Moderating effect of audit quality on the relationship between board characteristics and the likelihood of financial statement fraud among manufacturing firms listed in East Africa

Abstract

Incidents of financial statement fraud and the ensuing collapse of large corporate entities have eroded public confidence in financial markets, financial information, and the accounting profession. Over the last decade, East African capital markets regulators enacted corporate governance guidelines and financial reporting standards to mitigate agency problems associated with financial statements fraud. Though studies have demonstrated that board qualities reduce the risk of financial statement fraud, the findings are conflicting and inconclusive. Moreover, research indicates that the board's ability to oversee managers is strengthened by audit quality. However, the literature on the relationship between board qualities, audit quality, and financial statement fraud is limited. This study aimed to investigate the moderating effect of audit quality on the relationship between board characteristics and the likelihood of financial statement fraud among listed manufacturing firms on securities exchanges in East Africa. Specifically, the study sought to examine the extent to which board independence, frequency of board meetings, board gender diversity and board expertise influences the likelihood of financial statement fraud among listed manufacturing firms on the securities exchanges in East Africa. The study further assessed the moderating role of audit quality on the relationship between board independence; frequency of board meetings; board gender diversity, board expertise and the likelihood of financial statement fraud. The study was grounded on the agency, resource dependence, and fraud diamond theories. An explanatory and longitudinal design was used in the study. Annual financial statements were employed as the study's source of data, covering the years 2007 through 2021. The sample consisted of 15 manufacturing companies listed on East African securities exchanges. Utilizing STATA version 13, descriptive and inferential statistics were used to analyze the data. The results of the probit regression model were used to test the hypotheses. The study established that board independence (β = -2.064, ρ -value <0.05), frequency of board meetings (β = -9.046, ρ -value <0.05), board gender diversity (β= - 2.035, ρ<0.05) and board expertise (β= -3.668, ρ<0.05) had a negative and significant effect on the likelihood of financial statement fraud. Further, the study found that audit quality moderated the relationship between board independence (β= -2.065, ρ<0.05), frequency of board meetings (β= -2.512, ρ<0.05), board gender diversity (β= -2.267, ρ<0.05) and board expertise (β= 3.342, ρ<0.05). The agency theory proposition supports this study's findings that board attributes are vital in mitigating unethical managerial behaviors such as financial statement fraud. Based on the results, the study concluded that audit quality moderated the relationship between board characteristics and the likelihood of financial statement fraud. The findings have several implications. First, listed manufacturing firms should have a higher proportion of outside directors and more board members should be knowledgeable in accounting and finance. Secondly, the findings highlight the importance of board gender diversity among East African manufacturing listed firms to constrain the likelihood of financial statement fraud, which calls for policy interventions. Shareholders should consider board characteristics that enhance board effectiveness in mitigating the likelihood of financial statement fraud. To achieve this, boards must be independent, hold frequent meetings, have a high percentage of members with financial expertise, and more women should be included on boards. The firm should also consider providing board members with training in subjects like finance and accounting to equip them with the knowledge and skills necessary to spot financial fraud. This study was limited to listed East African manufacturing firms and four board characteristics. Future research may also consider additional board characteristics, unlisted companies, and other institutional settings to shed more light on the connection between board characteristics, audit quality and the possibility of financial statement fraud.