An empirical examination of corporate governance changes after the detection of financial reporting fraud

The incidence of financial reporting fraud indicates a serious breakdown in the financial reporting system. Theory suggests that efforts to repair the financial reporting system must necessarily include significant improvements in the corporate governance system. This study examines empirically whether financial reporting fraud detection induces a firm to improve its corporate governance monitoring structure through changes in board of director composition, audit committee activity and audit-firm quality. It also analyzes the relative speed at which fraud firms move toward an estimated equilibrium level of corporate governance, as contrasted to a matched sample of non-fraud firms. The study further investigates whether differences in fraud-specific factors affect the post-fraud changes in corporate governance structures, and whether governance changes are jointly made along different dimensions.; My results indicate that fraud firms increase their outside director percentage and the number of audit committee meetings in the three years following fraud detection. Although fraud firms' governance structures are initially significantly weaker, by the end of a three-year period following fraud detection, fraud firms have a board of director profile similar to that of their control firms, and indeed they exceed control firms in terms of the level of audit committee activity. Further, corporate governance changes appear to be jointly determined, but unrelated to variations in fraud-specific factors.; I also investigate the market's response to the changes fraud firms implement after the detection of financial reporting fraud. I find that fraud firms with the greatest change in the percentage of outside directors have higher abnormal returns in the three-year period following the fraud detection year than fraud firms with the smallest change in their outside director percentage.