics as well as three other variables related to corporate governance.

An important function of the BOD is to minimize costs that arise from the separation of ownership and decision control of corporations (Fama and Jensen 1983). The BOD receives its authority for internal control and other decisions from stockholders of corporations. This delegation occurs because stockholders generally diversify their risks by owning securities in a

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

number of firms (Fama 1980). Such diversification creates a free-rider problem where no individual stockholders have a large enough incentive to devote resources to ensure that management is acting in the stockholders interests (Grossman and Hart, 1980). Several corporations, including Salomon Inc., have stated in their proxy reportings or annual reports that the BOD s primary responsibility is to ensure that the company is managed in the long-term interests of shareholders. The BOD carries out this responsibility by meeting directly or through its committees with senior management to discuss, review and approve policies and actions relating to significant issues including maintaining high standards for compliance and for ethical behavior toward customers and counterparties. These statements imply that the high-quality BOD is a deterrence of not only financial reporting fraud but also non-financial reporting fraud. The quality of the BOD depends on two important aspects: its independence and its effectiveness.

The BOD, which is more independent from top managers, can perform a better function of decision control and monitoring activities of top managers (Jensen 1993 and Beasley 1996). Williamson (1984) posits that, because managers have substantial informational advantages due to their full-time status and insider knowledge, the BOD can easily become an instrument of management, therefore sacrificing the interests of stockholders. Domination of top management on the BOD can lead to collusion and transfer of stockholder wealth (Fama 1980). As a result, corporate boards normally include outside independent members who ratify decisions involving serious agency problems (Fama and Jensen 1983). Rosenstein and Wyatt (1990) s finding of positive abnormal stock return when outside independent directors are added to boards suggests that stockholders highly value the inclusion of outside independent directors on the BOD. Recent regulations such as the 2002 Sarbanes-Oxley Act and the new 2003 corporate governance rules of the NYSE and the NASDAQ stock markets highlight the importance of the role played by outside independent directors. The ongoing reform of the NYSE board also centers on the independence of directors. 2 All these lead to the following hypothesis.

H1: Firms experiencing non-financial reporting fraud have a lower percentage of outside independent members on the BOD than firms without such fraud.

This study defines outside independent directors as those who: (1) are not current employees of the company, its parent or its subsidiaries, (2) are not former employees of the company, its parent or its subsidiaries in the past five years, and (3) do not have immediate family members employed as current officers of the company, its parent or its subsidiaries. This definition is consistent with the current requirements of the NYSE and the NASDAQ stock markets.

In addition to the percentage of outside independent directors, this study also measures the BOD independence by the tenure of CEO on the BOD, whether the CEO is also the chairman of BOD, and the percentage of common shares owned by outside independent directors. Jensen (1993) and Dechow et al. (1996) argue that when the CEO is also the BOD chairman, this top executive could exert an undue influence on the board, which is supposed to supervise top management on behalf of the firm's stockholders. The CEO/Chairman could influence the BOD through the process of setting board agenda, managing meetings and controlling the flow of information to the board. These CEOs can handpick their directors who

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

would not seriously challenge them. In light of this concern, a panel of the Conference Board, a business group in New York, recommended splitting the role of chairman of the board from that of CEO, preferably with the chairman s position filled by an independent director (Burns 2003). Similarly, the special NYSE governance committee also recommends that the NYSE board be provided with the flexibility to split the chairman and CEO positions. The idea of separating the CEO and chairman functions is gaining support in the U.S. as indicated by McKinsey & Co. s survey result that 70% of directors of Fortune 500 companies favor splitting the two roles, and it is estimated that about one-third of U.S. firms have split the functions already. Therefore, this study tests the following hypothesis.

H2: The CEO of firms experiencing non-financial reporting fraud is more likely to serve as the BOD chairman than firms without such fraud.

As for the CEO tenure, the longer a CEO has been on the board, the more entrenched they are likely to become and the higher the influence a CEO can exercise over the board (Hill and Phan 1991). Hermalin and Weisbach (1988) also note that an established CEO has relatively more power than a new CEO. Real-world examples for this can be drawn from Enron and WorldCom, the two companies with the biggest corporate scandals in U.S. history. Before the scandals surfaced, Enron s CEO, Kenneth L. Lay, had been on its BOD for 15 years, and WorldCom s CEO, Bernard J. Ebbers, had served as a director for 18 years. 3 Therefore, the BOD independence is likely compromised if the tenure of CEO is long. This weakening in corporate governance could lead to a higher likelihood of non-financial reporting fraud.

H3: Firms experiencing non-financial reporting fraud have the CEO with longer tenure on the BOD than firms without such fraud.

Another measure of the BOD independence is the percentage of common shares owned by outside independent directors relative to total shares owned by all directors. Jensen (1993) argues that encouraging outside directors to hold substantial equity interest in the firm would provide better incentives for monitoring top management. Mace (1986) and Patton and Baker (1987) believe that a director with a sizeable equity stake in the firm is more likely to question and challenge management. Shivdasani (1993) finds that outside directors in hostile takeover target firms (i.e., firms subject to disciplinary takeover) have significantly lower ownership stakes in the firm. These studies support the view that equity ownership in the firm provides outside directors with greater incentives to monitor, which could help reduce the likelihood of non-financial reporting fraud. Therefore, this study tests the following hypothesis.

H4: Firms experiencing non-financial reporting fraud have a lower percentage of common shares owned by outside independent directors relative to total shares owned by all directors than firms without such fraud.

Another crucial aspect of the BOD is its effectiveness which is measured by the board size (the number of members) and the number of meetings in a year. A large board is less likely to function effectively and is easier for the CEO to control (Jensen 1993; Beasley 1996; and Dechow et al. 1996). Organizational theory also suggests that a larger group takes more time to make decisions (Steiner 1972). Eisenberg et al. (1998) finds that larger board size is associated

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

with lower profitability and decreasing firm value. This concern about the ineffectiveness of large BOD is reflected in the plan of John Reed, interim chairman of the NYSE, to trim down the NYSE board to eight members in contrast to the current rule allowing for 27-member board (Craig and Kelly 2003). This leads to the fifth hypothesis.

H5: Firms experiencing non-financial reporting fraud have larger boards of directors than firms without such fraud.

Another measure of the BOD effectiveness is the number of meetings held in a year. Meeting frequency reflects the diligence and vigilance of the BOD in carrying their monitoring duties. Conger et al. (1998) suggests that board meeting time is an important resource in improving the effectiveness of BOD. Vafeas (1999) finds that board meeting frequency is an important dimension of board operations. The BOD effectiveness could be compromised if the number of meetings is small. This leads to the sixth hypothesis.

H6: Firms experiencing non-financial reporting fraud have a smaller number of BOD meetings than firms without such fraud.

The ethical standards have increasingly become an important feature of recent regulatory requirements. The Sarbanes-Oxley Act of 2002 requires publicly traded companies to disclose whether they have adopted a code of ethics for senior financial officers. In addition, the New York Stock Exchange and the NASDAQ have new rules which require listed firms to have a code of business conduct and ethics that applies to all directors, officers and employees. This study measures the ethical standards by whether a firm discloses in its proxy statement about: (1) a specific committee designated to oversee executives' ethical conduct, or (2) using the ethical conduct of executives as a criterion to set their compensation or deciding their termination. The lack of such ethical-standard disclosure could be associated with the likelihood of non-financial reporting fraud.

H7: The lack of ethical-standard disclosure is more prevalent among firms experiencing non- financial reporting fraud than among firms without such fraud.

Another corporate governance variable is the percentage of stockholdings of outside independent blockholders with at least 5% holding of common shares. Examples of these blockholders are mutual funds and large pension funds such as TIAA-CREF and state pension funds. Jensen (1993) and Shleifer and Vishny (1997) note that these blockholders who are not affiliated with management have incentives to monitor management because they have larger cash flow stake in the firm. Shivdasani (1993) finds that large blockholders increase the likelihood that a firm is taken over, whereas Denis and Serrano (1996) show that, if a takeover is defeated, management turnover is higher in poorly performing firms that have blockholders. Large blockholders also have higher ability to monitor due to their greater control (voting) rights, which enable them to affect the BOD composition and other governance changes. 4 All these findings support the view that blockholders play an active role in corporate governance and can potentially reduce the likelihood of non-financial reporting fraud.

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H8: Firms experiencing non-financial reporting fraud have a smaller percentage of common shares held by outside blockholders than firms without such fraud.

A firm s profitability can potentially influence the likelihood of management s committing fraud. Maksimovic and Titman (1991) argue that the costs of committing fraud tend to be lower for poor performing firms than financially healthy firms. Kellogg and Kellogg (1991) also state that poor performance provides incentive for management to engage in fraud because poorly performance adversely affects managers job security and compensation. Proxy statements of all sample firms indicate that they use profitability to assess top executives performance and determine the executives compensation. The most common measure of profitability among sample firms is earnings per share (EPS) which is typically compared with the previous year s number. Therefore, this study uses the percentage change in EPS, computed as (EPS t EPS t-1 ) /EPS t-1 , to measure the change in firm s profitability. 5

H9: The change in profitability is more negative for firms experiencing non-financial reporting fraud than for firms without such fraud.

SAMPLE SELECTION

Firms with the revelation of non-financial reporting fraud were collected from the Wall Street Journal (WSJ) Index from 1992 through 2000. The following topics of the Index were used to identify firms that were accused of non-financial reporting fraud: "Bank Fraud," "Fraud," "Insurance Fraud," "Mail Fraud," "Securities Fraud" and "White Collar Crime". The Wall Street

Journal (on microfiche) was also read for any clarification regarding the nature of non-financial reporting fraud and timing of such fraud. These firms were then searched for the earliest press announcement of the fraud. As a result, the sample for fraud firms runs from 1991 through

2000. To be included in the sample, the firms must be publicly traded and filed proxy

statements and annual reports with the SEC. All corporate governance data and financial variables were collected from proxy statements and annual reports filed with the SEC in the year of fraud announcement.

Non-financial reporting fraud among sample firms falls into three broad categories. First is fraud of customers/consumers. Examples include Allstate Insurance Co. being investigated by the FBI for doctoring documents to reduce the amount of claims the company owed after the 1994 California earthquake, and Sears, Roebuck & Co. being accused by the California Department of Consumer Affairs of overcharging auto-repair customers. Second is fraud of governments in which the firms cheated or were accused of cheating on contracts with a government agency. For example, Alliant Techsystems Inc s Aerospace Systems unit was under criminal investigation for allegedly overcharging the Defense Department by tens of millions of dollars on various missile-production contracts, and Boeing was sued by the federal government for knowingly using defective helicopter parts. Third is regulatory violations which typically involve financial service firms violating federal laws. For example, Allied Group was accused by Commercial Crime Bureau for violating securities rules, and PaineWebber Group Inc was investigated for allegedly peddling bogus financial instruments. The final sample includes 83 fraud firms. 6 These firms come from 49 different industries based on the four-digit SIC code. The industry with the highest concentration of firms is Securities

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Brokers and Dealers (6 firms). Most of the firms (67 out of 83) are listed on the NYSE because the WSJ tends to cover larger firms. For each firm in the fraud sample, this study identified a potential control firm with the same stock exchange, the same industry (four-digit SIC code) and similar size (net sales closest to the fraud firm). 7 It s important to match on the basis of stock exchange because different exchanges have different corporate governance requirements, e.g., the NYSE has stricter governance requirements than the AMEX and the NASDAQ stock markets. Different industries can also have different corporate governance features, e.g., firms in the banking industry typically have much larger boards than firms in the other industries. In addition, larger firms generally have larger boards and a greater number of board meetings than smaller firms. The potential control firm is included in the final control sample if: (1) there is no report of fraud in the WSJ Index for that firm during the year before and the year of the matched fraud event, and (2) it has the proxy statement and the annual report for the same time period used to collect data of the related fraud firm.

METHODOLOGY

This study uses logit cross-sectional regression analysis to test the hypotheses. Logit regression is appropriate because the dependent variable is dichotomous (Stone and Rasp 1991). The use of logit regression for this type of study is also supported by Maddala (1991) and (Palepu 1986).

(1) FRAUD

=

a + b 1 OUTSIDE + b 2 CEOCHAIR + b 3 CEOTEN + b 4 OUTOWN

+ b 5 BODSIZE + b 6 BODMET + b 7 ETHIC + b 8 BLOCK + b 9 EPSCHG

FRAUD = 1 if a firm was engaged in non-financial reporting fraud and 0 otherwise. OUTSIDE = The percentage of outside directors on the board. CEOCHAIR = 1 if CEO is also the BOD chairman and 0 otherwise. CEOTEN = The CEO tenure on the BOD. OUTOWN = The percentage of common shares owned by outside independent directors relative to all shares owned by all directors. BODSIZE = The number of BOD members.

BODMET

ETHIC = 1 if the firm makes the ethical-standard disclosure in its proxy statement and 0 otherwise. BLOCK = The percentage of common shares held by outside independent blockholders. EPSCHG = The percentage change in earnings per share.

= The number of BOD meetings.

CEOCHAIR, CEOTEN and BODSIZE are expected to have positive estimated coefficients. OUTSIDE, OUTOWN, BODMET, ETHIC, BLOCK and EPSCHG are expected to have negative estimated coefficients. To alleviate the influence of observations with extreme values, all nine independent variables are truncated at its mean +/- three standard deviations. Five variables are truncated: CEOTEN, BODSIZE, BODMET, BLOCK and EPSCHG.

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Table 1. Univariate Tests on Corporate Governance Characteristics of Fraud vs. No-Fraud Firms.

Variables

Minimum.

Mean

Median

Maximum

T-Test a

Wilcoxon a

OUTSIDE

Fraud

35.29%

72.28%

76.47%

92.86%

-0.8213

-0.4700

No-Fraud

33.33

73.94

75.00

94.74

(0.2064)

(0.3191)

CEOCHAIR

Fraud

0.0000

0.7952

1.0000

1.0000

2.2605 ***

2.233 ***

No-Fraud

0.0000

0.6385

1.0000

1.0000

(0.0126)

(0.0128)

CEOTEN

Fraud

0.0000

10.4639

9.0000

33.0000

-0.4906

0.2130

No-Fraud

0.0000

11.0829

10.000

36.1914

(0.6878)

(0.4155)

OWNOUT

Fraud

0.18%

24.44%

11.82%

100%

-0.3051

-1.1010

No-Fraud

0.24

25.78

18.09

95.53

(0.3803)

(0.1354)

BODSIZE

Fraud

3.0000

10.8117

10.000

22.1844

2.0175 **

2.193 ***

No-Fraud

4.0000

9.6506

9.000

22.0000

(0.0226)

(0.0142)

BODMET

Fraud

3.0000

8.2081

7.0000

18.2739

0.8422

0.3540

No-Fraud

4.0000

7.7985

8.0000

18.2739

(0.7995)

(0.3615)

ETHIC

Fraud

0.0000

0.2651

0.0000

1.0000

1.7174 **

1.7070 **

No-Fraud

0.0000

0.1566

0.0000

1.0000

(0.0439)

(0.0439)

BLOCK

Fraud

0.00%

19.11%

16.35%

71.30%

-1.5036

-1.5940

No-Fraud

0.00

23.57

19.20

80.14

(0.0673)

(0.0555)

EPSCHG

Fraud

-1,698.87%

-81.39%

1.75%

1,082.50%

-2.2572 ***

-3.525 ***

No-Fraud

-1,405.26

54.61

21.15

821.88

(0.0128)

0.0002

There are 83 fraud firms and 83 non-fraud firms. OUTSIDE = the percentage of outside directors on the board. CEOCHAIR = 1 if CEO is also the BOD chairman and 0 otherwise. CEOTEN = CEO tenure on the BOD. OWNOUT = the percentage of common shares owned by outside directors relative to all shares held by all directors. BODSIZE = the number of BOD members. BODMET = the number of BOD meetings. ETHIC = 1 if the firm has the ethical standard disclosure and 0 otherwise. BLOCK = the percentage of common shares owned by blockholders. EPSCHG = the percentage change in earnings per share. ** , *** Statistically significant at p < 0.05 and p < 0.01, respectively.

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

RESULTS

Table 1 reports univariate test on the nine corporate governance variables for non- financial reporting fraud firms and the control no-fraud firms. This study uses t-test for testing the difference in mean and Wilcoxon rank-sum test for testing if the two groups are from population

Table 2. Correlations of Explanatory Variables

 

CEOCHAIR

CEOTEN

OUTSIDE

0.0199

-0.1492

CEOCHAIR

0.3495 ***

CEOTEN

OWNOUT

BODSIZE

BODMET

ETHIC

BLOCK

OWNOUT

BODSIZE

BODMET

ETHIC

BLOCK

EPSCHG

0.2823 ***

0.0989

0.0582

0.1542

0.0031

0.0074

 

-

-0.0381

0.1787

**

0.0307

-0.0685

0.1664

**

-0.0687

 

-

-0.2409 ***

0.2205 ***

-0.0397

-0.1239

0.1619 **

-0.0098

0.0185

0.0116

0.0389

0.1237

-0.0344

 

-

 

0.1878 **

-0.0378

0.2838 ***

0.1751

 

-0.0014

-0.134

0.0719

 

0.1275

-0.0023

 

-0.1445

OUTSIDE = the percentage of outside directors. CEOCHAIR = 1 if CEO is also the BOD chairman and 0 otherwise. CEOTEN = CEO tenure on the BOD. OWNOUT = the percentage of common shares owned by outside directors relative to all shares held by all directors.

BODSIZE = the number of BOD members. BODMET = the number of BOD meetings. ETHIC = 1 if the firm has the ethical standard disclosure and 0 otherwise. BLOCK = the percentage of common shares owned by blockholders. EPSCHG = the percentage change in earnings per share. ** , *** Statistically significant at p < 0.05 and p < 0.01, respectively.

with the same distribution. These univariate statistics test each corporate governance variables separately from one another. Variables with both tests statistically significant at < 0.05 level are CEOCHAIR, BODSIZE, EPSCHG and ETHIC. As expected, non-financial reporting fraud firms are more likely to have larger BOD, lower profitability, and the same person serving as CEO and the board chairman. Contrary to the expectation, these fraud firms are more likely than non-fraud firms to state in their proxy statement that they have a committee which oversees employees ethical conduct, or that they consider ethical conduct in determining executive compensation or termination.

Table 2 shows correlations of the nine explanatory variables. All correlations are below 0.35, and 89% of them are below 0.20. These generally modest correlations suggest that multicollinearity is not likely to be a problem in the regression analysis. 8 The interpretation based upon correlations with < 0.05 statistically significance is as follows. First, firms with higher percentage of outside independent directors are also likely to have these directors holding higher percentage of common shares relative to all directors equity holding. Second, firms

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

which have the CEO serving as the board chairman are likely to have longer CEO tenure, larger BOD size and lower percentage of common shares owned by outside blockholders. Third, firms with longer CEO tenure are likely to have lower percentage of common shares held by outside independent directors, larger BOD size and lower percentage of common shares owned by outside blockholders. Fourth, firms with larger BOD size tend to have higher number of BOD meetings and lower percentage of common shares owned by outside blockholders.

Table 3. Logit Regression Results for Non-Financial Reporting Fraud (FRAUD)

Variables

Expected Sign

Est. Coeff.

Std. Error

Z-Statistic

Prob. > Z

Intercept

n/a

0.3639

1.1732

0.31

0.378

OUTSIDE

-

-2.3434

1.4294

-1.64

0.051

**

CEOCHAIR

+

0.9179

0.4285

2.14

0.016

**

CEOTEN

+

-0.0470

0.0244

-1.93

0.027

**

OWNOUT

-

-0.0020

0.0067

-0.30

0.383

BODSIZE

+

0.1107

0.0531

2.09

0.019 **

BODMET

-

0.0231

0.0557

0.42

0.339

ETHIC

-

0.9653

0.4547

2.12

0.017 **

BLOCK

-

-0.0132

0.0100

-1.32

0.093

EPSCHG

-

-0.1293

0.0513

-2.52

0.006 ***

Wald Chi-Square

21.49

Probability Level

0.0106 ***

There are 83 fraud firms (FRAUD = 1) and 83 non-fraud firms (FRAUD = 0). OUTSIDE = the percentage of outside directors on the board. CEOCHAIR = 1 if CEO is also the BOD chairman and 0 otherwise. CEOTEN = CEO tenure on the BOD. OWNOUT = the percentage of common shares owned by outside directors relative to all shares held by all directors. BODSIZE = the number of BOD members. BODMET = the number of BOD meetings. ETHIC = 1 if the firm has the ethical standard disclosure and 0 otherwise. BLOCK = the percentage of common shares owned by blockholders. EPSCHG = the percentage change in earnings per share. ** , *** Statistically significant at p < 0.05 and p < 0.01, respectively.

Table 3 presents results of the logit regression analysis which jointly accounts for the effect of all nine explanatory variables at the same time. These results indicate six statistically significant corporate governance characteristics: OUTSIDE, CEOCHAIR, CEOTEN,

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Journal of Business & Economic Studies, Volume 12, No. 1, Spring 2006

BODSIZE, EPSCHG and ETHIC. Consistent with the expectation, firms with non-financial reporting fraud are likely to have lower percentage of outside independent directors, the same person serving as CEO and the BOD chairman, larger BOD size, and lower profitability. Results with respect to CEOTEN and ETHIC are contrary to the expectation. That is firms engaging in non-financial reporting fraud are likely to have shorter CEO tenure and have the ethical-standard disclosure in the proxy statement. A plausible explanation for the CEOTEN result is that long-tenure CEOs have lower incentive to commit fraud because they presumably have a well-established reputation/legacy to protect. The ETHIC result implies that having the ethical-standard disclosure does not guarantee an ethical conduct of a firm.

It is interesting to compare the results of this study on non-financial reporting fraud with the studies on financial reporting fraud by Beasley (1996) and Dechow et al. (1996). Two corporate governance features which help decrease the likelihood of both financial reporting and non-financial reporting fraud are the larger proportion of outside independent directors and not having the same person serving as the CEO and the BOD chairman. On the other hand, the equity ownership of outside directors and outside blockholders, which affect the lower likelihood of financial reporting fraud, do not help decrease the likelihood of non-financial reporting fraud. Likewise, the smaller BOD size, which affects the lower likelihood of non- financial reporting fraud in this study, is not a significant variable in the financial-reporting fraud studies. Therefore, hypotheses H1, H2, H4, H5, H8, H9 are accepted while hypotheses H3, H6, and H7 are rejected.

CONCLUSION

This study investigates corporate governance characteristics which can potentially decrease the likelihood of non-financial reporting fraud. These characteristics are the independence and the effectiveness of the BOD, the existence of ethical standards and the equity ownership of outside blockholders. It also tests the impact of the change in a firm s profitability on the fraud likelihood. The results based upon logit regression analysis indicate that both the independence and the effectiveness of the BOD can help reduce the likelihood of non-financial reporting fraud. In particular, the likelihood of non-financial reporting fraud is lower if: (1) the BOD has a larger proportion of outside independent directors, (2) the CEO and the BOD chairman are not the same person, (3) the BOD size is smaller, and (4) the profitability is higher. The results also suggest that shorter CEO tenure on the BOD and the existence of ethical- standard disclosure are associated with the fraud likelihood.

The result regarding outside directors supports the recent regulatory reform of corporate governance (e.g., the 2002 Sarbanes-Oxley Act, the NYSE and the NASDAQ new rules) which requires a majority of independent directors on the board. The result concerning the duality of the CEO and board chairman suggests that the corporate governance could be further improved by disallowing a person to serve as both the CEO and the BOD chairman. The BOD size result indicates that smaller board size is likely to be more effective in monitoring management. This is in line with the ongoing effort at the NYSE to substantially reduce its board size. On the other hand, the ethical-standard result implies that fraud firms do not necessarily implement or enforce ethical standards even when they so stated in writing. This suggests that the BOD and the

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regulators need to ensure that firms not only have the ethical standards but also enforce these standards.

ENDNOTE

1 Beasley (1996) studied financial statement fraud where management intentionally issued materially misleading financial statement information to outside users or misappropriated corporate assets. Dechow et al. (1996) investigated firms subject to accounting enforcement actions by the Securities and Exchange Commission (SEC) for alleged violation of generally accepted accounting principles.

2 John Reed, interim chairman of NYSE, told lawmakers he sees no place for Wall Street executives on the NYSE board and plans to propose installing a majority of independent directors to oversee regulation at the exchange (Solomon 2003).

3 The average tenure of directors on the boards of S&P 500 companies is 8.4 years (Burns 2003).

4 See (Burns 2003) for real-world examples of pension funds ability to affect corporate governance changes.

5 This study accounts for a flaw of this measure when EPS t-1 is negative by reversing the sign of this measure.

6 Because the sample is relatively small, this study does not divide sample fraud firms into different categories as in Karpoff and Lott (1993).

7 If there is no potential control firm with the closest net sales in the same four-digit-SIC-code industry, the search for such firm is expanded to the three-digit SIC code and the two-digit SIC code, respectively.

8 Subsequent diagnostic test does confirm that there is no multicollinearity problem in the logit regression analysis.

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ACKNOWLEDGEMENTS

The author gratefully acknowledges Summer Fellowship from Rider University in support of this study.

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