Corporate Fraud Culture: Re-Examining The Corporate Governance and Performance Relation

Accounting and Finance 57 (2017) 597–620
Corporate fraud culture: Re-examining the corporate

governance and performance relation
David T. Tana, Larelle Chappleb, Kathleen D. Walshc

a
School of Aviation, University of New South Wales, Sydney, NSW, Australia
b
QUT Business School, Queensland University of Technology, Brisbane, QLD, Australia
c
Research School of Finance, Actuarial Studies and Applied Statistics, Australian National
University, Canberra, ACT, Australia
Abstract
We analyse the corporate governance and performance relation, when

conditioning on corporate fraud, for fraud firms during 2000 – 2007. Fraud
firms are identified as either self- reported fraud events, or subject to regulatory
investigation. We use the inverse Mills ratio procedure to account for firms’
(unobservable) fraud culture in the dynamic system GMM model of the
performance- governance relation. We find that corporate governance is an
endogenously determined characteristic that has no causal impact on firm
performance when conditioning on fraud. Fraud is a significant regulatory
event but its overall economic impact at the firm level is highly variable.
Key words: Fraud; Corporate governance; Endogeneity
JEL classification: C36, G34
doi: 10.1111/acfi.12156
1. Introduction
Fraud in an accounting context is typically defined with reference to the audit

standard definition as either one of two types of misconduct – misappropri-
The authors would like to thank the following colleagues for their helpful comments and
feedback Robert Faff, Colin Ferguson, Emma Schultz, Tom Smith and Garry Twite;
and participants at the American Accounting Association Forensic Accounting meeting,
Denver, Colorado March 2015. In addition, we are grateful for funding and data from
the Australian Research Council, UNSW School of Business University of New South
Wales, Barclays Global Investors, Centre for Research in Finance, KPMG and the
Department of Accounting (University of Melbourne). All errors are our own.
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598 D. T. Tan et al./Accounting and Finance 57 (2017) 597–620
ation of assets or financial statement fraud (ISA240.2 The Auditor’s Respon-

sibility to Consider Fraud in an Audit of Financial Statements). Specifically,
fraud is ‘an intentional act by one or more individuals among management,
those charged with governance, employees, or third parties, involving the use of
deception to obtain an unjust or illegal advantage’: ISA240.11.
Researchers have found various ways to identify and observe instances of
financial statement fraud, for example, using account restatements (Ahmed and
Goodwin, 2007; and international databases such as Government Audit Office;
Audit Analytics), securities class actions (Chapple et al., 2014; and interna-
tional databases such as Stanford’s Securities Class Action Clearing House),
Australian Securities and Investments Commission (ASIC) actions (Da Silva
Rosa et al., 2008) and the SEC’s Accounting and Audit Enforcement Releases
(AAERs) (Karpoff et al., 2013). However, it is much more difficult to identify
and measure misappropriation-type fraud.
The purpose of this study is to investigate the impact of fraud as a
governance failure in an Australian setting due to data availability: within firm,
misappropriation-type fraud events are accessed through proprietary data from
the biennial KPMG Fraud Survey, and we identify other management fraud,
misconduct or financial statement fraud1 through media releases and annual
reports of the Australian regulator’s investigations.
The investment community has recognised the dangers of corporate fraud
and the importance of fraud prevention to ensure a well-functioning and
equitable financial market, although individual instances of detected within-
fraud firm may not necessarily amount to a material loss to that firm. For
example, according to the KMPG Fraud Survey data relied on herein, the
average reported fraud event amounted to approximately $1.5 million in 2008
(KPMG, 2008). Moreover, companies must divert further funds towards the
investigation of reported detected frauds and the implementation of fraud
prevention measures. Curbing executive excesses and fraudulent behaviour in
the corporate culture is a stated regulatory priority (Graycar and Smith, 2002).
The central question is whether fraud events are able to be systematically
attributed to governance failure. The motivation for good corporate gover-
nance mechanisms in agency theory is founded on the premise that agents of
the firm may choose to act against the best interests of shareholders (Shleifer
and Vishny, 1997). Managers and executives may be inclined to forsake the
interests of shareholders when an opportunity for fraudulent behaviour arises
that provides a substantial private pay-off. The ideals of maximising the long-
run total value of the firm for the sake of shareholder wealth (Jensen et al.,
2004) may be a distant thought for executives when faced with the prospect of
gaining dizzying amounts of private benefits. Shleifer and Vishny (1986) also
1
Also referred to as accounting fraud: Young and Peng (2013). The Australian regulator
does not maintain a public database such as the AAERs as is familiar to many
researchers.
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D. T. Tan et al./Accounting and Finance 57 (2017) 597–620 599
argue that considerable managerial discretion may not only manifest itself as
misappropriation – managers may simply choose to do nothing (shirk) if that is
in their interests. If faced with a threat of fraud, it may be less costly personally
and to the firm to tolerate some loss by fraud given the cost of a proactive
campaign to prevent it. If fraud occurs, managers may be reluctant to report
misappropriation-type fraud perpetrated by nonmanagerial agents (e.g.
employees) or take action, because of the damage to their reputation as
managers (Karpoff et al., 2008) and the firm’s reputation when it comes to
major valuation impacts such as cost of capital (Graham et al., 2008).
If good corporate governance is effective in aligning the interests of a firm’s
agents and principals, then governance mechanisms are required – and will add
value – in firms that are experiencing a material divergence in principal–agent
interests. That is, corporate governance measures may reduce the extent of
fraud and improve the welfare of shareholders only in firms where agents of the
firm are prone to fraudulent behaviour. In well-managed firms, abiding by
strict governance standards may in fact be a costly endeavour that reduces its
efficiency by forcing a deviation from their optimal governance structure.
Studies have identified various triggers that encourage the occurrence of
corporate fraud, such as external pressures on management to perform,
opportunities for executives to deceive stakeholders and the absence of effective
oversight (Goodwin and Seow, 2002; Graycar and Smith, 2002; Birchfield,
2004; and Davidson et al., 2005). A corollary of the corporate fraud and
governance relation is that firms that have a high risk of corporate fraud react
differently to improvements in governance than firms that are at low risk of
fraud. That is, there is heterogeneity in the corporate governance and
performance relation across firms. The tendency of agents to commit fraud
determines the most effective and optimal governance structure for the firm,
among other factors. Indeed, there is ample research suggesting that corporate
governance is an endogenously determined characteristic of the firm (Hermalin
and Weisbach, 2003; Brown et al., 2011; and Coles et al., 2012). The dynamic
generalised method of moments (GMM) panel models can be applied to the
corporate governance and firm performance relation (Pathan and Skully, 2010;
Schultz et al., 2010; Pham et al., 2011; and Wintoki et al., 2012) to account for
the various forms of endogeneity that may be present2 .
Pragmatically, the researcher is only able to link observable fraud events with
observable firm characteristics, which is a major obstacle when analysing firms’
propensity for corporate fraud. However, it is very likely that a firm’s
propensity for corporate fraud is related to unobservable firm characteristics,
such as firm culture and management style. In this paper, we use the Heckman
(1979) correction for sample selection bias to account for the propensity of
corporate fraud based upon private (unobservable) information (Li and
2
Simultaneity, dynamic endogeneity and unobserved heterogeneity (see Wintoki et al.,
2012).
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Prabhala, 2007). We offer the search for the unobservable as the major
innovation of this paper; that is, this study incorporates the dynamic GMM
panel model with private corporate fraud information. The dynamic GMM
panel model is applied as it is robust to the endogenous nature of corporate
governance and will produce unbiased coefficient estimates.
In sum, the primary research questions are as follows:
1 Do corporate governance measures have a significant impact on firm

performance for firms that have experienced fraud?
2 Do corporate governance measures have a significant impact on firm
performance after controlling for the fraud culture (propensity) of the firm?
3 Do corporate governance measures affect the firm’s likelihood of experienc-
ing fraud?
The ensuing analysis follows a two-pronged approach. First, by employing a

sample of fraud firms (i.e. firms that have experienced at least one occurrence of
fraud) in the period of 2000 to 2007, the corporate governance and firm
performance relation is analysed within the dynamic GMM framework that
corrects for the influence of unobserved heterogeneity, dynamic endogeneity
and simultaneity. This will discern whether adjustments in corporate gover-
nance have a significant effect on firm performance for companies that are
vulnerable to a corporate culture of fraud, to compare the results from previous
studies that have reported no relation between governance and firm perfor-
mance (Schultz et al., 2010; Pham et al., 2011; and Wintoki et al., 2012).
Second, the Heckman (1979) correction for sample selection bias is applied to
the sample firms and the inverse Mills ratio is included in the dynamic GMM
corporate governance and performance models as an exogenous regressor. This
facilitates the re-examination of the corporate governance and firm outcomes
relation whilst controlling for the firm’s likelihood of experiencing fraud based
upon private (unobservable) information. Additionally, the first-stage analysis
of the Heckman (1979) procedure entails a probit model to determine the
likelihood of a fraud event occurring based upon a firm’s corporate governance
structure and other firm-specific characteristics.
This study contributes to the literature in three important aspects. First,
although the relation between corporate governance and the likelihood of fraud
has been previously analysed in the Australian context (Sharma, 2004; and
Chapple et al., 2009), this study by combining the unique KPMG Fraud
Survey data with the ASIC fraud filings and media releases constructs a
comprehensive database of both self-reported and externally detected instances
of fraud in sample firms. An acknowledged limitation with the KPMG fraud
data is that it relies on self-reported fraud (Coram et al., 2008; and Chapple
et al., 2009). Second, the corporate governance and firm performance relation
is examined within a sample of firms that have experienced at least one instance
of fraud. Prior literature has been unable to condition the corporate
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governance and firm performance relation on the presence of fraud. Finally, the
corporate governance and firm performance relation is re-examined whilst
accounting for the likelihood of fraud based upon private (unobservable)
information. The findings show that corporate governance does not exhibit a
causal influence on financial performance and private fraud information – a
proxy for a firm’s culture or propensity for fraud – has no statistical impact on
firm performance.
2. Measuring misappropriation fraud
Much of the prior fraud literature focuses on identifying and measuring

accounting or financial statement-type fraud. Misappropriation-type fraud is
more difficult to observe and measure. One of the first studies on fraud and
corporate governance, Beasley (1996), used a sample of 67 fraud firms that
experienced financial statement fraud and 8 firms that experienced misappro-
priations of assets. In an early study on misappropriation fraud and corporate
governance with Australian data, Sharma (2004), using a matched-pair sample
of fraud and nonfraud firms, finds a relation between the decreasing likelihood
of fraud and the degree of independence of the board and the increasing
likelihood of fraud with chair and chief executive officer duality.
In a descriptive study using a sample of ASIC investigations of corporate
fraud and misconduct involving listed firms, Chapple and Tan (2012) also use
ASIC media releases and annual reports of regulatory investigations between
2004 and 2008 to identify a sample of firms subject to financial statement and
reporting fraud. They find that 70 percent of the firms investigated by ASIC
involve fraud and misconduct perpetrated by CEOs and/or senior management.
The KPMG Fraud Survey data of self-reported fraud have also been used by
Chapple et al. (2009) as the dependent variable when modelling the relation
between fraud and corporate governance. They find that the CEO–chair duality
and the audit committee composition are significant predictors of fraud, using a
model with the dollar value of self-reported fraud as well as a dichotomous
variable to separate fraud firms from nonfraud firms.
Misappropriation of assets fraud has been identified as a dependent variable
in studies focussed more specifically on audit committee effectiveness, fraud
detection and accounting outcomes. For example, Mustafa and Youssef (2010)
identified 28 US-listed firms that had experienced misappropriation of asset
fraud through the actions of employees, by undertaking media searches for
reported instances of fraud (following Mustafa and Meier, 2006). In an
earnings management study, Song et al. (2013) use a sample of Korean firms
that disclose, through the mandatory reporting mechanism, misappropriation
fraud to the market.
Accordingly, in fraud research there appear to be limited methods available
of measuring or proxying for misappropriation fraud: either self-reported fraud
(from survey data such as the KPMG survey or from market data such as the
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Korean mandatory disclosure listing rule); from publicly announced regulator

enforcement action, or from fraud prosecutions identified from media releases
or litigation databases. This study uses a combination of self-reported fraud
and regulator enforcement actions to identify the sample of fraud firms.
3. Empirical tests
3.1 Sample – identifying fraud firms
Prior literature identifies a common theme of entrenched relaxed attitudes to

fraudulent behaviour prior to reporting scandals (Jennings, 2003; Leung and
Cooper, 2003; Want, 2003; Knights and O’Leary, 2005; Peursem et al., 2007).
A fraud instance must be sizeable in its disruption to the firm’s operations for it
to result in a material impact on firm performance. Frauds of such magnitude
are often reported, if at all, only after observing deteriorating firm performance
and/or corporate failure (see Dyck et al., 2008). This leads to two significant
hurdles in any empirical analysis of fraud:
1 It is the significant fraud events that have a material impact on firm

performance.
2 Only a fraction of significant fraud cases are observed/reported. An
unknown number of significant fraud occurrences remains unobservable to
the researcher.
Although it is difficult to directly observe and quantify a corporate culture of

fraud, it is postulated that firms exhibiting a culture of fraud significant enough
to result in material consequences on firm outcomes will also likely experience
occurrences of minor fraud. This is consistent with DiNapoli (2008) who notes
that fraud starts small and gradually grows to a significant event. That is, an
entrenched corporate culture of fraudulent behaviour will facilitate both major
instances of fraud that destabilise the operations of the firm and minor
instances of fraud that are inconsequential to firm outcomes. As such, reported
frauds – even minor in nature and inconsequential to firm outcomes – are an
indication of a corporate culture of fraud.
The reporting of fraud occurs at varying durations after the act has taken
place; that is, the timing of the discovery of an ex post occurrence of fraud bears
little correlation with the timing of the act itself. Karpoff et al. (2013) refer to
this phenomenon as the ‘late initial revelation dates’. Hence, it is difficult to
capture the time-series dimension of fraud in a panel data set, and more
importantly, an unknown percentage of fraud occurrences remain undetected
and unobservable to the researcher. Although it is difficult to completely
identify all cases of both detected and undetected fraud, some assumptions
about the nature of fraud and the probability of detection can facilitate a
tractable setting for analysis.
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First, it is reasonable to assume that a firm with a significant corporate

culture of fraud that jeopardises its financial performance will also experience a
higher rate of both major and minor fraud occurrences (Dimmock and Gerken,
2012). If the probability of fraud detection is assumed to be fixed across firms,
then an arbitrary criterion can be implemented to identify firms more or less
vulnerable to a significant corporate culture of fraud. A fraud firm in this study
is one where at least one occurrence of (minor or major) fraud is detected.
Second, the timing of a firm’s corporate culture and fraud is difficult to
quantify. However, it is reasonable to assume that the firm’s corporate culture
is entrenched and remains constant throughout a relatively short to medium
length of time. Any firm that experiences an instance of fraud is assumed to
exhibit a significant culture of fraud over time and is categorised as a ‘fraud
firm’ throughout the sample.
A fraud dummy variable, FRAUD, categorises fraud firms as 1 and nonfraud
firms as 0. The identification of fraud and nonfraud firms is critical in this analysis.
3.2 The corporate governance and firm performance in fraud firms
Corporate governance mechanisms are imposed on all firms but are

particularly important to firms that experience fraud. Consequently, it is
difficult to decompose the value of corporate governance to the firms that need
it most. In contrast, the first analysis is performed using only fraud firms, as it is
hypothesised that the corporate governance and firm performance relation is
fundamentally different for firms experiencing significant agency conflicts.
Our first research question asks whether corporate governance measures
have a significant impact on firm performance for firms that have
experienced fraud, and we have identified the observable factors that may
influence the relation between governance and performance. However, we
also account for the event that governance and performance may be
endogenously determined.
We therefore employ a dynamic system GMM specification (Arellano and
Bover, 1995; and Blundell and Bond, 1998) as these parameter estimates are
robust to the effects of endogeneity that may be present in the corporate
governance and firm performance relation. The dynamic GMM specification
uncovers any causal effects of corporate governance mechanisms on firm
outcomes despite the presence of endogeneity (Wintoki et al., 2012).
We estimate performance as a function of lagged performance, governance
measures and control variables. The dynamic system GMM specification
examines the corporate governance and firm performance relation in the
presence of endogeneity for fraud firms only. The following equations in levels
and differences are estimated:
P ¼ L:Pa þ Gb þ Xg þ E ð1Þ
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DP ¼ L:DPa þ DGb þ DXg þ DE
where
L is a one-period lag operator;
D is the time-differencing operator;
P is a N 9 1 vector of the firm performance measure across N observations;
a is a 1 9 1 scalar of the coefficient for the lag of the firm outcome measure,
L, P, across N observations;
G is a N 9 H matrix of the H corporate governance variables across N
observation;
b is a H 9 1 vector of coefficients for the H corporate governance variables;
X is a N 9 Q matrix of the Q firm control variables across N observations;
g is a Q 9 1 vector of coefficients for the Q firm control variables; and
E is a N 9 1 vector of error terms across N observations.
We identify valid instruments, including the lags of the endogenous and
predetermined variables. First, for the differenced equation in (1), for
potentially endogenous variables, such as G, lags of 2 and higher are valid
instruments, and for predetermined exogenous variables, such as X and L, P,
the lags of 1 and higher are available as instruments (Roodman, 2009; and
Arrelano and Bond, 1991).
Second, the lags of the differenced corporate governance, firm outcome and
control variables are employed as instruments for the level equation in (1). For
endogenous variables, the lags of 1 and higher of the differences are available as
valid instruments, and the current and lags of differences in the predetermined
variables are employed as instruments (Blundell and Bond, 1998; and
Roodman, 2009). The lag specification of the internal instruments is consistent
with Wintoki et al. (2012) and Schultz et al. (2010).
3.3 The Heckman (1979) correction for private information
Our second research question considers whether corporate governance

measures have a significant impact on firm performance after controlling for
the fraud culture (propensity) of the firm. Applying a novel approach, the
Heckman procedure using the inverse Mills ratio takes into account the possible
selection bias/private information of the firms that self-reported their fraud
instances. The inverse Mills ratio is useful as not all instances of fraud are
observable.
Agents of the firm choose to self-select an action based on unobservable
private information. However, the likelihood of fraud is comprised of both
observable and unobservable determinants. Unobservable factors are those that
influence the agents’ decisions towards committing corporate fraud but are
intangible and/or difficult to observe and quantify. Hence, unobservable factors
that influence corporate fraud – otherwise referred to as private fraud information
– are often excluded in the equation of interest and may lead to an omitted
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variable bias in estimation. As the sample firms are categorised as either fraud or
nonfraud, a probit regression determines the likelihood of fraud conditional on
observable firm characteristics. The conditional estimate of private fraud
information (otherwise known as the inverse mills ratio) is then included in the
estimation of the corporate governance and firm outcome relation for fraud
firms. This tests the corporate governance and firm performance/default relation
whilst controlling for the effects of the propensity for fraud. The dynamic system
GMM models are re-estimated with the conditional estimate of private fraud
information included as a predetermined regressor.
4. Data
This study examines the performance and corporate governance character-

istics of the constituents of the Australian ASX 200 index as they are the most
widely held firms and exhibit the greatest amount of liquidity (efficiency), over
the period of 2000 to 2007. In a bid to maximise the sample size and mitigate
the effects of a survivorship bias, all data are extracted for the ASX 200
companies over the entire period of 2000 to 2007, on the condition that they
have been included in the index anytime during the period analysed. The data
are sourced from Connect 4, Aspect Huntley DatAnalysis, Worldscope, Centre
for Research in Finance (CRIF), The Reserve Bank of Australia, KPMG
Fraud Survey and ASIC website. We constructed our ASIC Fraud database by
hand-collecting and compiling the cases of corporate fraud extracted from the
ASIC annual reports and media releases.
4.1 Corporate governance variables
Consistent with Ferguson et al. (2011), Schultz et al. (2010) and Hutchinson
et al. (2008), we measure the composition of board of directors, ownership
structure, and director and executive remuneration. Our sample period includes
the 2003 introduction of the ASX Principles of Good Corporate Governance and
Best Practice Recommendations. This initiative may have generated greater
time-series variation in the corporate governance measures of our sample.
1 Board of Directors (POWER.RATIO; DUALITY; and BOARD.SIZE)
Board structure measures focus on the board’s independence from manage-

ment (Hart, 1995; and Borokhovich et al., 1996), measured by the ratio of
nonexecutive to executive directors (Schultz et al., 2010)3 . Further measures
include a dummy variable to indicate whether a duality in the roles of the CEO
and chairperson exists and the size of the board as a measure of the
3
In unreported results, we used the proportion of nonexecutive directors as an
alternative measure of board independence and the results remained consistent.
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effectiveness of the board of directors as a monitoring mechanism (Lipton and

Lorsch, 1992; and Jensen, 1994).
2 Ownership Structure (%INSIDE and %OUTSIDE)
The degree of a firm’s inside ownership has been claimed to alleviate agency
conflicts (Berle and Means, 1932; and Jensen and Meckling, 1976), although
high levels of inside ownership can lead to entrenchment, resulting in declines in
firm performance (Morck et al., 1988). Nonetheless, the degree of the firm’s
inside ownership is included as the results of the analysis may lend support to
either of the two theoretical arguments. Insider ownership (%INSIDE) is a
proxy for the level of executive and director ownership (Schultz et al., 2010).
Concentrated ownership can provide a shareholder with the incentive to
collect information and monitor management (Shleifer and Vishny, 1986).
Large outside shareholdings (%OUTSIDE) are defined as the sum of the
percentage held in the twenty largest shareholders by those who do not fall in
the category of ‘insiders’.
3 Executive and Director Remuneration (NON.EXE.FIX.PAY; NON.EXE.-

VAR.PAY; EXE.VAR.PAY; and EXE.FIX.PAY)
Remuneration that is sensitive to firm performance reduces the agency

conflict within the firm (Jensen and Meckling, 1976; Murphy, 1999). Executive
and director compensation packages are measured as follows: firm remuner-
ation outcomes include the levels of the fixed and variable components of
remuneration for both nonexecutive directors (NON.EXE.FIX.PAY and
NON.EXE.VAR.PAY) and company executives (EXE.FIX.PAY and EXE.-
VAR.PAY). All values are observed at the end of the firm’s financial year. The
fixed component of remuneration consists of salary, superannuation, allow-
ances, fees, nonmonetary benefits (such as the use of company assets, provision
of insurance policies) and accrued entitlements (such as paid leave), and the
variable component of remuneration includes cash bonuses, shares, rights,
options and long-term incentive plans.
4.2 Firm performance measures
The firm performance measures include a standard suite of measures of

corporate performance to ensure robustness, such as Tobin’s Q (Q), total
returns (TR), return on assets (ROA) and accounting profit rate (PR).
4.3 Fraud information
A fraud firm indicator variable, FRAUD, is constructed that is equal to 1 if a

firm is considered a fraud firm and 0 otherwise. Both major and minor fraud
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instances serve as valid indicators of fraud for this study, and both self-reported
and regulator-detected fraud are deemed equivalent.
During 2002–2008, the KPMG Fraud Survey was a joint study commis-
sioned biennially by KPMG Forensic, the University of Queensland and the
University of Melbourne. Data extracted from the 2002, 2004, 2006 and 2008
KPMG fraud survey comprise the sample. These data have been used in prior
research (Coram et al., 2008; and Chapple et al., 2009).
The 2000 to 2007 ASIC Annual Report publications and various media
releases were also used to identify the incidences of detected corporate fraud
within Australia. Similarly, the information retrieved from the ASIC Annual
Reports and media releases are matched with the firms in our sample. ASIC
media releases have been the source of data used in prior studies (Sharma,
2004; and Chapple and Tan, 2012).
4.4 Control variables
There are several firm- and industry-specific factors that are known to have a
significant influence on both corporate performance and governance standards,
consistent with recent studies of the performance and corporate governance
relation (Schultz et al., 2010; Pham et al., 2011; and Yarram and Dollery,
2015). Table 1 contains the definitions of the corporate governance, firm
performance and control variables used in this study.
The corporate governance and control variables (excluding the measure for
systematic risk4 ) are included as regressors in the first stage (probit-link model
of FRAUD) of the Heckman procedure. Prior research demonstrates a link
between a firm’s strength in corporate governance and its likelihood to
experience incidences of fraud (Sharma, 2004; Chapple et al., 2009; and
Chapple and Tan, 2012), supporting the inclusion of the corporate governance
measures as determinants of FRAUD. As the purpose of the Heckman
procedure is to estimate the private (unobservable) fraud characteristics of a
firm using the inverse Mills ratio, the probit-link model includes all observable
firm characteristics that may influence FRAUD. As these firm characteristics
are linked to performance, control variables are likely to also influence FRAUD
as it has been found that there exists a relation between firm performance and
fraud occurrences (Bowen et al., 2008; and Malone et al., 2010).
4.5 Data cleansing procedures
Financial companies (SIC codes 6000 to 6999) are excluded from the
analysis. To minimise the impact of potential outliers, all variables are trimmed
at the 1st and 99th percentile. Observations missing any of the aforementioned
variables in any year are excluded. Hence, there are 974 annual firm-year
4
Due to the exclusion restrictions of the Heckman model.
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Table 1
Variables and definitions
POWER.RATIO Ratio of nonexecutive to executive directors at the time of reporting.

DUALITY A dummy variable equal to 1 if the CEO serves as the board’s
chairperson, and equal to 0 otherwise.
BOARD.SIZE The number of directors serving on the board at the time of reporting.
NON.EXE.FIX.PAY The average value of nonexecutive director fixed pay for the fiscal year.
Fixed pay consists of salary, superannuation, allowances, fees,
nonmonetarybenefits and accrued entitlements.
NON.EXE.VAR.PAY The average value of nonexecutive director variable pay for the fiscal
year. Variable pay consists of cash bonuses, shares, rights, options and
long-term incentive plans.
EXE.FIX.PAY The average value of executive fixed pay for the fiscal year. Fixed pay
consists of salary, superannuation, allowances, fees, nonmonetary
benefits and accrued entitlements.
EXE.VAR.PAY The average value of executive variable pay for the fiscal year. Variable
pay consists of cash bonuses, shares, rights, options and long-term
incentive plans.
%INSIDE The percentage of shares held by company executives and directors listed
in the top twenty shareholders of the firm.
%OUTSIDE The percentage of shares held by the twenty largest shareholders who are
not classified as ‘insiders’.
TR The annualized continuously compounded return from investing in the
firm’scommon equity adjusted for dividends and capitalization changes.
Q The sum of the firm’s book value of debt, book value of preferred
stock and market value of common stocks all divided by its book value
of assets.
PR The ratio of the firm’s earnings before interest and tax to its book value
of assets.
ROA Net income divided by the book value of assets.
FIRM.SIZE The natural logarithm of the book value of the firm’s assets.
CAPEX The firm’s capital expenditure divided by its total sales.
LEVERAGE The ratio of the firm’s total debt to the book value of its assets.
RandD The ratio of the firm’s annual research and development expenditure to
its annual sales.
RandD.REPORTING. A dummy variable that is equal to 1 if the firm does not report on its
DUMMY research and development expenditure for the fiscal year and equal to
0 otherwise.
CONCENTRATION A Herfindahl index measuring the competition of the industry within
which the firm operates. A firm’s industry is determined by its 2-digit’
SIC codes, with its Herfindahl index calculated as the sum of each firm’s
squared market share.
BETA Beta is the slope coefficient from a simple linear regression of the
company’s monthly equity rate of return on that of the market index,
where both are measured as deviations from the risk-free rate. The
regression is estimated using a rolling 48 month window.
SPECIFIC The variance of the residuals calculated from a simple linear regression
of the company’s monthly equity rate of return on that of the market
index, where both are measured as deviations from the risk-free rate.
The regression is estimated using a rolling 48 month window.
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Table 1 (continued)
SEPT.DUMMY A dummy variable equal to 1 if the company’s financial year ends on 30

September and equal to 0 otherwise.
DEC.DUMMY A dummy variable equal to 1 if the company’s financial year ends on 31
December and equal to 0 otherwise.
FRAUD A dummy variable equal to 1 if the firm experienced a reported fraud
incidence in the sample period and equal to 0 otherwise.
MILLS The inverse Mills ratio calculated from the probit specification. In this
study, this captures the private (unobservable) information that
influences a firm’ s likelihood of experiencing fraud. The inverse Mills
ratio is time invariant.
observations, spanning the period of 2000 to 2007. There are 222 firms
spanning up to 8 years of observations in this unbalanced panel data set. Based
on the KPMG Fraud data, ASIC Annual Reports and media releases, 42 firms
in the data set are categorised as fraud firms. The subsample of fraud firms
consists of 212 firm-year observations. Table 2 outlines the descriptive statistics
of the corporate governance and firm performance variables for the full sample
and the subset of fraud and nonfraud firms.
The first panel contains the descriptive statistics for the full sample of firms –
fraud and nonfraud firms. On average, company executives receive a large
proportion (32 percent) of their compensation as variable or performance based,
in contrast to nonexecutive directors who receive only 7 percent in variable pay.
As recommended by the ASX guidelines, few firms (only 3 percent) have the CEO
serving concurrently as the chairperson, and the majority of the directors are
nonexecutive (the ratio of nonexecutive to executive directors is 4:1, on average).
An average low level of insider ownership (1.82 percent) is expected in our top
200 samples. Similarly, we expect and find a high level of institutional ownership
in the top 200 firms (large outside shareholders, on average, hold 61.45 percent).
The statistics of the nonfraud firms comprising 78 percent of the sample (Panel 2
of Table 2) do not differ significantly from those of the full sample.
Panel 3 reports the descriptive statistics of the fraud sample compared with
the nonfraud sample. In unreported statistics, fraud firms in our sample are
substantially larger than nonfraud firms: the average fraud firm has a book
value of $AUD1.80 million (market capitalisation of $AUD4.7 million), where
as the averagen on fraud firm in the sample has a book value of $AUD0.58
million (market capitalisation of $AUD1.9 million)5 . Overall, fraud firms are
substantially different from nonfraud firms, although these findings (e.g. board
size) are most likely attributed to the large differences in firm size.
Total executive pay in fraud firms (over $AUD287,720) is higher than in
nonfraud firms, on average. Fraud firms tend to have a higher proportion of
nonexecutive directors than nonfraud firms with a POWER.RATIO of 4.54.
5
This difference is statistically significant at the 1 percent level.
© 2015 AFAANZ
Table 2
Descriptive statistics of firm performance and corporate governance measures
Mean Standard deviation Minimum Maximum
Full sample (974 firm-year observations)
EXE.FIX.PAY ($) 411450.20 262646.34 77802.00 2052415.00

EXE.VAR.PAY ($) 189272.11 264143.92 0.00 1999110.92
NON.EXE.FIX.PAY ($) 107616.50 75716.88 16191.00 640120.40
NON.EXE.VAR.PAY ($) 8028.43 23734.21 0.00 244444.40
DUALITY 0.03 0.16 0.00 1.00
POWER.RATIO 4.02 2.71 0.14 15.00
BOARD.SIZE 7.45 2.20 3.00 16.00
%INSIDE 1.82 5.38 0.00 35.97
%OUTSIDE 61.45 16.59 18.43 95.89
Q 1.58 1.10 0.39 9.09
TR (%) 28.08 61.81 89.23 441.12
ROA 0.07 0.12 0.69 0.5
PR 0.09 0.14 1.08 0.59
NonFraud sample (762 firm-year observations)
EXE.FIX.PAY ($) 376127.90 236913.10 77802.00 2052415.00

EXE.VAR.PAY ($) 161969.50 234386.00 0.00 19977300.00
NON.EXE.FIX.PAY ($) 100928.00 72451.49 16191.00 640120.40
NON.EXE.VAR.PAY ($) 7612.86 24032.61 0.00 244444.40
DUALITY 0.03 0.17 0.00 1.00
POWER.RATIO 3.87 2.58 0.14 15.00
BOARD.SIZE 7.17 2.09 3.00 16.00
%INSIDE 1.84 5.35 0.00 35.97
%OUTSIDE 60.80 16.67 18.43 95.89
Q 1.61 1.17 0.39 9.09
TR (%) 28.47 65.32 89.23 441.12
ROA 0.07 0.13 0.69 0.50
PR 0.08 0.15 1.08 0.59
Fraud sample (212 firm-year observations)
EXE.FIX.PAY ($)*** 538410.20 308177.10 117968.80 1820797.00

EXE.VAR.PAY ($)*** 287407.00 333526.20 0.00 1999111.00
NON.EXE.FIX.PAY ($)*** 131657.10 82237.20 16307.80 555953.30
NON.EXE.VAR.PAY ($) 9522.14 22620.98 0.00 190351.90
DUALITY 0.02 0.15 0.00 1.00
POWER.RATIO*** 4.54 3.07 0.33 15.00
BOARD.SIZE*** 8.44 2.28 4.00 15.00
%INSIDE 1.74 5.51 0.00 34.77
%OUTSIDE** 63.78 16.14 19.81 92.00
Q** 1.47 0.81 0.41 6.11
TR (%) 26.68 47.15 79.06 279.69
ROA** 0.08 0.07 28.00 0.38
PR*** 0.11 0.08 0.34 0.50
The notation is as defined in Table 1. The fraud sample statistics include the results of the 2-
sample t-test (unequal variances) of differences with the sample of nonfraud sample. The null
hypothesis is that the difference is equal to 0. *, ** and *** denote significance at the 10, 5 and
1 percent level, respectively.
© 2015 AFAANZ
Moreover, fraud firms have a higher proportion of large outside shareholders

(63.78 percent) than in nonfraud firms (60.80). The level of insider ownership in
fraud firms is lower than in nonfraud firms by an average of 0.10 percent.
Finally, fraud firms have underperformed compared to nonfraud firms
according to Tobin’s Q yet outperformed nonfraud firms in the accounting-
based measures (ROA and PR).
5. Results
5.1 Testing for endogeneity
The Durbin–Wu–Hausman test for endogeneity ensures that the use of

internal instruments is justified. The test is conducted on the levels of the
corporate governance and control variables, using the internal instruments as
shown in Table 3. The null hypothesis is rejected at the 1 percent significance
level, indicating that the corporate governance variables are indeed endoge-
nously determined.
5.2 Results: the dynamic system GMM model for fraud firms
Dynamic system GMM model (1) is estimated using moment conditions (2)
for the subsample of fraud firms only. Lags 1 of the predetermined variables
Table 3
The Durbin–Wu–Hausman test for endogeneity of regressors
H0: Regressors are exogenous
Q TR ROA PR
DWH test statistic 40.1541** 41.7463** 66.1421** 57.9120**

p-value 0.0031 0.0019 0.0000 0.0000
Degrees of freedom 19 19 19 19
** and *** denote significance – and the rejection of H0 – at the 5 and 1 percent level,
respectively. The test is based on the levels of firm performance on the corporate governance
and control variables. The instruments are the lags of the differenced firm performance,
corporate governance and control variables. Lags 1 of the differenced corporate governance
variables, lags 0 and 1 of the differenced control variables and lags 1 and 2 of the differenced
firm performance measures are employed as instruments. The test is performed on the
corporate governance and control variables. The test statistic follows a chi-squared
distribution with p degrees of freedom, where p is the number of regressors tested for
endogeneity. The null hypothesis states that all regressors are exogenous. Year dummies are
included to account for contemporaneous correlations in the errors across firms. Industry
dummies are included to account for industry-specific characteristics, with industries defined
by SIC categories. Year and industry dummies are treated as exogenous variables.
© 2015 AFAANZ
and lags 2 of the endogenous variables are instruments in the differenced

equation. Lags 0 of the difference predetermined variables and lags 1 of the
difference endogenous variables are instruments in the level equation. The
estimation results for the corporate governance and firm performance relation
are presented in Table 4. Note that YEAR.DUMMY, INDUSTRY.DUMMY,
SEPT.DUMMY and DEC.DUMMY are not included due to the small sample
size and large instrument set.
Similar to the findings of Schultz et al. (2010), the coefficient estimates of the
corporate governance measures have a largely insignificant impact on firm
outcomes. Interestingly, all firm characteristics are insignificant in the dynamic
system GMM model, suggestive that all firm characteristics are endogenously
determined (optimised) outcomes. The Hansen/Sagan test statistics suggest that
the moment conditions are well specified and the null hypothesis cannot be
rejected at all levels, and the Arellano-Bond test statistics confirm the null
hypothesis that no autocorrelation is evident in the errors. Additionally, we
estimated the first-stage regressions of the endogenous variables (corporate
governance) on the instrument set (lags of corporate governance and controls)
and find that the Shea (1997) partial R-square statistics report that the
instruments are jointly significant and valid6 .
5.3 The Heckman correction for private fraud information
5.3.1 Results: stage 1 – the likelihood of fraud
The first stage of the Heckman correction for private information involves
the estimation of the probit-link regression of the fraud firm indicator variable,
FRAUD, on the corporate governance measures and various firm character-
istics. Due to the exclusion restrictions of implementing the Heckman
correction procedure, the firm characteristics employed in the probit-link
model are a subset, Z, of the firm control variables, X, and the corporate
governance measures, G. Z consists of all the corporate governance and firm
control variables outlined in Table 1 except for BETA7 . Table 5 contains the
results of the first-stage regression of the Heckman procedure.
Note that the likelihood ratio (LR) statistic is statistically significant at the 5
percent level, indicative that the probit model is jointly significant in explaining
variation in FRAUD. Although we observed a tangible difference in average
firm size in Table 2 across fraud and nonfraud firms, FIRM.SIZE is not
statistically significant once controlling for other firm-level characteristics. In
6
Results of the first-stage regression are unreported. Contact the corresponding author
for details.
7
A priori, one would expect that the systematic risk of a firm is orthogonal to its
propensity for fraud. It is reasonable to assume that corporate fraud remains unpriced
by financial markets and hence is an unsystematic risk.
© 2015 AFAANZ
Table 4
The performance and corporate governance relation dynamic system GMM model
Regressor Q TR ROA PR
L.Y 0.7974 (0.4055) 0.1873 (0.2439) 0.2424 (0.1601) 0.198 (0.1532)

EXE.FIX.PAY 4.23E-07 (1.17E-0.6) 6.08E-07 (6.43E-07) 4.84E-06 (7.61E-06) 5.38E-08 (1.18E-07)
EXE.VAR.PAY 5.45E-07 (6.46E-07) 4.03E-07 (4.29E-07) 4.82E-06 (4.26E-06) 8.25E-08 (7.24E-08)
NON.EXE.FIX.PAY 1.42E-07 (5.98E-06) 1.03E-07 (1.41E-06) 4.52E-06 (2.33E-05) 9.46E-08 (4.02E-07)
© 2015 AFAANZ
NON.EXE.VAR.PAY 1.79E-06 (1.52E-05) 1.41E-06 (5.94E-06) 3.42E-05 (1.03E-05) 7.23E-07 (1.83E-06)
DUALITY 0.6644 (3.3080) 0.9506 (0.9333) 13.9433 (12.2530) 0.1536 (0.2058)
POWER.RATIO 0.0035 (0.0926) 0.0528 (0.0321) 0.2665 (0.3870) 0.0059 (0.0105)
BOARD.SIZE 0.0789 (0.1769) 0.026 (0.0530) 0.3503 (0.6474) 0.0064 (0.0106)
%INSIDE 0.0322 (0.0867) 0.0147 (0.0393) 0.6326 (0.4924) 0.0067 (0.0057)
%OUTSIDE 0.0018 (0.0185) 0.0055 (0.0067) 0.1959 (0.1349) 0.0015 (0.0015)
FIRM.SIZE 0.55 (0.6806) 0.1129 (0.3981) 3.8152 (2.4042) 0.0652 (0.0356)
CAPEX 0.0029 (0.0104) 0.0005 (0.0056) 0.0904 (0.0883) 0.0001 (0.0008)
LEVERAGE 1.4162 (0.9704) 1.0061 (0.8531) 14.2951 (10.2703) 0.1386 (0.1132)
RandD 0.1051 (0.2617) 0.0264 (0.1379) 2.7156 (2.2647) 0.0155 (0.0172)
CONCENTRATION 1.0672 (2.8724) 0.2161 (1.3625) 3.8025 (10.1478) 0.1183 (0.1412)
BETA 0.0102 (0.2504) 0.1072 (0.0791) 0.3893 (1.1553) 0.004 (0.0142)
SPECIFIC 0.0329 0.2331 0.0123 0.1806 0.9227 1.3421 0.0162 0.0166
Observations 151 151 151 151
No. of instruments 35 35 35 35
No. of groups 37 37 37 37
J-statistics 15.03 17.54 21.72 15.15
Arellano-Bond AR(1) 2.48** 2.90*** 2.95** 1.62
Arellano-Bond AR(2) 0.26 0.09 0.53 0.46
The notation is as defined in Table 1. *, ** and *** denote significance at the 10, 5 and 1 percent level, respectively. RandD.REPORT-
ING.DUMMY is unreported for the sake of brevity. INDUSTRY.DUMMY, YEAR.DUMMY, SEPT.DUMMY and DEC.DUMMY are
excluded as regressors and instruments. L. is a lag operator. The parameter estimates are produced using the two-step GMM procedure, with the
inverse of the variance–covariance matrix of the moment conditions as the weighting matrix. The HAC robust two-step standard errors,
incorporating the Windmeijer (2005) small-sample correction, are included in parentheses. The lag 2 of the levels of corporate governance
D. T. Tan et al./Accounting and Finance 57 (2017) 597–620
variables and lags 1 of the controls are used as instruments and are collapsed to preserve sample depth. The J-statistic follows a chi-squared
distribution with (l-r) degrees of freedom, where l is the number of moment conditions and r is the parameters to be estimated, with H0: the
moment conditions are correctly specified. The Arellano-Bond test statistic follows an asymptotic normal distribution, with H0: no
autocorrelation of order v in the differenced errors. The sample size is 151 as lags of the endogenous and predetermined variables of the 212 fraud
613
firm-year observations were used as instruments, resulting in some observations being dropped.
Table 5
Determinants of corporate fraud probit-link model
Dependent variable: FRAUD
(Intercept) 5.0658** (2.0788) %INSIDE 0.0425 (0.0339)

EXE.FIX.PAY 1.17E-06 (8.61E-07) %OUTSIDE 0.0027 (0.0083)
EXE.VAR.PAY 5.75E-07 (8.14E-07) FIRM.SIZE 0.1606 (0.1764)
NON.EXE.FIX.PAY 7.39E-07 (2.46E-06) CAPEX 0.0016 (0.003)
NON.EXE.VAR.PAY 4.22E-06 (9.02E-06) LEVERAGE 1.1196 (0.9737)
DUALITY 1.3835 (0.9178) RandD 0.0004 (0.0141)
POWER.RATIO 0.0052 (0.0579) CONCENTRATION 0.5717 (0.5884)
BOARD.SIZE 0.0587 (0.068) SPECIFIC 0.0902 (0.0802)
Observations 223 LR statistic 36.17**
The notation is as defined in Table 1.*, ** and *** denote significance at the 10, 5 and 1 percent
level, respectively. Industry dummies are included (though unreported) to account for industry-
specific characteristics, with industries defined by SIC categories. Estimates for
RandD.REPORTING, SEPT.DUMMY and DEC.DUMMY are unreported for the sake of
brevity. The cross-sectional firm averages of these values are calculated and applied to the
specification. The likelihood ratio (LR) statistic tests the null hypothesis that the model
coefficients are jointly insignificant. Robust standard errors are reported in parenthesis. The
sample size of 223 represents the total number of firms in the full sample.
unreported results, firm size and executive fixed and variable pay are highly
correlated (0.70 and 0.60, respectively). When executive fixed and variable pay
are omitted from the probit model, the coefficient of firm size is statistically
significant at the 1 percent level. Formal tests suggest that multicollinearity is
not present in the model.
5.3.2 Results: stage 2 – the dynamic system GMM model and private fraud
information
The inverse Mills ratio (MILLS) is calculated using the estimates of the first-
stage probit-link model and acts as a proxy for unobservable factors
influencing the firm’s culture of fraud. The dynamic system GMM is re-
estimated for the corporate governance and firm outcome relation with MILLS
included as an exogenous regressor. Using the subsample of fraud firms, this
specification uncovers the marginal impact of the corporate governance
mechanisms on firm outcomes when controlling for the firm’s propensity for
fraud. Moreover, this model directly tests the hypothesis that the firm’s
likelihood of fraud influences firm performance. Lags 1 of the predetermined
variables and lags 2 of the endogenous variables are instruments in the
differenced equation. Lags 0 of the difference predetermined variables and lags
1 of the difference endogenous variables are instruments in the level equation.
The results of the dynamic system GMM specification are contained in
Table 6.
© 2015 AFAANZ
Table 6
The performance, corporate governance and fraud relation dynamic system GMM model
Regressor Q TR ROA PR
L.Y 0.3198 (0.2085) 0.1146 (0.1331) 0.0627 (0.1716) 0.0411 (0.1496)

MILLS 0.7599 (0.6859) 39.9569 (53.194) 11.4096 (8.4543) 0.0444 (0.1107)
EXE.FIX.PAY 4.95E-07 (1.21E-06) 4.14E-05 (6.96E-05) 5.14E-06 (1.25E-05) 8.90E-08 (1.50E-07)
EXE.VAR.PAY 6.71E-07 (7.14E-07) 1.02E-05 (6.18E-05) 1.32E-05 (9.29E-06) 1.03E-07 (1.32E-07)
© 2015 AFAANZ
NON.EXE.FIX.PAY 4.23E-06* (2.45E-06) 0.0003 (0.0002) 2.55E-05 (3.41E-05) 4.69E-07 (3.96E-07)
NON.EXE.VAR.PAY 7.25E-06 6.92E-06 0.0003 (0.0005) 2.46E-05 (9.18E05) 6.79E-07 (8.29E-07)
DUALITY 2.0809 (2.3108) 124.3622 (124.7092) 4.7574 (13.5864) 0.0047 (0.1599)
POWER.RATIO 0.0135 (0.0836) 3.5458 (4.7583) 0.1235 (1.0639) 0.0004 (0.0111)
BOARD.SIZE 0.1053 (0.0902) 3.4993 (7.2463) 1.0404 (1.4046) 0.007 (0.0160)
%INSIDE 0.0065 (0.0391) 0.7179 (1.6253) 0.3902 (0.4629) 0.0030 (0.0041)
%OUTSIDE 0.0130 (0.0114) 0.0804 (0.6954) 0.0818 (0.2315) 0.0003 (0.0025)
FIRM.SIZE 0.0073 (0.2248) 38.4563** (17.9968) 10.2457** (3.9775) 0.0708 (0.0542)
CAPEX 0.0001 (0.0006) 0.1070 (0.0987) 0.0132 (0.0219) 0.0001 (0.0003)
LEVERAGE 1.213852 (0.9653) 165.8688** (68.2112) 54.6792*** (16.592) 0.6548*** (0.1982)
RandD 0.0247* (0.0133) 0.4126 (0.8645) 0.3980* (0.2469) 0.0055 (0.0036)
CONCENTRATION 0.0942 (0.8252) 6.9390 (90.2448) 14.5074 (13.7126) 0.1035 (0.1595)
BETA 0.0626 (0.0824) 10.0269 (7.7212) 0.5252 (1.373) 0.0020 (0.0165)
SPECIFIC 0.0845 (0.0714) 5.1140 (7.8033) 0.6745 (1.3815) 0.0128 (0.0152)
Observations 662 662 662 662
No. of instruments 54 54 54 54
No. of groups 188 188 188 188
J-statistics 10.15 14.32 17.10 15.68
Arellano-Bond AR(1) 1.80** 3.66*** 1.92** 2.21**
Arellano-Bond AR(2) 0.95 0.34 0.25 0.00
The notation is as defined in Table 1. *, ** and *** denote significance at the 10, 5 and 1 percent level, respectively. RandD.REPORT-
ING.DUMMY, INDUSTRY.DUMMY, YEAR.DUMMY, SEPT.DUMMY and DEC.DUMMY are unreported for the sake of brevity. L. is a lag
operator. The parameter estimates are produced using the two-step GMM procedure, with the inverse of the variance–covariance matrix of the
moment conditions as the weighting matrix. The HAC robust two-step standard errors, incorporating the Windmeijer (2005) small-sample
D. T. Tan et al./Accounting and Finance 57 (2017) 597–620
correction, are included in parentheses. The lag 2 of the levels of corporate governance variables and lags 1 of the controls are used as instruments
and are collapsed to preserve sample depth. The J-statistic follows a chi-squared distribution with (l-r) degrees of freedom, where l is the number of
moment conditions and r is the parameters to be estimated, with H0: the moment conditions are correctly specified. The Arellano-Bond test statistic
follows an asymptotic normal distribution, with H0: no autocorrelation of order v in the differenced errors. The sample size is 662 as lags of the
endogenous and predetermined variables of the 974 firm-year observations were used as instruments, resulting in some observations being dropped.
615
Interestingly, some firm characteristics are statistically significant in the full

sample of fraud and nonfraud firms when private fraud information is included
as a control variable. Most notably, a firm’s financial leverage has a statistically
significant negative impact on the total returns, return on assets and profit rate
at the 1 percent significance level. For example, a 1 percent increase in leverage
is expected to reduce total returns by 1.66 percent, ceteris paribus. Firm size has
a positive impact on total returns and return on assets at the 5 percent level.
The ratio of R&D to sales is negatively related to Tobin’s Q and return on
assets at the 10 percent level.
The focus is on the corporate governance and firm performance relation. The
coefficient estimates for the corporate governance variables remain largely
insignificant in the presence of MILLS. The only exception is nonexecutive
director fixed pay, which has a positive impact on Tobin’s Q at the 10 percent
level. The Hansen/Sagan test statistics suggest that the moment conditions are
well-specified and the null hypothesis cannot be rejected at the 1 percent level,
and the Arellano-Bond test statistics confirm the null hypothesis that no
autocorrelation is evident in the errors. We estimated the first-stage regressions
of the endogenous variables (corporate governance) on the instrument set (lags
of corporate governance and controls) and find that the Shea (1997) partial R-
square statistics report that the instruments are jointly significant and valid.8 .
6. Robustness
As a test of robustness, we re-estimate the dynamic system GMM model for

the fraud-only subsample of firms with year dummy variables included. The
results are consistent with the findings in Section 5.3.
There exists little variation in DUALITY. As such, an alternative variable
that is equal to 1 if the chairperson is a nonexecutive director and equal to 0
otherwise (NON.EXE.CHAIR) is employed instead. The results remain
consistent.
7. Summary and conclusion
In a bid to address the impact of corporate fraud on the agency conflict

within the firm, this study examines the corporate governance and firm
outcome relation whilst incorporating fraud information in the analysis. The
primary econometric model of interest is the dynamic system GMM as it is able
to reveal causality in the performance–governance relation despite the presence
of simultaneity, dynamic endogeneity and unobservable heterogeneity. The
study involves a two-pronged approach: first, the robust dynamic system
GMM specification is applied to the corporate governance and firm outcome
8
Results of the first-stage regression are unreported. Contact the corresponding author
for details
© 2015 AFAANZ
relation for fraud firms only; second, the firm’s likelihood of fraud – including
information typically unobservable to the researcher – is incorporated into the
dynamic system GMM model.
Confirming the results of Wintoki et al. (2012) and Schultz et al. (2010), a
firm’s internal corporate governance structure has no statistically significant
impact on performance once endogeneity has been accounted for. Our findings
reaffirm this result for a sample of firms that have experienced instances of
corporate fraud. That is, corporate governance mechanisms are endogenously
determined (optimised) characteristics of the firm and are not determinants of
firm performance.
The first-stage of the Heckman procedure finds that the firm characteristics
considered in this study are jointly significant in predicting fraud and nonfraud
firms. However, individual coefficient estimates are insignificant, suggesting a
high degree of correlation among regressors. Indeed, we find this to be the case
for firm size and the level of executive compensation.
Using the full sample of fraud and nonfraud firms, the second stage of the
Heckman procedure added the inverse Mills ratio as an exogenous regressor in
the dynamic system GMM model of performance and governance. Leverage,
firm size, and research and development have a statistically significant influence
on selected performance measures. There is also weak evidence of nonexecutive
fixed pay having an impact on Tobin’s Q. That is, the average fixed component
of remuneration for nonexecutive directors has a positive effect on a firm’s
Tobin’s Q. The results of the GMM estimates for the full sample differ from
those of the subsample of fraud firms. This is likely due to the smaller sample
size, the adjustments to the data set due to the smaller sample size and/or the
power of the tests given the relatively high instrument count in the fraud-only
subsample of firms. Finally, the coefficient estimate for the inverse Mills ratio is
statistically insignificant, which suggests that private fraud information – or
firm fraud culture – has no impact on firm performance.
These findings are consistent with the growing literature on the equilibrium
view of corporate governance and the firm – that is, firms choose their
governance structure based on public and private firm information or are a
result of other firm characteristics/shocks (see Hermalin and Weisbach, 2003;
Schultz et al., 2010; and Wintoki et al., 2012). As such, exogenous adjustments
in its corporate governance mechanisms are inconsequential to firm outcomes,
regardless of the firm culture and propensity of corporate fraud occurrences.
Exogenous adjustments or ‘strengthening’ of the corporate governance
mechanisms employed in this study are not expected to improve firm
performance – with or without the presence of a culture of fraud.
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Accounting and Finance 57 (2017) 597–620

Corporate fraud culture: Re-examining the corporate

David T. Tana, Larelle Chappleb, Kathleen D. Walshc

We analyse the corporate governance and performance relation, when

Key words: Fraud; Corporate governance; Endogeneity

JEL classification: C36, G34

Fraud in an accounting context is typically deﬁned with reference to the audit

ation of assets or ﬁnancial statement fraud (ISA240.2 The Auditor’s Respon-

1 Do corporate governance measures have a signiﬁcant impact on ﬁrm

The ensuing analysis follows a two-pronged approach. First, by employing a

2. Measuring misappropriation fraud

Much of the prior fraud literature focuses on identifying and measuring

Korean mandatory disclosure listing rule); from publicly announced regulator

3.1 Sample – identifying fraud firms

Prior literature identiﬁes a common theme of entrenched relaxed attitudes to

1 It is the signiﬁcant fraud events that have a material impact on ﬁrm

Although it is diﬃcult to directly observe and quantify a corporate culture of

First, it is reasonable to assume that a ﬁrm with a signiﬁcant corporate

3.2 The corporate governance and firm performance in fraud firms

Corporate governance mechanisms are imposed on all ﬁrms but are

DP ¼ L:DPa þ DGb þ DXg þ DE

3.3 The Heckman (1979) correction for private information

Our second research question considers whether corporate governance

This study examines the performance and corporate governance character-

4.1 Corporate governance variables

1 Board of Directors (POWER.RATIO; DUALITY; and BOARD.SIZE)

Board structure measures focus on the board’s independence from manage-

eﬀectiveness of the board of directors as a monitoring mechanism (Lipton and

2 Ownership Structure (%INSIDE and %OUTSIDE)

3 Executive and Director Remuneration (NON.EXE.FIX.PAY; NON.EXE.-

Remuneration that is sensitive to ﬁrm performance reduces the agency

4.2 Firm performance measures

The ﬁrm performance measures include a standard suite of measures of

4.3 Fraud information

A fraud ﬁrm indicator variable, FRAUD, is constructed that is equal to 1 if a

4.4 Control variables

4.5 Data cleansing procedures

POWER.RATIO Ratio of nonexecutive to executive directors at the time of reporting.

SEPT.DUMMY A dummy variable equal to 1 if the company’s ﬁnancial year ends on 30

Mean Standard deviation Minimum Maximum

Full sample (974 ﬁrm-year observations)

EXE.FIX.PAY ($) 411450.20 262646.34 77802.00 2052415.00

NonFraud sample (762 ﬁrm-year observations)

EXE.FIX.PAY ($) 376127.90 236913.10 77802.00 2052415.00

Fraud sample (212 ﬁrm-year observations)

EXE.FIX.PAY ($)*** 538410.20 308177.10 117968.80 1820797.00

Moreover, fraud ﬁrms have a higher proportion of large outside shareholders

5.1 Testing for endogeneity

The Durbin–Wu–Hausman test for endogeneity ensures that the use of

H0: Regressors are exogenous

DWH test statistic 40.1541** 41.7463** 66.1421** 57.9120**

and lags 2 of the endogenous variables are instruments in the diﬀerenced

5.3 The Heckman correction for private fraud information

5.3.1 Results: stage 1 – the likelihood of fraud

L.Y 0.7974 (0.4055) 0.1873 (0.2439) 0.2424 (0.1601) 0.198 (0.1532)

Dependent variable: FRAUD

(Intercept) 5.0658** (2.0788) %INSIDE 0.0425 (0.0339)

L.Y 0.3198 (0.2085) 0.1146 (0.1331) 0.0627 (0.1716) 0.0411 (0.1496)

Interestingly, some ﬁrm characteristics are statistically signiﬁcant in the full

As a test of robustness, we re-estimate the dynamic system GMM model for

7. Summary and conclusion

In a bid to address the impact of corporate fraud on the agency conﬂict

Ahmed, K., and J. Goodwin, 2007, An empirical investigation of earnings restatements

DWH test statistic 40.1541 41.7463 66.1421 57.9120