Introduction
The proponent of the study examined the association between the believability of the financial reporting system within corporate America and the effectiveness of the government systems that were in place to prevent fraud. In order to accomplish this goal, the proponent of the study utilized a sample comprised of 87 firms that were identified by the SEC as fraudulent. At the early stage of the research process, a confirmation was made that the behavior of the said fraudulent firms were consistent with the results of previous research. For example, it was confirmed that these problematic companies were guilty of poor governance.
In addition, the said firms were characterized by the least number of outside board members, fewer numbers of audit meetings, fewer number of financial experts on the audit team, and a higher number of CEOs found to have dual roles as chief executive officer of the company and chairman of the board of the same company. Nevertheless, it was also found out that firms with fraud issues have the capability to make changes and improvements to the company’s financial reporting protocols. However, fraudulent firms suffer due to trust issues. Nevertheless, the companies that labored diligently to improve financial auditing procedures were rewarded by superior stock performance. According to the author, the improved performance was a clear indicator that investors value effective and appropriate governance improvements.
Main Research Question
According to research findings, financial reporting fraud is the inevitable outcome of poor corporate governance. However, little is known about the changes that firms made after fraud detection. In addition, little is known about the effectiveness and impact of fraud detection and improvements made to the system for the purpose of restoring the trust that was once enjoyed by investors. Due to the absence of meaningful research and crucial data, the proponent of the study sought to find out if there was any association between the discovery or detection of financial reporting fraud, the improvements made on the quality of corporate governance, and the subsequent economic consequences of the said improvements that were applied to the firm’s corporate reporting protocols. Thus, the secondary objective of the study was to find out if the diligent application of quality governance measures were helpful in restoring the firm’s reputation as manifested by the reaction of analysts, institutional investors, short-sellers, and the stock market.
Hypothesis
The said research design draws heavily on the assumption that the higher the quality of the corporate governance that was manifested in the accounting procedures of the company, the better the performance of the company. The general public seems to interpret these changes as a manifestation of high-quality corporate governance. In this regard, the proponent of the study also believed that several firms discovered to have been guilty of financial reporting indiscretion utilized a strategy based on governance improvements. In addition, the application of improvement strategies was perceived as a practical step in regaining investor confidence.
Model Used
With regard to the fraud sample selection, the proponent of the study made the determination based on publicly held companies that were identified by the SEC’s Accounting and Auditing Enforcement Releases as violators of SEC Rule 10b during the period between 1982 and 2000. In other words, these firms made material misstatements with regards to the facts of the company’s registration, prospectuses, and the periodic reports that they filed to the SEC. The violations also include the filing of false reports that affect how the market perceives the offer, sale, and purchase of the firm’s securities. Furthermore, three models were created to reflect variations in the outcome if certain factors were changed for the purpose of checking the validity of the results.
The Results
In Table 1 – Pane C: Fraud Statistics, this particular graphic revealed that of the 87 problematic firms, the majority of the reporting fraud detected was in fictitious transactions. However, close to 50% of the firms were also guilty of misstatements regarding the timing difference transactions. Using the said critical data, the proponent of the study also detected an emerging pattern that prompted the following conclusion: fraud firms have weaknesses when it comes to applying key governance protocols. For example, these firms have a board of directors that when examined, the percentage of outside directors was significantly lower compared to the firms in the control group. In addition, comparative studies found out that fraud firms have fewer audit committee meetings. Furthermore, there was evidence to prove that fraud firms utilize low-quality external audit firms.
In Figure 1 – Panel B: Means of Governance Variables in Levels, the results were tabulated to show the significant improvements in the percentage of outside directors in fraud firms after three years of deliberate changes and improvements. There was also a marked increase in the number of audit committee meetings. The same thing can be said of audit committee members. There was also tremendous strides that were made in terms of the number of outside directors that were present in audit committees. Finally, three years after fraud detection, there was a surge in the number of financial experts on audit committees.
In Table 5 – Descriptive Statistics and Pearson Pairwise Correlation for Returns, there was a significant difference in the buy and hold patterns when it comes to increasing the percentage of outside directors. There were also significant changes in the book value of the firms after fraud detection, especially when changes were applied to the governance and reporting process.
The proponent of the study cautioned analysts on interpreting the results of the regression analysis. It was made clear that the analysis that came as a result of studying the long-term buy-and-hold abnormal returns were fraught with econometric and interpretation issues. Nevertheless, the proponent of the study was confident to say that the results clearly indicated that increasing the percentage of outside directors after fraud detection was beneficial to the respective firms. Those seeking to improve performance and desiring to restore tarnished reputation was rewarded with positive changes in stock performance.
Contribution to Research
It was hard to deny the significance of the study with regards to inquiries in the area of fraud detection and corporate governance. In fact, the research design was unique, on the basis of examining the linkage between the credibility of a firm’s financial reporting mechanisms and the quality of governance systems. In other words, the value of the study can be found in determining the link by focusing on the changes that occurred after fraud detection. Thus, the significance of the results of the observations and statistical analysis was the capability to glean insights with regards to the impact on the firm’s performance and reputation if deliberate steps were made to apply recommended changes in financial reporting and overall corporate governance.
In addition, the examination of the firm’s background in the context of fraud firms strengthened theories and observations made in previous studies that highlighted the problematic firm’s poor governance mechanisms prior to the revelation that these firms were indeed guilty of misstatement and other reporting irregularities.
It was also made clear that poor governance was actually related to the absence of transparency frameworks as manifested in the fewer number, as well as lower percentages of outside board members. There was also a marked difference in the number of audit meetings that were held. There were fewer financial experts that were supposed to handle the audit committees. The fraud firms were also not keen on paying for the services of top-quality third-party auditors. The aforementioned problems form a pattern that compels an outsider to conclude that there was indeed a significant lack of transparency.
In addition to the glaring lack of transparency before the date of detection, fraud firms also had the largest number of CEOs who also served as chairmen of the board of directors. In this regard, one can argue that fraud firms had greater tendencies to suffer from the impact of conflicts of interest.
On a brighter note, the value of this study was also revealed in the discovery that fraud firms were willing to make drastic changes and that these changes were made through a conscious effort on the part of corporate leadership supporting the implementation of stricter guidelines and better accountability measures. Finally, the significance of the study was also revealed after the discovery that fraud firms continue to suffer as a direct result of reputation problems. Nevertheless, those willing to make changes were rewarded by superior stock performance.
Implementation
Improvements in the performance of fraud firms and the restoration of reputation are possible if drastic actions and the demonstration of a clear resolve to implement accountability measures were made after the detection of fraud. It is imperative that fraud firms suffering from the negative backlash of the loss of confidence from investors and analysts to quickly make changes and correct problematic areas especially with regards to corporate governance. It is also crucial to focus on implementing strategies that addressed the issues of accountability and transparency. With regards to transparency issues, the lack of outside directors and financial experts in auditing teams revealed the weakness in the governance protocols, because the lack of expertise and the lack of third party intervention makes it easier for conflicts of interest to thrive and for greed to affect the day-to-day operations of the company.
This was reflected in the significant number of problems associated with giving a false statement or erroneous reports. It was also difficult to correct the errors in thinking in certain transactions and corporate decisions if the CEO also served as the chairman of the board of directors. This study revealed the importance of establishing checks and balances. The presence of the board of directors was supposed to have a counter-checking mechanism in order to protect the interest of the investors. However, the practice of installing the CEO as the chairman of the board of directors negates the purpose of the board. In addition, the CEO is in a position to make decisions that favor his or her interest and not the overall performance and long-term value of the firm. Finally, the results of the study should inspire corporate leaders with the realization that even with the destructive label of fraud, the discovery of fraud firms does not automatically destroy the reputation and future of the company.