Corporate Governance and Financial Reporting Irregularities. Nadia Smaili University of Quebec in Montreal Business School

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1 Corporate Governance and Fnancal Reportng Irregulartes Nada Smal Unversty of Quebec n Montreal Busness School Réal Labelle** Stephen A. Jarslowsky Char n Governance HEC Montréal **Correspondng author HEC Montréal Department of Accountng Studes 3000 Chemn de la Côte Sante Catherne Montréal (Québec) Canada H3T 2A7 Emal: real.labelle@hec.ca Tel: (514) Acknowledgments We apprecate the valuable comments receved from Bernard Snclar-Desgagné, Mchel Magnan, Luo He, Zoe-Vonna Palmrose, Stéphane Rousseau, Jean-Marc Suret, and Danel B. Thornton, as well as those from partcpants n the EAA Annual Meetng, the CAAA Ph.D. Workshop, and workshops at UQAM, Laval Unversty, and Ivey Busness School. The authors also gratefully acknowledge fnancal support from the Socety and Culture Research Fund of Quebec (FQRSC) and the Socal Scences and Humantes Research Councl of Canada (SSHRC). The usual caveat apples. February

2 ABSTRACT Ths study examnes the extent to whch corporate governance acts as an effcent means of protectng nvestors aganst accountng rregulartes. It s grounded n the lteratures on publc enforcement of securtes laws by market authortes, governance, and fraudulent fnancal statements. A number of nnovatons concernng nsttutonal settng, and the defnton and level of noncomplance of fnancal reportng rregulartes are brought to bear n revstng ths fundamental research queston. A matched-control-frm desgn s employed to compare qualty of corporate governance to that of frms found n default of the fnancal statement flng requrements of the Ontaro Securtes Commsson (OSC). A unque feature of the OSC trackng and enforcement system for reportng ssuers n default s used to refne the defntons of accountng rregulartes or fraudulent fnancal statements used n other studes. Reportng frms n default are separated nto those that were able to restate ther fnancal statements to comply wth OSC flng requrements and those that were not, leadng to a cease trade order or, n the most severe cases of rregulartes, were sued for fraudulent fnancal statements. Compared to matched control frms, we fnd that reportng ssuers found n default durng the frst fve years of exstence of the OSC system: (1) have fewer ndependent drectors on ther boards and audt commttees and no non-afflated blockholders, (2) have recently changed audtors, (3) have a CEO who s also the char, and (4) show poor communcaton between audt commttee and audtor. Such frms also appear to fulfll ther fnancng requrements through prvate placements rather than publc funds, whch s consstent wth the fact that reportng ssuers n default are less lkely to be n a poston to return to the publc market to fulfll ther needs. Compared to frms that were able to restate, we also fnd lower governance qualty n cease trade order and fraudulent frms, but no dfference n ths characterstc between these two categores of frms. Keywords: Governance, accountng rregularty, fnancal reportng qualty, fraudulent fnancal statement, restatement, regulaton, reportng ssuer n default JEL Classfcaton: G38, G34, G32 2

3 1. INTRODUCTION Corporate governance has attracted ncreasng attenton over the last 15 years, owng n part to fnancal scandals stemmng from accountng rregulartes. However, the lterature shows mxed results n relatng fnancal reportng rregulartes 1 to poor corporate governance (Neschwetz et al. 2000; Cohen et al. 2004; He et al. 2009; Beasley et al. 2010). An examnaton of ths lterature reveals several shortcomngs, whch we address n ths study. Frst, as ponted out by Bushman and Smth (2001: 286), Cohen et al. (2004), García Lara et al. (2009), and Bozec and Bozec (2012), most studes only examne characterstcs of boards, audt commttees, or audtors one at a tme. Our study consders governance as a system by combnng these characterstcs nto scores and nteracton terms n our emprcal model. Thus, as n pror research, we frst use partal models to determne whether ndvdual corporate governance mechansms are negatvely related to the level of noncomplance (LNC) or rregularty. We then use ntegratve models to study the effect of governance as a system. The second shortcomng s that rregulartes are often defned dfferently from one study to another (Stolowy and Breton 2004) and sometmes even nclude earnngs management wthn generally accepted accountng prncples (GAAP) (Dechow and Sknner 2000). Ths may create confuson and lead to dffcultes n comparng and nterpretng results. In ths study, we only focus on the use of fnancal reportng practces outsde GAAP. 1 We use nterchangeably fnancal reportng or accountng rregularty to descrbe corporate fnancal reportng practces found by the OSC to be n default of ts fnancal statement flng requrements. 3

4 Further, studes do not always dstngush between whether the rregularty s detected by management, the board, the audtor, or the regulator. For nstance, Agrawal and Chadha (2005) examne restatements ntated by the audtor or the Securtes and Exchange Commsson (SEC), Abbott et al. (2004) focus on those ntated by the board of drectors, the audtor, or the SEC, and McMullen (1996) examnes restatements ntated by the board or the audtor. When an rregularty s detected by the board or the audtor, ths s usually consdered good governance, whle when t s detected by the regulator, t ndcates that the frm s corporate governance system faled to prevent the accountng rregularty. To examne whether corporate governance qualty s related to the extent to whch fnancal reportng rregulartes are detected by market authortes, governance of frms n default of flng requrements s compared to a control group of frms not n default. Whle some studes examne the relatonshp between governance and restatements (Abbott et al. 2004; Palmrose and Scholz 2004; Baber et al. 2005; Burks 2010), and others focus on the relaton between governance and fraudulent fnancal statements (Beasley 1996; Abbott et al. 2000; Farber 2005; Beasley et al. 2010), ths study goes a step further by examnng whether fraudulent frms, the most severe case of accountng rregularty, have worse governance than frms upon whch a cease trade order (CTO) or a restatement s mposed. In other words, t takes nto consderaton that rregulartes are part of a contnuum between errors (Hennes et al. 2008), low levels of noncomplance wth regulatons, and outrght fraud (Beasley et al. 2010) and may vary dependng on governance qualty. 4

5 Fnally, lttle s known about publc enforcement of securtes laws by market authortes outsde the Unted States, partly because, untl recently, there was a lack of publc data, such as the nformaton publshed by the Government Accountablty Offce and the SEC n ts accountng and audtng enforcement releases (AAER). Further, for reasons outlned n the COSO 2 study conducted by Beasley et al. (2010: 45), t has become more dffcult to conduct research on the presumed relatonshp between governance qualty and fnancal reportng qualty n the US wthout takng nto consderaton the nteracton of varous governance mechansms: Board governance characterstcs often do not dffer meanngfully between fraud and no-fraud frms. These characterstcs have been the focus of recent regulaton, thus reducng or even elmnatng prevous fraud/no-fraud dfferences. Future research on governance processes and the nteracton of varous governance mechansms may be needed to dentfy less-observable governance dfferences assocated wth fraudulent fnancal reportng. European countres and Canada have adopted a prncple-based approach wth regard to governance practces (La Porta et al. 2000). Therefore, we conduct ths research n Canada, because the comply or explan approach adopted n ths nsttutonal settng allows management more lattude n ther choce of governance polcy and allows for the varablty needed to conduct statstcal analyses. The objectve of ths paper s to contrbute to the lteratures on publc enforcement of securtes laws, governance, and fraudulent fnancal statements (La Porta et al. 2006: 4 & 12; Palmrose 1999; Bonner and Palmrose 1998; McMullen 1996; Beasley et al. 2010). We hope to further these lnes of research by studyng the effect varous levels of corporate governance qualty may have n mnmzng rregulartes. Our sample of rregulartes s drawn from a shame lst mantaned by the Ontaro Securtes Commsson (OSC), whch sngles out frms n 2. Commttee of Sponsorng Organsaton of the Treadway Commsson. 5

6 default of fnancal statement flng requrements (FSFR). Snce the Toronto Stock Exchange s the man Canadan fnancal market, the OSC s the de facto Canadan market authorty (Brooks and Labelle 2006). To our knowledge, ths s the frst tme these OSC regulatory data are used n academc research on poor governance and fnancal accountng msreportng. Snce dentfcaton of reportng ssuers n default (RID) s mportant for nvestor protecton, the ultmate objectve s to help polcy makers and natonal securtes admnstrators mprove ther nvestgatve effectveness. We hope to acheve ths through a better understandng of the corporate governance characterstcs of those reportng ssuers dentfed as beng n default. Ths study covers the fve-year perod followng mplementaton of the OSC trackng and fnancal reportng enforcement system. Thus, usng the OSC lst for the perod 2001 to 2005, we dentfy three levels of noncomplance by RID frms accordng to the level of sancton mposed by the OSC; the frst ncludes 43 frms. These were removed from the RID lst and placed n a Re-flng and errors lst after makng the correctons requred by the OSC. To be placed on that second lst consttutes the lowest level of sancton mposed by the OSC. The second level of rregulartes ncludes 64 RID frms that were ssued a full CTO or a CTO lmted to management and nsders (M&I-CTO). The thrd level conssts of 11 RID frms that, n addton to beng ssued a CTO, were cted for fraudulent fnancal statements, the most severe level of sancton. As n Beasley et al. (2010), ths sample of 107 RID frms s matched wth 107 non-rid control frms on the bass of sze, ndustry, Canadan stock exchange lstng, and date of default or sancton. 6

7 Compared to matched frms, we fnd that RID: (1) have fewer ndependent drectors on ther boards and audt commttees and no non-afflated blockholders, (2) have recently changed audtors, (3) have a CEO who s also the char, and (4) show poor communcaton between audt commttees and audtors. These frms also appear to fulfll ther fnancng requrements through prvate placements rather than publc funds. Ths s consstent wth the fact that RID are less lkely to be n a poston to return to the publc market to fulfll ther needs. Compared to frms that were able to restate, we also fnd lower governance qualty n CTO and fraudulent frms, but no dfference between the latter two categores. Ths paper s organzed as follows. In Secton 2, we present the nsttutonal settng of our study. In Secton 3, we revew the relevant theoretcal and emprcal lterature and dscuss the assumed negatve relatonshp between corporate governance and the serousness of accountng rregulartes. In Secton 4, we descrbe our methodology. Emprcal analyss and nterpretaton of results are presented n Secton 5. Fnally, n Secton 6, we conclude wth a summary as well as caveats and suggestons for future research. 2. INSTITUTIONAL SETTING Most research on whether governance matters to the preventon and detecton of fnancal reportng rregulartes s conducted n the US. Despte the contnung mportance of ths queston, ths lne of research has become dffcult to contnue n the US. Indeed, changes n stock exchange lstng requrements mplemented by the major U.S. exchanges (Beasley et al. 2010: 4) have had the effect of standardzng governance practces and removng some of the 7

8 varance needed to examne the ssue. Further, lttle s known about publc enforcement of securtes laws by market authortes outsde the US. Ths s largely because, untl recently, there was a lack of publc data, such as the nformaton publshed n the SEC AAER on rregulartes and enforcement actons. In contrast to the rule-based approach n the US, Canada and most countres n Europe and Asa 3 pursue a prncple-based approach wth regard to governance practces (Saltero and Conrod 2009). Ths nsttutonal settng allows management more lattude n ther choce of governance polcy and allows for the varablty needed to conduct statstcal analyses. In Canada, a frm lsted on the Toronto Stock Exchange must comply wth FSFR. The FSFR refers to all annual or nterm OSC flng requrements relatve to fnancal statements or documents such as the Management Dscusson and Analyss. OSC polcy descrbes the key defcences wth regard to FSFR, whch are summarzed n Appendx 1. Ths research focuses on accountng rregulartes that are defned as default H n Appendx 1. Ths FSFR defnton concerns defcent fnancal statement dsclosures or acknowledgement by an ssuer that the audtor report may no longer be reled upon. Pursuant to subsecton 72(9) of the Ontaro Securtes Act, snce 2001, falure to comply wth OSC requrements may result n nserton on the RID lst. OSC polcy also ndcates how the Commsson determnes whether a reportng ssuer s n default of any requrement, and the related sanctons. Appendx 2 descrbes several cases of RID frms. As shown on the left-hand sde of Fgure 1, when a defcency s detected by the OSC, the defaultng frm s put on the Reportng ssuer n default lst and the Commsson requres that the default be corrected. If the correcton satsfes the Commsson, the ssuer must re-fle, and ts 3 See European Corporate Governance Insttute - Index of all codes ( 8

9 name s put on another lst referred to as the Re-flng and errors lst 4 for a perod of three years [OSC staff notce (amended May 2005)]. In more serous cases n whch the defcency cannot be corrected or where the frm s proposed restatement does not satsfy the Commsson s requrements, the OSC keeps the ssuer under nvestgaton, as the ssuer s then suspected of fraud. The OSC may then ether mpose an M&I-CTO or a full CTO under paragraph 2 of subsecton 127(1) of the Ontaro Securtes Act. The two types of CTO may be mposed permanently or for such a perod as specfed n the order. Fnally, n the most serous cases of default, such as ssung fraudulent fnancal statements, management s ndcted by the OSC for fraud and the frm s subject to OSC enforcement acton. Thus, as shown on the rght-hand sde of Fgure 1, rregulartes commtted by RID frms may gve rse to three levels of dscplnary acton: (1) a restatement, (2) an M&I-CTO or a full CTO, and (3) enforcement acton. An rregularty that leads to a restatement s less serous than one that leads to a CTO. In turn, an rregularty that leads to a CTO s less severe than fnancal statement fraud, whch also leads to enforcement acton. In our research desgn, we use the above OSC trackng and enforcement system of RID to measure the serousness or level of noncomplance of fnancal reportng rregulartes. [Insert Fgure 1 here] 4 The Re-flng and errors lst dentfes reportng ssuers that were requred as a result of a regulatory revew to (a) restate and re-fle fnancal statements; (b) mplement accountng or dsclosure changes on a retroactve bass, where such an accountng change represents the correcton of an error n the fnancal nformaton as orgnally fled or; (c) amend and re-fle other contnuous dsclosure documents. 9

10 3. THEORY AND HYPOTHESIS DEVELOPMENT Publshed research on the relatonshp between corporate governance and fnancal reportng qualty focuses ether on earnngs management, whch may be done wthn GAAP, or on accountng rregulartes such as fraudulent fnancal statements, whch clearly oversteps both GAAP and legal bounds (Abbott et al. 2004; Baber et al. 2005; Farber 2005). In most studes, these unethcal fnancal reportng practces and ther consequences are examned ndvdually and n relaton to a lmted number of corporate governance practces. Cohen et al. (2004) ndcate that these studes fal to consder that governance practces nteract and are part of a mosac, and that earnngs management occurs on a contnuum, whch may lead to fraud and value destructon (Jensen 2005). Beasley et al. (2010) also call for research on governance processes and the nteracton of varous governance mechansms. McMullen (1996) appears to be the only researcher to examne several consequences of fnancal statement unrelablty n the same study. Ths author examnes whether the presence of an audt commttee s assocated wth any one of fve potental consequences: shareholder ltgaton, management fraud, SEC acton, llegal acts, or audtor turnover. McMullen examnes each consequence separately and n relaton to one governance mechansm, the presence or absence of an audt commttee. McMullen admts (p. 101) that several varables, such as audt commttee composton, ndependence, and experence are omtted; these varables can affect fnancal statement relablty. Klen (2002) focuses on the relatonshp between earnngs management and the characterstcs of audt commttees and boards of drectors, whle Beasley (1996) carres out an emprcal analyss on the relatonshp between board of drector 10

11 composton and fraudulent fnancal statements. We contrbute to ths lne of research by examnng the relatonshp between corporate governance as an nteractve system and a range of fnancal reportng rregulartes. Fgure 2 presents the conceptual framework adapted from Smal et al. (2009) that we use to descrbe the hypotheszed relatonshp between varous corporate governance mechansms and the gravty or level of noncomplance of rregulartes as defned n the prevous secton. The framework s based manly on agency theory (Jensen and Mecklng 1976). Under ths contractual vson of organzatons, managers are apponted by shareholders to manage the frm n ther best nterests. In ths settng, the separaton of ownershp and control over decson makng creates a potental governance problem or a stuaton of nformaton asymmetry n favor of managers, who do not entrely assume the economc consequences of ther decsons. Ths stuaton can gve rse to an ex ante adverse selecton problem, f managers take advantage of ther poston to manpulate nformaton by commttng fnancal reportng rregulartes, or even fraud, and to an ex post moral hazard problem, f managers use ther poston to shrk or undertake projects other than those specfed n the contract. To reduce ths asymmetry and the ensung potental opportunstc behavor, managers select the level of agency costs they are wllng to bear to attan the desred governance qualty target. Ths ncludes agreeng to work under the authorty of a more or less effcent board of drectors or under the montorng of a more or less effcent audt commttee or governance system (rghthand sde of Fgure 2) to reassure shareholders that they are actng n shareholder nterests. These 11

12 mostly nternal mechansms complement external market mechansms, such as nsttutonal and outsde block ownershp, as shown n the left porton of Fgure 2. Fgure 2 also ncludes control varables for frm fnancng requrements, sze, and current ndebtedness. For nstance, managers have an nterest n beng forthcomng to mantan ther frm s credt ratng n the fnancal markets, and ther reputaton n the labor market. [Insert Fgure 2 here] 3.1 Board and audt commttee montorng effectveness The board of drectors and ts audt commttee play a crtcal role n corporate governance, especally n montorng top management. Fama and Jensen (1983) vew the board as the frm s hghest-level control mechansm, wth ultmate responsblty over how the frm s run. The lterature on restatement, fraudulent fnancal statements, and fnancal reportng qualty n general ndcates that the composton and characterstcs of the board nfluence ts effectveness n ths regard. The man proxes used for board power, competence, and ndependence nclude: (1) proporton of ndependent drectors on the board (Uzun et al. 2004; Baber et al. 2005; Farber 2005; Beasley et al. 2010) or on ts audt commttee (Abbott et al. 2000; Abbott et al. 2004); (2) presence of fnancal experts (Farber 2005); (3) number of seats drectors hold on other boards (Beasley 1996); and (4) separaton of the postons of CEO and charperson of the board, a measure of ndependence of the board from CEO domnance (Dechow et al. 1996; Abbott et al. 2000). 12

13 The deterrence effect of board ndependence on restatements may not be the same as for fraudulent fnancal statements. Beasley (1996) shows that the percentage of ndependent drectors s negatvely assocated wth fraudulent fnancal statements. In contrast, Abbott et al. (2004) and Baber et al. (2005) show that the relatonshp between board ndependence and the probablty of restatement s not sgnfcant. Besdes, Beasley et al. (2010) fnd that frms wth fraudulent fnancal statements had sgnfcantly more nsde drectors than non-fraudulent frms n the perod, but ths dfference dd not contnue n the perod. Ths may be due to the fact that board ndependence was mposed on all frms by SOX, followng Enron. Our conceptual framework predcts that the percentage of ndependent drectors 5 n fraudulent frms s lkely to be lower than n CTO and restatement frms (Fgure 2: H1). Smlarly, t s expected that the presence of a non-afflated blockholder on the board, as n Abbott et al. (2004), s negatvely assocated wth rregulartes. Followng Farber (2005), we also surmse that the presence of fnancal experts on the board of drectors and on the audt commttee prevents rregulartes and mnmzes ther severty. To better reflect the partcular characterstcs of Canadan regulatons, we use two varables to dstngush fnancal expert drectors from fnancally lterate ones, as defned n OSC regulatons. The BoardExpert varable represents the number of drectors wth a professonal desgnaton n accountng or fnance (CA, CMA, CGA, or CFA) or wth a specalzed unversty dploma n accountng or fnance. The fnancally lterate 6 varable (BoardComp) s the number 5 Defned as a drector unrelated to management as n Dey (1994) and Saucer (2001). 6 Accordng to MI , fnancal lteracy s the ablty to read and understand a set of fnancal statements wth comparable breadth and complexty of accountng ssues. 13

14 of drectors wth a Master of Busness Admnstraton (MBA) or a Bachelor of Busness Admnstraton (BBA) or wth experence n fnance or n accountng. In summary, nasmuch as they are presumed to contrbute to the ndependence and competence of the board, we expect that the features mentoned above and represented n Fgure 2 (H1) wll, on average, be negatvely assocated wth frm rregulartes. Further, consderng the lkely synergy and nterdependence between corporate governance varables (Cohen et al. 2004), these varables must be aggregated to measure board effectveness. Therefore, we formulate a score (Score_Board) as n Abbott et al. (2000) to proxy for the level of effectveness, or the extent to whch Board characterstcs are n complance wth best governance practces. Ths score 7 takes the value of 3 when: the poston of CEO s separated from the poston of char (COB); the percentage of unrelated drectors s greater than 50%; and board membershp ncludes fnancal experts. Score_Board takes the value of 1 f: the CEO s also the COB; the percentage of unrelated drectors s lower than 50%; and board membershp does not nclude fnancal experts. Fnally, ths score s equal to 2 n all other cases. Score_Board s used to emprcally test the followng hypothess, n alternate form: H1. Board effectveness s negatvely assocated wth the level of non complance (LNC) or the serousness of fnancal reportng rregulartes. As suggested by McMullen (1996: 101), we study the effectveness of the audt commttee by examnng ts characterstcs. Abbott et al. (2004), Farber (2005), and Marcukatyte et al. (2006) 7 The cut-offs used for scores are based on Canadan recommendatons wth regard to corporate governance presented n the OSC MI followng the Dey (1995) and Saucer (2001) reports on the governance of Canadan frms. 14

15 fnd that the competence and ndependence of the audt commttee s negatvely assocated wth the occurrence of accountng rregulartes. Agrawal and Chadha (2005) and Abbott et al. (2004) suggest a negatve relatonshp between the presence of fnancal experts on the audt commttee and the occurrence of restatements. Compared to matched control frms, Farber (2005) shows that fraudulent frms have a lower proporton of fnancal experts on ther audt commttees. Consstent wth prevous studes, we suggest that the proporton of ndependent drectors and fnancal experts s negatvely assocated wth noncomplance level. We therefore formulate a score for audt commttee effectveness (Score_Audt), whch equals 3 f the percentage of unrelated drectors on the audt commttee exceeds 75% and f there s at least one fnancal expert on the audt commttee. Ths score s equal to 1 when the percentage of unrelated drectors drops below 75% and when there s no fnancal expert. Fnally, ths score s equal to 2 n all other cases. Score_Audt s used to test the followng hypothess: H2. Audt commttee effectveness s negatvely assocated wth LNC or the serousness of fnancal reportng rregulartes. 3.2 Audtor effectveness Audt qualty and audtor tenure are mportant determnants of audt effectveness and are lkely to play a crtcal role n preventng and detectng rregulartes. Accordng to Farber (2005) and Sennett and Turner (2001), the presence of a Bg 4 audtor, a proxy for audt qualty, s negatvely assocated wth the occurrence of accountng rregulartes. For nstance, Farber 15

16 (2005) ndcates that fraudulent frms are, on average, less often audted by one of the Bg 4 audtors as compared to matched control frms. The relatonshp between a change of audtors or ther tenure and the probablty of fraud s not clear. Farchld et al. (2009) suggest that audtor tenure may have conflctng effects on the detecton and/or revelaton of management fraudulent behavor. Due to the learnng curve effect, the audtor s ablty to detect fnancal fraud may be weak n the perod followng a change of audtor. On the other hand, a new audtor may be more ndependent from management and more forthcomng about possble abuses (the ndependence effect). Stanley and DeZoort (2007) suggest a negatve relaton between the length of audtor clent assocaton and the lkelhood of restatement. Pot and Jann (2007) fnd that the occurrence of restatements s often preceded by (postvely assocated wth) a change of audtor. Mtra et al. (2009) fnd that the shorter an audtor s tenure, the hgher the rsk of ms-statements n the fnancal reportng process. Fnally, Carcello and Nagy (2004) suggest that frms wth a tenure of three years or less are more lkely to face SEC sanctons. We combne these varables nto a score for audtor effectveness (Score_Audtor); ths score equals: 3 f the audtor s a Bg 4 frm and there s no change n audtor n the year precedng default detecton; 1 f the audtor s not a Bg 4 frm and there s a change of audtor; and 2 n all other cases. Score_Audtor s used to test Hypothess 3, whch s stated as follows: H3. Audtor effectveness s negatvely assocated wth LNC or the serousness of fnancal reportng rregulartes. 16

17 3.3 Interacton between corporate governance mechansms As suggested by Cohen et al. (2004) and Beasley et al. (2010), rather than examnng only ndvdual board, audt commttee, or audtor characterstcs, we also consder governance as a system by combnng these characterstcs nto scores and nteracton terms n the emprcal model. Thus, we frst run partal models to test the above three hypotheses regardng whether these ndvdual corporate governance mechansms are negatvely related to the serousness of accountng rregulartes. Then, to test nteracton and examne the presumed effect of governance as a system, full or ntegratve models are run. We hypothesze that synergy or nteracton between corporate governance mechansms may further prevent accountng rregulartes, as set forth n Hypothess 4: H4. The nteracton between the effectveness of the board of drectors, ts audt commttee, and the audtor s negatvely assocated wth LNC or the serousness of fnancal reportng rregulartes. All hypotheses are summarzed n Fgure 2, whch presents our framework. 17

18 4. METHODOLOGY Ths secton presents the sample selecton and model development processes and defnes the dependent, ndependent, and control varables of the varous models used. Table 1 presents the characterstcs of the sample studed, and Table 2 summarzes and defnes the varables. 4.1 Sample selecton and descrpton of the dependent varable Ths study examnes the extent to whch corporate governance acts as an effectve means of nvestor protecton aganst fnancal reportng rregulartes. The OSC s responsble for enforcng good reportng practces by TSX ssuers under ts polces and Thus, the ntal sample conssts of all 425 frms dentfed as n default by the OSC durng the frst fve years of exstence of the OSC system, endng March Ths total s frst reduced by 268, as we focus only on fnancal reportng rregulartes, as defned under H n Appendx 1. Then, 43 fnancal frms are removed because they are subject to dfferent regulatons, along wth 7 other frms because we are unable to fnd data for them. As shown n Table 1, panel 1, ths leaves a fnal sample of 107 frms lsted on the TSX or TSX Venture n default of the OSC H requrement. Forty-three of the 107 RID frms were requred to restate and re-fle ther fnancal statements. Sxty-four remaned under nvestgaton and were mposed a CTO because they were not able or dd not accept to restate ther fnancal statements as per OSC requrements. Among these 64 CTO frms, 11 were mposed an enforcement acton because of fraudulent fnancal statements. 18

19 We use the severty of the sanctons mposed on these RID frms to measure LNC or the serousness of the rregularty, as dsplayed n both Fgure 1 and n the central secton of the conceptual framework presented n Fgure 2. In other words, we use the lst of RID to dentfy fnancal reportng rregulartes of varous levels of gravty, along wth ther correspondng OSC dscplnary sanctons. As n Beasley (1996: 450) and Beasley et al. (2010), each of the ssuers n default s matched wth a non-rid frm, based on the followng characterstcs: 1. Industry: All RID frms are matched wth a non-rid frm wthn the same ndustry. 2. Stock Exchange: RID and matched non-rid shares must be traded on the same stock exchange, ether the Toronto or the TSX Venture exchange. 3. Tme perod: A non-rid frm s ncluded n the fnal control sample f a proxy statement s avalable on the System for Electronc Document Analyss and Retreval 8 for the same year the RID frm was cted as beng n default. 4. Sze: For each RID frm, we select a non-rid frm n the same sze category. 9 Corporate governance data are collected from proxy statements. Fnancal nformaton s from the Mergent Onlne and Corporate Retrever databases. Informaton regardng fnancal and accountng expertse s from the FRnformat database and the Canadan Busness edton of Who s Who. Panel 2 of Table 1 ndcates that RID frms are clustered n the mnng, technology, and servce ndustres. Ths s consstent wth pror research, whch ndcates that fnancal reportng 8 SEDAR s the offcal ste that provdes access to publc securtes documents and nformaton n Canada ( It s smlar to EDGAR n the Unted States. 9 We used the same sx sze categores as n SEDAR: less than 5 mllon n assets, between 5 and 25 mllon, between 25 and 100 mllon, between 100 and 500 mllon, between 500 mllon and 1 bllon, and more than 1 bllon. 19

20 rregulartes are more prevalent n more volatle ndustres (Gerety and Lehn 1997; Sennett and Turner 2001; Farber 2005). For nstance, computer hardware/wholesalers represent the largest porton of fraud frms n Beasley et al. (2010), at 20%. Panel 3 of Table 1 shows that 44% of RID frms are small. These results mrror those of Knney and McDanel (1989) and Sennett and Turner (2001), who nterpret ths as meanng that small frms have fewer formal procedures of nternal control. [Insert Table 1 here] 4.2 Models We use ordnal logt regresson models to test our hypotheses, because the dependent varable, LNC or rregularty, s an ordered categorcal varable. LNC takes the value of 0 for matched control frms, 1 for restatement frms, 2 for CTO frms, and 3 for frms subject to enforcement actons because of fraudulent fnancal statements. Table 2 summarzes and defnes the varables used n the model. The followng partal models (PM) are used to test the hypotheszed relatonshp between rregulartes and ndvdual board of drectors (H1), audt commttee (H2), and audtor (H3) characterstcs. In the PM1 model, we test H1 by examnng the proporton of ndependent drectors (Unrelated) and fnancal experts on the board (BoardExpert), drector ownershp (OwnerBoard), dual functons of the CEO (CEO=COB), presence of a blockholder (BlocknBoard), and number of drectorshps n other frms (Nseats). Three control varables are 20

21 also ncluded. Frst, we expect frms also lsted n the US (USA) to be more lkely to comply than frms lsted only n Canada because of the more strngent regulatons n the US. Second, Dechow et al. (1996) fnd that fraudulent frms are lkely to have greater fnancng needs than control frms. We use the same varable (Fnancng) as these authors to control for RID fnancng requrements,.e., announcement of a prvate placement n the year precedng default. The underlyng hypothess s that RID frms are less lkely to be n a poston to return to the publc market to fulfll ther needs. Thrd, Bozec (2008) fnds a non-monotonc relatonshp between Canadan corporate ownershp structure and earnngs management. The varable (OwnerBlock) controls for ownershp concentraton, whch should deter fraudulent behavor. LNC = Unrelated+ 2 OwnerBoard+ 3 BoardExpert+ 4 (CEO=COB)+ 5 BlocknBoard + 6 Nseats+ 7 USA+ 8 Fnancng + 9 OwnerBlock+ (PM1) In the second partal model, PM2, we test the hypotheszed relatonshp between the audt commttee and LNC or rregulartes (H2). We examne the proporton of unrelated drectors (UnrelatedAudt), ther fnancal expertse (AudtExpert) and fnancal lteracy (AudtComp), the presence of a non-afflated blockholder (BlocknAudt) on the audt commttee, and ts sze (AudtSze). The control varables reman the same. LNC = UnrelatedAudt+ 2 AudtExpert+ 3 BlocknAudt + 4 AudtSze + 5 AudtComp + 6 USA+ 7 Fnancng+ 8 OwnerBlock+ (PM2) Fnally, we test the hypotheszed relatonshp (H3) between audtor qualty as measured by whether t belongs to one of the Bg4 (Bg4) and LNC n model PM3. We also examne whether a recent change of audtor (ChangeAudtor) may be related to the serousness of accountng rregulartes. All control varables reman the same. 21

22 LNC = Bg4+ 2 ChangeAudtor+ 3 USA+ 4 Fnancng + 5 OwnerBlock+ (PM3) The precedng partal models separately examne the mpact of three corporate governance mechansms (board, audt commttee, and audtor) on LNC. We also use full models (FM) to examne whether corporate governance mechansms work as a system. Models FM1 and FM2 examne whether the board, the audt commttee, and the audtor affect LNC. The varable CEO ownershp (OwnerCEO) s also ntroduced to examne whether t affects the level of rregularty. Contrary to the algnment of nterests hypothess, Johnson et al. (2008) suggest that the percentage of CEO ownershp n fraudulent frms s hgher than n control frms. Smlar to Hermaln and Wesbach (1988) and Chung and Prutt (1995), who show that the relatonshp between CEO ownershp and performance s curvlnear, we hypothesze that the same relatonshp exsts wth LNC. Indeed, an ncrease n CEO ownershp may ntally algn nterests and consequently be assocated wth a reducton n the serousness of accountng rregulartes. However, over and above a partcular ownershp threshold, entrenchment may set n and facltate fraudulent behavor. Model FM1 examnes whether board, audt commttee, and audtor characterstcs affect LNC. In FM2, we ntroduce an nteracton term nto FM1 between the percentage of ndependent drectors on the audt commttee and the presence of a Bg 4 audtor (UnrelatedAudt*Bg4). Ths model allows us to test H4. In FM1 and FM2, we control for CEO ownershp, 10 US lstng, and fnancng needs. 10 The control varable (OwnerBlock) s omtted n the FM1 and FM2 models due to hgh correlaton wth the CEO ownershp varable (coeffcent = 0.4, sgnfcant at 5%). 22

23 LNC = Unrelated+ 2 BoardExpert+ 3 (CEO=COB)+ 4 BlocknBoard+ 5 UnrelatedAudt + 6 AudtExpert+ 7 Bg4+ 8 ChangeAudtor + 9 OwnerCEO + 10 (OwnerCEO) 2 (FM1) + 11 USA + 12 Fnancng + LNC = Unrelated+ 2 BoardExpert+ 3 (CEO=COB)+ 4 BlocknBoard+ 5 UnrelatedAudt + 6 AudtExpert+ 7 Bg4+ 8 ChangeAudtor + 9 OwnerCEO + 10 (OwnerCEO) (UnrelatedAudt*Bg4)+ 12 USA+ 13 Fnancng + (FM2) In FM3 and FM4, we aggregate the corporate governance mechansms n scores and nteracton terms, as descrbed earler, to examne the presumed relatonshp between corporate governance as a system and LNC. LNC = Score_Audt+ 2 Score_Audtor+ 3 Score_Audt*Score_Audtor+ 4 USA + 5 OwnerBlock + 6 Fnancng + (FM3) LNC = Score_Board+ 2 Score_Audt+ 3 Score_Audtor+ 4 Score_Board*Score_Audtor + 5 Score_Audt *Score_Audtor+ 6 USA+ 7 Fnancng + 8 OwnerBlock+ (FM4) [Insert Table 2 here] 5. RESULTS In ths secton, we frst descrbe the characterstcs of RID, then we employ unvarate analyses to compare RID to non-rid frms. Fnally, we dscuss the results of the multvarate analyses, followed by a dscusson of senstvty analyses. 23

24 5.1 Unvarate analyses We frst segregate the RID sample nto sub-samples accordng to the severty of the default, as defned n Fgure 1. Panel 1 of Table 3 provdes comparatve statstcs for board of drector characterstcs. The comparson reveals that, n 71% of frms that restate ther fnancal statements and are allowed to re-fle, the CEO s also the presdent of the board of drectors, as compared to only 14% n control frms. Ths dfference s statstcally sgnfcant at the 1% level (t = 5.279). The board and audt commttees (panel 2) of these frms are generally composed of nternal or afflated drectors and do not beneft from the presence of non-afflated blockholders. In addton, as n Beasley et al. (2010), twce as many CTO or fraudulent frms than control frms (21% vs 10%) changed audtors (panel 4) n the one-year perod before default detecton and planned to fll ther fnancng needs va prvate placement. Results also show that 20% of restatement frms are lsted n the US (panel 5) as compared to 34% n the case of control frms. There s no sgnfcant dfference wth respect to the presence of fnancal experts on the board and audt commttee. Comparson between CTO and matched control frms shows that CTO frms have a lower proporton of ndependent drectors and fnancal experts on ther boards and audt commttees. At 31%, the proporton of shares held by blockholders (panel 5) n CTO frms s 6 percentage ponts lower than n control frms, at 37%. Fnally, the results also show that fraudulent frms, the hghest LNC, have lower proportons of ndependent drectors and fnancal experts on ther boards and audt commttees. Fraudulent frms have an average of 0.45 fnancal experts on ther audt commttees (panel 2) as compared to 1 expert n control frms, a statstcally sgnfcant 24

25 dfference at the 10% level (t = ). Ths result s consstent wth Farber (2005). In common wth Persons (2005) and Beasley et al. (2010), we also note that n a majorty of fraudulent frms, the CEO s also the charperson of the board. Ths proporton compares wth the Beasley et al. (2010) results, where the CEO also serves as the char of the board n 70% of fraud frms. However, Beasley et al. report no statstcally sgnfcant dfference between fraud and no-fraud frms. Fnally, there s no statstcally sgnfcant dfference wth regard to the USA, Fnancng, and OwnerBlock varables. In general, the above dfferences are n lne wth our hypotheses. [Insert Table 3 here] In Table 4, snce we wsh to examne whether the qualty of governance s negatvely related to the serousness of rregulartes, we also compare the dfferences n the mean value of governance mechansms between the three types of rregulartes and matched control frms. Column 1 shows the dfference between restatement and matched frms, column 2 shows the dfference between CTO and matched frms, and column 4 shows the dfference between fraudulent frms and matched frms. Drector ownershp of restatement frms s sgnfcantly lower than n CTO frms, whch suggests that t s related to LNC. However, as expected, the severty of rregulartes decreases (from fraud to restatement) wth the presence of fnancal experts on the audt commttee and board of drectors. Snce t appears that the relatonshp between corporate governance and the serousness of rregulartes may not be lnear, we use two multvarate models of estmaton: the ordnal and the generalzed ordnal logt models. [Insert Table 4 here] 25

26 We also run correlaton analyses to nsure that the level of correlaton between varables s not too hgh, so that they may be used smultaneously n multvarate analyses. The results are presented n Table Multvarate analyses Snce our dependent varable representng fnancal reportng rregulartes s ordnal, we frst use the ordnal logt (proportonal odds) statstcal method. Assumng that m takes 0 for matched frms, 1 for restatement, 2 for CTO, and 3 for fraudulent frms, the dependent varable s calculated va the followng formula: Y K m ) Ln m X = Z m Y m) P exp( Z m ) ( Y m) 1 exp( Z m ) Ths method supposes that β k coeffcents are the same for m (known as the parallel assumpton hypothess. Table 6 provdes results from ths estmaton for our partal and FM. 1 Effectveness of ndvdual corporate governance mechansms (partal models) In accordance wth Hypothess 1 (H1, Fgure 2), the results from the partal board model PM1 presented n the thrd column of Table 6 show that an ndependent board s more lkely to prevent rregulartes and to lmt ther serousness. Indeed, the lkelhood of fnancal fraud s hgher when the CEO s also the charman of the board ( 4 = 0.991, p < 0.001) and when the 26

27 board s composed of a majorty of afflated or nternal drectors ( 1 = , p < 0.05). These results are consstent wth the fndngs of Marcukatyte et al. (2006), Dunn (2004), and Farber (2005). They also show that the number of non-afflated blockholders on the board (BlocknBoard) s negatvely assocated wth LNC ( 5 = , p < 0.1). However, BoardExpert, OwnerBoard, and Nseats coeffcents are not sgnfcant. In summary, we may conclude from PM1 that an ndependent board s an mportant factor n the preventon of accountng rregulartes and n mnmzng ther severty. Ths result supports the wdely held belef of regulators n Canada and elsewhere (He et al. 2009) that the presence of unrelated drectors on the board and the separaton of the CEO and COB postons are mportant factors n fnancal reportng qualty. Beasley et al. (2010) also report that frms engagng n fraudulent fnancal reportng had more nsde drectors than dd no fraud frms durng the perod However, followng changes n U.S. stock exchange lstng requrements, these authors report that dfferences n the composton of boards no longer were present between the two frm categores n the perod, a post-sox perod smlar to ours. In the fourth column of Table 6, the PM2 audt commttee model shows, as hypotheszed, that the number of fnancal experts on the audt commttee s negatvely assocated wth LNC ( 2 = , p < 0.001). However, the coeffcent of AudtComp, whch represents fnancal lteracy, s not sgnfcant. Ths does not support current Canadan polcy (MI ), whch merely recommends that members of the audt commttee be fnancally lterate rather than fnancal experts, as n the US. Ths result suggests that the polcy should be tghtened to match the SOX requrement of the presence of a fnancal expert on the audt commttee. 27

28 Estmaton of the fnal audtor partal model, PM3 (col. 5), shows that a change of audtor s postvely assocated wth LNC ( 2 = 0.614, p < 0.1). Ths s consstent wth the fndngs of Pot and Jann (2007), Knapp (1991) and Mtra et al. (2009). Further, consstent wth Dechow et al. (1996) and Baber et al. (2005), the coeffcent of Bg4 s not sgnfcant. Effectveness of corporate governance as a system In the next four columns of Table 6, four full models (FM1, FM2, FM3, and FM4) are developed to determne whether an effcent corporate governance system may negatvely affect the severty of the accountng rregulartes commtted. These models are labeled full, as they smultaneously test the effects of board of drectors, audt commttee, and audtor on LNC. In general, results from FM1 confrm results obtaned from partal models. Accountng rregulartes are more severe when: (1) the CEO s also the presdent of the board, (2) the board s manly composed of nternal and afflated drectors, (3) there are no non-afflated blockholders on the board, (4) the board and the audt commttees are deprved of fnancal experts, and (5) the frm recently changed ts audtor. As the effectveness of corporate governance mechansms probably derves at least n part from ther nterdependence, we ntroduce an nteracton term n the FM2, FM3, and FM4 models to examne the presumed synergy or nterdependence between board of drectors, audt commttee, and audtor. Model FM4 confrms that collaboraton between a Bg4 audtor and the audt commttee, as measured by the coeffcent of UnrelatedAudt*Bg4, whch s sgnfcant at the 10% level, may lmt the severty of accountng rregulartes (H4, Fgure 2). In comparng 28

29 models FM1 to FM2, we also fnd that ntroducton of the nteracton term mproves the explanatory power of the ntal model. The model s explanatory power, as measured by the Akake nformaton crtera (AIC) s better for FM2 than for FM1. Besdes, models FM3 and FM4 show that the coeffcent of the nteracton term Score_Audt*Score_Audtor s negatve and sgnfcant. The coeffcent of Score_Audt s also sgnfcant. These results suggest that audtor effectveness can renforce audt commttee effectveness n lowerng the level of serousness of accountng rregulartes. Thus, our results generally show that nterdependence between corporate governance mechansms can lmt the severty of accountng rregulartes. [Insert Table 6 here] The ordnal logt method compares each type of rregularty and matched control frm wth all types pooled together, but does not compare them level by level; for nstance, t does not compare CTO frms to fraudulent frms. 11 Further, ths method s not robust when the parallel assumpton test 12 s not satsfed. Ths s the case here as the assumpton s rejected for (PM3) and (FM3). We thus run a generalzed ordnal logt (non-proportonal odds) as developed by Fu (1998) to valdate the robustness of our results and to avod the shortcomngs of the ordnal logt method. In ths subsecton, we examne results from the non-proportonal odds or generalzed ordnal logt model presented n Table 7. As n the ordnal logt method, m takes the value 0 for matched control frms, 1 for restatement frms, 2 for CTO frms, and 3 for fraudulent frms. Ths method compares each level of non-complance to fraudulent frms. As noted n Secton 3, most prevous studes compare only one type of rregularty to matched control frms, thus falng to relate qualty of governance to varous levels of noncomplance. We choose fraudulent frms as a 11 The ordnal logt method frst compares matched control frms (m = 0) to restatement (m = 1), CTO (m = 2), and fraudulent frms (m = 3); t then compares both matched and restatement frms to CTO and fraudulent frms; fnally, t compares matched, restatement and CTO frms to fraudulent frms. 12 We use SAS. In ths statstcal software, the parallel assumpton s an ant-conservatve test (Harrell, 2001). 29

30 reference category because they represent the worst-case rregularty. The dependent varable s calculated accordng to the followng formula: y m) Ln m y 3) K 1 mk X = Z m exp( Z m ) P ( y m), 1 3 m 0 exp( Z m ) P ( y 0) 1 3 m 0 1 exp( Z m ) Results from the board of drectors model PM2 (Table 7) show that sgnfcant dfferences exst between fraudulent frms (m = 3) and matched control frms (m = 0) as far as board of drector characterstcs are concerned. Fraudulent frms have less unrelated and non-afflated blockholder members on ther boards compared to control frms. The second model under PM2 shows that restatement frms are less lkely than fraudulent frms to combne the CEO / charman of the board postons. There s no sgnfcant dfference between CTO (m = 2) and fraudulent frms. Results from runnng the PM3 audt commttee model show that there are no sgnfcant dfferences between levels of rregulartes, except for the presence of fnancal experts on the audt commttee, whch appears to be lower n fraudulent frms. In audtor model PM4, swtchng audtors n the precedng year decreases the probablty of all types of rregulartes. Except for ths last varable, there appear to be no sgnfcant corporate governance dfferences between CTO and fraudulent frms. Ths suggests that governance makes a dfference when the frm s n a poston to restate ts fnancal statements; however, t appears useless when the rregularty s so serous that the frm s mposed a CTO or sued for fraud. 30

31 Results from the FM 13 presented n Table 7 confrm the fndngs of prevous studes when comparng fraudulent to matched frms. The frst FM2 model shows that fraudulent frms have fewer ndependent and non-afflated blockholder members on ther boards, and fewer fnancal experts on ther audt commttees. Turnng to the second and thrd FM2 models, the only sgnfcant dfference between fraudulent frms, CTO frms, and restatement frms confrms the fact that the separaton of the CEO and charperson postons decreases the serousness of rregulartes. [Insert Table 7 here] 5.3 Senstvty analyses To valdate the robustness of the results obtaned, we conduct several senstvty analyses (not presented, but avalable on request). We frst reproduce the results of the unvarate analyses presented n Table 3 after elmnatng TSX Venture frms. Generally, these frms are smaller than TSX frms and may be under less pressure than those lsted on the TSX to follow corporate governance practces recommended by regulators, nsttutonal nvestors, and other nterested partes. Unvarate analyses show that these frms generally have fewer ndependent drectors on ther boards and that the same person more often holds the postons of CEO and char of the board. For nstance, the CEO s also the char of the board n 63% of RID, compared to only 22% n control frms. Moreover, RID frms have 37% unrelated drectors on ther board compared to 51% n control frms. However, the presence of the TSX Venture frms n the sample does not materally change the multvarate results. After elmnatng these frms, our results generally 13 Some varables are omtted due to co-lnearty problems. 31