Financial accounting and corporate governance:a discussion $

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1 Journal of Accounting and Economics 32 (2001) Financial accounting and corporate governance:a discussion $ Richard G. Sloan* School of Business Administration, University of Michigan, 701 Tappan Street, Ann Arbor, MI , USA Received 30 October 2000; received in revised form 5 January 2001 Abstract Bushman and Smith (2001, this issue) provide a useful review of research on the role of accounting in management compensation contracts and an appealing future research agenda that builds on recent research using a cross-country approach. This paper rounds out their discussion by highlighting some limitations of their research agenda, providing a critical review of the contributions of accounting scholars to governance research and highlighting research opportunities on the role of financial accounting in governance mechanisms other than managerial incentive contracts. r 2001 Elsevier Science B.V. All rights reserved. JEL clasification: M41; G14 Keywords : Corporate governance; Accounting; Contracting 1. Introduction The study of corporate governance is concerned with understanding the mechanisms that have evolved to mitigate incentive problems created by the separation of the management and financing of business entities. Financial $ I am grateful for the comments of Patricia Dechow, Scott Richardson, Doug Skinner and Jerry Zimmerman. *Corresponding author. Tel.: ; fax: address: sloanr@umich.edu (R.G. Sloan) /01/$ - see front matter r 2001 Elsevier Science B.V. All rights reserved. PII:S (01)

2 336 R.G. Sloan / Journal of Accounting and Economics 32 (2001) accounting provides financiers with the primary source of independently verified information about the performance of managers. Thus, it is clear that corporate governance and financial accounting are inexorably linked. Indeed, many of the central features of financial accounting, such as the use of historical costs, the reliability criterion, the realization principle and the conservatism principle are difficult to understand unless one adopts a corporate governance perspective. Without governance problems, the role of financial accounting would be reduced to providing investors with the risk and return information required to facilitate the optimal portfolio allocation decision. The review by Bushman and Smith (2001, B&S hereafter) therefore addresses an area of fundamental importance in financial accounting. B&S s review focuses on two main areas of governance research. First, they provide a comprehensive summary and evaluation of research on the role of financial accounting information in managerial incentive contracts. Second, they propose an agenda for future research that builds on previous research exploiting cross-country differences in financial reporting and governance regimes. While B&S provide a useful and thorough analysis in each of these two areas, my task is to identify potential limitations of their review. I identify three broad limitations. First, their proposed research agenda only analyzes the role of accounting information at a very macro-level. Second, they provide little in the way of a critical assessment of the contributions of accounting scholars to governance research. Finally, they provide only a superficial discussion of the role of accounting in governance mechanisms other than managerial incentive contracts. Below, I discuss these limitations in more detail and suggest additional research opportunities in this area. 2. Limitations of cross-country research agenda B&S s most specific and detailed suggestions for future research involve the use of cross-country research designs to investigate the effects of financial accounting on economic performance. While appealing and well worthy of serious consideration, this research agenda is nevertheless subject to some limitations. First, it is not clear that accounting researchers have a comparative advantage in conducting such research. The determinants of national economic performance are many and varied, with the financial accounting system representing only one small and interrelated piece. Moreover, such research only analyzes the role of accounting information at a macro-level, using crude measures of the quality of the accounting system, such as the CIFAR Index described by B&S. Financial economists have conducted the seminal research in this area, and are best equipped to conduct this research moving forward. Financial accountants most useful role in this research agenda is in helping to develop improved measures of the quality of alternative financial accounting

3 R.G. Sloan / Journal of Accounting and Economics 32 (2001) systems, including the institutional arrangements that support them, such as auditors, analysts and regulators. However, as I will argue in Section 4, accounting researchers are also well equipped to conduct more micro-level research focusing on the role played by accounting information in facilitating various governance mechanisms. Another major limitation of the cross-country research agenda proposed by B&S is the particularly thorny set of econometric issues that it raises. While acknowledged by B&S, these issues are serious enough to warrant additional emphasis. Problems with correlated omitted variables, multicollinearity, endogeneity and limited degrees of freedom combine to make meaningful inferences very difficult. One particular example is worthy of mention. Economically developed countries tend to have more highly regulated financial accounting systems, resulting in a positive correlation between economic performance and the CIFAR index. However, it would be dangerous to conclude that more accounting regulation leads to improved economic performance. Economic performance and financial accounting both thrived in numerous developed countries even before the introduction of extensive accounting regulation. In less-developed countries, costly regulation by opportunistic regulators may well hinder economic development. 3. Evaluation of accounting scholars contribution to governance research Governance research is truly interdisciplinary in nature, drawing heavily on the fields of economics, finance, law and management. Accounting also has a potentially important role to play in governance research since, as I will discuss later in this review, accounting provides the information required for most governance mechanisms to operate efficiently. Indeed, some have attributed the tremendous success of US capital markets to the sophistication of the US financial reporting system. 1 It is therefore worth reflecting on the contributions of accounting scholars to governance research. As with any critical assessment of research, an evaluation of this nature is inherently subjective, but is nevertheless useful for evaluating past contributions and guiding future research efforts. The basic method by which I propose to provide some perspective on accounting scholars contribution to the governance literature is to examine the relative frequency with which research in accounting journals is referenced in a recent survey article on corporate governance. Of course, this approach has its limitations. In particular, the individual biases of the authors will influence the referenced articles, and there is no obvious benchmark against which to judge 1 See, for example The Numbers Game, remarks by Arthur C. Levitt, Chairman of the SEC, September 28, 1998.

4 338 R.G. Sloan / Journal of Accounting and Economics 32 (2001) the relative frequencies of references across disciplines. Nevertheless, I believe the analysis provides some useful insights. The survey article used is Shleifer and Vishny (1997). This is, to the best of my knowledge, the most recent general survey article published in a top tier journal. The fact that this survey is published in a finance journal by two financial economist s raises concerns that it probably has a bias toward research in finance and economics. For comparative purposes, I also conduct an analysis of the references in the B&S review paper. Recall that the explicit focus of B&S is financial accounting information and corporate governance. As such, we expect that paper to have a significant accounting bias when compared to a general survey paper. However, an analysis of the B&S references should nevertheless provide corroborative evidence on the relative contributions of the non-accounting disciplines. Results of the reference analysis are reported in Table 1. I classify all referenced articles by the primary areas of the journals in which they are published. In cases where a journal title refers to two areas (e.g., Journal of Accounting and Economics), I classify the article according to the area appearing first (i.e., Accounting). Books, monographs and working papers are left unclassified. As expected, the vast majority of the references in Shleifer and Vishny are to publications in the Economics (31%) and Finance (29%) literature. However, we also see that the economics and finance journals feature prominently in the B&S review with 17% and 15% of the references, respectively, despite the fact that this review has an explicit focus on financial accounting. It seems clear that the majority of the academic contributions to governance research have been made in economics and finance. Law comes in third with 10% of the references, while Accounting comes in a distant fourth with 3%, trailed only by Management with 2%. Table 1 References in governance survey papers classified according to journal areas a Panel A: References in Shleifer and Vishny (1997) Area ECON FIN LAW ACC MNGT UNC Total Freq % Panel B: References in Bushman and Smith (2001) Freq % a Key:ECONFEconomics Journal, FINFFinance Journal, LAWFLaw Journal, ACCFAccounting Journal, MNGTFOther General Management Journal, UNCFUnclassified (book, monograph or unpublished manuscript).

5 R.G. Sloan / Journal of Accounting and Economics 32 (2001) The fact that only 3% of the papers referenced in a general survey of corporate governance are published in accounting journals seems disappointing at first glance. Accounting information undoubtedly plays an important role in corporate governance and most business schools expend significant resources on accounting research. However, if one digs a little deeper into the referenced accounting papers, the situation becomes even more disturbing. Panel A of Table 2 lists the papers appearing in accounting journals that are referenced by Shleifer and Vishny. Panel B of Table 2, lists the papers referenced in Shleifer and Vishny that I was able to identify as including a substantive analysis of accounting-related phenomena. While some subjectivity is required to construct this list, I doubt that anyone going through the same exercise would disagree with the general spirit of my findings. Of the eight papers published in accounting journals, only one makes both lists. That is, only one of the papers published in accounting journals involves a non-trivial analysis of accounting-related phenomena. This paper is Palepu s (1986) Predicting Takeover Targets paper. Palepu shows, among other things, that financial accounting data are useful in predicting takeover targets. Thus, Palepu s research highlights the role of accounting data in facilitating corporate takeovers. The remaining seven papers cover such issues as the relation between executive compensation and stock price performance, executive deaths, golden parachutes, executive stock ownership and board Table 2 Accounting-related research referenced by Shleifer and Vishny (1997) a A: Research published in Accounting Journals Benston (1985) The self-serving management hypothesis JAE Coughlan and Schmidt (1985) Executive compensation, management turnover and firm performance JAE Johnson et al. (1985) An analysis of the stock price reaction to sudden executive deaths JAE Lambert and Larcker (1985) Golden parachutes, executive decision making and shareholder wealth JAE Lewellen et al. (1985) Merger decisions and executive stock ownership in acquiring firms JAE Murphy (1985) Corporate performance and managerial remuneration JAE Palepu (1986) Predicting takeover targets JAE Shivdasani (1993) Board composition, ownership structure and hostile takeovers JAE B: Research involving a substantive analysis of the role of accounting in governance Asquith and Wizman (1990) Event risk, covenants, and bondholder returns in leveraged buyouts JFE Palepu (1986) Predicting takeover targets JAE Smith and Warner (1979) On financial contracting:an analysis of bond covenants JFE Teoh et al. (1998) Earnings management and post-issue under-performance of seasoned equity offerings JFE a Note:JAE=Journal of Accounting and Economics, JFE=Journal of Financial Economics.

6 340 R.G. Sloan / Journal of Accounting and Economics 32 (2001) composition. None of these seven papers, however, contain a substantive analysis of the role of financial accounting in corporate governance. Fortunately, panel B of Table 2 does consist of more than one paper. There are several papers containing a substantive analysis of the role of financial accounting in corporate governance. However, these papers are not published in accounting journals. For example, Smith and Warner (1979) provide a detailed analysis of the role of accounting information in bond covenants, including the purposes of the various covenants and the importance of GAAP. There are also many other papers referenced by Shleifer and Vishny that make extensive use of accounting data in their empirical tests, but panel B of Table 2 lists only those that contain a substantive analysis of accounting-related phenomena. In summary, the analysis in this section highlights two key points: 1. There is a dearth of influential research published in accounting journals that contains a substantive analysis of the role of financial accounting in corporate governance. 2. Accounting research has the potential to play an important role in governance research, as evidenced by the impact of several influential papers on the role of accounting in corporate governance that are published in non-accounting journals. In the next section, I provide a framework for summarizing the more important roles played by accounting in corporate governance and highlight related opportunities for research involving a substantive analysis of accounting-related phenomena. 4. Overview of the roles played by accounting in corporate governance Fig. 1 provides an overview of the relation between financial accounting and the various corporate governance mechanisms that facilitate the separation of management and financing. The basic agency problem resulting from the separation of management and financing is that the managers will have incentives to take actions to increase their own utility, but not to maximize the returns on capital invested by the financiers. This problem may manifest itself in numerous ways, including direct wealth transfers from the financiers to the managers, sub-optimal allocation of capital and managerial perquisite consumption. The financial accounting system provides an important source of information to governance mechanisms that help alleviate the agency problem described above. The use of accounting information in these governance mechanisms can be either explicit or implicit. The use of accounting-based covenants in bond contracts is an example of the explicit use of accounting information. The use of accounting information in the

7 R.G. Sloan / Journal of Accounting and Economics 32 (2001) Fig. 1. Illustration of the role of financial accounting and corporate governance mechanisms in facilitating the separation of management and financing. selection of takeover targets is an example of the implicit use of accounting information. This section provides an overview of the explicit and implicit uses of accounting information in governance mechanisms. In addition to constituting an important input to the governance process, financial accounting information is itself a product of the governance process. Financial accounting information is produced by management, and management knows that this information will be used as an input to the governance process. As such, a series of governance mechanisms have evolved to ensure that the accounting information supplied by management is not unduly compromised. We begin with a brief discussion of these mechanisms Financial accounting information as a product of the governance process The process through which accounting information is supplied from managers to investors is summarized at the bottom of Fig. 1. While Fig. 1 focuses on the US environment, it is broadly applicable to other countries. The financial reporting process for public entities is typically regulated through the government and the legal system, with the Securities and Exchange Commission (SEC) serving as the primary regulatory body in the US Determination of the generally acceptable set of accounting principles (GAAP) is delegated to the accounting profession, which has its own oversight structure (FASB, AICPA, etc.). The financial statements supplied by management are

8 342 R.G. Sloan / Journal of Accounting and Economics 32 (2001) subject to external audit to certify that they are prepared in accordance with the applicable statutory and professional principles. Finally, firms typically appoint an audit committee from the board of directors, which exercises oversight over the preparation of the financial statements and communicates with the auditors on behalf of investors. The nature and extent of the mechanisms described above differs widely across different countries and companies. Yet only recently have researchers started to conduct research in this area. B&S summarize research investigating how the quality of the financial reporting system relates to the nature and extent of other governance mechanisms (e.g., La Porta et al., 1998; Bushman et al., 2000). There is also a body of developing literature investigating other issues relating to the quality of the financial reporting system. This literature can be categorized into three broad areas. The first area is research examining the relation between the overall quality of financial disclosures and the cost of capital (e.g., Lang and Lundholm, 1996; Botosan, 1997; Botosan and Plumlee, 2000). The second area consists of research on the effectiveness of specific mechanisms monitoring the financial reporting process. This area includes research on audit quality (e.g., Becker et al., 1998; Francis et al., 1998) and board of directors/audit committee quality (e.g., Beasley, 1996; Dechow et al., 1996; Carcello and Neal, 2000; Peasnell et al., 2000). The final area consists of research on the causes and consequences of failures in the financial reporting process. This research focuses on the determinants and effects of earnings management (e.g., Rangan, 1998; Teoh et al., 1998) and earnings manipulation (e.g., Feroz et al., 1991; Dechow et al., 1996). The research summarized above is recent and evolving and requires a good understanding of the financial reporting process. Thus, there are rich opportunities for accounting research in this area. The recent debate over conflicts of interest for auditors created by the joint provision of consulting services provides a representative opportunity Explicit uses of accounting information in corporate governance The explicit use of accounting information in contracts between management and financiers represents perhaps the most visible use of accounting information in governance mechanisms. In particular, the use of accountingbased performance measures in managerial compensation contracts represents perhaps the best known and most heavily researched governance role of accounting information. B&S provide an excellent and comprehensive review of this research, and I have little to add. The one point that I would like to emphasize is that accounting-based compensation accounts for just a small proportion of the incentives for a typical top executive. Incentives provided by stock and option holdings tend to dominate (e.g., Murphy, 1985; Core et al.,

9 R.G. Sloan / Journal of Accounting and Economics 32 (2001) ). Thus, the incredible amount of research in this area is perhaps overkill, given the relative insignificance of this particular role of accounting earnings. In contrast to the compensation literature described above, the explicit role of accounting information in debt contracts is extensive, but there is a relative little research in this area. Early research by Smith and Warner (1979) and Leftwich (1983) documents the existence and function of accounting-based covenants in public debt contracts. Subsequently, what little research has been done in this area tends to focus on the implications of accounting covenants for accounting choice (e.g., Press and Weintrop, 1990; Sweeney, 1994). Yet the role of accounting information in financial contracting has continued to develop and flourish, particularly in private placements of debt and private lending agreements. For example, the use of performance pricing (grid-pricing) in private lending agreements is now commonplace. Performance pricing involves linking the interest rate that is charged on debt to measures of financial strength that are based on accounting data. Performance pricing represents an interesting development for two reasons. First, the return to investors, and hence the pricing of the debt is explicitly tied to accounting information. Second, unlike debt covenants that are only violated in extreme circumstances, performance-pricing bounds are frequently triggered in the normal course of business. Despite the pervasiveness of performance pricing and its heavy reliance of accounting-based ratios, there is little research to date. The only research paper of which I am aware is a recent working paper by Beatty and Weber (2000). More generally, there has been little research on the role of accounting information in financial contracting, and the little research that has been done has often not been done by accountants (e.g., Gilson and Warner, 1998; Kaplan and Stromberg, 1999). This represents a missed opportunity for accounting researchers. Many accounting researchers are well-trained in financial economics and frequently engage in governance-based research that has little to do with accounting. Accounting researchers could make more significant contributions to governance research if they exploited their comparatively strong knowledge of accounting to help explain observed financial contracting practices Implicit uses of accounting information in corporate governance The implicit use of accounting information in corporate governance mechanisms probably represents the most important role of accounting information. In this context, the valuation and governance roles of accounting become intertwined. The terms on which investors are willing to part with their capital are a function of the informational efficiency and liquidity of the capital markets in which they will subsequently trade their claims. Thus, any capital markets research focussing on the role of accounting information in the

10 344 R.G. Sloan / Journal of Accounting and Economics 32 (2001) formation of security prices has potential governance implications. However, rather than focussing on the governance role of accounting through its role in facilitating the informational efficiency of stock prices, I focus on situations where accounting information appears to directly facilitate the operation of specific governance mechanisms. Empirical research suggests that accounting information be implicitly used in a variety of governance mechanisms. Following the structure laid out in Fig. 1, I organize this research into the two categories of legal protection and large investors. In the legal protection category, a large body of research has illustrated the role of accounting information in the enforcement of investors legal rights against management. Investors cannot bring lawsuits against managers simply because the managers did a bad job or because the stock price declined. A common avenue for litigation in the US is to allege a violation of Rule 10b-5 of the Securities Exchange Act of This rule requires investors to have relied upon a material misstatement or omission when purchasing or selling a security. Since the financial reporting system is the primary regulatory mechanism through which management communicates with investors, most investor lawsuits brought under Rule 10b-5 allege a material misstatement or omission in the financial statements. Research has demonstrated that accounting and disclosure problems are most frequently associated with stockholder litigation and that management act as if they take steps to manage their reporting strategy in order to mitigate the costs associated with this litigation (e.g., Kellogg, 1984; Francis et al., 1994; Skinner, 1994; Skinner, 1996). Accounting information also plays an important role in the enforcement of creditors rights in the event of default and/or bankruptcy. However, while this particular role of accounting information is of great practical significance, it has attracted almost no research (an exception is Lehavy, 1999). The second category of research where accounting information implicitly facilitates the operation of governance mechanisms is large investors. Large investors can affect management s actions through the board of directors, which has the authority to hire and fire top management. Academic research confirms that the board uses accounting earnings performance as an input into their firing decisions (Weisbach, 1988). However, in many cases, a large investor may not have a clear voting majority on the board, and may have to take more drastic action, such as a takeover or a proxy contest to wrest control of the board and discipline management. In this respect, preliminary research also shows that measures of accounting performance are related to takeovers (Palepu, 1986), proxy contests (DeAngelo, 1988), and institutional investor activism (Opler and Sokobin, 1998). Yet there are clearly opportunities for more detailed research in this area. In summary, accounting information provides an important input into the major corporate governance mechanisms. Accounting information is implicitly used both to indicate whether governance actions against management are

11 R.G. Sloan / Journal of Accounting and Economics 32 (2001) required and to help determine the payoffs to different stakeholders in the case of legal disputes and financial distress. Yet current research only provides a superficial analysis of accounting information in these respective roles. 5. Concluding comments Financial accounting is a key ingredient in the corporate governance process. A complex set of institutions and rules have evolved to facilitate the financial reporting process, and the information provided by this process is an important input to major governance mechanisms. Indeed, it is no surprise that the US financial reporting system is often cited as an important factor in the tremendous success of US capital markets. In this review, I have sought to highlight the many and varied links between financial accounting and corporate governance mechanisms. However, in doing this, I have also sought to highlight the limited contribution of accounting researchers in this area. Accounting researchers have over-invested in certain areas of governance research at the expense of other areas, and have failed to probe very deeply into the characteristics of financial accounting information that make it useful in specific governance mechanisms. The managerial compensation research reviewed by B&S provides a good illustration of my concerns in this respect. An enormous amount of accounting research has focussed on the topic of managerial compensation. This is despite the fact that a relatively insignificant proportion of top management incentives are tied to accounting-based performance measures. Moreover, this research has not moved much beyond viewing accounting earnings as a generic noisy signal of firm performance. In contrast, while detailed accounting information is used extensively in corporate lending agreements, there is relatively little research in this area. In summary, despite the undeniable importance of financial accounting in corporate governance, the current body of research is modest, and nonaccountants have made many of the most significant advances. As a result, there are tremendous opportunities for future accounting-based research in this area. These research opportunities call for us to exploit our comparative advantage as accountants in understanding the many and varied roles of accounting numbers in corporate governance mechanisms. Accounting journal editors can help to encourage accounting researcher to take advantage of these opportunities by resisting the temptation to serve as an overflow outlet for finance papers that have little to do with accounting. For their part, accounting researchers should move beyond thinking about accounting information as providing generic noisy signals of firm performance, and instead focus on identifying the unique structure and characteristics of accounting information that make it useful in specific governance mechanisms.

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