Restoring Trust after Fraud: Does Corporate Governance Matter?

This paper examines the association between the credibility of the financial reporting system and the quality of governance mechanisms. Using a sample of firms cited for violation of SEC Rule 10b-5, I find a positive association between fraud detection and subsequent improvements in the quality of the board of directors and audit committee activity. I also find a positive association between the magnitude of the increase in outside director percentage and buy-and-hold abnormal returns for the threeyear period after fraud detection. These findings add to our understanding of the consequences of failures in the financial reporting process and may be useful to regulators debating governance rules and to management when designing strategies for restoring investor trust after fraud detection.

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