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Boards of directors and fraud.

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 companies 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 and operating effectiveness of internal control to top management, the board is generally 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.

Composition of the Board. Much of the focus on the role of the board of

directors in preventing and detecting material instances of fraudulent financial reporting has emphasized the composition of the board. The Report of the National Commission on Fraudulent Financial Reporting (the Treadway Commission), the AICPA's 1993 Special Report: Issues Confronting the Accounting Profession, and the AICPA's 1994 Strengthening The Professionalism of the Independent Auditor contain recommendations calling for changes in [TABULAR DATA FOR EXHIBIT OMITTED] board of director composition to enhance the board's independence for purposes of reducing the likelihood of financial statement fraud.

It is natural for a portion of the board to be composed of internal managers (referred to as "inside directors"), because they have valuable specific information about the company's activities. While the inclusion of inside directors is viewed as important, board reform proponents believe it is important for the board to limit the influence and power of top management. This limitation is often accomplished by including members on the board of directors who are not currently serving as top management of the company (referred to as "outside directors"). Viewed as objective overseers, outside directors help to ensure the board remains effective as a key internal control in its overview of top management actions. This view is evident in the report of the Committee of Sponsoring Organizations of the Treadway Commission, Internal Control - Integrated Framework (the COSO Report), which notes it is necessary that the board contain nonmanagement directors to effectively question and scrutinize management's actions.

The comparison of board composition between fraud and no-fraud companies indicates that differences do exist consistent with these noted recommendations. The exhibit illustrates that boards of fraud firms have fewer outside directors and more management directors than boards of no-fraud companies. More specifically, for companies experiencing fraud, managers and outsiders each comprise about 50% of the seats on the board. In contrast, outside directors of the no-fraud companies have a majority position on the board of directors, comprising approximately 65% of the board seats.

This comparison is based on a definition of outside director that includes all nonmanagement directors, consistent with the definition used by national stock exchanges. However, much of the literature that reports on board composition matters notes this particular definition of outside directors may fail to recognize potential conflicts of interest between outside directors and the companies they serve. The traditional classification of "outside director" can be subdivided into two classes: "independent directors" and "grey directors." Independent directors represent those outside directors who have no tie to the company other than through their role as a board of director member. Grey directors represent outside directors who have some nonboard affiliation with the firm. Nonboard affiliations with the company result from the outside director being a relative of management, former employee, current supplier, customer, consultant, or outside legal counsel for the company. While grey directors satisfy the outside director requirement of the national exchanges, they are involved in nonboard relationships with the companies. Many critics of boards believe these additional ties to the company potentially impair a grey director's ability to objectively monitor top management.

The exhibit also highlights that the fraud companies have fewer independent directors serving on the board relative to the no-fraud companies. Only 28% of the board of director seats for the fraud companies are held by independent directors, whereas 43% of the board seats for the no-fraud firms are held by independent directors. Thus, greater percentages of the outside directors for the fraud companies are grey directors relative to the no-fraud companies, given that grey directors represent 44% of the outside directors in fraud companies relative to 34% in no-fraud companies.

Outside Director Tenure. The length of time an outside director serves on the board may also affect the director's effective ability to scrutinize top management's actions. An outside director who lacks seniority on the board may be less willing to challenge top management, particularly given that top management is often heavily involved in identifying and recommending outside directors for service on the board. As tenure on the board increases, the outside director may be less susceptible to group pressures to conform.

The comparison of tenures of outside directors across the fraud and no-fraud companies, as reported in the exhibit, indicates the outside director's tenure on the board is longer for the no-fraud companies relative to the fraud companies. Average tenure for outside directors of no-fraud firms is 6.6 years of service compared to an average tenure of only 3.8 years for the fraud companies. Similarly, the comparison of average tenure of the subset of outside directors classified as independent directors indicates that independent directors of the no-fraud companies serve on average 5.5 years, which is longer than the average tenure of 3.1 years for independent directors of the fraud companies.

Outside Director Ownership. To provide better incentives for monitoring top management, board reform proponents encourage outside directors to hold substantial equity interests in the company. Such proponents believe a director with a sizeable stake in the company is more likely to question and challenge top management's actions.

The average cumulative percentage of common stock shares held by outside directors is 12.0% for no-fraud companies, which exceeds the average cumulative percentage of 5.4% held by outside directors of the fraud companies. Likewise, the average cumulative percentage of common shares held by independent directors of no-fraud companies is 5.5%, which is greater than the aver~ age equity interest of 2.9% held by independent directors of fraud companies.

Audit Committee Presence. Often the board delegates responsibility for financial reporting oversight to an audit committee. Audit committees are believed to enhance a board's ability to monitor management actions by providing detailed analyses and understanding of the financial statements issued by the company.

Interestingly, the exhibit highlights that for the sample companies included in this study, only 63% of the no-fraud companies and 41% of the fraud companies had an audit committee in existence in the year prior to the fraud. For those companies with audit committees, the audit committees for both fraud and no-fraud firms met an average of 1.8 times during the year preceding the year of the fraud. And, 35% of the fraud companies with audit committees and 11% of the no-fraud companies with audit committees never held an audit committee meeting during that year. This contrasts greatly with the recommendation that audit committees meet at least four times per year and make provisions for special meetings when warranted as reported in the 1993 report prepared by Price Waterhouse for the Institute of Internal Auditors' Research Foundation titled, Improving Audit Committee Performance: What Works Best. Finally, for the subset of sample companies where both the fraud company and its matched no-fraud company had an audit committee, the no-fraud companies had higher percentages of outside directors on the audit committee relative to audit committees of the fraud companies. Ninety-four percent of the audit committee seats of the no-fraud companies were held by outside directors whereas outside directors of the fraud companies held only 84% of the audit committee seats.

The Study's Implications

The underlying study highlights that the mere inclusion of outside members on the board of directors may not be sufficient to prevent occurrences of financial statement fraud. Instead, the board's effectiveness in preventing such fraud may be affected by whether outside directors have a majority position on the board, the length of the tenure of board service by outside directors, and the extent of equity ownership levels in the company held by outside directors. In addition, the board's ability to effectively reduce occurrences of financial statement fraud may also be impacted by the existence of an active audit committee composed of outside members. Of course, the presence of these conditions is no guarantee that financial statement fraud is not present. However, auditors may find the consideration of the relationship of these board of director characteristics to instances of financial statement fraud beneficial as they evaluate the likelihood of material financial statement fraud in the audits they perform.

Mark S. Beasley, PhD, CPA, is an assistant professor at North Carolina State University.
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Author:Beasley, Mark S.
Publication:The CPA Journal
Date:Apr 1, 1998
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