Boards of Directors and Fraud

Article excerpt

What characteristics of the board of directors play a role in preventing financial statement fraud? Useful insights can be obtained by comparing board characteristics for companies experiencing financial statement fraud with board characteristics for com panies not experiencing such fraud. Knowledge about board of director characteristics likely to affect the occurrence of financial statement fraud will be particularly useful to auditors as they fulfill their fraud risk assessment responsibilities described in the recently issued SAS No. 82, Consideration of Fraud in a Financial Statement Audit.

While the board of directors often delegates day-to-day responsibility for the design and operating effectiveness of internal control to top management, the board is gener ally viewed as a key internal control mechanism within a company because it is ultimately responsible for top management's actions. Auditing standards recognize the significant influence the board has over a company's internal control. Those standards particularly highlight the role of the board in establishing an effective control environment component of a company's internal control. In fact, SAS No. 55 requires the auditor to obtain "sufficient knowledge of the control environment to understand management's and the board of director's [emphasis added] attitude, awareness, and actions concerning the control environment." Other auditing standards recognize the importance of the board of directors by requiring the auditor to communicate various matters related to the audit directly to the board of directors or its audit committee (see, for example, SAS Nos. 54, 60, 61, and 82).

Even though auditing standards identify the board as a critical component of a company's internal control, little insight is provided about characteristics of the board of directors that might influence its ability to reduce instances of material financial statement fraud. While the recently issued SAS No. 82 notes that "Domination of management by a single person or small group without compensating controls such as effective oversight by the board of directors or audit committee" can be a risk factor relating to misstatements arising from fraudulent financial reporting, guidance is not provided as to the nature of characteristics of boards that may affect the board's ability to prevent or detect the occurrence of such fraud.

A potentially useful study examines differences in certain board of director characteristics between companies experiencing financial statement fraud and companies not experiencing financial statement fraud. Findings from the study may prove helpful to auditors as they evaluate fraud risk factors described in SAS No. 82.

The underlying Study

The population used to examine the relation of board of director characteristics and instances of financial statement fraud includes 150 publicly traded companies. Seventy-five of the 150 companies had an occurrence of material financial statement fraud reported during the period 1980-1991. Most of these fraud companies (67 of 75) were identified from a review of Accounting and Auditing Enforcement Releases (AAERs) issued by the Securities and Exchange Commission (SEC). The remaining eight fraud companies were identified from reports of financial statement fraud allegations in The Wall Street Journal. Seventy-five additional companies very similar in size, industry, national stock exchange, and time period to the 75 fraud companies were identified to serve as a benchmark for comparison. Thus. the total population consists of 75 fraud companies, each individually matched with a similar no-- fraud company.

Differences in Characteristics

Several differences in board of director characteristics are evident when comparing boards of the fraud and no-fraud companies. Boards of fraud companies differ from boards of no-fraud companies in composition, tenure, and ownership levels of its members and in the presence of an active audit committee as described more in the paragraphs that follow. …