Is the Structure of the Board of Directors Associated with Accounting Fraud?
Evidence from Japan
Masumi Nakashima, Ph.D.
Chair and Professor of Accountancy
Chiba University of Commercemasumi.nakashima@converse.edu

ABSTRACT: This study investigates the types of firms that disclosed fraudulent accounting(fraud firms). Next, this study examines whether the fraud firms have common innatecharacteristics by comparing fraud and non-fraud firms. Finally, I clarify the differences in thecomposition of the board of directors between fraud and non-fraud firm and show the evidence
from Japan regarding the association between accounting frauds and the structure of the board of
directors. I focus on a sample of 280 firms that disclosed that the inappropriate accounting had
impact on prior financial statements or that the inappropriate accounting would have an impact on
the future through Tokyo Shoko Research (TSR) Investigation Report from 2007 to 2015. I use acomparison between the fraud and non-fraud firms that are similar to the fraud firms in industry
and size for the empirical study.
The finding is the following: First, I document the number of accounting frauds
increased since 2012 and the accounting frauds occurred at the First Section of the Tokyo Stock
Exchange. Accounting fraud is prevalent in the industry of wholesale, retail, construction andcommunication. Also, accounting frauds occurred at the level of top management and subsidiary.
And the incentive to commit accounting fraud is to sustain a firm’s financial performance, not topursue an individual private gain. This suggests that this is a feature of accounting frauds in Japan.
Since the type of fraudulent financial reporting is related to sales and losses, this is the pressurethat causes accounting frauds. Second, the results of t-test show that there is a difference in a
firm’s performance and business complexity, and the percentage of outside directors. Thissuggests that the poorer performance a firm possesses, and the larger the size of a firm, the more
likely accounting fraud occurs. Third, there is a significant positive association between
accounting fraud and the percentage of outside directors; however, there is a significant negative
association between fraud and the independence of the outside directors. This suggests that while
the fraud firms have a positive attitude to improve the composition of board of directors, they do
not acquire the higher independence possessed by the outside directors.
Key Words: fraudulent accounting; innate characteristics; the board of directors; outside
directors; independence.

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1

INTRODUCTION

Nakashima and Ziebart (2015) examined whether the Japanese internal control regulation(the Financial Instruments and Exchange Act of 2006, J-SOX)1 impacted both earnings
management and earnings quality in Japan. They found that the Japanese results to be somewhat
different than results found in prior U.S. studies. Nakashima and Ziebart (2015) documented theinconsistent results are because of the differences in the enforcement mechanism and corporate
governance as well as differences between US- SOX 2 and J-SOX.
Internal control reporting regulation has enacted both in Japan and the U.S. to operate afirm’s internal control system. Although the objective of the internal controls system is not todetect fraud, if an effective internal control system were implemented, it is likely thatunintentional errors and intentional errors would be decreased. In practice, the number of thefirms which disclosed material weaknesses has decreased in Japan. Nakashima and Ziebart (2015)
documented that the effective internal control system help earnings quality improved in the
post-J-SOX period and the results of earnings quality are consistent with the results for the U.S.
and SEC standard Japanese firms.
However, Nakashima and Ziebart (2015) found that while accruals management and real
management remained unchanged for control firms, accruals management increased for material
weakness disclosing firm. The results of earnings management are inconsistent with the results for
the U.S. and SEC standard Japanese firms. They concluded that they were skeptical regarding theextent to which J-SOX improved corporate governance and more effective enforcement was
1 Since there is our original act for internal control regulation, the Financial Instruments and Exchange Act of 2006 in Japan, thisact is not the Japanese version of the U.S. Sarbanes-Oxley Act of 2002. However, following the U.S. where it is called
Sarbanes-Oxley Act of 2002 as SOX in the literature, the Financial Instruments and Exchange Act of 2006 is called as J-SOX in
Japan. Therefore, I call the Financial Instruments and Exchange Act of 2006 as J-SOX in this study.
2 Although Sarbanes-Oxley Act of 2002 is called as SOX in the literature in general, Sarbanes-Oxley Act of 2002 is called as
US-SOX in this study for making a distinction with J-SOX.

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needed in Japan.
Therefore, incidentally or inevitably, the accounting fraud was found at one of excellent
public firm, Toshiba in July 2015. 3 If an effective internal control system was organized andimplemented, the opportunity of fraud involved by directors and employees should be prevented
and results in the decreases in fraud occurrence, though the direct purpose of internal control
regulation is not to detect fraud. Although the internal control regulation required the public firms
in Japan to organize their controls system well and their internal control system should have had
worked substantially, the accounting fraud occurred at one of excellent firms in Japan.
The Toshiba accounting scandal becomes one of case studies of accounting fraud
triangle. 4 It is said that fraud occurs when pressure, rationalization, and opportunities coexist(Cressey 1973, 30). If these three factors coexist, regardless of the excellence of a firm, a fraud 5
can occur. According to the Investigation Report of Toshiba (Investigation Committee 2015), it
seemed that there were three factors of fraud triangle at Toshiba. I regard the following as threefactors of the fraud triangle at Toshiba: Pressure, where representatives are supposed to achieve
profits and losses required by each budget and to meet improvements in the profits and losses
mandated during each relevant period (Investigation Committee 2015, 44-45). Rationalization,
where the people concerned must have considered that the activities for inappropriate accounting
should not be stopped by the era of those presidents. Opportunity, where internal controls do notwork well, and as a result, such frauds cannot be prevented (Investigation Committee 2015, 48).
Following Cressey’s (1953) theory, if the opportunity had been constrained at Toshiba,
3 The recent accounting scandal of Toshiba declined the creditability of the market in Japan. Media asserts that Toshiba is one ofexcellent firms for corporate governance since it changed its corporate model from traditional “Audit & Supervisory Board” to “aCompany with a Committee” very early as a public firm in Japan (Nikkei Shinbun, July 22 2015).
4 In recent days, the theory of the fraud is called as the fraud diamond, incentive, opportunity, rationalization, and capability.
Capability should exist in addition to the fraud triangle. See the details, Wolfe and Hermanson (2004).
5 Statement of Auditing Standard No. 99 (SAS 99) (AICPA 2002, para.5) defines fraud as an intentional act that results in amaterial misstatement in financial statements and state that there are two kinds of fraud that means (1) misstatements arising fromfraudulent financial reporting, that is an intentional misstatements or omissions of amounts or disclosures in financial statementsand (2) misstatements arising from misappropriation of assets.

3the accounting fraud should not have occurred. It is likely that an insufficient monitoring system
under the governance structure composing a powerless internal auditor and mere façade of outside
directors were not able to constrain the opportunity of the fraud occurrence. This is motivation ofthis study. Therefore, I investigate the relationship between fraud and governance mechanism.
First, I investigate what innate characteristics the fraud firms have commonly. Second, I examine
the composition of boards of director and audit committees in the fraud firms. Third, I discuss theassociation between fraud and the composition of board of directors.
This study contributes to literature in the following ways. First, this study provides
insight into the types of the firms that disclosed fraudulent accounting, based on the theory of
fraud triangle. Second, this study shows the Japanese evidence on the innate characteristics of thefraud firms by comparing fraud firms and non-fraud firms, although there are several studies
regarding the particular fraud firm. Third, this study clarifies the differences in board of directors’
composition, and in independence of board of directors and audit committees between fraud firms
and non-fraud firm and provide evidence from Japan regarding the association between
accounting fraud and board of directors’ composition.
The remainder of this study proceeds as follows: Section 2 describe the corporate
governance reform in Japan. Section 3 presents sample selection and describes the type of frauds
engaged in by the fraud firms. Section 4 reviews prior research and develops hypotheses. Section
5 shows the research design. Section 6 presents the empirical results. The final section includes asummary and my conclusions.

2

Corporate Governance Reform

Prime Minister of Japan and his cabinet formulated the Basic Concept of Japan
Revitalization Strategy 2016 (Cabinet 2015). In the content, they proposed further enhancement4

of corporate governance as a regulatory reform for future investment as follows:
The Government will support efforts by listed companies for improvement of the effective ness ofcorporate governance through learnings and publicizing the state of listed companies’ efforts concerning
the CEO selection and dismissal process and composition, operation, and evaluation of the board of
directors (Cabinet 2015, p.22)

The Council of Experts Concerning the Corporate Governance Code (CECCG) issued
the Corporate Governance Code in June 2015. Principle 4.8 of Code states that companies should
appoint at least two independent directors that have such qualities. Moreover, if a company in its
own judgment believe that it needs to appoint at least one-third of the directors as independent
directors based on the board’s consideration of factors such as the industry, company size,
business characteristics, organizational structure, and circumstances surrounding the company, it
should disclose a strategy for doing so (CECCG 2015 Principle 4.8.27).
Drucker (1974, 635) states that an effective board means the review and appeal board.
Since management needs to have access to the financial community to understand each other,
Drucker insists that a board of directors should comprise people from outside the company.
Moreover, based on the Corporate Governance Code, the Tokyo Stock Exchange required all
public firms in Japan to prepare a report on corporate governance which is called as corporate
governance report. This is supposed to provide stakeholders with information regarding the public
firms’ corporate governance situation and attitude.6
A Company with Board of Company Auditors shall have three or more company auditors,
and the half or more of them shall be Outside Company Auditors (Company Law 2005, Article
373, Paragraph 1, Item 2). The Company Law states the following: the outside directors for “aCompany with an Audit and Supervisory Board, if they do not appoint outside directors, should
6

TSE http://www.jpx.co.jp/english/equities/listing/cg/01.html

5explain the reason why appointment of outside directors is not appropriate (Revised Company
Law 2015, Article 327, Paragraph 2) A company with a supervisory auditor committee should
establish the supervisory auditor committee and this committee should consist of more than three
directors who are supervisory auditors and half of the members should be outside directors(Company Law 2005, Article 331, Paragraph 6). A company with such a committee should
establish the committee and the committee should consist of more than half outside directors(Company Law 2005, Company Law, Article 400, Paragraph 3). To enhance corporate
governance and control the board of directors, the Revised Corporate Law of 2015 introduced“company with audit and supervisory committee.” in May 2015 and required them to appoint
three more directors and among them half of directors should be outsiders.
Principle 4-8 of the Corporate Governance Code requires that public firms should
appoint more than two independent outside directors. However, these firms are allowed not toappoint them as far as they have the proper reason why they do not have independent outside
directors. As prescribed by the TSE Listing Code Article 436-1, public firms should appoint morethan one independent outside directors (TSE 2015, 1).
Figure 1 presents the assessment of independence of the board (CECCG 2015). Two
dimensions are displayed, the time horizon and the relationship with the firm when evaluating theindependence of outside executives. As shown in Figure 1, the independence criteria must be
evaluated along two dimensions to determine whether the outside director is independent or not.
These two dimensions are the relationship between the directors appointed and the insiders and or
clients and suppliers, and the time period of the appointment of the directors. If a relationship isfound between the director and the related party or person of the firm within ten years, it is thenconsidered as “no independence.” If there is a relationship between the directors and the investors
or no main stakeholders within ten years, these relationships must be disclosed.
[Insert Figure 1 Here]6

3 SAMPLE SELECTION AND DESCRIPTION
3.1. Fraud Firms
The fraud firms consist of 280 public firms in Japan during the period from 2007 to 2015.
The fraud firm sample that disclosed that inappropriate accounting impacted the prior financial
statements or would have an impact in the future in their annual reports which were issued from
April 2007 to March 2015 through Tokyo Shoko Research (TSR) Investigation Report.
Figure 2 shows the trend of the number of fraud occurrences during the period from
April 2007 to March 2015. The increase in frauds is seen from 2012. The number of accounting
frauds increased gradually during this period. It seems that the reason why frauds increased after
2012 is because many public firms in Japan established a “Public Interest Whistle-Blowing
System” in accordance with the Whistleblower Protection Act that was enacted in 2006. 7
Table 1 and Figure 3 present fraud firms by their listed stock markets. Figure 2 showsthat while the number of the fraud firms listed on JASDAQ and MOTHERS increased by 2011,
the fraud firms listed on the First Section and the Second Section of the Tokyo Stock Market
increased after 2012. Table 2 and Figure 4 show the fraud firms divided as per industries. The
industrial distribution is based on Nikkei’s Intermediate Classification for public firms in Japan.
7

The Act prescribes that the purpose of the Act is to protect whistleblowers to provide for nullity, etc. of dismissal of
Whistleblower. on the grounds of Whistleblowing and the measures that the business operator and Administrative Organ shall takeconcerning Whistleblowing, and to promote compliance with the laws and regulations concerning the protection of life, body,property, and other interests of citizen, and thereby to contribute to the stabilization of the general welfare of the life of the citizens
and to the sound development of socioeconomy (Consumer Affairs Agency 2004, Article 1). The act also prescribes that thebusiness operator provided for in Item (i) of Paragraph 1 of Article 2 shall not give any disadvantageous treatment such as
demotion, a salary cut or other treatment to Whistleblower who is or was its employee on the basis of such Whistleblowing(Consumer Affairs Agency 2004, Article 5).The survey was implemented by the Consumer Affairs Agency for 3,624 persons who
experienced an internal notification based on the Whistler-Blowing Act of 2004, private firms, public firms, and employees andattorney, and academician as style of the questionnaire-answering. According to the survey, 61.5% of all the private firms
recognized the Act, the people who know both of Act and the guideline and the people who know only the Act are 36.8%, and24.7% respectively. Focusing on the employees, the more numbers employees the firms have, the more they know the Act. While
93.9% of more than 3, 000 employees know the Act, 61.1% of 101-300 employees know the Act. Focused on the introduction of
public interest whistler blowing system, 46.3% of the private firms has introduced the public interest whistler blowing system, and96.8% of more than 3, 000 employee firms and 40.0% of the employees of 101-300 employees have introduced the system
respectively.

7Frauds mostly occurred in 46 wholesale firms (16.4 percent), followed by 39 communication
firms (13.9 percent), 33 service firms (11.8 percent), 31retail firms (11.1 percent), and 20
construction firms (7.1 percent).
[Insert Figure 2 Here][Insert Table 1 Here][Insert Figure 3 Here][Insert Table 2 Here][Insert Figure 4 Here]I analyze the management levels where a fraud occurred and who were involved with thefraud. Of the four levels, top management has the greatest number of frauds. This result is
consistent with Doyle et al. (2007) that company-level material weaknesses are related with
accrual management by managers. Figure 5 presents that following top management, subsidiary
has the second greatest number of frauds. A manager of public firms is evaluated by the firm’s
financial results. Sometimes, it seems that since the top of a subsidiary is transferred from one of
top management of the parent firm, the parent firm sometimes pushes the top of the subsidiary to
implement the fraud as an exchange of tokens. Since a manager is evaluated by his or her firm’s
financial performance, the manager tries to be involved with fraud to sustain his or her own
authority. This is a type of incentive of committing a fraud by managers. This is from greed associal approval.
[Insert Figure 5 Here]Figure 6 presents a breakdown of specific type of frauds: embezzlement by employees,
fraud by a subsidiary, private gains for senior management, and protecting a firm as a whole. Of
these four incentives of committing frauds, protecting a firm as a whole is the key incentive. It isfollowed by fraud by a subsidiary, and by embezzlement by employees and private gains forsenior management as incentives to commit frauds. This is one of the characteristics founded in

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Japan.
Figure 7 and 8 show the four categories account-specific frauds as per the account type.
In Figure 7, I found that of the four fraud categories, “Account-Specific frauds” has the highest
number of frauds. When I focus on Account-Specific frauds in Figure 8, the greatest number ofaccount specific frauds is founded in the Sales/Purchases, which is then followed by Other
Liabilities. This indicates that a firm commits fraud in areas involved with revenue-recognition,such as Sales/Purchases and Other Liabilities. This leads to aggressive earnings management.
[Insert Figure 6 Here][Insert Figure 7 Here][Insert Figure 8 Here]3.2. Comparison between Fraud and Non-Fraud Firms
I used the following process to select a sample selection to analyze the two hundreds
eighty firms that disclosed fraud through TSR survey. I dropped twenty duplicate firms. There areseveral firms that have one more fraud during the period. I also dropped one financial institution.
Finally, I have just reached sixty-one firms that disclosed their Corporate Governance Report in2015 or 2016. The final sample was obtained from Nikkei Data, whose have complete data from2001 through 2015. Data was obtained from the Nikkei Economic Electronic Databank System(NEEDS).
Table 3 outlines the sample selection process. To form a pair sample group, non-fraud
firms are that are similar to the fraud firms in the stock exchange, industry, size, time period, andaccounting method, were identified. Each fraud firm was matched with a non-fraud firm based on
the following criteria: Stock Exchange, Industry Firm, and Size: total assets, Time Period:
2001-2015, Accounting method: Japan-GAAP.

9[Insert Table 3 Here]

4 PRIOR RESEARCH AND HYPOTHESES DEVELOPMENT
Ge and McVay (2005) presented that firms disclosing material weaknesses tend to haveinnate characteristics such as complexity of operations, small firm size, and poor profitability. I
also predict that fraud firms tend to have innate firm characteristics, such as financial performance,business complexity, firm size, and firm age.
Firms manage reported earnings to avoid earnings decreases and losses (Burgstahler andDichev 1997; Suda and Shuto 2005). Burgstahler and Dichev (1997) found that cash flow fromoperations and changes in working capital, have been used to manage earnings. Therefore, since
positive operating cash flows is the result of whether the firm has good sales, managers tend to
focus on operating cash flows. Consequently, they try to manage earnings by utilizing operating
cash flows. Suda and Shuto (2005) stated that Japanese managers have an incentive to manage
earnings by focusing on simple earnings benchmark, nonzero earnings, because firms have no
explicit contracts of earnings-based compensation for managers and the compensation is highly
sensitive to negative earnings. Thus, I predict that there is a relationship between fraud andfinancial performance.
Firms with business complexity likely have a higher chance for occurrence of
deficiencies in internal controls (Ge and McVay 2005, 148). This not only leads to non-intentional
errors but also to intentional errors. I have focused on the number of segments as variable ofbusiness complexity.
Large firms have more assets and resources and tend to organize their internal controls
system. However, since bureaucracy and rigid hierarchy penetrates in a larger firm, there is thefirm culture where it is hard for an employee to notify authorities about the occurrence of frauds

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in the large firm.
Since employees of older firms have experience of businesses, older firms likely havemore established good internal controls system (Ge and McVay 2005, 149). On the other hand,since order firms have a long history with good reputations, they might try to protect theirreputation even if they perform poorly. This might leads to the occurrence of frauds.
Therefore, I posit the following hypothesis with four working hypotheses:
H1: There are four common innate characteristics of the fraud firms.
Working H1a: The poorer the financial performance of the firm, the more fraud it commit.
Working H1b: The greater the business complexity of the firm, the more fraud it commit.
Working H1c: The greater the size of the firm, the more fraud it commit.
Working H1d: The older the firm, the more fraud it commit.

Fama and Jensen’s theory (1983) suggests that a higher percentage of outside directors
increases the board effectiveness as a monitor of management. To enhance corporate governance,
the Revised Corporate Law of 2015 introduced “a company with a committee of audit and others”
in May 2015. It is expected to strengthen the monitoring of the executives’ executions by theinternal and outside board of directors. Moreover, ethical education should be provided for all
levels management and employees to improve their attitude for promoting appropriate accounting.
Beasley (1996) found that fraud firms have boards of directors with significantly lower
percentages of outside directors than non-fraud firms by using the U.S. data in 1980-1991 and thatlarger proportions of outside directors significantly reduce the likelihood of fraud occurrences.
Moreover, Uzun et al. (2004) found that board composition was significantly related to fraud
occurrence by employing the U.S. data in 1978-2001 period. Chen et al. (2004) documented thatthe proportion of the board of outside directors is associated with the fraud occurrences.
However, there are empirical studies that more outside directors is related to fraud. The

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reason is following: while outside directors bring knowledge, experience and objectivity to bear
upon board decisions, it is difficult for them to understand the complexities of the firm andmonitor its operations (Estes 1980) and a large number of outside directors representing diverse
interests reduce the economic flexibility of a firm and result in more conflicts between the board
and the top management (Sethi et al. 1979).Chaganti et al. (1985) did not find that there issignificant relationship between the proportion of outside directors and corporate failure.
Thus, there are a mix result regarding the association between the percentage ofoutside directors on board of directors and fraud in English-speaking counties. Here, the structureof the board of directors in Japan should be explained.
Under the Company Law, 97.7% of all public firms set up a Companies with Board ofAuditors and 2.3% of all public firms introduced a Companies with Committee. A director on theboard for public firms in Japan is appointed by CEO (Chief Executive Officer) or president
among core employees who have dedicated themselves for the firm since entering the firm rightafter graduation. CEO has a central power for directors to execute management under CEO’s
direction. Therefore, although directors should monitor CEO’s management, in really it is hard for
directors to monitor CEO’ management in public firms in Japan since directors are located under
top management at a firm’s hierarchy (Osada 2016). An internal auditor who also is appointed by
CEO among core employees but is not expected to become top management by CEO unlike
directors, is supposed to audit whether directors’ management is legally appropriate or whether
directors’ management is appropriate or rational but it is hard for him or her to assert his or her
opinion to top management (Direct Force 2016).
Although originally the board of directors and internal auditors should monitor and audit
the CEO’s management respectively, it seems that it is hard for them to audit CEO’s management.
According to the Survey for public firms (Deloitte 2016), the roles of the outside directors for
public firms to expect outside directors are management experiences and legal professional

12knowledge. Saito (2011) documented by the survey that a firm expects outside directors toguarantee legality and appropriateness of management (44.8% of all respondent public firms) andto advice a new project (36.8%). Only 6.8% of respondent firms is to monitor of management.
This suggests that public firms in Japan expect outside directors not to monitor management but
to advice management (Saito 2011).
Therefore, as stated before, Revision of Companies Act of 2014 enacted and asked public
firms to appoint outside directors on the board and required them to explain if they do not comply
this (Ministry of Justice 2014). Also, firm “a company with audit and supervisory committee.” hasbeen established as a new structure of a firm in order to enforce corporate governance (Ministryof Justice 2014, Article 2, 11-2、Article 331, para 3, para. 6). Because of issuing the Revision,
3,118 firms (88.9%) have appointed an independent outside directors among 3,507 all public
firms. And, 3,358 firms (95.8%) have an outside director among 3,507 all public firms according
the survey for public firms in Japan by TSE (TSE 2016).
Nakashiminda and Ziebart (2016) found that there was a positive link between ‘tone at
the top’ and outside directors ratio. They suggests that a higher percentage of outside directors theboard has, more positive tone at the top the firm has. The fraud firms have a positive attitude forreforming the governance. Thus, I predict that fraud firms have a higher percentage of outside
directors in order to enhance governance through strengthening auditing and receiving objective
opinions . Accordingly, the following hypothesis is posited:

H2: Fraud firms have a positive attitude for governance, and thus a higher percentage ofoutside directors of board of the directors.

Epps and Ismail (2008) documented that the boards controlled by 90 percent of independent
outsiders were negatively associated with the income-decreasing earnings management. Beasley13

(1996, 455) found that there is a significantly negative relationship between the likelihood of
fraud occurrences and the percentage of independent directors. Xie et al. (2003) provide evidence
that earnings management is less likely to occur when the board composition has more
independent outside directors.
I predict that fraud firms have a higher percentage of independence of the board of
directors to prevent fraud and enhance corporate governance. Accordingly, the following
hypothesis is posited:

H3: Fraud firms have a positive attitude for governance, therefore, they have a higher
independence of the board of directors.

5 RESEARCH DESIGN
5.1. Proxy of Fraud Occurrences
The fraud firm sample that disclosed that inappropriate accounting had an impact on priorfinancial statements or would have a future impact on their annual reports which were issued
during the period from April 2007 to March 2015 through Tokyo Shoko Research (TSR)
Investigation Reports.

5.2. Independence of the Board of Directors
Figure 1 shows the criteria of independence standards as per the Corporate Governance
Code (The Council of Experts Concerning the Corporate Governance Code 2015). According to the
independence standards of the Corporate Governance Code (The Council of Experts Concerning
the Corporate Governance Code 2015), the criteria to determine whether a director is independent
or not should be assessed along two dimensions: the relationship between the directors appointed

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and the insiders/clients and suppliers and the time period of the appointment of the directors. If
there has been a relationship between the director and the related party or person of the firms
within ten years, it is then considered as “'no independence.” If there has been a relationshipbetween the directors and investors/not main stakeholders within ten years, these relationshipmust be disclosed.

5.3. Test Hypothesis
To test H1, I analyze the innate firm characteristics of the fraud firms. Specifically, I
investigate the following four dimensions: financial performance, business complexity, firm size,and firm age. The descriptive statistics of each of the variables are shown in TABLE 3.
To test H2, I implement univariate tests. To test the relationship between fraud
occurrences and the composition of the board of directors. I examine if there are significant
differences between the fraud firm sample and non-fraud firm sample. T-test is used to check forsignificant differences. Moreover, to test H2, multivariate tests should be implemented. Similar to
Beasley (1996), the logit regression model is presented as follows. I estimate the following
regression equation to test H2:
FRAUD = θ0+ θ1GOVENANCEt +θ2BOARDSIZEt+θ3OUTSIDEDIRETOR_percentaget
H2&H3+ θ4OUTSIDEDIRECTOR_indepdencet+θ5FRGNt+θ6 OUTSIDEAUDITOR_percentaget+θ7OUTSIDEAUDITOR_independence t+θ8OCt+θ9SEGMENTt+θ10OCFt+θ11NIt+θ12GROWTHt+θ13AGEt+θ14SIZEt+εt+1

5.4. Control variables

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In the multivariate analyses, factors associated with firm characteristics are controlled.
Firms with strong operating cash flow performance have no incentive to manage earnings throughdiscretionary accruals (Lobo and Zhou 2006). I also predict that firms with larger operating cash
flows do not need to manage earnings to report increases in earnings or income, however, I might
consider that firms with larger operating cash flows might have an incentive to manage earnings
through real management using OCF. Fraud, is 1 if the firm is committed, and 0 otherwise.

6 EMPIRICAL RESULTS
6.1. Descriptive Statistics
Table 4 provides descriptive statistics of the variables chosen in this study. The
descriptive statistics indicate that the mean (standard deviation) of OCF of fraud and non-fraud
firms are 0.038 (0.095) and 0.053 (0.060) respectively. The descriptive statistics indicate that themean (standard deviation) of NI of fraud and non-fraud firms are 0.023 (1.034) and 0.034 (0.071)
respectively. This indicates that fraud firms’ performance is less than that of non-fraud firms.
The mean (standard deviation) of SEGMENT of fraud and non-fraud firms are
1.397(0.815) and 1.249 (0.846) respectively. This indicates that fraud firms’ business complexity
is greater than that of non-fraud firms. The mean (standard deviation) of AGE is 4.40 (0.572), and3.971 (0.560) and the mean (standard deviation) of SIZE is 11.217 (2.337), and 10.246 (3.484),
respectively. Surprisingly, fraud firms’ AGE and SIZE are greater than non-fraud firms’ AGE and
SIZE.
The descriptive statistics indicate that the mean (standard deviation) of GOVERNANCE
of fraud and non-fraud firms are 1.232 (0.626) and 1.129 (0.474) respectively and indicate that themean (standard deviation) of BOARD SIZE of fraud and non-fraud firms are 8.983 (3.295) and
8.236 (2.669) respectively and the mean (standard deviation) of16

OUTSIDEDIRECTOR_percentage of fraud and non-fraud firms are 23.457 (13.938) and 17.842(12.422) respectively.
[Insert Table 4 Here]6.2. Empirical Results 1-H1: The Innate Firm Characteristics
Table 5 shows the correlation coefficient between fraud and firm characteristics. With
regard to the correlation coefficient of FRARD and firm characteristics, the Pearson correlation(Spearman correlation) of FRAUD and performance OCF and NI are -0.083 (-0.075) and -0.060(-0.083) respectively. The Pearson correlation (Spearman correlation) of FRAUD and businesscomplexity, SEGMENT are 0.089 (0.016). The Pearson coefficient (Spearman coefficient) of
FRAUD, and SIZE and AGE are 0.160 (0.118) and 0.060 (0.088) respectively.
[Insert Table 5 Here]
Table 6 shows the regression analysis result of the association between fraud and firm
characteristics. The results indicate that fraud is significantly associated with operating cash flows.
This suggests that there is a common firm characteristics and this supports H1.
[Insert Table 6 Here]6.3. Empirical Results 2-H2: Association between Fraud and the Composition of Board of
Directors
Table 5 shows the correlation coefficient between fraud and corporate governanceattributes. With regard to the correlation coefficient of FRARD and corporate governance, thePearson correlation (Spearman correlation) of Fraud and CORPORATE GOVERNANCE and
BOARD SIZE are significantly 0.093 (0.089) and 0.124 (0.101) respectively. The Pearson
correlation (Spearman correlation) of FRAUD and OUTSIDER_percentage is significantly 0.208

17

(0.016). However, the Pearson coefficient (Spearman coefficient) of FRAUD and OUTSIDE
AUDITOR_percentage are 0.006 (0.011) respectively; those are insignificant.
Table 6 provides the results regarding the association between fraud and corporate
governance attributes. Corporate governance variable are the dependent variables in the
regression analysis. Table 6 presents a significant positive association between FRAUD and
CORPORATE GOVERNANCE, BOARD SIZE, and OUTSIDE_percentage. This may helpt in
explaining the link between fraud and a positive attitude for corporate governance, which supports
H2.

6.4. Empirical Results 3-H3: Association between Fraud and Independence of the Board of
Directors
Table 5 shows the correlation coefficient between fraud and corporate governanceattributes. With regard to the correlation coefficient of FRARD and
OUTSIDEDIRECTOR_indepndence, the Pearson correlation (Spearman correlation) of Fraud
and FRARD and OUTSIDEAUDITOR_independence are -0.021 (-0.056) and 0.062 (-0.059)
respectively. While the Pearson and Spearman correlations between FRARD and
OUTSIDEDIRECTOR_independence FRARD and OUTSIDEAUDITOR_independence are bothsignificant, only the Pearson correlations between FRARD and
OUTSIDEAUDITOR_independence is significant.
Table 6 presents a significant positive association between FRAUD and
OUTSIDEDIRECTOR_independence and a significant positive association between FRAUD and
OUTSIDEAUDITOR_independence. Thus, this supports H3.

7 CONCLUSIONS AND FUTURE RESEARCH

18

This study investigates the types of firms that disclosed fraudulent accounting (fraud
firms). Next, this study examines whether the fraud firms have common innate characteristics bycomparing fraud and non-fraud firms. Finally, I clarify the differences in the composition ofboards of directors between fraud and non-fraud firm and show the evidence from Japan
regarding the association between accounting fraud and the structure of boards of directors.
First, I document that the number of accounting frauds increased since 2012 and theaccounting fraud occurred at the First Section of the Tokyo Stock Exchange. Accounting fraud isprevalent in the industry of wholesale, retail, construction and communication industries.
Moreover, accounting frauds occurred at the level of top management and subsidiary. And, theincentive to commit accounting fraud is to sustain a firm’s performance, not to pursue anindividual private gain. This suggests that this is a feature of accounting fraud in Japan. Since thetype of fraudulent financial reporting is related to sales and losses, this is the pressure that causes
accounting fraud. I found that accounting fraud in Japan occurred at top management level andthe manager’s incentive exists in his or her sustainability of authority.
Second, the results of t-test show that there are differences in a firm’s performance, suchas operating cash flows and business complexity, and the percentage of outside directors as theboard of directors influences the propensity to commit frauds. This suggests that the poorer
performance a firm possesses, and the greater the size of a firm, the more likely accounting fraud
occurs.
Third, there is a significant positive association between accounting fraud and thepercentage of outside directors; however, there is a significant negative association between fraud
and the independence of outside directors. This suggests that while the fraud firms have a positive
attitude to improve the board of director composition, they do not acquire the higher
independence possessed by the outside directors. Without increasing the independence of theboard improves the corporate governance mechanism, it is likely that an accounting fraud would

19

reoccur.
Further research is needed to validate the empirical results on the analyses should be
conducted. Moreover, the interview of the sample fraud firms’ management should be
implemented. The possibility of the background and the financial knowledge of outside directors
could constrain the accounting fraud occurrences should be further investigated.

20

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http://www.kantei.go.jp/jp/singi/keizaisaisei/pdf/2016_hombun1_e.pdf
Saito. T. 2011. Managers’ incentive and role of outside directors, Research Instituteof Economy, Trade and Industry.
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Tokyo Stock Exchange. 2015. Japan’s Corporate Governance Code Seeking Sustainable
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2015.http://www.jpx.co.jp/english/equities/listing/ind-executive/tvdivq0000008
o74-att/20150729_2.pdf
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Companies, Final Figure, July 26, 2016.

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5b4pj00000171dc.pdf

Vintila, G.and S. C. Gherghina. 2012. An Empirical Investigation of the Relationshipbetween Corporate Governance Mechanisms, CEO Characteristics and Listed
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Wolfe, D.T. and D.R. Hermanson. 2004. The fraud diamond: considering the four
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Corporate Finance 9(3):295–316.
FIGURE 1
Independece Standards of Corporate Governance CodeCharcteristics of Directors of Board

Time Period

Executives at
Public Parent
firm/Subsidiary

Current

X

Previous years

X

Past: within ten
years

X

No Independence
Executives at
ParentRelatives
firm/SubsidiaryX

Executives at
Main Clientsor Suppliers

Independence
Executives at Executives at
Executives at
Person otherNot Main Cliants Related Firms
Main Investors
than the leftor Suppliersor SupprtersX

NO INDEPENDENCE

Disclosure is required.

Past: ten years
beforeNotes:

No disclosure is required.

This table is adapted from the Corporate Governance Code (CECCG 2005).
As shown in this diagram, independence criteria must be evaluated along two dimensions to determine whether the director is independent or not. Those two dimension
are the relationship between the directors appointed and the insiders/clients and suppliers and the time period of appointment of directors. If there is a relationshipbetween the director and the related party or person of the firms within ten years, then it is considered 'no independence.' If there is a relationship between the directors
and the investors/not main stakeholders within ten years, which must be disclosed.
The independence criteria set by securities exchanges (Principle 4.9.) p.28.
X

The criteria which the independent is denied by Companies Act.
The criteria in which disclosure on the relationship between independent directors and the firm is required in their corporate governancereports.

23

FIGURE 2
Fiscal Year of Fraud Number
50
45
40
35

43

2014

2015

32

30
25

42
38

25

27
21

20

27

24

15
10
5
0
2007

2008

2009

2010

2011

2012

2013

The fraud firms consist of 280 p ublic firms in Jap an. The fraud firm samp le which disclosed that inap p rop riate
accounting imp acted the p rier financial statements or would imp act in the future in their annual rep orts which were
issued the p eriod from Ap ril 2007 through M arch 2015 through Toky o Shoko Research (TSR) Investigation
Rep ort.

TABLE 1
Numbe r of Firm with Fraud By Stock Exchange
NEW
HERACLES JASDAQ MOTHER LOCAL TOKYO1 TOKYO2
Number of Firm with

2007 Fraud

0

Total

2

4

1

2

13

3

25

8.0

16.0

4.0

8.0

52.0

12.0

100.0

Percentage of Fraud
Firms

0

Number of Firm with

1

1

8

2

3

9

3

27

Percentage of Fraud
Firms

3.7

3.7

29.6

7.4

11.1

33.3

11.1

100.0

0

0

6

2

2

10

1

21

0

0

28.6

9.5

9.5

47.6

4.8

100.0

0

0

6

6

1

9

2

24

0

0

25.0

25.0

4.2

37.5

8.3

100.0

2008 Fraud

Number of Firm with

2009 Fraud

Percentage of Fraud
Firms
Number of Firm with2010 Fraud

Percentage of Fraud
Firms
Number of Firm with2011 Fraud

Percentage of Fraud
Firms
Number of Firm with

2012 Fraud

Percentage of Fraud
Firms

7
21.9

0
0

Number of Firm with

3

Percentage of Fraud
Firms

7.9

2013 Fraud

Number of Firm with

1

Percentage of Fraud
Firms

2.4

Number of Firm with

2

2014 Fraud

2015 Fraud

0
0

0
0

0
0

0
0

0

14

3

2

6

43.8

9.4

6.3

18.8

12
44.4

0
0

0
0

32
100.0

5

8

2

27

18.5

29.6

7.4

100.0

13

5

2

10

5

38

34.2

13.2

5.3

26.3

13.2

100.0

12

4

2

16

7

42

28.6

9.5

4.8

38.1

16.7

100.0

11

1

1

21

8

44

Percentage of Fraud
4.5
25.0
2.3
2.3
47.7
18.2
100.0
0
Firms
Lacal indicates local stock exhanges such as Nagoya and Kyushu. New indicates theemerging stock exchange othan than HERACLES, JASDAQ, and M OTHERS.
The fraud firm sample which disclosed that inappropriate accounting impacted the prier financial statements or would impact in the future in their annual reports
which were issued the period from April 2007 through M arch 2015 through Tokyo Shoko Research (TSR) Investigation Report.

24

TABLE 2
Number of Firm with Fraud by Industry
2007
2008
Number Percentag Number Percentage ofof Fraud e of Fraud of Fraud Fraud Firms

2009
2010
Number Percentage Number Percentage
of Fraud of Fraud
of of Fraud

2011
Number Percentag
of Fraud e of2012
Number Percentag
of e of Fraud

Agliculture
Glass
Rubber1

4.0

Wholesale

6

24.0

5

18.5

Chemical

5

23.8

1

4.8

1

4.8

4

16.7

Pharmaceous
Machinary

3

12.0

3

11.1

Financial Institution

1

4.0

Construction

3

12.0

2

7.4

Retail

3

12.0

4

14.8

Communication
Metal

3

12.0

4

14.8

4.8

Other Products

1

Food

1

4.0

Fablic

1

4.0

Steel

1

4.0

Electric Appliance

2

8.0

3

9.4

1

3.1

1

3.1

1

3.1

1

3.1

8.3

1

4.2

1

3.1

3

12.5

4

2

8.3

6

25.0

1
1

7.4

2

9.5

Automobile
Warehouse

1
2

3.7
7.4

2

9.5

Service

3

11.1

5

23.8

Utility
Real Estate

1

3.7

3.7

7

25.9

2.4

1

2.4

7 15.9
1

2.3

1

2.3

2.6

2

4.8

4

9.1

2

4.8

3

6.8

5

15.6

1

3.7

5

13.2

3

7.1

7 15.9

3

9.4

4

14.8

9
1

23.7
2.6

8
2

19.0
4.8

2
1

4.5
2.3

1
1

3.1
3.1

1

2.3

4.2

3

7.1

2

4.8

4.2

2

6.3

1

2.4

4.2

1

4.2

2

8.3

1

3.1

1

3.1

5

15.6

1

14.8

3.7

1

2.6

1

2.6

Transportation

1

4.8

1

3.7

21

100.0

27

100.0

25

5.3

18.4

3.7

100.0

2

7

3.7

32

2.6

7.4

1

100.0

1

2
1

24

1

5.3

4.8

100.0

2.6

1

4.8

27

7.1

1

2

1

100.0

3

3.7

1

25

2.4

15.8

2.3

1

Air Transportation

Total

1
6

1

12.5

4

1

2.4

11.1

4.8

2

1

1

2015
Percentage
Number Percenof Fraud tage of Total of Fraud

3

Non-Ferrous Metal
Precise Mechanical Equipment

3.1

2

Puple Paper

1

1

2013
2014
Number of Percentage Number Percentage
Fraud of Fraud
of of Fraud
1
2.6
1
2.4

38

100.0

1

2.4

2

4.8

3

6.8

1

2.3

3

6.8

3

6.8

1

2.4

4

9.5

5 11.4

3

7.1

1

42

100.0

44 100.0

2.3

2 0.7%
3 1.1%
3 1.1%
46 16.4%
4 1.4%
2 0.7%
15 5.4%
1 0.4%
10 3.6%
20 7.1%31 11.1%
39 13.9%
4 1.4%
2 0.7%
5 1.8%
8 2.9%
8 2.9%
2 0.7%
2 0.7%
16 5.7%
8 2.9%
4 1.4%
33 11.8%
1 0.4%
3 1.1%
2 0.7%
6 2.1%
280 10000.0%

26

TABLE 3 : Sample Selection
Number of
Observation

Selection Criteria
The firms which disclosed inappropriate accounting

280

Less: Duplicate firms

20260

Less Financial institutions

10
250

Less: The firms which the corporate governance reports are not available

192

Total observation

58

27

TABLE 4
Descriptive Statistic of Firm Characteristics and Board Composion for Fraud Firms and NonFraud Firms (2007-2015)
Fraud Firms
Category

N

OCF
OC
NI
FOREIGN
SEGMENTSIZEGROWTH
AGE
GOVERNANCEFOREIGN
BOARD SIZEOUTSIDEDIRECTOR_percentage
OUTSIDEDIRECTOR_Independence
OUTSIDEAUDITOR_percentage
OUTSIDEAUDITOR_Independenc

Mean

Non-Fraud Firms

S ign

S .D.

N

Mean

t-value

S .D.

significance

753
753

0.038
3.613

0.095
0.117

＜

838

0.053

0.060

-3.2240.001 ***

＞

843

3.402

1.416

3.429

0.001

753

0.023

1.034

＜

819

0.034

0.071

-2.338

0.020

753

0.835

1.108

＞

843

0.796

1.060

0.725

0.469

753

1.397

0.815

＞

838

1.249

0.846

3.562

0.000

753

11.217

2.337

＞

843

10.246

3.484

6.602

0.000

744

2.990

21.948

＞

779

2.742

15.071

0.256

0.798

753

4.040

0.572

＞

843

3.971

0.560

2.417

0.016

753

1.232

0.626

＜

843

1.129

0.474

3.678

0.000

753

.8353

1.10823

＞

753

.7960

1.06047

.725

.469

753

8.983

3.295

＞

843

8.236

2.669

4.938

753

23.45713.938＞843

17.84212.422

8.454

0.000

753

69.42541.104＜843

71.20443.919-0.8360.403

753

56.72530.596＞843

56.38030.024

0.227

0.820

753

52.93039.529＞843

47.82342.176

2.496

0.013

***
**

***
***

**
***

0.000 ********

Variable Definitions ; *, **, and *** indicate significance at p< 10 %, p< 5%, p<1%;. t-value is based on White's (1980) standard error.
all variables are deflated by total assets in the beginning of the year.
OCF
OCF (cash flows from operations) minus mean of OCF
OPERATING CYCLE (OC)The log of the average of[(sales/360)/(Average Accounts Receivable)+(Cost of Goods Sold/360)Average Inventory)]NI
SEGMENTNet income/Average assets
Number of reported business segments
log of SALESSIZEGROWTH
AGE

Sales in the beginning of the year / Sales in the end of the year
The years when the firm passed since the firm was established

GOVERNANCE

1 if the firm is a company with company auditors, 2 if the firm is a company with nominating committee, and 3 if the firm is a company
with audit and supervisory committee.

FOREIGN

Rate of foreign investors sharing

BOARD SIZE

Number of Board of Directors

OUTSIDEDIRECTOR_percentage
OUTSIDEDIRECTOR_Independence
OUTSIDEAUDITOR_percentage

Number of Outside Directors / Number of Board of Directors
Number of Independent Outside Directors / Number of Outside Directors
Number of Outside Auditors / Number of Company Auditors

OUTSIDEAUDITOR_Independenc

Number of Independent Outside Auditors / Number of Outside Auditors

TABLE 5
Correlations Diagonal

FRAUD

FRAUD
1.000

OCF
-.083**
.001

NI

SIZE

OC

-.060*.017.160**.000.084**.001.390**.000.154**.000

GROWTH.007

AGE

SEGMENT

.796

.060*
.016

.089**.000.099**.000.081**.002.086**.001.038

FOREIGN
GOVERNANCE.018.093**
.469
.000

BOARD
SIZE
.124**.000

OUTSIDEDIREC OUTSIDEDIRECT OUTSIDEAUDITOR_ OUTSIDEAUDITOR
TOR_percentage OR_Independence
percentage_Independenc
-.021
.006
.208**
.062*
.000

.405

.820

.013

.078**.002-.115**.000.003-.094**
.000

-.018

.042

-.125**
.000

.001

.098

.968

.205

.055*
.030

.379**-.040.203**-.059*.137**-.075**
.003

1.000

NI

-.083**.001.513**.000

1.000.126**.000.075**.003.431**
.000

.027
.284

SIZE

.118**.237**.197**

1.000.522**.039.564**

.000

.000

.000

.000

.128

.000

.000

.000

.085

.000

.113

.000

.018

.000

OC

-.028

.176**.000.065**
.009

-.047

1.000

.085**.001.409**.000.224**.000.147**.000-.019-.141**.000.059-.078**
.002

.034

.448

.098**
.000

.047

.260
-.044

.261**.099**.000

1.000-.099**
.000

.000

.016

.014

.005

.037

.026

.986

.080**
.002

.006

.000

.498**
.000

-.036

.084

.820

.523

.598

.837

.150

.319

.088**.000.084**.001-.006.487**.000.070**
.005

-.018

1.000

.306**.000.160**
.000

.015
.547

.269**.000-.119**.000.097**.000-.219**
.000

.030

.811

.106**.084**.058*.413**.184**.013.327**

1.000.298**.031.305**.092**.112**-.084**

.039

.000

.001

.022

.000

.000

.617

.000

.000

.216

.000

.000

.000

.001

.120

.010

.263**.635**.000.177**.000.340**
.000

.005

.112

.172**
.000

1.000

.000

.290**
.000

.040

.698

.845

.349**.000.106**.000.189**.000-.161**.000.098**.000.089**

-.004

.008

-.035

-.041

.037

.015

.074**

.027

1.000

.268**.193**.181**-.601**-.394**

.000

.881

.741

.166

.102

.146

.542

.003

.290

.000

.000

.000

.000

.000

.101**.113**.052*.476**.001.087**.369**.369**.381**.297**

1.000-.067**.124**-.228**

-.046

.000

.000

.038

.000

.971

.001

.000

.000

.000

.000

.008

.000

.000

.067

OUTSIDEDIRECTOR_percentage.179**-.086**-.068**.097**-.097**

-.040

.007

.107**.062*.226**

1.000.241**-.086**

-.043

.000

.001

.007

.000

.000

.121

.795

.000

.013

.000

.018

.000

.001

.083

-.056*

.055*

.051*

.262**

.014

.034

.046

.122**.205**.183**

OUTSIDEDIRECTOR_Independence.095**.205**

1.000-.137**

-.005

.000

.831

1.000

.390**OCF

GROWTH
AGE
SEGMENTFOREIGN
GOVERNANCE

BOARD SIZEOUTSIDEAUDITOR_percentage

OUTSIDEAUDITOR_Independence

.061
.155

.479

.192**.000.000.211**
.000

-.024

.476

.348

.414**.468**

-.043

.135
.018

.991

-.059*

.921

-.032

.026

.029

.043

.000

.578

.181

.065

.000

.000

.000

.000

.000

.011

-.136**-.107**-.174**-.088**-.021-.187**-.118**-.238**-.477**-.310**-.077**-.162**

.646

.000

.000

.000

.000

.422

.000

.000

.000

.000

.000

.002

.000

.059*

.012

.058*

.157**

.007

.034

-.006

.053*

.106**-.402**-.066**

-.038

.006

.215

.018

.625

.021

.000

.766

.188

.801

.033

.000

.000

.008

.127

.821

.000

Correlations above (below) the diagonal are Pearson (Spearman) correlations.
The bottom number in each is a two-tail p-value. * significant at 10% level; ** significant at 5% level; *** significant at 1% level.
See Table 4 for definition of each variable.

28

.477

.169

.230

.000
**

1

TABLE 6
Logit Regression Results for Fraud Firms and Non-Fraud Firms

Estimated Coefficients
2.164

Standard Errors.658

T-Statistics
.001

NI

-2.118
-.269

.929
.846

.023
.751

SIZE

.062

.044

.156

OC

.007

.060

.912

.001

.003

.794

For Variable Definitions, See TABLE 4+B76
Intercept
OCF

GROWTH

***
**

AGE

-.148

.129

.251

SEGMENT

-.074

.076

.330

FOREIGN

-.169

.069

.014

**

GOVERNANCE

.446

.140

.001

***

BOARD SIZE

.103

.024

.000

***

.049

.005

.000

***

OUTSIDEDIRECTOR_Independence

-.007

.001

.000

***

OUTSIDEAUDITOR_percentage

.003

.003

.298

OUTSIDEAUDITOR_Independence

.006

.002

.000

OUTSIDEDIRECTOR_percentage

Pseudo R2
Chi-Square Test of M odel's Fit

***

.157
188.715 (0.0001)(14 degreees of freedom)

For Variable Definitions, See TABLE 4; *, **, and *** indicate significance at p< 10 %, p< 5%, p<1%;. t-value is based on White's(1980) standard error.

2930