Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Department of Banking and Finance

Government College University, Faisalabad
Title Page
Synopsis for the degree of MBA (Banking and Finance)

Name of Student Muhammad Umair

Department Banking & Finance
Registration No. 2013-GCUF-056945 Date of Registration
Name of Research Supervisor Dr. Aamir Inam Bhutta
Members of Supervisory Committee
1.

2.

Title of Research Impact of Corporate Governance Attribute on Fraudulent

Proposal Financial Reporting

Student Signature

Research Supervisor
Signature Stamp

Research Coordinator
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 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Impact of Corporate Governance Attribute on Fraudulent

Financial Reporting

Summary

Conceding agency theory use to test the relationship between the corporate governance attributes
and fraudulent financial reporting, also helps to find why fraud occurs and motive of fraud in an
organization. The purpose of this study is to find whether any relationship exists between the
corporate governance attributes and fraudulent financial reporting. Recently, fraud scandals are
reported in Pakistan, these scandals involve embezzlement and manipulation by the top
management. The reason of this problem is lack of monitoring and poor corporate governance
practices.

To fulfill the objective of the study, we will use board of director composition, ownership
structure, audit committee functionality and external auditor factor as proxies of corporate
governance attributes. Furthermore, proxy of fraudulent financial reporting is a dummy variable
based on action of SEC on firms which are commented in financial irregularities.

The population of this study total listed companies in Pakistan stock exchange. Sample of fraud
firm that are violate the rules of company ordinance, find by the SECP issuance against the
company and collect the information weather company manipulate the financial reporting.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Introduction:
The financial reporting fraud or "cooking the books" means to portray the picture of the firm
financial position for deceiving its users intentionally through the misrepresentation of a
company financial condition or disclosures. Fraud is a global problem. According to Association
of Certified Fraud Examiners (ACFE, 2010 and 2014), estimated cost of fraud losses has
increased from $2.9 trillion to $3.7 trillion from 2009 to 2014. The formulation of Sarbanes-
Oxley Act of 2002 to smooth the corporate governance practices of the firm is a response to a
series of corporate failure scandals such as Enron, WorldCom, Cendant, Adelphia, Parmalat,
Royal Ahold, Vivendi and SK Global.

According to Persons (2005), corporate governance characteristics are associated with the
likelihood of fraudulent financial reporting. Previous studies Todorovic (2013); Cohen,
Krishnamoorthy, and Wright, (2004); Braga-Alves and Shastri (2011); and Pricea, Román, and
Rountree (2011), provide the significant and systematic evidence in this regard. The better
corporate governance increases the performance of the organization and decrease the fraudulent
activity in an organization. But some researchers argue that the present corporate governance
practice is not providing the better control for reducing fraud, Kirkpatrick (2009); Dechow,
Sloan, and Sweeney (1996); and PANFILII and Iulia (2011). According to, Sharma (2010), the
current fraud in Satyam Computer Services Limited has shaken the trust of investors,
government, regulatory authorities and other stakeholders. It is a questionable sign for the
developing countries corporate governance ethics and practices. Unethical corporate governance
practices and imperfect ownership structure are the reasons of failure the Satyam.

Fraud can also be seen in Pakistani corporate sector. In Pakistan, the recently scandal reported
against the National Bank of Pakistan. The Federal Investigation Agency reports the complaint of
irregular withdrawal of Rs1.5 billion from bank account. The National Accountability Bureau is
already investigating Rs18.5 billion frauds against the national bank of Pakistan. There are
numbers of other fraud scams like; Axact IT scam sale of fake degree, and Khanani and Kalia
International forex scam. Just like India, Pakistan is also a developing country which have weak
law enforcement system and corporate governance practices.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

On the other hand, Corporate governance is a set of techniques of a business for providing the
security of every stakeholder as well as improving the performance, (Tahir, Sabir, Arshad, Haq
2012). According to Ameer (2013), “Corporate governance in Pakistan has recently started
scratching the surface”. Shah, Butt, Hasan (2009) describe, that Pakistan needs great attention
on corporate governance issues. Management structure is not favorable to establishing the
standards of good governance, most of Pakistani listed companies are not practicing the code of
good governance.

Agency theory and the stakeholder theory are relating to the corporate governance. Corporate
governance helps to reduce the conflict between the agent and principle, conflict is referred as
agency problem, (Donaldson and Davis, 1991). According to Amara, Amar, Jarboui (2013), if
the company has weak internal control and faces the financial difficulties, then the agency
relation is affect and the management are more like to commit the fraud. Conceding agency
theory use to test the relationship between the corporate governance attributes and fraudulent
financial reporting, also helps to find why fraud occurs and motive of fraud in an organization.

Statement of the Problem

Individual investor is investing their money in the listed companies stock for the purpose of
earning. Investor’s confidence is shake badly due to collapse of highly reputed organization
worldwide over the previous decade, as well as may affect the economic condition. Pakistan is a
country where the investment opportunities attract the foreign investor. However, recently
number of firms involve in the fraudulent activity that could cause the demotivation investors in
the Pakistan (e.g. Khanani and Kalia International forex scam, Axact IT scam sale of fake degree,
and The National Bank of Pakistan embezzlement).

Pakistan is a developing country, even rich with raw resources, but development is limited due to
weak corporate governance and law enforcement. According to Tahir, Sabir, Arshad, Haq (2012)
and Ameer (2013) overall management structure not favorable for establishing the corporate
governance rules, because of many listed companies are not practicing the corporate governance
code. Ullah, Arentsen, Lovett (2017) describe the weak croporate governance structure in
Pakistan are responsibal for poor performance of the firm. Prior studies, Todorovic (2013);
Cohen, Krishnamoorthy, and Wright (2004); Braga-Alves and Shastri (2011) and Pricea, Román,
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

and Rountree (2011) evident that good corporate governance reduces the chances of financial
statement fraud in an organization.

Aim and Objectives

The main objective of this study is to test the relationship between the corporate governance
attributes and fraudulent financial reporting. The current research has the following sub
objectives.

 To analyze how ownership structure of the organization is related with fraudulent

financial reporting.
 To test whether board composition affects the fraudulent financial reporting.
 To find how the audit committee functionality reduces the chances of fraudulent financial
reporting.
 To examines the impact of external auditor factors on fraudulent financial reporting.

Significance of Study/Justification and Contribution of study

Prior studies indicate various aspects of corporate governance attributes and fraudulent financial
reporting. While some studies exist worldwide to this topic corporate governance attribute and
fraudulent financial reporting. Fraudulent financial reporting is a worldwide issue, it’s a billion
of dollar’s fraud losses has reported. Fraud can also be seen in the Pakistani corporate sector,
because now most of fraud scam is reported.

As per author’s knowledge, there is no specific research conduct in Pakistan, so that this study
will meaningful contribution in the Pakistan corporate sector in real time activity of fraudulent
financial reporting. The present study would be useful to understand the concept of fraud in the
corporate sector of Pakistan, also paves the way for the future researcher to analyze fraud in the
corporate sector. It will also broader the vision of the reader to conduct research on different
fields which are related to fraud. This research will justify the answer of fraudulent financial
reporting is concerned with the corporate governance practice, the impact of the financial
statement fraud on the firm as well as better protection to financial statement user. This study
will contribute significantly to the literature of corporate governance and fraudulent financial
reporting.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

This study will help to develop understanding shareholders, management, creditors, investor,
regulatory authority, government with respect of corporate governance practices and fraudulent
financial reporting. According to this, it is considered that the findings of this study will provide
the protection to shareholders, management, creditors and investors also to regulators for making
law.

Literature Review
Generally, Fraud is an act that perform intentionally to deceive the trust of others (Ata and
Seyrek, 2009). Fraudulent financial reporting mainly occurs by the falsification of financial
statement for getting the extra benefits to abolish the official benefits of the others (Nia, 2015).
Spathis (2002), describes the manipulation financial statement by overstating the assets, sales
and profits or understated liabilities, expenses and losses, fraudulent activity not present the real
portray of the business.

Porter and Cameron (1987) and Coderre (1999), argue that management fraud is not easy to
detect until the organization has suffered irreversible losses, it’s not contain direct theft of assets.
So that when the companies face the financial difficulties, move to bankruptcy and liquidation
that have more likely to involve in the fraudulent financial reporting, (Beasley, Carcello, and
Hermanson 1999). Bratton (2002) and McNulty (2002) find that the overstated income and
understating liabilities intentionally are the reasons of financial reporting fraud in Enron. Which
was the 7th largest organization of America, its market capitalization US$70 billion at the end of
2000 and was bankrupt after eighteen months in 2001.

Corporate governance is a process of collective goal and allocation of corporate resources for
maximization the value of all stakeholders, (Raut, 2011). It is combination of core external
stakeholders (shareholders, debt holders, creditors, suppliers, and customers) and internal
stakeholders (board of director, executives and employees). Javid Iqbal (2010), define the good
corporate governance supports the economic development through improving the performance of
the firms. Law (2011) and Uadiale (2012), concludes that better corporate governance practice
reduces the chance of fraud within organization. Cohen, Krishnamoorthy, Wright (2002), point
out that the corporate governance is one of the most important factor for ensuring whether the
company involve in fraudulent financial reporting or not.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Corporate governance are mainly concerns with management, board of directors, shareholders,
audit committee and other stakeholders, (Javid Iqbal, 2010). (Blue Ribbon Committee (BRC),
1999) define the better corporate governance promote relationship among the primary corporate
member and to enhance the corporate performance. (Blue Ribbon Committee (BRC), 1999)
define the board ensure the management is working with best effort and interest of the firm and
shareholders. Because, board have higher interest of organization benefits than management, so
that monitor the management activities and take the better decision making for company
benefits, (Jensen M. C., 1993). Because of that (Williamson, 1984) suggest managers have large
flow of informational advantages as a results of their full-time status and inside knowledge. So
that they sacrificing the interest of other stakeholders, (Persons, 2005).

(Blue Ribbon Committee (BRC), 1999) describe the major element of the board is oversight1 the
working of the management to follow the legal and ethical corporate practices. (Rosenstein
Wyatt, 1990) Provide the results stockholder get positive abnormal return when outside
independent directors are added to Board of directors. Beasley, (1996) examine a large number
of independent outside directors on the board are significantly decrease the likelihood of the
financial statement fraud. Beasley, Carcello, Hermanson, and Neal, (2010) find the results board
of directors are not independent in fraud comapanies.

Jensen (1993), describes the chairman run the operation is held the board meeting, management
recruitment and compensation of CEO in an organization. According to Jensen (1993), in U.S.
corporations, there is most common to have the CEO also hold the position of the chairman of
the board. (Dunn, 2004), (Gavin, 2003) and (Ward, 2003) describe, if the CEO of the company
also chairman of the board in this way the power centralization is just in one person. So that it
may reduce the monitoring on management (Chen, Firth, Gao, Rui, 2006). Beasley (1996) and
Dechow, Sloan, and Sweeney (1996), both of them provide the same results, there are significant
impact of CEO duality on the fraudulent financial reporting. Persons (2005), concludes the
results the independence of the nominating committee is not significant variable in reducing the
likelihood financial statement fraud.

1
“Such oversight includes ensuring that quality accounting policies, internal controls, and
independent and objective outside auditors are in place to deter fraud, anticipate financial risks
and promote accurate, high quality and timely disclosure of financial and other material
information to the board, to the public markets, and to shareholders”.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Cafferty (2004), describe the one way of fraud preventing is the ownership structure, its consider
the two thoughts, share held by the management and independent person. It is theorized by
(Jensen Meckling, 1976) when insider ownership increases the need of monitoring is decreases,
because of the insider interest increases the performance of the management than the other
shareholders. Moreover, the increase manager’s ownership is might be a reason for fraudulent
financial reporting, (Cheng Warfield, 2005). Klein (2002) support this results insider ownership
motivate the fraudulent financial reporting. Institutional ownership in an organization is known
as blockholders, (Cronqvist Fahlenbrach, 2006). Shleifer Vishny (1997), they conclude large
number of the outside blockholders that are not a part of the management have great incentive of
monitoring activities due to a high proportional stake in the firm. Sharma (2004), conclude the
results blockholders invertors high investment in organization so that its reduce the involvement
of fraud.

Conger, Finegold, and Lawler (1998), examine the board meeting crucial tool for improving the
efficiency of the board. A large number of board meetings are a signal of fraud (Chen, Firth, Gao,
Rui, 2006). Uzun, Szewczyk, Varma (2004), provide the results number of board meetings are
less in fraud firms than the non-fraud firms. Gibbins, Richardson, Waterhouse (1990), and Haat,
Rahman, Mahenthiran (2008), describe the board of directors are take the decision about the
materiality information are disclosed in annual reports.

Audit committee in an organization was overseen the financial reporting, its important function
of ensuring the correctness of the financial reports (Buchalter Yokomoto, 2003). Also audit
committee role, Blue Ribbon Committee (BRC) (1999), describe the role of the audit committee
is directly oversight the board operations. Abbott, Parker, and Peters (2002), they find the result
fully independent audit committee and meet the minimum of 4 meetings attend in a year are
reduce the fraudulent financial statement. Firth (1980) and Dykxhoorn Sinning (1982), examine
the audit committee independence is reflecting the financial statement of the firms. Dechow,
Sloan, and Sweeney (1995) and Persons (2005), conclude the results audit committee
independency is significantly associated to reduce the financial statement fraud.

Fan Wong (2005), examine the external auditor support to assessing the corporate governance
practices for reducing the fraudulent financial reporting. Chen, Firth, Gao, Rui (2006), they find
negative results of its study, China’s firms have external auditor not contribute to detecting the
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

fraudulent reporting effectively. Michaely Shaw (1995), describe that firms are use high reputed
(big five, big four) auditors have disclosed clear audit opinion because of that they maintain its
reputation.

Research Design (Methodology)

Data

We will use two sources for data of the study. The corporate governance variables and firm level
control variable will be retrieve from manually collected annual reports of non-financial firms of
Pakistan between 2009 to 2015.

For detection of the fraudulent financial reporting, this study follows the methods used by
previous studies, McMullen (1996); Beasley (1996); Persons (2005); and Bonner, Palmrose,
Young (1998). To identify the reporting year as a fraud year, we rely to the firm order issued by
the SECP against the financial irregularities.

Dependent Variable

The dependent variable is a dummy variable given a value 1 for the firm year against which
SECP issued order, (Persons, 2005).

Independent variable

A list of Independent variables, definition of the variable of this study is shown in the appendix
1.

Modal

Multiple regression models will be employed to test the variable relation between firms
convicted in financial statement fraud and corporate governance mechanisms. This study modal
is related to the (Persons, 2005) study.

FRF = f (Corporate governance attributes, Firm level variables)

 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Appendix 1:
Variables and Definition
Variable Definition Source Prior Studies

Dependent variable
Fraud A dummy variable use 1 if the SECP issuance (Persons, 2005)
listed company commit the fraud, against the and Beasley M. S.,
0 otherwise. company for Carcello,
violation of the Hermanson, and
regulations is use Lapides (2000)
for fraud company
taken from the
SECP website.

Independent Variable
Audit Committee Functionality
Size of Audit Number of Audit Committee Annual Reports (Felo,
Committee Members Krishnamurthy,
Solieri, 2003) and
(Salihi Jibril,
2015)

Independent A dummy variable use 1 if Annual Reports (Persons, 2005);

Director in Audit Independent Director in Audit (Abbott, Parker,
Committee Committee, 0 otherwise. Peters, 2002) and
(Felo,
Krishnamurthy,
Solieri, 2003)

Number of Audit Accounting and Financial Experts Annual Reports (Persons, 2005)
Committee based on whether they had an
Accounting and education and experience as a
Financial Experts financial officer, accounting
officer.
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Audit committee The audit committee meeting Annual Reports (Persons, 2005)
Meetings frequency in a year.

Board of Director Composition

Board Size Total member of the board Annual Reports (Razali Arshad,
2014) and Dechow,
Sloan, and
Sweeney (1996)

Number of Percentage of Female director to Annual Reports (Gavious, Segev,

Female Directors total board. Yosef, 2012)
in the Board

Non-executive Percentage of Non-executive Annual Reports (Razali Arshad,

director in the director to total board. 2014) and
Board (Anderson, Mansi,
Reeb, 2004)

CEO Duality Dummy/Indicator Variable coded Annual Reports Dechow, Sloan,

1 if the Company CEO is also the and Sweeney
Chairman of the Board, and 0 (1996); Beasley M.
otherwise S., Carcello,
Hermanson, and
Lapides (2000) and
Persons (2005)

Number of board Number of board meetings held Annual Reports (Persons, 2005)
meetings in a year.

Family Member The proportion of family Annual Reports (Hashim Devi,

in Board members to total number 2008)
directors in the board

Ownership Structure

Directors The percentage of common shares Annual Reports (Hashim Devi,

Ownership held by directors to total number 2008) and Beasley
 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

of shares issued (1996)

Blockholders ownership

Total Number of Total numbers of shareholders Annual Reports (Persons, 2005)

Blockholder that holding more than 5% of the
total number of shares of the
company

Ownership of The percentage of common shares Annual Reports (Persons, 2005)

Blockholders held by blockholders to total
number of shares issued

Institutional Ownership

Domestic The percentage of common shares Annual Reports (Hashim Devi,

institutional owned by Domestic institutional 2008)
ownership ownership to total number of
shares issued.

Foreign The percentage of common shares Annual Reports (Hashim Devi,

ownership owned by Foreign ownership to 2008)
total number of shares issued.

External Auditor Factors:

Big4Aud Dummy/Indicator Variable coded Annual Reports (Sirois,

1 if the Company's External Marmousez,
Auditor is one of the Big4 Simunic, 2012);
Accounting Firms, and 0 and Dechow,
otherwise Sloan, Sweeney
(1996)

Control Variables:

Firm size Logarithm of the total assets, Annual Reports (Menon Williams,
1994); (Razali
Arshad, 2014)

Leverage Total Debts divided by Total Annual Reports Dechow, Sloan,

 Student’s Name: Muhammad Umair Registration: 2013-GCUF-056945

Assets and Sweeney

(1996); (Razali
Arshad, 2014) and
(Menon Williams,
1994)

Age How many years to incorporate. Annual Reports

Growth The average percentage change in Annual Report (Abbott, Parker,

total assets for the two years Peters, 2002)
ending before the year of the
misstatement.

Profitability Net income to total assets or net Annual Reports (Zainudin Hashim,
income to total sale 2016)

Loss Dummy variable 1 if company Annual Reports (Mulcahy, 2014)

gain loss from consecutive 2
years otherwise 0.

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