The Latest Research in Corporate Governance: Accounting

1
The Latest Research inCorporate
GovernanceAccounting

• D. G. DeBoskey, Ph.D., CPA
• Professor of Accountancy

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Top-Tier Accounting Journals

• Contemporary Accounting Research (CAR)
• Journal of Accounting Research (JAR)
• Review of Quantitative Finance and Accounting
  (RQFA)
• The Accounting Review (TAR)

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• Research Types

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Research TypesTaxonomy

• Research Methods
• Analytical Internal Logic
• Archival Primary
• Empirical Case
• Empirical Field
• Empirical Lab
• Inference Style
• Inductive
• Deductive

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Research TypesTaxonomy (cont.)

• Mode of Reasoning
• Descriptive Statistics
• Regression
• ANOVAs
• Other Multivariate Techniques
• Mode of Analysis
• Normative
• Descriptive

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• Research Synthesis 2008

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Research Synthesis 2008

• During 2008, several studies examined corporate
  governance (CG) and its impact on firm
  performance
• Associations studied include
• CG and Agency Conflicts (AC)
• CG and Firm Performance
• CG and Accounting Outcomes
• CG (board independence) and CEO Turnover
• CG and Disclosure

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• CG and Agency Conflicts (AC)

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CG and Agency Conflicts (AC)

• This noteworthy study investigates whether CG is
  associated with the level of agency conflicts in
  firms
• CG variables/measures
• 22 governance variables are reduced to 7 readily
  interpretable CG dimensions
• Performed via a principal components analysis
  (PCA), a tool used for dimensionality reduction
  where a number of potentially correlated
  variables are transformed into a smaller subset
  of uncorre-lated variables called principal
  components
• (Dey, 2008)

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CG and Agency Conflicts Proxies

• Agency conflict proxied with 7 measures firm
  size, organizational complexity, growth, risk,
  ownership, leverage, and free cash flows
• A cluster analysis puts firms into homogenous
  groups
• A factor analysis is then performed to derive an
  overall score for each firm
• Mean values within each cluster indicate the
  level of agency conflict
• 1.12 highest mean value (HIGH AC)
• -0.82 lowest mean value (LOW AC)

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CG and Agency Conflicts Findings

• Firms with High AC have better governance
  mechanisms
• Particularly those related to the board, audit
  committee, and the independence of the auditor
• Governance mechanisms are associated with firm
  performance (measured with Tobins Q)
• Composition and functioning of the board, auditor
  independence, and equity-based compensation of
  the directors, but primarily for firms with High
  AC

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CG and Agency Conflicts Overall

• Findings support a popular theory in the
  accounting CG literature stream that CG
  mechanisms are an endogenous response to a
  firms business and economic environment
• (Dey, 2008)

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• CG and Firm Performance

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CG and Firm Performance

• This study examined whether poor governance
  quality is associated with greater accounting
  discretion, and whether firms with weaker
  governance structures report poorer future
  performance as a consequence, ceteris paribus
• Much of the prior literature stops at this stage
  and interprets the association between accounting
  discretion and poor governance quality as
  evidence that lax governance structures encourage
  managerial opportunism
• (Bowen et al., 2008)

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CG and Firm Performance (cont.)

• Examples of lax structures are greater short-run
  managerial compensation, balance of power tilted
  in favor of managers over shareholders, chief
  executive officer (CEO)-chair duality, and closer
  relations between the executive team and the
  board
• They argue that such an interpretation is
  premature unless one can show that excess
  accounting discretion has negative conse-quences
  for shareholders wealth

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CG and Firm Performance Variables

• Surrogates are used for governance quality and
  accounting discretion
• Accounting discretion (dependent) variables
• They measure accounting discretion in three ways
  
• Abnormal accruals use
• Smoothing of earnings by means of accruals
• Avoiding earnings decreases by reporting small
  quarterly positive earnings surprises
• These three measures are then reduced to an
  overall accounting discretion index

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CG and Firm Performance Variables

• CG proxies (independent) variables
• Shareholders rights (Gompers et al., 2003)
• Board monitoring (Dual, Onboard, Meetings and
  Interlock)
• Institutional ownership ( held by institutions)
• Managerial ownership ( stock held by top
  management)
• Incentive compensation bonus (bonus to CEO
  wealth)
• Incentive compensation stock (in-the-money
  exercisable stock options to CEO wealth)

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CG and Firm Performance Methods

• Two-stage least-squares regression
• Stage 1 - Association between accounting
  discretion and firm economic determinants and
  corporate governance proxies
• Stage 2 - Association between predicted future
  performance and excess accounting discretion

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CG and Firm Performance Findings

• As expected in stage 1 regression, they find
  significant associations between accounting
  discretion and proxies for weak governance
  structures, e.g.,
• Greater short-run managerial compensation
• Balance of power tilted in favor of managers over
  shareholders
• Chief executive officer (CEO)-chair duality
• Closer relations between the executive team and
  the board

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CG and Firm Performance Findings

• As expected in stage 2 regression, they do not
  find a negative association between accounting
  discretion due to governance and subsequent
  performance
• Results do not support the claim that managers,
  on average, exploit lax governance structures to
  exercise accounting discretion at shareholders
  expense
• They do find some evidence that discretion due to
  poor governance is positively associated with
  future operating cash flows and return on assets
  (ROA), consistent with shareholders benefiting
  from earnings management, on average ( OCF AND
  ROA)

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CG and Firm Performance Overall

• This study is an improvement (in my professional
  opinion), in that it clearly shows that
  accounting discretion is beneficial to
  shareholder wealth over a long horizon
• (Bowen et al., 2008)

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• CG and Disclosure

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CG and Disclosure

• A recent study examines the role of corporate
  governance quality on voluntary disclosure of
  executive compensation practices
• In this study, the author examines whether
  certain board and compensation committee
  characteristics, as proxies for board governance
  quality, are associated with the extent of board
  disclosure of compensation practices
• (Laksmana, 2008)

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CG and Disclosure Overall Tension

• To make effective disclosure decisions, boards
  and compensation committees need to devote a
  significant amount of time and resources (i.e.,
  personnel and their knowledge base) to
• Set compensation disclosure policies
• Examine potential disclosure items
• Consider the consequences of several disclosure
  options
• Make the final decisions

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CG and Disclosure Overall Tension

• As a result of this tension, the researcher
  posits that the time and resource commitment of
  directors to perform these tasks is positively
  associated with the extent of compensation
  practice disclosure

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CG and Disclosure Measures

• Three proxies are used to measure the time and
  resource commitment of boards
• The proportion of busy outside directors
  (measured by number of directorships)
• Meeting frequency
• Board (compensation committee) size

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CG and Disclosure Measures

• Self-constructed disclosure index (23 items)
• The selection of items included in his
  compensa-tion disclosure checklist was guided by
  the SEC rules for the Board Compensation
  Committee Report (SEC 1992)
• Composed of items from the following categories
• Compensation process (3 items)
• Base salary (1 item)
• Pay-for-performance (3 items)
• Annual incentives (8 items)
• Long-term incentives (8 items)
• Firms receive 1 point for each item disclosed

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CG and Disclosure Measures

• Board governance measures are classified into
  five categories
• Board and compensation committee independence
  (4 variables)
• CEO power over the director nomination process
  (3 variables)
• Time commitment of directors (board/compensation
  committee busy status) (4 variables)
• Board and compensation committee diligence
  (2 variables)
• Board and compensation committee size (2
  variables)

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CG and Disclosure Measures

• Board governance measures (cont.) Because some
  variables are highly correlated, he uses
  principal component analysis (PCA) to classify
  the original variables into multiple aspects of
  board governance quality and obtains factor
  scores that would be used in the regression
  analyses
• This procedure resulted in reducing the
  dimension-ality of the data from 15 measures to 5
  discrete factors
• 70.82 percent of the total variance in the
  original governance variables is retained
  (personal interpretation very acceptable)

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CG and Disclosure Methods

• Ordinary least squares (OLS) regression was
  performed to examine, as follows
• Disclosure f(Corporate Governance Factors
  Control Variables)
• Two proxy seasons were examined 1993 (1992 FY)
  and 2002 (2001 FY) (In my opinion, this may be a
  major limitation, given the massive changes in
  SOX and recent CDA mandates. Are the results
  generalizable?)

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CG and Disclosure Findings

• Descriptive Statistics (1992 vs. 2001)
• The average firm in 2001 has a greater proportion
  of independent directors serving on its board and
  compensation committee, has a smaller proportion
  of outside directors appointed after the current
  CEO took office, and is more likely to have a
  fully independent nominating committee than that
  in 1992 (plt.01)
• The outside directors serving on boards and
  compensation committees in 2001 have a greater
  number of other directorship positions than those
  serving in 1992 (plt.01)

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CG and Disclosure Findings

• Descriptive Statistics (1992 vs. 2001) (cont.)
• However, the percentages of busy boards and
  compensation committees (with more than 50
  percent of outside members serving on three or
  more other boards) are not significantly
  different between the two time periods
• The frequency of board and compensation committee
  meetings remains the same between the two periods
• A typical board and compensation committee held
  about seven and four meetings, respectively

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CG and Disclosure Findings

• Descriptive Statistics (1992 vs. 2001) (cont.)
• Despite increased board and compensation
  committee independence, the average number of
  directors serving on a board decreased between
  1992 and 2001 (plt.05)
• In both periods, however, the average number of
  compensation committee members remains constant
• A typical compensation committee has about four
  members

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CG and Disclosure Findings

• 1993 OLS Regression Results (Disclosure on CG
  Controls)
• Board independence is positively related to
  disclosure
• Suggesting that independent-dominated boards
  report more details on compensation practices
  than management-dominated boards (plt.05,
  one-tailed)
• Greater CEO power in the director nomination
  process is associated with a smaller number of
  disclosed items (plt.01, one tailed)
• Implying that dominant CEOs are more likely to
  limit compensation disclosures

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CG and Disclosure Findings

• 2002 OLS Regression Results (Disclosure on CG
  Controls)
• Overall, the 2002 results are weaker than the
  1993 results
• DILIGENCE/SIZE is the only governance variable
  significantly associated with SCORE (plt.05,
  two-tailed)

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CG and Disclosure Findings

• 2002 OLS Regression Results (Disclosure on CG
  Controls)
• Unlike 1993, INDEPENDENCE and CEOPOWER are
  insignificantly associated with DISCLOSURE. Why?
  (author speculates)
• First, firms have responded to pressure on
  governance reform by increasing the number of
  independent direc-tors serving on boards and
  compensation committees
• Overall Board Independence 67 percent in 1992 to
  79 percent in 2001
• Overall Compensation Committee Independence 87
  percent in 1993 to 97 percent in 2002)

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CG and Disclosure Findings

• Unlike 1993, INDEPENDENCE and CEOPOWER are
  insignificantly associated with DISCLOSURE. Why?
  (author speculates) (cont.)
• Second, with the pressure from shareholders for
  better board governance in recent years,
  independent outside directors whose careers are
  more closely tied to their reputations as good
  monitors of management are more sensitive to this
  shareholder pressure

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CG and Disclosure Overall

• The study shows some evidence that effective
  board and committee characteristics are
  associated with greater communication about board
  practices to shareholders
• Particularly, the study complements prior
  research by providing evidence that board
  (compensation committee) meeting frequency and
  board (committee) size are positively associated
  with the transparency of board disclosure
  practices
• (Laksmana, 2008)

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• Global Trends

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Global Trends Emerging Markets

• Brazil
• October 2007 Code of Best Practice issued by
  Organization for Economic Cooperation and
  Development (OECD)
• Significant improvement and uptake is noted
• The 2000 launch of the Novo Mercado by the
  Bovespa stock exchange, with its focus on
  transparency, was one of many factors that drove
  uptake
• A new edition of the Code is expected to be
  released in 2009

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Global Trends Emerging Markets

• China/Hong Kong (China)
• Both China and Hong Kong (China), have adopted
  the comply or explain corporate governance
  model practiced in the United Kingdom, which
  calls for abiding by CG guidelines or describing
  the reasoning behind deviations.
• The latest Hong Kong (China) Code, released in
  January 2005, requires publication of a corporate
  governance report containing comply or explain
  disclosures failure to issue such a report
  constitutes a breach of the listing

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Global Trends Emerging Markets

• China/Hong Kong (China) (cont.)
• China Securities Regulation Commission (CSRC)
  issued guidelines entitled,Regulations on
  Information Disclosure of Listed Companies, in
  December 2006
• A RiskMetrics report comparing CG between China
  and Hong Kong (China), determines that the CSRC
  regulations are not as developed
• RiskMetrics report argues that enforcement of
  these rules faces challenges in both China and
  Hong Kong (China)
• The report gives Hong Kong (China) an aggregate
  score of 67 on a 100-point scale, while China
  scores 45, against an average of 52 for all
  countries in the ACGA study

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Global Trends Emerging Markets

• India
• With an aggregate score of 83.6 percent, India
  tops a January 2008 corporate governance study
• (Florida International University, 2008)
• While India places in the observed category on
  almost all CG elements, including Access to
  Information, the country places in the lower
  category of largely observed for Disclosure
  Standards
• In February 2008, the IFC Global Corporate
  Gover-nance Forum initiated a research project
  surveying 500 publicly traded companies in
  India to identify opportunities to improve
  corporate governance practice.

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Global Trends Emerging Markets

• The Middle East and North Africa
• Dialogue on corporate governance in the region is
  moving from more general CG issues to specific
  issues related to the composition and the role of
  the board in implementing transparency and
  disclosure
• (Dr. Mahmoud Mohieldin, Minister of Investment
  for the Arab Republic of Egypt, 2008)

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Global Trends Emerging Markets

• Russian Federation
• Dramatic improvement in standards of CG since the
  2002 introduction of a voluntary CG code
• Much more responsive to investor requests and
  disclose more information than they used to
• Still lacking a sufficient number of independent
  directors on company boards
• (Aneta McCoy, RiskMetrics, 2008)

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Global Trends Developed Markets

• European Union
• Since September 2008, listed companies must have
  complied with Fourth and Seventh Accounting
  Directives
• By publishing a discrete corporate governance
  statement, either in the annual report or
  separately

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Global Trends Developed Markets

• Japan
• 2008 Japanese proxy season pitted shareholder
  activists against companies for the second
  straight year
• Companies are using every weapon in their arsenal
  to fight back
• Most notable weapon in managements arsenals is
  all-out effort to attract management-friendly
  shareholders from among the ranks of companies
  lenders and business partners
• (Mark Goldstein, RiskMetrics, 2008)
• Cross-shareholding rates rose in 2007/2008
• Cross-shareholding resulted in a drop of latent
  profits amounting to several hundred billion yen

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Global Trends Developed Markets

• United States
• Anomalies in reporting loss contingencies
• For example, on page 39 of Mercks Third Quarter
  2007 10-Q, filed on November 1, 2008, the company
  noted that it cannot reasonably estimate the
  possible loss or range of loss with respect to
  the Vioxx Lawsuitsthe company has not
  established any reserves for any potential
  liability relating to the Vioxx lawsuits
  (emphasis added)
• A week later, the company announced a 4.85
  billion settlement of the lawsuits
• New FASB Exposure Draft Disclosure of Certain
  Loss Contingencies comment period ended August
  2008

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Global Trends Developed Markets

• United States (cont.)
• New Compensation Discussion Analysis (CDA)
  assessment by the SEC
• 350 first-year CDAs analysis
• CDA statements ran over 6,000 words
• Wheres the Analysis?

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Global Trends Developed Markets

• United States (CDA cont.)
• Great amount of detail, but lacking sufficient
  discussion of how philosophies and processes
  resulted in the numbers the company presented
  in tabular disclosure
• Too much jargon and legalese obfuscate the key
  analysis of executive compensation philosophies
  and practices

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Global Trends Developed Markets

• United States (CDA cont.)
• ISS recently reported that say on pay policies
  received an average level of shareholder support
  of 41.7 percent at 41 meetings in the first half
  of 2007 and received a majority vote at seven (7)
  companies
• In 2008, that number rose to 10 companies
• Both Verizon and Aflac have announced that they
  will hold shareholder advisory votes on executive
  compensation at their 2009 annual meetings. Also,
  Pfizer and several other large companies are
  starting internal campaigns to invoke similar
  policies
• As a final note, in April 2008, say on pay
  legislation received the approval of the U.S.
  House of Represen-tatives, and a companion bill
  was promptly introduced in the Senate

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• Issues Facing Boards in 2009

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Issues Facing Boards in 2009

• Shareholder proposals
• To implement or not implement, that is the
  question
• Executive compensation
• Shareholder activismfriend or foe?
• How do we juggle short-term performance and
  long-term success?

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Issues Facing Boards in 2009 (cont.)

• Director elections
• New SEC rule allowing Internet distribution of
  proxy statements
• Withhold-the-vote campaigns
• Majority voting for director elections promoted
  by shareholder activists
• See for example, that Intel, FedEx, Cisco and
  many others have amended their bylaws to
  implement a majority voting standard for
  uncontested elections

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The Latest Research inCorporate
GovernanceAccounting

• D. G. DeBoskey, Ph.D., CPA
• Professor of Accountancy