SAN DIEGO STATE UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION

The Latest Research inCorporate Governance:

Accounting

D. G. DeBoskey, Ph.D., CPAProfessor of Accountancy

Top-Tier Accounting Journals

Contemporary Accounting Research (CAR) Journal of Accounting Research (JAR) Review of Quantitative Finance and Accounting

(RQFA) The Accounting Review (TAR)

Research Types

Research Types–Taxonomy

Research Methods Analytical Internal Logic Archival Primary Empirical Case Empirical Field Empirical Lab

Inference Style Inductive Deductive

Research Types–Taxonomy (cont.)

Mode of Reasoning Descriptive Statistics Regression ANOVAs Other Multivariate Techniques

Mode of Analysis Normative Descriptive

Research Synthesis: 2008

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

CG and Agency Conflicts (AC)

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)

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)

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 Tobin’s Q) Composition and functioning of the board, auditor

independence, and equity-based compensation of the directors, but primarily for firms with High AC

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 firm’s business and economic environment

(Dey, 2008)

CG and Firm Performance

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)

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

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

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)

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

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

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)

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)

CG and Disclosure

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)

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

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

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

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

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)

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)

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 CD&A mandates. Are the results generalizable?)

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 (p<.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 (p<.01)

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

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 (p<.05)

In both periods, however, the average number of compensation committee members remains constant A typical compensation committee has about

four members

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 (p<.05, one-tailed)

Greater CEO power in the director nomination process is associated with a smaller number of disclosed items (p<.01, one tailed)

Implying that dominant CEOs are more likely to limit compensation disclosures

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 (p<.05, two-tailed)

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)

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

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)

Global Trends

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

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

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

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.

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)

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)

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

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

Global Trends – Developed Markets

United States Anomalies in reporting loss contingencies

For example, on page 39 of Merck’s 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 Lawsuits…the 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

Global Trends – Developed Markets

United States (cont.) New Compensation Discussion & Analysis

(CD&A) assessment by the SEC 350 first-year CD&A’s analysis CD&A statements ran over 6,000 words “Where’s the Analysis?”

Global Trends – Developed Markets

United States (CD&A 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

Global Trends – Developed Markets

United States (CD&A 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

Issues Facing Boards in 2009

Issues Facing Boards in 2009

Shareholder proposals To implement or not implement, that is the question

Executive compensation Shareholder activism—friend or foe?

How do we juggle short-term performance and long-term success?

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

SAN DIEGO STATE UNIVERSITY COLLEGE OF BUSINESS ADMINISTRATION

The Latest Research inCorporate Governance:

Accounting

D. G. DeBoskey, Ph.D., CPAProfessor of Accountancy