STRONG BOARDS, MANAGEMENT ENTRENCHMENT, AND ACCOUNTING RESTATEMENT William R. Baber Sok-Hyon Kang Lihong Liang The George Washington University School of Business Government Hall 401 710 21 st Street, NW Washington, DC 20052 This version: July 2005 Baber: [email protected](202) 994-5089 Kang: [email protected](202) 994-6058 Liang: [email protected](202) 994-8346 We thank Chris Jones, Krishna Kumar, and seminar participants at the George Washington University, the 2005 European Accounting Association Meetings, the Investor Responsibility Research Center (IRRC), University of Minnesota, and Rutgers University for helpful comments. We are grateful to Carol Bowie, Robin Cowles, Annick Dunning, Sergio Shuchner, and Karen Taranto for their assistance with the data, and to Suhair Musa for her research assistance. The study is funded partially by John C. Richardson of JMR Financial, Inc. We also thank IRRC for granting access to portions of their databases.
Transcript
STRONG BOARDS, MANAGEMENT ENTRENCHMENT, AND ACCOUNTING RESTATEMENT
William R. Baber
Sok-Hyon Kang
Lihong Liang
The George Washington University School of Business
We thank Chris Jones, Krishna Kumar, and seminar participants at the George Washington University, the 2005 European Accounting Association Meetings, the Investor Responsibility Research Center (IRRC), University of Minnesota, and Rutgers University for helpful comments. We are grateful to Carol Bowie, Robin Cowles, Annick Dunning, Sergio Shuchner, and Karen Taranto for their assistance with the data, and to Suhair Musa for her research assistance. The study is funded partially by John C. Richardson of JMR Financial, Inc. We also thank IRRC for granting access to portions of their databases.
STRONG BOARDS, MANAGEMENT ENTRENCHMENT, AND ACCOUNTING RESTATEMENT
ABSTRACT
Using a large sample of widely-held U.S. firms, we investigate cross-sectional
associations between the probability of financial restatements and contractual and legal provisions that restrict shareholder rights, while controlling for other key governance characteristics representing the strength of the Board of Directors, equity incentives of the CEO, and share ownership structure. Comparisons of 185 restatement firms with 1,487 non-restatement firms indicate that the vast majority of popular corporate governance indicators such as board and audit committee independence, CEO-chair separation, board size, whether or not the audit committee has an outside financial expert, director interlock, busy directors, equity incentives of the CEO, and share ownership of various claimants -- fail to explain the propensity of a financial statement restatement. We do find, however, that the probability of a restatement varies directly with restrictions against shareholder participation in the governance process.
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STRONG BOARDS, MANAGEMENT ENTRENCHMENT, AND ACCOUNTING RESTATEMENT
I. INTRODUCTION
Despite serious agency problems that result from the power and information advantage
enjoyed by corporate managers, shareholders of modern corporations typically lack both the
ability and incentive to question management (Bainbridge 1995). Instead, shareholders
delegate management oversight to the board of directors (the board), a group of agents
empowered to monitor and discipline management on shareholders’ behalf. Corporate
boards are often criticized as the source, rather than the solution, of corporate control
failures, however. For example, Jensen (1993) notes that board members, often appointed by
-- and therefore indebted to -- the CEO, are inclined to permit the CEO to advance
management, rather than shareholder, interests. These circumstances promote a culture of
acquiescence rather than effective oversight (Lorsch and MacIver 1989; Crystal 1991; Byrne
1996). Accordingly, effectiveness of corporate boards is a central issue in contemporary
corporate governance literature.
When corporate boards fail to execute their fiduciary responsibilities, shareholders can
intervene or even displace the management and the board. In practice, however,
shareholders’ ability to do so differs considerably across firms (Gompers, Ishii, and Metrick
2003; hereafter GIM). In some cases, the legal and contractual environment makes it
relatively easy for shareholders to replace the board and/or the management. In other cases,
however, charter and bylaw provisions increase shareholder costs of challenging
management, and generally restrict the ability of shareholder participation. Such provisions
tilt the balance of power from shareholders to corporate insiders (GIM 2003).
2
The objective of this study is to compare and contrast associations between accounting
restatements and shareholder rights, and between restatements and characteristics of the
board of directors. A distinguishing feature of the study is the consideration of both
mechanisms advocated by academics and policy-makers as remedies for control problems
and statutory/chartered provisions that facilitate or restrict shareholder participation in the
corporate governance process. This feature of the investigation permits us to consider the
possibility that these mechanisms and provisions are compensatory as they relate to the
incentives and consequences of accounting misstatements by corporate managers.
Similar to previous literature (Abbott, Parker, and Peters 2003; Argawal and Chadha
2005; Srinivasan 2005), the investigation is motivated by the supposition that weak corporate
governance is at least partially responsible for recent high-profile financial reporting failures
and accounting restatements (The U.S. General Accounting Office (GAO) 2002; Byrne
2002). Given this context, investigating the extent that corporate governance characteristics
correlate with the incidence of accounting restatements potentially informs evaluations of the
effectiveness of governance procedures often prescribed in response to accounting scandals
and restatements (e.g., Sarbanes-Oxley Act (SOX) of 2002).
The analysis is interpreted in the context of two competing, but not necessarily
mutually exclusive, characterizations of how corporate governance systems evolve and
operate. First, the entrenchment hypothesis posits that managers design control systems that
advance their private interests (Bebchuk, Cohen, and Ferrell 2004). More specifically,
managers have incentives to construct governance systems that restrict shareholder
participation – and thus, increase and preserve management’s influence -- in the policy-
making process. Management’s ability to act on these incentives depends in part on legal
3
and contractual provisions that are costly to modify and that define the role and influence of
management relative to shareholders. These provisions, which may or may not be
implemented by current management, distinguish firms cross-sectionally. If accounting
misstatements indicate management negligence or malfeasance, then the entrenchment
hypothesis predicts that accounting misstatements vary directly with contractual provisions
that establish or preserve management’s dominant position.
Second, the substitution hypothesis presumes that firms, acting on behalf of all
interested parties, choose among control alternatives to achieve a governance system – that
is, a portfolio of control mechanisms and procedures – that minimizes combined control and
agency costs (Agrawal and Knoeber 1996). Each entity faces unique control problems and
circumstances, and therefore, the specific control procedures that shareholders use to monitor
or discipline management vary cross-sectionally. This characterization implies that control
systems need to be evaluated in the aggregate as a compensatory process, rather than as a
collection of independent control procedures. Thus, to the extent that all firms choose an
optimal mix of corporate governance mechanisms, systematic associations between a specific
corporate governance mechanism and the incidence of accounting restatements are unlikely.1
To consider these two characterizations, we focus on potential tradeoffs between the
strength of shareholder rights and the strength of the board, while controlling for other
corporate governance mechanisms. We use the “Governance Index” (hereafter G-Index) --
developed by GIM (2003), along with derivative sub-indices advanced in other studies (e.g.,
Bebchuk, et al. 2004), as a composite measure of the strength in shareholder rights. For
1 Recent papers that use the substitution-entrenchment characterization include Cyert, Kang, and Kumar (2002), Fahlenbrach (2004), and Klock, Mansi, and Maxwell (2004).
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board strength, we consider a fairly comprehensive set of corporate board characteristics,
including (but not limited to) independence of the board and its subcommittees, board size,
whether or not the CEO sits on the nominating committee, whether an independent director
serves as the board chair, the extent of interlocked directors, and the number of boards served
on other companies (“busy” directors).
The extent that the members are independent monitors of management is of particular
interest. This focus reflects the prominence of board independence in recently enacted or
proposed rules governing public corporations.2 We therefore extend existing research to
consider independence of key oversight committees -- audit, nominating, and compensation
committees -- in addition to considering independence of the full board. Recognizing that
certain board strengths and other governance attributes are potential substitutes, we consider
other governance characteristics, including the structure of CEO compensation, the age and
tenure of the CEO, and ownership structure of the firm. In total, we consider in excess of
twenty-five corporate governance attributes.
The empirical investigation focuses on accounting restatements announced by Standard
& Poor’s (S&P) 1500 publicly-traded and most-widely held small, medium, and large U. S.
firms from 1997 to 2004. These restatements relate to accounting errors that occurred during
1997-2002. The principal finding is that the vast majority of corporate governance indicators
fail to play a significant role in the likelihood of an accounting restatement, either
individually or in the aggregate. In particular, notwithstanding the popular enthusiasm for
board independence as a mechanism for improving corporate governance, our analysis offers
2 See recommendations of the Corporate Accountability and Listing Standards Committee (NYSE 2002) and the Sarbanes-Oxley Act of 2002.
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little support for the notion that board independence, or independence of subcommittees
(audit, compensation, and nominating committees), is related to accounting restatements.
Likewise, we find little support for associations between accounting restatements and
governance mechanisms frequently advanced in prior studies and endorsed by governance
experts and policymakers -- as examples, whether or not the audit committee has a financial
expert, an audit committee comprised entirely of outside directors, board size, CEO-chair
separation, the CEO’s equity incentives, ownership structure (equity ownership of the CEO,
the board, blockholders, and institutions), whether an independent director serves as the
board chair, the extent of the interlocked or “busy” directors.
The only governance characteristic that is reliably related to accounting restatements is
the G-Index, an indicator of shareholder rights. In particular, the probability of an accounting
restatement is greater for firms where legal and contractual provisions limit shareholder
rights and thus encourage management entrenchment (Bebchuk et al. 2004).3 This result is
robust to considering the effects of industry, firm size, alternative governance procedures,
and economy-wide changes in governance characteristics.
Finally, we find a positive association between the G-Index and a composite score
constructed from nine board characteristics frequently considered as indicators of board
effectiveness. Such evidence, which suggests a tradeoff between weaker shareholder
protection and a stronger board, is consistent with the substitution hypothesis.
In sum, we find that legal and contractual provisions that influence shareholder rights
are correlated with the incidence of accounting restatements. We can offer no evidence,
3 As noted in Bebchuk, et al (2004), this view is not universally supported, and the effect can be context-specific, as in Cremers and Nair (2005).
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however, that board independence or other recommended procedures alleged to improve
corporate governance systems are related to restatements.
Failure to detect associations between corporate governance indicators and restatements
can indicate inadequacies or measurement error in governance indicators or it can indicate
that firms substitute one dimension of corporate governance with another. Regardless of
which of these characterizations applies, the evidence documented in this study suggests the
futility of incorporating a few dimensions of corporate governance into rules and regulations.
If the measurement error explanation applies, then efforts to change some identifiable
measure of corporate governance (such as board independence or requiring financial experts)
lead to “apparent” but not substantive improvement in corporate governance. If the
substitution explanation applies, then improvement on one dimension of corporate
governance potentially leads to deterioration on another dimension, which implies a
suboptimal and more costly mix of governance mechanisms. Thus, the study informs the
debate about whether and how corporate governance can be legislated.
The remainder of the paper is organized as follows. Section II discusses the relevant
literature and presents specific hypotheses. Section III explains the methodology, and
Section IV contains data collection procedures. Results are reported and discussed in
Sections V. Concluding remarks are in Section VI.
II. HYPOTHESES
A. Financial Misstatements versus Restatements
The objective is to document associations between accounting misstatements and
corporate governance characteristics. Since not all misstatements are detected and disclosed,
previous studies adopt either of two sampling approaches. The first is to examine accounting
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restatements as in Abbott, et al. (2003), Kim (2004), Kinney, Palmrose and Scholz (2004),
Srinivasan (2005), and Agrawal and Chadha (2005). The second approach is to explore cases
of fraud alleged by the U. S. Securities and Exchange Commission (the SEC) identified
during the Commission’s enforcement of Accounting and Auditing Enforcement Releases
(AAER).4 Studies in the second category are Beasley (1996), Dechow, Sweeney and Sloan
(1996), Erickson, Hanlon, and Maydew (2004), and Farber (2005). In the case of AAER,
willful misrepresentation is alleged by the SEC but not necessarily acknowledged by the
company. In the restatement case, however, the firm acknowledges the prior financial
reporting error, but not necessarily intent to mislead investors.
Both samples are noisy indicators of intentional misstatement of financial conditions,
and likely partition the observations with error. First, some restatements can be “honest
mistakes” rather than attempts to manage earnings. Second, since not all misstatements are
discovered or investigated, undetected misstatements are classified incorrectly, leading to a
sample which does not fairly represent the population. Although the AAER sample likely
alleviates the first problem, it exacerbates the second. Furthermore, since the SEC can
examine only a small subset of publicly traded firms based on less-than-transparent selection
criteria, potential selection bias could be an issue.5 Beasley, Carcello, and Hermanson (1997)
report that firms investigated under AAER during 1987-1997 were typically small (total
assets and sales well below $100 million), and 78% of them were not traded on large stock
4 To ease the presentation, we do not address literature that considers associations between earnings management and corporate governance (e.g., Klein 2002). 5 For example, controversial management practices or actions, which can be correlated with poor corporate governance, can elicit the attention or intervention by regulators.
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exchanges (that is, the NYSE and ASE). Thus, neither of these sampling approaches
dominates the other.
Existing literature supports the notion that restatements are non-trivial events which
usually trigger substantial declines in equity price (Palmrose, Richardson, and Scholz 2004).
The GAO (2002) and Palmrose et al. (2004) report that firms restating the financial reports
lose about 9 to 10% of shareholder value during the 2 or 3 trading days surrounding the
announcement of the restatement. The magnitude is comparable to price reaction to AAER
fraud announcements of -8.8% documented in Dechow, et al. (1996). Furthermore, similar to
the case of AAER, restatements often trigger subsequent SEC investigation, lawsuits,
removal of management, or bankruptcy (Kim 2004). Such evidence supports the use of
published accounting restatements to study financial statement misrepresentations.
In sum, we assume that the incidence of restatements is a noisy proxy of between-firm
differences in the probability of an accounting failure. At the minimum, a restatement is a
significant event which indicates low-quality financial reporting. In the extreme, it indicates
an intent to mislead investors. In either case, it is evidence of mismanagement abetted
potentially by weak corporate governance (GAO 2002).6
B. Existing Studies on Financial Misstatements and Restatements
Exhibit 1 summarizes prior studies that examine associations between corporate
governance characteristics and the incidence of accounting failures, accounting restatements,
or SEC AAER actions for alleged accounting violations. Evidence in Dechow, et al. (1996)
6 The GAO (2002) observes that “the recent increase in the number and size of financial statement restatements and accounting issues and irregularities underlying these restatements have raised significant questions about the adequacy of the current system of corporate governance and financial disclosure oversight (p. 7).”
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suggests that 86 firms subject to SEC enforcement actions during 1982-1992 are more likely
to have a board dominated by insiders, a CEO who also serves as the board chair or who is
from the founding family; and are less likely to have an outside blockholder or an audit
committee, than control firms that do not experience enforcement actions. Beasley (1996),
who examines 75 SEC AAER firms during 1979-1990 in a multivariate (logit) context,
reports that the probability of SEC action is unaffected by CEO-Chair separation or the
existence of an outside blockholder, but increases with weaker board independence
(measured as the percentage of independent and grey directors on the board) and absence of
an audit committee.7 Using a sample of AAER 87 firms during 1982-2000, Farber (2005)
reports results consistent with those in Dechow, et al. (1996) with respect to board
independence, CEO-Chair duality, and outside blockholder, but not audit committee
independence. In contrast, Abbott, et al. (2003) find that, for 88 restatements during 1991-
1999, the probability of accounting failure is unaffected by board independence, CEO-Chair
separation, or existence of outside blockholder, but the probability varies positively with
board size and inversely with audit committee independence and presence of an accounting
expert. Agrawal and Chadha (2005), who compare 159 fiscal year 2000 restatement firms
with industry- and size- matched firms, report that none of the key governance characteristics
-- notably board and audit committee independence, blockholder, CEO-Chair separation,
CEO ownership, and the provision of non-audit services by outside auditors -- is related to
the probability of earnings restatements. The authors do find, however, that the probability
of restatements is lower for companies where the board or audit committee has an
7 Both Beasley (1996) and Dechow et al. (1996) classify directors as insiders versus outsiders, where outsiders include “affiliated” directors (not generally considered independent in recent studies).
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independent director with financial expertise, and higher for companies with a CEO from the
founding family. Finally, Larcker, Richardson, and Tuna (2004) use proprietary data to
examine various aspects of managerial behavior and corporate performance (such as
abnormal accruals, CEO pay, debt ratings, Tobin’s Q, investment, class action lawsuits, and
accounting restatements) for fiscal year 2002.8 The authors conclude that typical indicators
of corporate governance used in academic research and institutional rating services have
limited ability to explain managerial behavior and organizational performance. As a whole,
results reported in these prior studies do not offer consistent evidence regarding associations
between governance characteristics and the incidence of accounting irregularity.
This paper builds on previous studies in three dimensions. First, we consider a measure
of corporate takeover defense, or the G-Index, which is often considered an indicator of
management entrenchment (e.g., Bebchuk et al. 2004; Fahlenbrach 2004). Second, we
consider a more comprehensive set of corporate governance mechanisms than those
employed in most prior studies. Larcker, et al. (2004) suggest that previous studies do not
permit a consistent and integrated set of inferences because they use different, relatively
small sets of conveniently available indicators for corporate governance. This point is
particularly important to the extent that governance mechanisms are substitutes. Finally, we
address a larger sample of both restatement and non-restatement firms over a longer period
(1997-2002) than most prior studies. The increased statistical power is useful because
restatements occur infrequently.
8 Larcker, et al. (2004) is not summarized in Exhibit 1 because they use factor scores which are not comparable to individual governance characteristics. While Larcker, et al. (2004) seek to examine how much corporate governance indicators as a whole explain broader issues of management in terms of statistical explanatory power, our study examines directional impact of governance indicators.
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C. Shareholder Rights and Governance Index
GIM (2003) construct a governance measure, designated the G-Index, from 22 firm-
level charter and bylaw provisions and six state takeover laws. One point is added for each
provision or state law that restricts shareholder rights; duplications among firm-level
provisions and state laws yield 24 unique provisions. Thus, the index ranges from zero to 24,
with zero being the most shareholder-friendly environment. GIM (2003) report that firms
with low G-Index (designated “Democracy” firms) have higher long term shareholder
returns, higher firm value (Tobin’s Q), greater accounting profits, and higher sales growth
than firms with high G-Index (“Dictatorship” firms).9 While the robustness of results
reported in GIM (2003) is debatable (Bebchuk, et al. 2004; Core, Guay, and Rusticus 2005;
Cremers and Nair 2005), a number of studies establish that the G-Index, or sub-indices
derived from the G-Index, indicates the strength of corporate governance on at least some
dimensions (Cremers, Nair, and Wei 2004; Cremers and Nair 2005; Klock, Mansi, and
Maxwell 2004).
Much of the analysis is interpreted in the context of two, not necessarily mutually
exclusive, perspectives about how the balance between the potentially conflicting interests of
insiders and outside shareholders relates to accounting failures. First, the substitution
hypothesis postulates that firms choose among control mechanisms to construct a portfolio of
control procedures and mechanisms that minimizes combined control and agency costs
(Agrawal and Knoeber 1996). As examples, Almazan and Suarez (2003) argue that weak
9 Some provisions restricting shareholders rights are initiated as anti-takeover devices which are characterized typically as inimical to shareholder interests, but which can also benefit shareholders. As examples, such provisions can encourage CEOs to pursue long-term investments (Stein 1988) or can be employed tactically in ways that extract higher takeover offers from bidders (DeAngelo and Rice 1983).
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boards and large severance pay are substitutes, and Cyert, Kang, and Kumar (2002) consider
external takeover threats and internal governance mechanisms as substitutes. The logic
behind the substitution hypothesis suggests that firms balance the costs and benefits of
alternative control devices such that corporate governance mechanisms cannot be evaluated
in isolation.
Second, the entrenchment hypothesis implies that limitations or restrictions of
shareholder rights, once they are implemented for whatever reason, permit managers to
behave opportunistically and to engage in wealth transfers from shareholders to managers -
for example, by awarding themselves excessive compensation (Fahlenbrach 2004). Thus, the
entrenchment hypothesis predicts an inverse association between shareholder rights and
managerial malfeasance. We use these two perspectives to consider associations between
governance characteristics and accounting restatements.
The first hypothesis considers cross-sectional differences in measures of shareholder
rights during the period of financial statement misstatement.
Hypothesis 1: Restrictions on shareholder participation (as indicated by the G-index)
and the incidence of financial reporting misstatements are unrelated. Higher G-Index indicates more provisions that discourage shareholder participation,
and therefore, rejecting the null in favor of a positive association between the G-Index and
accounting restatement is consistent with management entrenchment.10
10 Restatements initiated by the board itself can be construed as evidence of responsible board oversight. If this interpretation applies, then we expect positive empirical associations between restatements and indicators of strong corporate governance.
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D. Board Independence and Board Strength
The G-Index indicates the relative power between shareholders and insiders (the
management and the board of directors), but another potentially important issue is the extent
that the board provides objective, disinterested monitoring and oversight of management
(Fama 1980; Fama and Jensen 1983; Jensen 1993). Thus, the second hypothesis relates
strong board (in the sense that the board of directors represents a strong corporate governance
mechanism) with the likelihood of a firm misstating financial reports.
Hypothesis 2: Strong board characteristics and the incidence of financial reporting
misstatements are unrelated.
Director independence is a popular gauge of board effectiveness. Despite its intuitive
appeal, however, existing evidence is less than persuasive regarding the effectiveness of
board independence as a control device (Bhagat and Black 2002). In particular, results are
mixed regarding whether board independence is effective for disciplining management
(Weisbach 1988), for increasing share values in the context of takeovers (Byrd and Hickman
1992; Brickley, Coles and Terry 1994; Cotter, Shivdasani, and Zenner 1997), for setting
executive compensation (Core, Holthausen, and Larcker 1999; Cyert, et al. 2002), and for
enhancing firm performance (Baysinger and Butler 1985; Hermalin and Weisbach 1991;
Yermack 1996; Bhagat and Black 1999; 2002).
Recent public policy debate considers independence of not only the full board, but also
the key oversight committees (audit, nominating, and compensation committees). As
examples, the SOX Act specifically requires that listed firms have an audit committee
composed solely of independent directors (one of whom is an expert in accounting or
finance). Also, the NYSE, as well as various watchdog organizations and corporate
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governance experts, advocate that not only the audit committee, but also the compensation
and nominating committees, be fully independent of management (e.g., California Public
Employees Retirement System (CALPERS 1998)).
The literature also suggests that the following characteristics are relevant to board
effectiveness beyond board independence: whether the CEO is also the board chair (Jensen
1993), whether the CEO is on the nominating committee (Jensen 1993), whether an
independent director is the board chair (CALPERS 1998), the extent of interlocked directors
and other company directorships (Core, Holthausen, and Larcker 1999), and the number of
directors on the board (Jensen 1993; Yermack 1996). We consider the impact of these
attributes on accounting restatements both individually and in the aggregate.
Since more than one attribute contribute to a strong board, we also consider a
composite score – similar to the G-Index -- denoted B-Index, which is computed using nine
board attributes. In particular, B-Index increases by one if: (1) more than 2/3 of the board is
comprised of independent directors; (2) all audit committee members are independent
directors; (3) all compensation committee members are independent directors; (4) all
nominating committee members are independent directors; (5) the CEO is not the board
Chair; (6) the Chair is an independent outside director.11 B-Index also increases by one if (7)
the board size is less than the median of the distribution for all firms (adjusted for firm size
and time); (8) the board interlock is less than the median of all firms (adjusted for firm size
and time); or (9) the mean number of other boards served by a director is less than the
11 Notice that if an outside director serves as the board chair, the B-Index increases by two.
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median of the distribution of means for all firms (adjusted for firm size and time).12 We note
that governance experts can disagree about whether some of these attributes used in the
construction of the B-Index indicate effective governance. As examples, the consequences of
changing board size, separating the duties of the CEO and the board chairman, or proscribing
the number of directorship held by board members are not straightforward. Even so, we
propose B-Index as a summary indicator of board strength that is comparable to the G-Index.
Strict application of the substitution hypothesis suggests no systematic association
between specific corporate governance mechanisms and the incidence of accounting failures
– to the extent that all firms choose an optimal, potentially unique, mix of governance
mechanisms. We cannot be confident that all firms employ an optimal portfolio of corporate
governance procedures, and therefore, the substitution hypothesis cannot feasibly be tested
directly. Instead, we address a less ambitious proposition that tests whether strong boards
and shareholder rights are complementary.
Hypothesis 3: Strong board characteristics and restrictions on shareholder participation
are unrelated. The G-Index serves as a proxy for shareholder rights, and the B-Index indicates the
relative strength of the board. Thus, in the context of the substitution hypothesis, rejecting
the null in favor of a positive association between the G-Index and B-Index supports the
hypothesis that strong boards and shareholder rights are complementary.
12 Size and time adjustments are appropriate because governance attributes are often related to firm size (e.g., larger companies tend to have more board members who more often serve on other boards) and because we find a time trend in board characteristics. To adjust for firm size and time, each variable is compared against the median for each firm size decile and time period.
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III. METHODOLOGY
A. Specification
We use the following logistic regression to address hypotheses 1 and 2 (time t subscripts
omitted).
i
K
jijij
N
jijijii ControlBOARDGIndexstate εγβαα ++++= ∑∑
== 1,,
1,,10Re , (1)
(+) (-)
where Restate = 1 if firm i restates its financial reports; 0, otherwise. Directions of
associations between the probability of restatement and the independent variables under the
alternative hypotheses are shown parenthetically. Variable definitions are in Exhibit 2. We
emphasize that independent variables indicate circumstances at the time when the
misstatement occurs, not the time when the misstatement is announced.
The G-Index (GIM 2003) indicates the extent that contractual and legal provisions
restrict shareholder rights. Recently, Bebchuk et al. (2004) argue that only six of the 24
provisions included in the original G-Index are principally correlated with firm values.13
Thus, we consider an alternative measure, designated the entrenchment index (E-Index),
comprised of these six provisions.
The variables ∑=
N
jjiji BOARD
1,,β consider nine attributes of a strong board discussed
before (N=9). The primary specification considers all nine measures individually and jointly.
Recall that we also use a composite measure, designated B-INDEX, that is constructed from
13 This measure is constructed from six provisions – four “constitutional” provisions that discourage shareholders intervention (staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, and supermajority requirements for charter amendments), and two “takeover readiness” provisions against a hostile takeover (poison pills and golden parachutes).
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all nine board characteristics. Independence of the board (subcommittees) is measured as the
fraction of independent directors on the board.14
We consider two modifications when estimating specification (1). First, because not all
firms have separate nominating committees, we decompose NOM_INDEP (independence of
the nominating committee) into two variables – an indicator variable (denoted DNOM),
which equals one when the firm has a separate nominating committee (0, otherwise), and an
interaction DNOM*NOM_INDEP. Accordingly, the estimate on DNOM indicates the
incremental effect of the presence of a separate nominating committee, and
DNOM*NOM_INDEP indicates the effect of nominating committee independence given that
the firm has a nominating committee.
Second, recent recommendations are that boards have “supermajority” (e.g., more than
2/3) independent directors and that oversight subcommittees (such as the audit and the
nominating committees) consist entirely of independent directors (e.g., Council of
Institutional Investors 2003). Thus, we consider two alternative summary measures of
independence. The first, denoted FULL_INDEP, is a dummy variable set equal to 1.0 (0,
otherwise) when greater than 2/3 of the board members are independent and each member of
the audit, the nominating, the compensation committees is independent. The second, denoted
MAJ_INDEP, is a dummy variable set equal to 1.0 (0, otherwise) when the full board and
each of the three oversight committees has majority independent directors (i.e., more than
50% of committee/board members are independent).
14 The independent director designation excludes current and former employees, providers of professional services (legal consulting, etc.), customers and suppliers, family members of employees or other individuals not deemed independent, and employees of organizations that receive charitable gifts from the firm.
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B. Other Governance Characteristics and Control Variables
Variables designated ∑=
K
jjiji Control
1,,γ consider financial and corporate governance
firm-specific characteristics that prior literature suggests can be related to the dependent and
the primary explanatory variables. Some of these variables -- as examples, ownership
structure and CEO compensation structure — can be construed as dimensions of the
governance system.
Although the literature suggests that executive equity ownership aligns manager with
shareholder preferences (Jensen and Meckling 1976), arguments and evidence advanced
recently suggest incentive effects to the contrary. For example, Erickson et al. (2004) report
that the probability of accounting fraud varies directly with the portion of executive
compensation that is stock-based. Moreover, evidence in Peng and Roell (2004) suggests
that compensation in the form of stock options increases the probability of securities class-
action lawsuits and magnifies incentives to manipulate earnings. In general, such results
imply that large management equity stakes, particularly in the form of stock options, can
induce managers to maximize short-term earnings at the expense of long-run profitability.
Following Erickson et al. (2004), we consider STK_COMP, the ratio of equity-based
compensation (stock option and restricted stock awards) to total current compensation.15
Following Peng and Roell (2004), we include OPTVESTED, vested or exercisable stock
options as proportion of total outstanding shares.16 We do not include levels of compensation,
15 Studies that use this measure include Mehran (1995), Bryan, Hwang, and Lilien (2000), and Kang, Kumar, and Lee (2005). 16 OPTVESTED is included to approximate the sensitivity of option-related pay to firm value, which is the only variable consistently significant in Peng and Roell (2004). The authors report that results are comparable using the Core and Guay (2002)’s approximation of option delta, in lieu of this measure.
19
however, since neither study finds levels to be a significant factor. Notwithstanding the
findings of Peng and Roell (2004) and Erickson et al. (2004), the conventional view is that
granting equity-based options aligns manager incentives to maximize shareholder wealth
(Murphy 1995). Thus, we offer no predictions about the impact of CEO ownership
(CEO_OWN), inside director ownership (EMPDIR_OWN), the outside director ownership
(OUTDIR_OWN), and equity-based compensation (STK_COMP, OPTVESTED) on
accounting misstatements. The literature is similarly ambiguous with respect to the effects of
CEO’s age (CEO_AGE) (e.g., Gibbons and Murphy 1992) or director’s age (DIR_AGE),
although some argue against boards comprised of elderly directors (e.g., Core, Holthausen,
and Larcker 1999). Hence, we offer no predictions about directions of effects for these
variables.
On the other hand, a widely-held view is that large, independent outside blockholders,
and institutional investors, can effectively monitor and discipline management (Shleifer and
Vishny 1986; 1997; Jensen 1993). Thus, as with Beasley (1996) and Dechow et al. (1996),
we expect a negative association between the incidence of accounting misstatements and the
number of outside blockholders (BLOCK) or institutional owners (INST_OWN).
Various studies report that the probability of accounting failure is less when the audit
committee includes an accounting expert (Abbott, et al. 2003; Agrawal and Chadha 2005;
Farber 2005). We therefore include a variable designated EXPERT to distinguish firms
where an independent accounting expert serves on the audit committee. We anticipate that
20
EXPERT varies negatively with the likelihood of a restatement.17 Dechow et al. (1996) and
Agrawal and Chadha (2005) report that the likelihood of an accounting failure increases
when the CEO or the board chair is from the founding family; we use an indicator variable
(FOUNDER) to distinguish such firms.
Other control variables follow previous studies (Abbott, et al. 2003; Richardson, Tuna,
and Wu 2002; Larcker, et al 2004): BIG6 (large accounting firms), LOGSIZE (log of
beginning total assets), GROWTH (growth rate of sales during the previous two years),
DIV_YIELD (dividend yield: dividend per share/stock price per share), MARGIN (net
income/sales), FREECF (free cash flow/total assets), and LEVERAGE (interest-bearing
debt/total assets). All variables except for BIG6 are measured at the beginning of the
misstatement year, and observations are removed when GROWTH, MARGIN, LEVERAGE,
DIV_YIELD, or FREECF is in the top or the bottom one percent of the distribution for all
sample firms.18
IV. DATA AND SAMPLE DESCRIPTION
A. Data
The primary sample consists of 2,431 firms in the S&P 1500 stock indices (S&P 500,
S&P MidCap 400 and SmallCap 600, hereafter the S&P 1500) during 1997-2002; 231 of
these firms restate financial reports. Table I summarizes the sample selection procedure
which is described in greater detail below.
17 Independent directors with financial expertise have a CPA, CFA, or expertise in corporate financial management (CFO, treasurer, controller, VP of Finance or Accounting, and CEO of financial institutions). Notice that the firm’s executives are excluded from this designation. 18 Results are robust to alternative profitability measures (ROA, or EBITDA/Sales, rather than MARGIN), and to log transformation of BOD_SIZE.
21
[Insert Table I here]
The sample is the intersection of four data sets. The first, compiled by the Investor
Responsibility Research Center (IRRC), contains Board of Director characteristics such as
BOD_INDEP and BOD_SIZE. These data are taken from publicly-available 1997-2002
proxy statements issued in anticipation of the annual meetings for the S&P 1500 companies.
The IRRC is also the source of the G-Index measure, which is constructed using
Corporate Takeover Defenses [Rosenbaum 1990, 1993, 1995, 1998, 2000, and 2002]. This
publication covers S&P 500 firms as well as large U.S. corporations listed in Fortune,
Forbes, and Business Week. These firms arguably represent more than 90 percent of the total
capitalization of the combined New York Stock Exchange (NYSE), American Stock
Exchange, and NASDAQ (GIM 2003). The G-index measure is relatively stable within each
firm, although it varies considerably across firms (GIM 2003).19
The third dataset is from a study prepared and submitted to the U. S. Congress by the
General Accounting Office (GAO 2002). The study lists 919 accounting restatements by 845
public companies during January 1, 1997 to June 30, 2002, although careful investigation
reveals that some of the alleged restatements are inconsistent with the objectives of this study
(see below).
These three datasets are combined and merged with the fourth, COMPUSTAT financial
data, to obtain 2,431 firms; 231 of these firms disclose one or more restatements according to
the GAO. We designate restatement firms as Test firms and the remainder as Control firms.
19 Mean change in the index between the publication dates (for which the average length is 2.38 years) is 0.34, and the index changes no more than +1 in 85% of the cases. To align the data, we use the G-Index that is published closest to the annual meeting of the fiscal year that is being restated.
22
We find that some GAO restatements are early adoptions of accounting rule changes
and opinions or revisions or those that yield no change in earnings. We exclude 43 such
observations.20 Finally, we remove 41 restatements where explanatory variables used in
equation (1) are missing.21
Notice that restatement is an infrequent event, whereas the statistical power of the logit
model increases in the frequency of occurrence. To enhance the statistical power, we hand-
collect additional restatement announcements during the post-GAO period, that is, from July
2002 to December 2004. This effort yields additional 55 firms with complete data, and with
1997-2002 accounting errors announced during 2002-2004. Finally, we remove 17 firms
with dual-class securities because G-Index for these firms may not be comparable to those
with single-class security due to wide variety of voting and ownership differences (GIM
2003). In sum, we address a sample of 1,672 firms -- 185 firms that restate (Test sample) and
1,487 firms that do not restate (Control sample) financial reports.
An investigation of stock price response to the restatement announcement (not
reported) indicates substantial reduction of shareholder value – sample firms lost, on average,
13.7% of equity value during the 30 days leading up to the announcement.22 This evidence is
consistent with a characterization that restatement disclosures, at a minimum, indicate serious
mismanagement.
20 Seventeen restatements due to SAB (Staff Accounting Bulletin) 101 are included because there is evidence that SAB101 restatements reflect earnings management (Altamuro, Beatty, and Weber 2003). Inferences are comparable without the SAB101 restatements. 21 To preserve sample size and statistical power, we hand-collect the test-sample data that are missing from the IRRC dataset. Even so, 41 observations lack the requisite data. 22 The common stock price decline is 6.26% from day -1 to day +1, and 7.45% during -28 to day -2 (market-adjusted).
23
The potential consequences of focusing on the S&P 1500 firms are relevant for
evaluating how the empirical results apply generally. More specifically, conclusions may not
apply to all U.S. public firms to the extent that these firms differ from all firms. On the other
hand, S&P 1500 firms are selected from large, medium, and small firms and represent
approximately 85% of market capitalization of all publicly traded firms. Thus, they are
economically significant. Furthermore, since S&P 1500 firms are more widely-held than
other firms, they are of considerable interest to the investing public. Finally, the availability
of computer-readable data for these firms permits investigation of a comprehensive set of
governance characteristics.
Straightforward use of the pooled data is inappropriate because serial dependence in
corporate governance data potentially violates i.i.d. assumptions.23 Thus, we construct the
Test sample using a single observation for each restatement firm. For Test firms where
financial reports are restated in only one year, we use firm data for the restatement year. For
firms with multiple years misstated, we consider the year prior to the most recent year that is
misstated.24 To identify the sample of Control firms, we select one fiscal year for each firm
such that the fiscal years of the Control firms are closely matched to those of the Test firms.25
Matching by time period considers significant time trends in corporate governance
23 Unlike stock returns, governance characteristics are correlated over time, and as such, considering observations for all years for a single firm potentially overstates statistical significance. 24 Designating the event year as the first or the middle restated year, rather than as the year prior to the last restated year, does not alter the results materially. 25 Specifically, for each of the 185 restatement firms, we select a firm-year observation for a non-restatement (control) firm that has required data for the same year. We iterate the process -- each iteration provides 185 firm-year control observations -- until we exhaust the set of candidate control observations for a test observation. In the final round, when we are unable to identify control observations that match the year for the test firm, we select a random fiscal year for the control firm. This process yields a control sample with a distribution across years comparable to the distribution for the test sample.
24
characteristics (to be described below), while maintaining the original sample of 185 Test
firms and 1,487 Control firms.
As in Richardson et al. (2002), we prefer the full sample analysis to a matched-pair
design, because the latter approach cannot dominate the former in terms of statistical power
or representativeness of the sample.26 Two variables, EXPERT and FOUNDER, are
unavailable from the computer-readable database, however. Since these variables are hand-
collected, we consider these variables using a matched-pair design following conventional
procedures (e.g., Beasley 1996). More specifically, for each Test firm, we select a single
companion firm that is similar in four dimensions: industry, fiscal year, stock exchange
membership, and firm size (within 15% of the Test firm’s log total assets). This procedure
yields 178 pairs, after losing seven test firms that cannot be matched using these criteria.27
B. Descriptive Statistics
Panel A in Table II shows descriptive statistics, and Panel B displays correlations
between governance characteristics and financial variables.
[Insert Table II here]
Mean and median G-Index, 9.152 and 9.0 respectively, are in line with those reported in
GIM (2003). Mean (median) board independence (row 2) is 63.3% (66.7%) -- the median
coincides with the minimum independence level recommended by watchdog organizations
26 If clustering occurs in the test sample (e.g., with respect to industry, size, or exchange membership), the matched-pair design can yield a sample that is not representative of the population. 27 As seen in Table II panel B, firm size is correlated with most explanatory variables. Thus, our matching requirement (within 15% of the test firm log of assets) is more stringent than in previous papers (typically within 25%). Relaxing the size matching requirement to within 25% of Test firm log total assets increases the sample by only two, and thus, is not deemed worthwhile.
25
(e.g., Council of Institutional Investors 2003). The degree of independence is greater for
audit committees (AUD_INDEP) where the mean (median) is 86.2% (100%).
Information not tabulated indicates that all sample firms have an audit committee, and
virtually all (98.9%) have a compensation committee, but only 62.9% have a separate
nominating committee. Independent directors comprise the majority of the board and the
three oversight committees (MAJ_INDEP=1) for 44.0% of sample observations. Instances
where at least two-thirds of the Board is independent and all members of the three oversight
committees are independent (FULL_INDEP=1) are 16.5% of the sample.
Finally, median board size (BOD_SIZE) is nine, and median audit committee size is
three, the latter being consistent with the minimum audit committee size recommended by
the Blue Ribbon Committee (1999). Duties of the CEO and the board chair are segregated
for 27.3% of the sample (SEP_CHAIR=1). At least one financial expert (EXPERT=1) sits on
the audit committee for 69.7% of sample observations.
(1B, 1C), frequency of board meetings (1D), and other board and director characteristics
(1E). Data are aligned according to the year the annual meeting is held (which typically
occurs two to three months after the end of the fiscal year).28 Because the sample composition
differs in each year, cross-sectional levels of governance variables are not comparable inter-
temporally. Thus, we compute firm-specific annual percent change of each variable for each
28 Some information in proxy statements is forward-looking (such as the board and subcommittee composition, size of the board and the committee, whether the CEO is the board chair), whereas other information (such as the number of board and committee meetings) is backward-looking. We align the data accordingly.
26
year, and then cumulate the mean changes through 2002. Except for the change in mean
number of board directorships held (BUSYBOARD in Figure 1E), all cumulative increases or
decreases during 1997-2002 are statistically significant (α< 0.01).
Some argue that board activity indicates board effectiveness – that is, effective boards
(or committees) meet more frequently than ineffective boards (e.g., Lavelle 2002; Abbott, et
al. 2003). Figure 1D indicates that board and committee activity increases from 1997 to
2002. Notice, in particular, that audit committee meetings more than double during the
period. Also, audit committee meetings increase by 34% shortly after the issuance of the
Blue Ribbon Committee report (1999) which recommends regular meetings between the
audit committee and management. Related to this, and consistent with the supposition that
restatements are significant events, we also find that boards and audit committees of
restatement (Test) firms meet more frequently during and after restatement disclosures (result
not tabulated). It is not surprising, however, that boards and audit committees meet more
frequently when a restatement is detected or disclosed. Since the direction of the causality is
unclear -- that is, whether board activity precipitates or responds to an accounting crisis -- we
do not use the frequency of board meetings in the empirical analysis.
Overall, the evidence in Figure 1 indicates that boards of all firms are increasingly
independent and active, and more concerned about financial reporting during the 1997 to
2002 period. This feature of the data, which is likely, in part, due to more stringent stock
exchange listing requirements imposed during 2000-2002, underscores the importance of
controlling for time trends in studies that use governance characteristics. The evidence also
suggests that there has been a systematic and broad-based improvement in corporate
governance characteristics well ahead of Sarbanes-Oxley Act of 2002.
27
[Insert Table III here]
Table III Panel A indicates that the Test and the Control samples are comparably
distributed in calendar year (the χ2- = 2.39; p = 0.79). Of course, this similarity is by
construction as control observations are selected to achieve a comparable distribution. Panel
B indicates that the sample distributions are also comparable across stock exchanges (χ2 =
4.70; p = 0.32), even though exchange membership is not used to match the samples. Panel
C displays the GAO classification of the specific accounting error that precipitated the
misstatement.29
V. RESULTS
A. Primary results
[Insert Table IV here]
Table IV reports estimates for four specifications of expression (1). The first two
specifications differ in terms of how BOD/oversight committee independence is considered.
In the first column, all four indicators of board/committee independence (BOD_INDEP,
AUD_INDEP, COM_INDEP, NOM_INDEP) appear individually. In the second column,
these four variables are combined into a single indicator variable, FULL_INDEP. Estimates
not tabulated using MAJ_INDEP are comparable to those using FULL_INDEP. The
29 GAO (2002) identifies the party that instigated the restatement for 90 firms (SEC=33, auditor=6, the firm itself=51). We do not exploit this information because careful investigation of restatement announcements undermines our confidence that this feature of the data can be reliably verified using publicly available information. For example, a number of high-profile accounting irregularities such as Cendant, WorldCom, Waste Management, and Xerox are allegedly prompted by firm management. This observation leads us to suspect that credit for discovering and disclosing accounting errors is negotiated privately among the parties involved. Even so, analyses using the SEC-prompted sub-sample of 33 restatements indicate that, except for SIZE and CEO_AGE, no variables are statistically significant at conventional levels.
28
specification in column 3 further combines the nine variables indicating board strength into a
single index, B-Index. The specification in the last column is comparable to column 1 except
that it includes three additional variables, INDEP_CHAIR, CEO_ON_NOM, and
BUSYBOARD. Owing to lack of data for these three variables in 1997, specifications 3 and 4
can be computed only for the 1998-2002 observations. All specifications include dummy
variables to extract mean effects of: (1) industry, where industries are delineated into 13
groups as in Barth, Beaver, Hand, and Landsman (1999);30 (2) fiscal year;31 and (3) stock
exchange – NYSE, ASE, NASD, and OTC. For brevity, we do not report the estimates for
these dummy variables. Statistical significance is evaluated using one-tailed levels when an
alternative hypothesis is specified, and using two-tailed levels, otherwise.
Perhaps the most conspicuous aspect of the results in Table IV is the absence of
statistically significant associations for governance variables that are frequently advanced in
prior studies and commonly used in practice to evaluate board effectiveness. More
specifically, measures of board and committee independence (BOD_INDEP, AUD_INDEP,
OUTDIR_OWN, EMPDIR_OWN, BLOCK, INST_HOLD), CEO incentives (STK_COMP,
OPTVESTED) and other board characteristics (SEP_CHAIR, INTERLOCK, BUSYBOARD,
INDEP_CHAIR, DIR_AGE, CEO_ON_NOM) are not statistically significant.32 Moreover,
the positive association between B-INDEX and restatements contradicts expectations.
30 Classification into 48 industries as in Fama and French (1997) does not alter conclusions. We do not use the Fama-French classification because it yields industries with as few as three firms. 31 Although Control firms are matched to Test firms using fiscal year, we include fiscal year dummies as additional precaution. 32 Statistical significance for stock ownership of outside directors (OUTDIR_OWN) for 1997-2002 observations appears to be attributable to 1997 observations. That is, OUTDIR_OWN is not significant for specifications that use 1998-2002 data.
29
The large number of independent variables included in the specifications raises
concerns about whether multicollinearity undermines the ability to achieve statistical
significance. The evidence does not support this explanation, however. In particular, both
variance inflation factors (VIF) and condition indices (Belsley, Kuh, and Welsch 1980)
indicate that multicollinearity is not a concern.33 Excluding specific variables from the
specification, or combining variables with correlations greater than 0.40 (e.g., BOD_INDEP,
AUD_INDEP, COM_INDEP, NOM_INDEP), yields comparable parameter estimates and
significance levels. Stepwise regression indicates that only three governance variables and
two control variables (G-INDEX, DIR_AGE, BUSYBOARD, GROWTH, and FREECF) are
related to restatements at the five percent significance level. Finally, the low pseudo-R2 (less
than 6%) for all specifications is comparable to evidence in Larcker, et al. (2004) who also
report low explanatory power for governance indicators.34
In contrast with results for governance characteristics, all specifications reveal a
positive association between the probability of accounting restatement and the G-Index,
which indicates the extent that statutory or corporate provisions entrench management. The
estimate on G-Index 0.108 (p = 0.001) in the first column suggests that, on average, the odds
of accounting misstatement increase by about 11% (e0.108 = 1.114) for each additional
provision restricting shareholder rights. Thus, accounting misstatements are more likely in
firms where legal or contractual provisions restrict shareholder rights.
33 The recommended cut-off for variance inflation factors is 10. For condition indices, the recommendation is that at least two or more independent variables with variance proportions greater than 0.5, combined with a condition index greater than 30, potentially indicate multicollinearity. 34 In the first specification, the pseudo-R2 excluding financial control variables is 3.2%.
30
Note that estimates for financial control variables consistently indicate statistically
significant associations between 1997-2002 accounting restatements and growth (GROWTH),
free cash flow (FREECF), and size (LOGSIZE). That is, restatements are more likely to
occur for large firms (which, to our knowledge, is not documented elsewhere) and for high
growth and cash-strapped firms (as documented in Richardson, et al. 2002 and Larcker, et al.
2004). Finding statistical significance for financial control variables undermines arguments
that failure to find statistically significant associations for corporate governance variables is
attributable to lack of statistical power.
To summarize, results consistently indicate that accounting misstatements vary directly
with the corporate and statutory restrictions that encourage management entrenchment, but
misstatements are unrelated with corporate governance indicators commonly advanced both
in academic research and practice. Moreover, associations are unlikely to be attributable to
multicollinearity or lack of statistical power. Thus, based on the evidence in Table IV, we
reject Hypothesis 1 in favor of the alternative hypothesis restatements are more likely in
firms with provisions that restrict shareholder rights, but we cannot confidently reject
Hypothesis 2 that restatements and board, director or firm characteristics commonly
associated with strong governance are unrelated.
B. Matched-pair results
[Insert Table V here]
Estimates for the matched-pair sample, displayed as Table V, support these
conclusions, although, perhaps owing to the smaller sample, significance levels are lower for
G-Index and financial control variables.
31
Recall that we are particularly interested in associations for two variables – EXPERT
and FOUNDER – which cannot be feasibly collected for the larger sample, but which are
identified in previous studies. Estimates indicate that the probability of a restatement is
related to neither the presence of a financial expert on the audit committee nor whether the
CEO or the board chair is from the founding family.
Failure to find a statistically significant association for financial expert (EXPERT) is
surprising, as recent evidence using the accounting expertise measure suggests otherwise
(Abbott, et al. 2003; Agrawal and Chadha 2005; Farber 2005). We find that the proportion
of restatement firms with an expert on the audit committee is nominally higher than the
proportion of the Control firms (70.8% vs. 68.5%), but the difference is not statistically
significant for univariate comparisons. To investigate further, we consider an alternative,
more restrictive, definition of “accounting expert” proposed initially by the SEC during the
SOX deliberations. Specifically, following DeFond, Hann, and Hu (2005), we define an
accounting expert as a CPA, CFO, controller, or a chief accounting officer. Although the
proportion of audit committees with this more narrowly-defined accounting expertise
measure is lower for the restatement firms (24.7% vs. 29.8%), the difference is not
statistically significant (t = 1.07 for a univariate comparison and p = 0.32 in the multivariate
logit).
C. G-Index, E-Index, and sub-indices
Given consistent evidence that restatements are related to the G-Index, we investigate
the extent that the source of the association can be attributed to specific provisions. GIM
(2003) partition shareholder protection provisions into five categories: Delay (tactics
designed to increase the cost of hostile takeover); Protection (protection of officers and
32
directors from liability); Voting (limitations on shareholder voting rights); Other (direct
takeover defense measures, e.g., poison pills); and State (state anti-takeover laws). Several
provisions in the category designated State duplicate those in the other four categories. Thus,
we do not examine the State category separately. We anticipate positive associations
between accounting restatements and G-index components.
[Insert Table VI here]
Table VI displays a specification where G-Index components are considered. Control
variables are included in these specifications but not reported in the table. Results for the E-
Index, the composite governance measure advanced in Bebchuk, et al. (2004), are in the first
row.
We find positive parameter estimates for all five indices, but only estimates for E-
Index, Delay and Other are statistically significant (ά < 0.05). The index designated Delay
(column 1, p-value=0.02) includes four provisions which delay takeovers or restrict the
ability to hold shareholder meetings. The index designated Other (column 2, p-value=0.01)
includes six provisions (anti-greenmail, poison pill, silver parachutes, pension parachutes,
directors’ duties, fair price) designed to increase the cost of a takeover. Observe that the
magnitudes of estimates for these two indices are greater than for the aggregate G-Index. For
example, the estimate 0.283 (5th column) indicates that, on average, the odds of an
accounting restatement increase by about 32.7% for each provision that is classified in the
category designated Other. (Recall that the odds of accounting restatements increase by
about 11% for each additional restriction on shareholder rights that is considered in the
aggregate G-index.) Estimates for Protection and Voting indices are not statistically
significant at acceptable confidence levels. Thus, provisions more directly related to
33
delaying or increasing the costs of takeovers are more significantly associated with
accounting failures than other limitations on shareholder rights or participation.
Finally, the magnitude of the estimate on the E-Index, although statistically significant
(α < 0.05), is neither as large as the estimate on Other nor as statistically significant as the G-
Index (Table IV). The implication is that the E-Index does not dominate both the G-Index
and other sub-scores for predicting accounting restatements.
D. Trade-offs between board characteristics and shareholder participation
Hypothesis 3 considers whether strong boards and the possibility of direct shareholder
participation (takeover threats) are substitutes. If so, then we expect that G-Index and B-
Index are positively correlated. Table VII shows estimates for a regression of B-Index on G-
Index, after controlling for firm size, industry, year, and stock exchange. In column 1, B-
Index is regressed on G-Index and firm size, defined as the log of beginning total assets.
Industry, fiscal year, exchange membership, as well as size, are considered in column 2.
Finally, column 3 considers a specification where the B-Index and G-Index are adjusted by
subtracting the mean index for the firm’s corresponding size decile. In all three
specifications, a positive correlation obtains between B-Index and G-Index, indicating that
stronger board is correlated with stronger takeover defense (weaker shareholder rights).
We recommend a cautious interpretation of this result, as the evidence does not
definitively support the substitution hypothesis. In particular, we lack the ability to ascertain
whether the prevailing mix of governance mechanisms is optimal for a specific firm.
Moreover, we cannot consider an exhaustive set of governance mechanisms, and the choice
of measures used to construct the indices can be debated. Despite this caveat, the result
34
suggests that the statutory/charter provisions and board strength function as compensatory
mechanisms.
[Insert Table VII here]
E. Alternative Procedures
Additional procedures ensure that results are robust to alternative specifications and
procedures.35 First, we use security price reactions to restatement announcements to consider
whether results are obscured by the inclusion of restatements that are either trivial or
anticipated. In particular, restricting the analysis to 116 firms that experience negative three-
day stock returns around the restatement disclosure (63.0% of the restatement sample) yields
comparable results.
We also consider the following variables which arguably can be considered along with
those addressed in Table IV -- the CEO’s tenure, length of time since the firm was on stock
exchange, whether the CFO sits on the audit committee, and whether the CEO is on the
compensation committee, and audit fees.36 Incorporating these variables reduces sample sizes
substantially, but does not materially influence interpretations of the results. Thus, we do not
tabulate results for specifications that include these variables.
VI. CONCLUDING REMARKS
We investigate a comprehensive list of corporate governance characteristics and a large
sample of accounting restatements. These restatements are significant events in that we find
35 Robustness tests are executed using specification 1 in Table IV. 36 Since audit fee data are available only for fiscal year 2000 to 2002, we estimate Specification 1 of Table IV including FEERATIO (defined as non-audit fee/total audit fee) for 2000-2002 observations. The coefficient for FEERATIO is negative, as opposed to positive, and insignificant (p=0.44). The lack of explanatory power for audit fees is consistent with existing studies (Raghunandan, Read, Whisenant 2003; Agrawal and Chadha 2005), although failure to find statistically significant associations can also indicate a small sample size.
35
that sample firms experience 13.7% loss of shareholder value around the time of the
restatement disclosure. Despite the significance of the event, our investigation offers
relatively little evidence that accounting restatements are associated with remedies
commonly endorsed by both academic and practicing corporate governance experts and, in
some cases, imposed by policy-makers. Such results are consistent with at least three, not
necessarily mutually exclusive, explanations.
The first explanation is that, in contrast with assertions that accounting restatements are
attributable to weak corporate governance (GAO 2002, Byrne 2002), commonly
recommended procedures (e.g., board/committee independence and separation of the CEO
from the board chair) are ineffective remedies for curbing financial misstatement. A second
explanation, which is suggested by the substitution hypothesis, is that the recommended
practices and procedures are effective in some situations, but they are not appropriate for all
firms. Given this context, mandating specific governance requirements potentially causes
firms to reduce reliance on less costly governance mechanisms. A third explanation is that
the effectiveness of corporate governance as a check on accounting misstatements is
determined primarily by board or director attributes that are difficult to observe and measure
– e. g., individual or group values and culture. That is, empirical measures of corporate
governance fail to capture the richness and complexity of effective board oversight.
Regardless of which of these explanations applies, our evidence raises questions about
whether effective corporate governance can be imposed through regulation (Bhagat and
Black 2002; Anderson and Bizjak 2003; Homlstrom and Kaplan 2003; Romano 2004). The
evidence also elevates concern about whether the public media create, and regulators respond
36
to, political crises in ways that lack substance but advance their commercial or political
objectives (Watts and Zimmerman 1979; Romano 2004).
The evidence does suggest that firms with significant restrictions against shareholder
participation have greater propensity to commit accounting misstatements, however. This
evidence – particularly when considered along with evidence reported elsewhere that firm
performance varies inversely (GIM 2003), and CEO compensation varies directly
(Fahlenbrach 2004), with the G-index – suggests that these restrictions reinforce management
entrenchment.
37
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42
EXHIBIT 1
A summary of published studies on accounting restatements and financial reports accused of fraud by the SEC (AAER: Accounting and Auditing Enforcement Releases)
Reference Table 5 Table 4 Table 3 Table 5 Table 4 Table 8 ** significant at the five percent level, two-tailed. A positive sign indicates a positive relation with restatement.
(a) Abbott, et al. (2003) also examine SEC’s AAER (Accounting and Auditing Enforcement Releases) firms which are accused of committing fraud.
(b) Beasley (1996) and Dechow et al. (1996) consider whether the firm has an audit committee.
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EXHIBIT 2
Variable Definitions
Variable Description
Entrenchment G-INDEX governance index advanced by Gompers, Ishii, and Metrick (2003) E-INDEX entrenchment index advanced by Bebchuk, Cohen, and Ferrell (2004) (See note 1) B-INDEX composite score of nine board characteristics (See note 2) Board Strength BOD_INDEP* fraction of independent directors on the board AUD_INDEP* fraction of independent directors on the audit committee COM_INDEP* fraction of independent directors on the compensation committee NOM_INDEP* fraction of independent directors on the nominating committee MAJ_INDEP 1 if the fraction of independent directors on the board, audit committee,
compensation committee and nominating committee is greater than 0.5; zero, otherwise
FULL_INDEP 1 if the fraction of independent directors on the board is greater than 2/3 and all members on the audit committee, compensation committee and nominating committee are independent directors; zero, otherwise
BOD_SIZE* number of board members SEP_CHAIR* 1 if the CEO is not the board chair; zero, otherwise INDEP _CHAIR* 1 if an independent outside director is the board chair; zero, otherwise CEO_ON_NOM 1 if the CEO is on the nominating committee; zero, otherwise INTERLOCK* fraction of interlocked directors on the board BUSYBOARD* number of other company boards served by all directors, divided by number of
board members EXPERT 1 if an outside accounting and financial expert serves on the audit committee Ownership OUTDIR_OWN fraction of company stocks held by independent directors EMPDIR_OWN fraction of company stocks held by insider-directors, excluding the CEO CEO_OWN fraction of company stocks held by the CEO BLOCK number of outside blockholders. INST_OWN fraction of shares held by institutions Compensation STK_COMP the CEO’s total equity-based compensation (stock options, SARs, and restricted
stocks: EXECUCOMP variables Blk_valu+Rstkgrnt) divided by the CEO total compensation (EXECUCOMP variable TDC1)
OPTVESTED number of exercisable or vested options of the CEO divided by the number of shares outstanding (EXECUCOMP variable UEXNUMEX/Shrsout*1000)
Other CEO_AGE age of the CEO DIR_AGE average age of the board members FOUNDER 1 if CEO or the Board Chair founded the company; zero otherwise Financial Control Variables BIG6 1 if the firm is audited by a Big Six firm; zero, otherwise LOGSIZE log of beginning total assets GROWTH growth rate of sales during the two years preceding the event year FREECF beginning-of-the-year free cash flow /beginning total assets DIV_YIELD beginning-of-the-year dividend yield MARGIN beginning-of-the-year net income/sales LEVERAGE beginning-of-the-year interest-bearing debt/total assets
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1. E-Index includes six anti-takeover provisions distilled from the components of G-Index by Bebchuk, Cohen, and Ferrell (2004). (Classified Board, Bylaws, Charter, Supermajority, Golden Parachutes, Poison Pills).
2. B-Index is a composite score constructed from nine indicators of board characteristics denoted in the table by an asterisk (*). B-Index increases by one if: (1) more than 2/3 of the board is comprised of independent directors; (2) all of the audit committee members are independent directors; (3) all of the compensation committee members are independent directors; (4) all of the nominating committee members are independent directors; (5) the CEO is not the board Chair; (6) the Chair is an independent outside director; (7) if the board size is less than the median of all firms (adjusted for firm size and time); (8) the board interlock (INTERLOCK) is less than the median of all firms (adjusted for firm size and time); or (9) BUSYBOARD is less than the median of all firms (adjusted for firm size and time). To adjust for firm size and time, the composite measure is computed net of the median for each firm size decile identified for each year.
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TABLE I
Sample selection procedure
Description Number
Firms included in both the IRRC (Investor Responsibility Research Center) corporate governance database and in the S&P COMPUSTAT database (1997-2002).
2,431
Test Sample: firms that restated financial statements during 1997-2002 according to GAO
231
1. Restatements in anticipation of pending EITF or SFAS pronouncements, or involve no change in earnings.(1)
(25)
2. Restatements cannot be verified. (14) 3. Restatements did not change or decreased earnings (4) 4. Missing G-Index in the event year. (20) 5. Missing governance data or financial data (in the event year
for the test firm) (21)
Remaining GAO sample (announced during 1/1/1997- 6/30/2002)
147
Hand-collected sample (announced during 7/1/2002- 12/31/2004)
55
6. Exclusion of firms with dual class securities (17)
Total Test Sample 185
Total Control (Non-restatement) meeting the same data requirement as the Test sample.
1,487
Final sample 1,672
1. Excluded restatements include those issued for Emerging Issues Task Force (EITF) Issue No. 00-10, on shipping and handling fees and costs, EITF 00-14 on certain sales incentives, EITF 00-22 relating to the classification of certain sales incentives, and EITF 00-25 "Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor's Products," and adoptions of SFAS 132, 133, and 142.
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TABLE II
PANEL A: Descriptive Statistics for the Full Sample
(1) These variables address 178 matched-pairs only (356 observations). Descriptive statistics are for the full sample of 1,672 firm-year observations (185 Test and 1,487 Control observations). G-INDEX = the governance index advanced by Gompers, Ishii, and Metrick (2003); BOD_INDEP = fraction of independent directors on the board; AUD_INDEP = fraction of independent directors on the audit committee; COM_INDEP = fraction of independent directors on the compensation committee; NOM_INDEP = fraction of independent directors on the nominating committee; MAJ_INDEP = 1 if the fraction of independent directors on the board, audit committee, compensation committee and nominating committee is greater than 0.5; zero, otherwise; FULL_INDEP = 1 if the fraction of independent directors on the board is greater than 0.667 and all members on the audit committee, compensation committee and nominating committee are independent directors; zero, otherwise; BOD_SIZE = number of board members; SEP_CHAIR = 1 if the CEO is not the board chair; zero, otherwise; INDEP_CHAIR = 1 if an
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independent outside director is the board chair; zero, otherwise; CEO_ON_NOM = 1 if the CEO is on the nominating committee; zero, otherwise; INTERLOCK = fraction of interlocked directors on the board; BUSYBOARD = total number of other companies’ boards served by all directors, divided by total number of board members; EXPERT = 1 if an outside accounting and financial expert serves on the audit committee; DIR_AGE = mean board member age; OUTDIR_OWN = fraction of company stocks held by independent directors; EMPDIR_OWN = fraction of company stocks held by insider-directors other than the CEO; CEO_OWN = percentage of company stocks held by the CEO; BLOCK = number of outside blockholders; INST_OWN = fraction of shares held by institutions; STK_COMP = the CEO equity-based compensation (stock options, SARs, and restricted stocks) divided by the CEO’s total compensation; OPTVESTED = number of exercisable or vested options of the CEO divided by the number of shares outstanding; CEO_AGE = age of the CEO; FOUNDER = 1 if CEO or the Board Chair founded the company; zero, otherwise; B-INDEX = composite score of 9 board characteristics; TENURE = CEO’s tenure; BIG6 = 1 if the firm is audited by a Big Six firm; zero, otherwise; LOGSIZE = log of beginning total assets; GROWTH = growth rate of sales during the previous 2 years; FREECF = beginning-of-the-year free cash flow /beginning total assets; DIV_YIELD = beginning-of-the-year dividend yield; MARGIN = net income/sales; LEVERAGE = interest-bearing debt/(Interest-bearing debt +market value of equity).
Asterisks *, **, *** denote two-tailed significance at the 10%, 5%, 1% level, respectively.
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Figure 1.ACumulative change in board and oversight
committee independence
-1%
1%
3%
5%
7%
9%
1998 1999 2000 2001 2002
BOD_INDEP AUD_INDEP
NOM_INDEP COM_INDEP
Figure 1.BCumulative percent growth in
the size of the committee
0%
5%
10%
15%
20%
25%
1998 1999 2000 2001 2002
BOD_SIZE AUD_SIZE
NOM_SIZE COM_SIZE
Figure 1.DCumulative percent growth in
the number of meetings
-10%10%30%50%70%90%
110%130%150%
1998 1999 2000 2001 2002
# of BOD Meeting # of Audit C. Meeting
# of NOM Meeting # of COMP Meeting
Figure 1.CCumulative percent growth in
the size of the committee, adjusted for firm growth (growth in the number of employees)
-35%-30%-25%-20%-15%-10%-5%0%5%
1998 1999 2000 2001 2002
BOD_SIZE AUD_SIZE
NOM_SIZE COM_SIZE
Figure 1.ECumulative change in other board and
CEO characteristics
-11%
-6%
-1%
4%
9%
1998 1999 2000 2001 2002
CEO_ON_NOM SEP_CHAIR
BUSYBOARD INTERLOCK
Figure 1 Intertemporal change in governance characteristics for all firms
1997-2002 The statistics are compiled using 1997 through 2002 observations for 1,672 companies in the full sample. Figures show the cumulative increase (Fig. 1A. 1E) and cumulative percent increase (Fig. 1B, 1C, 1D) for the respective variable. Cumulative increase for a given year is computed as the arithmetic sum of annual increases since 1997. Cumulative percent increase is the compounded growth rate realized since 1997 through the end of the specified year. All changes between 1997 and 2002 differ from zero at the 0.01 significance level with the exception of BUSYBOARD.
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Table III
Distribution of the event year, exchange listing, and the nature of accounting misstatements for the Test (Restatement) sample and the Control sample
The restatement sample includes 185 firms announcing restatements during 1997-2002; the control sample includes 1,487 firms that do not experience restatements during 1997-2002. Firm-years for the control sample are selected to approximate the event year distribution of the Test sample.
A. Distribution of the event year by fiscal year1
1997
1998
1999
2000
2001
2002
Total Restatement sample
20
(10.8%)
36
(19.5%)
37
(20.0%)
40
(21.6%)
36
(19.5%)
16
(8.6%)
185
(100%) Control sample
193
(13.0%)
284
(19.1%)
275
(18.5%)
293
(19.7%)
272
(18.3%)
170
(11.4%)
1,487
(100%) 1. χ2 statistic for the null hypothesis that event years are identically distributed has a p-value of 0.79 (χ2
=2.39).
B. Distribution of the stock exchange membership2
2. χ2 statistic for the null hypothesis that exchange membership is identically distributed has a p-value of 0.32 (χ2 =4.70).
C. Restatements by the type of accounting irregularity Nature of Misstatements Frequency Percent Revenue Recognition 83 44.9 Expense, or Revenue and Expense 92 49.7 Other 10 5.4 Total 185 100.0
NYSE
NASD
AQ
ASE
OTC
Other
Total
Restatement sample
113
(61.1%)
66
(35.6%)
0
(0%)
4
(2.2%)
2
(1.1%)
185
(100%) Control sample
980
(65.9%)
446
(30.0%)
17
(1.1%)
25
(1.7%)
19
(1.3%)
1,487
(100%)
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TABLE IV Cross-sectional logistic regressions of misstatement probability
The dependent variable is set equal to one, if the firm restated financial statements during 1997-2002; zero, otherwise. Variable definitions are in Exhibit 2. Asterisks *, **, *** indicate significance at 10%, 5%, 1% confidence levels, two-tailed when there is no direction specified under the alternative hypothesis and one-tailed when there is a specified direction under the alternative hypothesis (as indicated by predicted signs). Specifications 1 and 2 address 185 Test firms and 1,487 Control firms. Specifications 3 and 4 address 165 Test firms and 1,278 Control firms during 1998-2002. Specifications also consider fiscal year, industry, and stock exchange listings (corresponding estimates not reported). 1 2 3 4 Pred.
TABLE V 178 Matched-pair cross-sectional logistic regressions of misstatement probability
The dependent variable is one, if the firm restated financial statements during 1997-2002; zero, otherwise. Variable definitions are in Exhibit 2. Asterisks *, **, *** indicate significance at the 10%, 5%, 1% level, two-tailed when there is no alternative and one-tailed when there is an alternative hypothesis (as indicated by the predicted signs). The sample comprises 178 Test firms and 178 Control firms selected to match the Test firms with respect to the year, stock exchange, firm size, and industry. Specifications include controls for fiscal year, industry, and stock exchange listings (estimates not reported). 1 2 3 4 Pred.
TABLE VI Cross-sectional logistic regressions using four governance sub-indices
E-Index includes six anti-takeover provisions distilled from the components of G-Index by Bebchuk, Cohen, and Ferrell (2004). (Classified Board, Bylaws, Charter, Supermajority, Golden Parachutes, Poison Pills); Delay includes four provisions designed to delay hostile takeovers (Blank Check, Classified Board, Special Meeting, Written Consent; titles from Gompers, Ishii, and Metrick (2003)); Protection includes six provisions designed to protect officers and directors from liability (Compensation Plans, Contracts, Golden Parachutes, Indemnification, Liability, Severance); Voting comprises six provisions limiting shareholder voting (Bylaws, Charter, Cumulative Voting, Secret Ballot, Supermajority, Unequal Voting); Other includes six provisions representing direct takeover defense measures (Anti-greenmail, Directors’ Duties, Fair Price, Pension Parachutes, Poison Pill, Silver Parachutes). Italics indicates χ2 statistic. Asterisks *, **, *** indicate significance at the 10%, 5%, 1% level, two-tailed when there is no alternative and one-tailed when there is an alternative hypothesis (as indicated by predicted signs). The sample comprises 185 Test firms and 1,487 Control firms selected to match the Test firms. Estimates not reported for control variables displayed in column 1 of Table IV.
OTHER 0.613*** 0.504*** 0.262*** 0.117*** 0.260***
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TABLE VII
Regression estimates for association between G-INDEX and B-INDEX controlling for firm size
B-Index is a composite score constructed from 9 indicators of board characteristics. B-Index increases by one if: (1) more than 2/3 of the board is comprised of independent directors; (2) all of the audit committee members are independent directors; (3) all of the compensation committee members are independent directors; (4) all nominating committee members are independent directors; (5) the CEO is not the board Chair; (6) the board chair is an independent outside director; (7) board size is less than the median of all firms (adjusted for firm size and time); (8) the board interlock (INTERLOCK) is less than the median of all firms (adjusted for firm size and time); or (9) BUSYBOARD is less than the median of all firms (adjusted for firm size and time). To adjust for firm size and time, each variable is net of the median for corresponding size decile and year. G-INDEXR denotes size-adjusted G-INDEX (deviation from the mean G-INDEX for corresponding size decile and year); similarly B-INDEXR deviation from the mean B-INDEX of each size decile.
Regression Estimates
B-INDEX (or B-INDEXR)i,t=β0+β1(G-INDEX or G-INDEXRi,t)+β2(LOGSIZE,t) + Controls +εi,t
