The Latest Research in Corporate Governance: Accounting

1. The Latest Research inCorporate Governance:Accounting D. G. DeBoskey, Ph.D., CPA Professor of Accountancy

2. Top-Tier Accounting Journals • Contemporary Accounting Research (CAR) • Journal of Accounting Research (JAR) • Review of Quantitative Finance and Accounting (RQFA) • The Accounting Review (TAR)

3. Research Types

4. Research Types–Taxonomy • Research Methods • Analytical Internal Logic • Archival Primary • Empirical Case • Empirical Field • Empirical Lab • Inference Style • Inductive • Deductive

5. Research Types–Taxonomy (cont.) • Mode of Reasoning • Descriptive Statistics • Regression • ANOVAs • Other Multivariate Techniques • Mode of Analysis • Normative • Descriptive

6. Research Synthesis: 2008

7. 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

8. CG and Agency Conflicts (AC)

9. 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)

10. 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)

11. 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

12. 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)

13. CG and Firm Performance

14. 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)

15. 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

16. 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

17. 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)

18. 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

19. 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

20. 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)

21. 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)

22. CG and Disclosure

23. 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)

24. 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

25. 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

26. 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

27. 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

28. 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)

29. 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)

30. 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?)

31. 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)

32. 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

33. 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 fourmembers

34. 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

35. CG and Disclosure – Findings • 2002 OLS Regression Results (Disclosure on CG + Controls) • Overall, the 2002 results are weaker than the 1993 results • DILIGENCE/SIZEis the only governance variable significantly associated with SCORE(p<.05, two-tailed)

36. 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)

37. 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

38. 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)

39. Global Trends

40. 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

41. 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

42. 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

43. 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.

44. 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)

45. 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)

46. Global Trends – DevelopedMarkets • 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

47. 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

48. 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

49. 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?”

50. 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