The Relationship between Corporate Governance and Management Fraud: An Empirical Analysis

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ABSTRACT

Management fraud is an important issue, as determined by significant governing bodies and major accounting firms. There are significant implications for the profession and the capital markets stemming from instances of management fraud. This study determined instances of management fraud using SEC Accounting & Auditing Enforcement Releases (AAER's) and advances our understanding of how corporate governance factors might impact instances of management fraud. Overall, results of the analysis point to the importance of corporate governance playing a role in limiting instances of management fraud, especially auditor identity and tenure.

INTRODUCTION

The purpose of the study is to determine the relationship between corporate governance and the incidence of management fraud. There is evidence that cases of MF are ever increasing and that millions of dollars are being lost to such crimes. Management Fraud has wide ranging ramifications with all stakeholders being affected in varying ways.

Regulatory organizations have commented on the responsibility of the auditor to detect management fraud. There is agreement among interested parties that audit firms need to play an active role in the detection and reporting of management fraud. Consequently, the responsibility of the audit firm to detect and report management fraud has increased through the issuance of SAS No. 53 (AICPA, 1988).

Despite an increase in responsibility, access to inside information, and applying audit procedures, audit firms have not been successful in detecting and reporting management fraud. The reasons for this lack of success are several. First, the auditing standards, while increasing the role of the auditor in detecting management fraud, state that if the audit has been performed according to generally accepted auditing standards the auditor has done his job (SAS 53, AICPA, 1988). Second, management fraud represents a situation where management intentionally misstates financial statements. As acknowledged by numerous individuals, since auditing involves testing a sample, management may have a well-concealed fraud such that the auditor is misled (Hanson, 1977; Kapnick, 1977; Arens & Loebbecke, 1988; AICPA, 1988; Campbell & Parker, 1992; Bintliff, 1993). Third, considerable amount of litigation against the auditor, large settlements by auditors, and negative press exists against the auditor, stemming from management fraud (Palmrose, 1987; Palmrose, 1991), as well as evidence pointing to the inability of the audit firm to detect management fraud (Park, 1989; Welch et al., 1995). Fourth, representatives of the auditing profession have pointed out that they are neither trained nor are necessarily able to detect violations of law that govern corporate conduct (Cressey, 1987).

This increase in responsibility but consequent inability of the audit firm to detect management fraud has had repercussions. Authoritative bodies have determined that a gap exists between the expectations of the users of financial statements and the performance of the auditing profession. They further determine that one way to reduce the gap would be for the audit firms to improve their ability to detect and report management fraud.

As early as 1977, Hanson called for increased research, development, and application of techniques to aid the auditor in detecting management fraud. Limited research has been conducted on the detection and reporting of management fraud. Additionally, the research suffers from multiple weaknesses including design and sample issues, and a lack of theory used to motivate variables.

CONCEPTUAL FOUNDATION

Agency theory is based on the view that firms are legal fictions that serve as a nexus for a set of contractual relationships among self interested individuals whereby ownership and control are separate (Alchian & Demsetz, 1972; Jensen & Meckling, 1976; Fama, 1980). …