Corporate governance and fraudulent financial reporting
| DOI | https://doi.org/10.1108/JFC-07-2021-0160 |
| Published date | 20 August 2021 |
| Date | 20 August 2021 |
| Pages | 1009-1026 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial crime |
| Author | Vahab Rostami,Leyla Rezaei |
Corporate governance and
fraudulent financial reporting
Vahab Rostami and Leyla Rezaei
Department of Economics and Administrative Sciences, Payame Noor University,
Tehran, Islamic Republic of Iran
Abstract
Purpose –This study aims to trace the impact of corporategovernance and its mechanisms in preventing
companiesfrom turning to fraudulent financial reporting.
Design/methodology/approach –For this purpose, using the systematic elimination pattern, the
information of 187 listed companies on theTehran Stock Exchange over six years from 2013 to 2019 were
collected,and the hypotheses were examined usinga linear regression model. To measure fraudulentfinancial
reporting, the adjusted modelof Beneish (1999) was used to evaluate corporate governance. Its mechanisms
based on nine corporate governance mechanisms, including board independence, boardremuneration, CEO
financial expertise, expertise in CEO industry, board financial expertise, board industry expertise, board
effort, CEO duality and managerialownership, have been examined. These mechanisms are calculated as a
combinedindex of corporate governance.
Findings –The findings indicate that robust corporate governance significantly reduces companies’
intention towardfraudulent financial reporting. In the same way, a negativeand significant relationship was
observed between each of the nine corporate governance mechanisms, except for board compensation and
fraudulentfinancial reporting.
Originality/value –This study’sfindings provide valuableinsight into the importance of strengthening
companies to preventcompanies’managers from engaging in fraudulent financialreporting activities. Hence,
it is suggested that professionalreferences bodies more seriously follow the rules to dictateto companies for
using and empoweringtheir corporate governance.
Keywords Corporategovernance, Corporate governancemechanism, Fraudulentfinancial reporting,
Beneish model
Paper type Research paper
Introduction
One of the essential preconditions for attracting investors and creditors for constructive
economic activities and ultimately economic growth is to provide information that will be
useful in making financial, economic and commercial decisions (Wang, 2018, pp. 955-992).
However, fraud is one of the effective factors in reducing the reliability of financial reports
and statements. Fraud in financial reporting refers to a major distortion of financial
statements in a way that misleads users. While causing significant losses to organizations,
this issue also damages the credibility of the accounting profession and negatively affects
public confidence in financialstatements (Awang et al., 2017, pp. 81-97; Ghorbani and Salehi,
2021). In addition, fraudulent financial statements negatively influence the world economy
and have consequences such as providing incorrect information to the market, deepening
market inefficiency in allocatingresources and accumulating significant financial lossesfor
individuals and companies (Moradi et al.,2014, pp. 141-173). According to a 2012 report by
the Association of Certified Fraud Examiners (ACFE), fraudulent financial statements are
among the most expensive forms of fraud. It imposes the highest financial loss. Moreover,
fraud is also a major ethical problem for businesses and the most serious concern in the
Fraudulent
financial
reporting
1009
Journalof Financial Crime
Vol.29 No. 3, 2022
pp. 1009-1026
© Emerald Publishing Limited
1359-0790
DOI 10.1108/JFC-07-2021-0160
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1359-0790.htm
current business environment (Smith et al.,2005, pp. 73-85). Therefore, there is an urgent
need for effective methodsto prevent and detect fraud (Segal, 2016, pp. 45-64). In thisregard,
several studies have been conducted to investigate and identify the effective factors of
fraudulent financial management.Among them, variables such as the effect of the presence
of a female senior financial manager (Liao et al., 2019, pp. 449-463) on the study of
accounting fraud in commercial companies (Bao et al., 2018), the role of the three main
components of corporate governance including internal audit, internal control and
independent auditor (In’airat,2015, pp. 119-128; Lari Dashtbayaz et al.,2020) can be named.
In addition to the structural characteristics of the company, which can increase the risk of
fraud, conflicts of interestand information asymmetry between ownership and management
also predispose to corruption. Fraud in financial statements is a noteworthy issue in an
agency (Khajavi and Ebrahimi, 2018, pp. 71-84). To direct management actions in the
interests of the company’s stakeholders and affect the quality of financial reporting, a
regulatory and control mechanism is required. Corporate governance plays a key role in
ensuring the quality of financial reporting and preventing fraud in financial reporting. Its
role has been proven in numerousstudies as one of the main factors in increasing the quality
of financial reporting. In this regard, Habib and Jiang (2015, pp. 29-45) state that one of the
desirable features of an effective corporate governance system is ensuring the quality of
financial reporting for the effective allocation of resources and economic growth and is one
of the major factors influencing the probabilityof occurrence. Fraudulent financial reporting
refers to the weakness of corporate governance (Ndofor et al., 2015, pp. 1774-1797). The
effectiveness of the corporate governance structure reduces the likelihood of fraudulent
financial reporting and contributesto increasing the credibility of financial reporting (Razali
and Arsha, 2014, pp. 243-253; Nassir zadeh et al., 2018). To develop the existing theoretical
foundations, the present study seeks to test the existence of a significant relationship
between corporate governanceand its fundamentals and fraudulent financial reporting,and
whether strong and effective corporate governance can reduce the likelihood of companies’
tendency to financialreporting fraud or not?
Considering the effect of the quality of financial reporting on gaining the trust of
investors and capital market activists and preserving the rights of shareholders and, in
other words, preserving market’sefficiency based on accurate and high-quality financial
reports, as well as Iran’s high rate of corruption and the lack of sufficient research in this
area convinced the authors that the present study has the necessary knowledge and
usefulness to increase the richnessof existing literature and understanding of the functions
of corporate governance system on the possibility of fraudulent financial reporting. The
authors hope that the study results will provide significant findings to prevent fraudulent
financial reporting and reduce itsadverse effects on market value, company credibility and
its ability to achievestrategic goals.
Theoretical bases and literature review
Fraudulent financial reporting, corporate governance and corporate governance
mechanisms
Fraud is a pervasive socio-economicdisease that affects the public and private sectors of the
economy in developed and developing countries around the world (Udeh and Ugwu, 2018,
pp. 590-607). The ACFE defines fraudas follows: Fraud refers to the intentional act of one or
more managers, employees, or third partiesthat result in the misrepresentation of financial
statements. According to Auditing Standard No. 240 of Iran, fraud is an intentional act by
one or more executives, management bodies, employees, or third parties that implies
deception to have an unlawful or illegal advantage (Auditing Standards Committee, 2018).
JFC
29,3
1010
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