Financial accounting information, organizational ...

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Journal of Accounting and Economics 37 (2004) 167?201

Financial accounting information, organizational complexity and corporate

governance systems$

Robert Bushmana, Qi Chenb, Ellen Engelc,*, Abbie Smithc

a Kenan-Flagler Business School, University of North Carolina-Chapel Hill, Chapel Hill, NC 27599-3490, USA

b Fuqua School of Business, Duke University, Durham, NC 27708, USA c Graduate School of Business, University of Chicago, Chicago, IL 60637, USA Received 10 August 2000; received in revised form 18 July 2003; accepted 28 September 2003

Abstract

We posit that limited transparency of firms' operations to outside investors increases demands on governance systems to alleviate moral hazard problems. We investigate how ownership concentration, directors' and executive's incentives, and board structure vary with: (1) earnings timeliness, and (2) organizational complexity measured as geographic and/or product line diversification. We find that ownership concentration, directors' and executives' equity-based incentives, and outside directors' reputations vary inversely with earnings timeliness, and that ownership concentration, and directors' equity-based incentives increase

$Formerly titled ``The Sensitivity of Corporate Governance Systems to The Timeliness of Accounting Earnings.'' We thank an anonymous referee and Jerry Zimmerman (the editor) for challenging us to sharpen the theoretical foundations of the paper. We also appreciate comments from Ray Ball, Sudipta Basu, Bill Beaver, Judy Chevalier, Thomas Hemmer, Bob Kaplan, Randy Kroszner, Darius Palia, Canice Prendergast, Cathy Schrand, Ross Watts and seminar participants at CUNY-Baruch, UC-Berkeley, University of Chicago, Harvard Business School, University of Illinois-Chicago, London Business School, University of Minnesota, University of Rochester, University of Texas- Austin, the 1999 Big Ten Faculty Consortium, 1999 Stanford Summer Camp, 1999 Burton Summer Workshop at Columbia, 2000 European Finance Association Annual Meetings and the 2000 AAA Annual Meetings. We thank Hewitt Associates for providing ProxyBase data, and the Graduate School of Business at the University of Chicago, Fuqua School of Business at Duke University, and Kenan-Flagler Business School, University of North Carolina-Chapel Hill for financial support. Finally, we appreciate the research assistance of Xia Chen, Darin Clay, Kathleen Fitzgerald and Rebecca Glenn.

*Corresponding author. Tel.: +1-773-834-0966; fax: +1-773-834-3976. E-mail address: ellen.engel@gsb.uchicago.edu (E. Engel).

0165-4101/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/j.jacceco.2003.09.005

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with firm complexity. However, board size and the percentage of inside directors do not vary significantly with earnings timeliness or firm complexity. r 2003 Elsevier B.V. All rights reserved.

JEL classification: G30; M41; J33

Keywords: Corporate governance; Corporate transparency; Earnings timeliness; Organizational complexity; Diversification

1. Introduction

In the U.S. and in other economies with strong legal protection of outside shareholders' rights, transparency of a firm's operations and activities to outside investors disciplines managers to act in shareholders' interests.1 We posit that limited corporate transparency increases demands on corporate governance systems to alleviate moral hazard problems resulting from a more severe information gap between managers and shareholders, ceteris paribus. We consider two factors that limit corporate transparency to varying degrees across large public U.S. companies: (1) relatively uninformative financial accounting systems characterized by the inability of firms' GAAP earnings to explain changes in shareholder value in a timely fashion (low earnings timeliness) and, (2) firm complexity due to extensive geographic and/or line of business diversification.

We develop and test two sets of hypotheses concerning how corporate governance systems vary with the diversification of firms and the timeliness of their earnings. Our first set of hypotheses predicts that corporate governance systems of diversified firms and firms with relatively low earnings timeliness are characterized by a relatively strong link between stock price performance and the wealth of executives and directors, and by high ownership concentration, to provide incentives to increase shareholder value through monitoring and other costly activities. Our second set of hypotheses concerns how the composition of the board of directors varies with the diversification of firms and the timeliness of their earnings. We predict that, in order to enable highly effective board monitoring, the boards of diversified firms and firms with low earnings timeliness have a relatively high percentage of outside directors with (1) a strong reputation as an outside director, and (2) expertise in the firm's main industry. We also explore how board size and the percentage of directors who are insiders vary with diversification and the timeliness of earnings, but make no directional predictions.

Our hypotheses build on prior research concerning the determinants of corporate governance structures. In a seminal paper, Demsetz and Lehn (1985) conjecture that the scope for moral hazard is greater for managers of firms with more volatile operating environments. They document that ownership concentration is increasing

1 We use the term corporate transparency to refer to the clarity of the activities and performance of the firm to outsiders.

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in stock return volatility, consistent with the idea that benefits of ownership concentration increase in response to the difficulty of monitoring managers in volatile environments. Himmelberg et al. (1999) extend Demsetz and Lehn (1985) by considering additional firm attributes that proxy for the scope of managerial discretion, such as research and development, advertising, and intangible asset intensities. In related research, Smith and Watts (1992) document that firms' growth opportunities, as measured by book-to-market ratios, are associated with benefits to imposing risk on managers via bonus plans and stock option grants.

Consistent with this literature, we adopt the perspective that observed governance structures represent optimal contracting arrangements endogenously determined by firms' contracting environments.2 We extend this literature by expanding the characterization of the scope for moral hazard to explicitly consider monitoring technology and organizational complexity. This extension flows naturally from Himmelberg et al. (1999). Using panel data, they document that a significant fraction of the cross-sectional variation in managerial equity ownership is explained by unobserved firm heterogeneity not captured by their proxies for the scope of moral hazard. We posit monitoring technology and organizational complexity as two important components of the scope for moral hazard that can be extracted from this ``unobserved'' firm heterogeneity and studied independently, while controlling for components considered in previous research.

With respect to monitoring technology, we conjecture that inherent limitations of firms' information systems in generating information relevant for monitoring managerial behavior influence governance structure formation by affecting the costbenefit trade-off underlying governance mechanism configurations. Financial accounting systems are a logical starting point for investigating properties of information systems important for addressing moral hazard problems. Audited financial statements prepared under Generally Accepted Accounting Principles (GAAP) produce extensive, credible, low cost information that forms the foundation of the firm-specific information set available for addressing agency problems. In monitoring top managers, boards and outside investors cannot simply rely on stock price changes to provide necessary information about the source of changes to firm value. For example, agency models generally imply that managers should be held accountable for controllable events and not uncontrollable events, while stock returns aggregate the implications of all events. The accounting system facilitates boards' efforts to separate controllable from uncontrollable events. As an illustration, managers often submit budgets to the board and then make periodic reports explaining variances from budget, presumably aiding boards in separating controllable from uncontrollable events (e.g., Zimmerman, 2002, Chapter 6).

2 As noted by Hermalin and Weisbach (2002), governance research struggles with the issue of whether to interpret results as deriving from an equilibrium or out-of-equilibrium phenomenon. While some papers directly address the equilibrium issue (e.g., Himmelberg et al., 1999; Core et al., 1999), that is not our intention here. Thus, for example, we do not ask whether an optimal board should have 10% insider directors or 50% (see, e.g., Byrd and Hickman, 1992; Brickley et al., 1994). Instead, we posit optimality, and predict that in equilibrium relatively opaque firms will utilize relatively more costly monitoring and specialized information gathering.

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We proxy for the intrinsic governance usefulness of accounting information with earnings timeliness, which, paralleling Basu (1997) and Ball et al. (2000), we define as the extent to which current GAAP earnings incorporate current economic income or value-relevant information. While accounting reports used internally to monitor managers may utilize methods that differ from GAAP, our premise is that earnings timeliness proxies for inherent limitations of any transactions-based accounting system to capture relevant information in a timely fashion, and that the usefulness of these internal financial reporting systems to the board depends on earnings timeliness. We predict that where the timeliness of financial accounting information is relatively low, firms will substitute towards relatively more costly monitoring and specific information gathering activities to at least partially compensate for low timeliness of the accounting information.3

While we posit earnings timeliness as an inherent property of firms' information systems that impacts governance choices, it is important to ask whether timeliness really is a distinct characteristic, rather than simply a byproduct determined by the set of fundamental firm characteristics examined in previous research as governance determinants. We examine this directly and conclude that timeliness is a distinct characteristic. We find that a small portion of the cross-sectional variation in our timeliness metric is explained by firm characteristics found to be linked with governance structures in prior work including firms' growth opportunities, return volatility, size, the number of years a firm is public, CEO tenure, industry and geographic diversification, and past performance.

We also investigate the relation between organizational complexity and governance structures. While the construct ``organizational complexity'' could encompass a wide range of organizational design features (see, e.g., Brickley et al., 1997, Chapters 8?10), we operationalize it with two measures of diversification. We utilize segment revenue information to compute Hirfindahl-Hirschman indices measuring with-in firm industry and geographic concentration. Our premise is that firms competing in multiple industries and/or multiple geographic regions face more complex operational and informational environments, and therefore, benefit more from costly monitoring activities and specific information than firms with tighter industry and geographic focus.

On the basis of a cross-section of 784 firms in the Fortune 1000, we find substantial support for the predicted negative relation between the ``strength'' of corporate governance systems and the timeliness of earnings, after controlling for other factors, including growth opportunities, return volatility, firm size, the number of years a firm is public, CEO tenure, whether the CEO or Chairman of the Board is the founder, past performance, and membership in the banking or utility industries. As predicted, we find that concentrated shareholdings, and the stock price-wealth link

3 This prediction parallels results demonstrating that traders increase costly, private information gathering and processing activities as the precision of accounting disclosures shrinks (e.g., Verrecchia, 1982). It is also consistent with evidence that incentive plans rely relatively more on non-accounting performance measures where financial accounting information is more limited (Bushman et al., 1996; Ittner et al., 1997; Hayes and Schaefer, 2000), and that ownership concentration across countries varies inversely with the quality of a country's accounting disclosures (La Porta et al., 1998).

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of inside directors and the top five executives vary inversely with the timeliness of earnings. We also document the predicted negative relation between the reputation of outside directors and the timeliness of earnings. However, we fail to document a significant negative relation between the stock price-wealth link of outside directors and the timeliness of earnings unless we exclude the dummy variables for banks and utilities, and fail to find that the percentage of outside directors with expertise in the firm's main industry, the percentage of directors who are insiders, or board size vary significantly with the timeliness of earnings.

Our results concerning the predicted positive relation between the ``strength'' of corporate governance systems and firm diversification are mixed. We document that, as predicted, the stock price-wealth link of inside and outside directors increases with line of business diversification, and the stock-price wealth link of specific outside shareholders (i.e., ownership concentration) increases with geographic diversification. The other predicted relations between diversification and the stock price wealth links and the composition of the board are not supported.

The remainder of this paper is organized as follows. Section 2 further discusses the role of earnings timeliness and organizational complexity in influencing governance mechanism choices. Section 3 describes our governance variables and develops hypotheses concerning their sensitivity to the timeliness of accounting numbers and organizational complexity. Section 4 describes control variables, sample, and data. Section 5 describes our empirical design, results and sensitivity analyses. Issues relating to the possibility of reverse causality in our model are discussed in Sections 6 and 7, presents a summary and discussion of implications of the paper.

2. Measuring governance value of accounting numbers and organizational complexity

Section 2.1 discusses the timeliness of earnings as a measure of accounting's governance value and describes its construction. Section 2.2 further develops our approach to measuring organizational complexity.

2.1. Earnings timeliness as a measure of the governance usefulness of accounting information

We conjecture that the extent to which current accounting numbers capture the information set underlying current changes in value (i.e., earnings timeliness, as defined in our study) is a fundamental determinant of their governance value to directors and investors. Directors monitor managerial and firm performance, ratify managerial decisions, provide managerial incentives, and aid in strategic planning activities (e.g., strategy development, succession planning). To carry out these duties, directors demand information to help them understand both how and why equity values are changing. For example, the detailed accounting system facilitates boards' efforts to separate controllable from uncontrollable events to aid in the managerial evaluation process. Outside investors and financial analysts who monitor firm and managerial performance also demand such information. Stock prices provide

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information about overall changes in equity value. Accounting systems, by collecting and summarizing the financial effects of firms' investment, operating, and financing activities, convey information about the underlying sources of changes in equity value.

Earnings timeliness measures the extent to which current earnings capture the information set underlying contemporaneous changes in stock price. However, we acknowledge that the nature of this measure raises conceptual issues about our hypothesis that earnings timeliness is a determinant of governance choices. In particular, if stock prices efficiently reflect all information available to market participants, is not the information also available to residual claimants and the board? And if so, why would firms need costly monitoring mechanisms or specific knowledge gathering to substitute for low earnings timeliness? Why not just use stock price directly, or simply extract the information included in stock price? We draw on economic theory to address these questions in support of our hypotheses.

The detailed information set reflected in stock price is not freely available to the board and residual claimants. Grossman and Stiglitz (1980) demonstrate that fully revealing stock prices are incompatible with costly information collection activities of investors. In an equilibrium where private information collection and processing activities are costly, prices cannot be fully revealing. This implies that boards and others cannot extract the underlying information from price.

However, one could argue that even if prices are not invertible back to the market's underlying information set, managers and directors have direct access to all this information. Is this the case? Research documents a significant relation between changes in stock price and subsequent investment decisions (e.g., Morck et al., 1990; Baker et al., 2001). One potential explanation for this is that stock price communicates new information to a firm's managers that is then incorporated into investment decision (see Morck et al., 1990 for a discussion of competing hypotheses).4 But, even if a firm's managers know the entire information set, this does not imply that the board of directors knows it, and so board structure may respond to low earnings timeliness as the board seeks to close the information gap between them and top management.5 In addition, even if the board knows the entire information set, it is not necessarily the case that residual claimholders know it, and so costly monitoring activities may respond to low earnings timeliness as residual claimholders attempt to compensate for the information gap between them and both the firm's executives and board of directors.

Finally, stock price formation is a complex process and the aggregated nature of information impounded in price potentially limits its governance usefulness (e.g., Paul, 1992). As a result, utilizing stock price as a substitute information source for

4 A number of recent theory papers formally derive equilibria supporting a strategy directing role of stock price (see Dow and Gorton, 1997; Subrahmanyam and Titman, 1999; Dye and Sridhar, 2001).

5 Evidence in Frankel and Li (2001) suggests that earnings timeliness captures the extent of information asymmetry between managers and the market. Specifically, they find that the ability of insider trading activity to predict future stock returns--their measure of information asymmetry--is negatively related to the R2 from a price on earnings and book value regression, after controlling for analyst following and the extent of voluntary disclosure.

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poor accounting numbers is likely to involve substantial error and to require extensive sophistication, knowledge, and effort on the part of board members. Thus, consistent with our hypotheses, costly governance mechanisms characterized by strong equity-based incentives for outside shareholders, directors, and executives, as well as a relatively knowledgeable, capable, and highly motivated board are likely demanded when earnings timeliness is low.

Our timeliness metric aggregates three firm-specific metrics. The first two metrics are based on firm-specific regressions of annual earnings on contemporaneous stock returns over a period of at least 8 years beginning in 1985 and ending in 1994 as follows:

EARNt ? a0 ? a1NEGt ? b1RETt ? b2NEGt ? RETt ? et;

?1?

EARNt is ``core'' earnings of a given firm in year t, defined as earnings before extraordinary items, discontinued operations, and special items, deflated by the beginning of year market value of equity.6 RETt is the 15-month stock return ending 3 months after the end of fiscal year t: NEGt is a dummy variable equal to 1 if RETt is negative and 0 otherwise.7 This specification allows b1 to capture the speed with which good news in a firm's stock returns is reflected in earnings, while b1 ? b2 captures the speed with which bad news is reflected in earnings.

Our first metric is b1; which measures the relative speed with which firms' earnings reflects good news.8 We expect low values of b1 for firms with severe delays in their accounting recognition of value-enhancing activities and outcomes. Our second metric of the timeliness of earnings is R2 from Eq. (1), which, as observed by Ball

et al. (2000), is decreasing in the lag with which earnings capture the news reflected in

stock returns. Our third metric is R2 from Eq. (2):

RETt ? a0 ? b1EARNt ? b2DEARNt ? et;

?2?

where RET and EARN are defined as before, and DEARNt is the change in core earnings from year t ? 1 to year t; deflated by the market value of equity at the beginning of year t: As with Eq. (1), the estimation is conducted over a period of at least 8 years beginning in 1985 and ending in 1994. Eq. (2) allows stock prices to vary with both levels and changes in earnings. R2 from Eq. (2) measures the ``percentage'' of all value relevant information captured by the level and change in annual

6 Managers are likely to have high levels of discretion in the timing of recognizing special items relative to their discretion in the timing of core earnings. To the extent that managers' ability and incentives to manipulate bottom line earnings vary with corporate governance structures, the use of core earnings is less likely to lead to a violation of our assumption that the timeliness of earnings is exogenous under GAAP. Section 6 further discusses the potential impact of earnings management activities on our earnings timeliness measures.

7 Allowing the intercept and slope to vary with the sign of stock returns is patterned after Basu (1997) and Ball et al. (2000). For sample firms that do not have any negative stock returns during the estimation period for model (1) (i.e., NEG=0 for all observations), we drop NEG and NEG ? RET from the specification of Eq. (1).

8 Although it also might be interesting to consider b2 as a metric, it is not practical as a large number of sample firms have no negative annual stock returns during the estimation period.

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earnings, and is expected to decrease in the lag with which earnings captures changes in equity value.

Throughout the paper, we refer to the slope estimate from Eq. (1) (i.e., b1) as REV SLOPE; R2 from Eq. (1) as REV R2; and R2 from Eq. (2) as ERC R2: We develop a composite index for these three individual metrics (REV SLOPE; REV R2; and ERC R2) as our primary metric of the timeliness of earnings.9 We calculate the percentile rank for each firm in the sample for each of the three metrics. The composite timeliness metric for a given firm, EARN TIMELY ; is computed as the average of all three percentile rank values. Due to data limitations, we are unable to estimate Eq. (2) for 39 firms.10 To maximize sample size, in these case we use the percentile rank for each firm in the sample for ERC R2 only as the timeliness metric. Our results are not sensitive to this decision.11

We close this section by addressing a critical interpretative issue with our timeliness metric. As discussed above, our timeliness metric embeds two R2 measures, with higher R2 interpreted as more timely accounting information. The issue is how does one interpret an R2 of one? Does this imply that, rather than being more useful, earnings information is actually superfluous? The answer is no. While stock price changes provide overall information about changes in firm value, information from the accounting system aids directors and investors in understanding the source of changes in firm value. For example, stock price changes commingle events under the control of managers with events that are not, while agency theory counsels that managers should be held accountable for controllable events and not uncontrollable events. The accounting system facilitates boards' efforts to separate controllable from uncontrollable events through analysis of budget variances and other techniques. Thus, even if disaggregated accounting information explained 100% of the variance in returns, accounting would not be superfluous to governance as stock price is not a sufficient statistic for the detailed information necessary to separate controllable from uncontrollable events.

2.2. Measures of organizational complexity

We focus on two aspects of organizational complexity: industry and geographic concentration. Existing research rarely incorporates industry and geographic

9 We do not use the slope from Eq. (2) because we expect different timing problems to have opposing effects on the slope from Eq. (2). For example, we expect the ``smoothing'' of the recognition of holding gains on assets in place over the lives of the assets to increase the slope in model 2 (analogous to positive effects of the persistence in earnings on ERCs documented in the prior literature). In contrast, we expect distortions in earnings resulting from mismatching of revenues and expenses to decrease the slope in Eq. (2).

10 We require the estimation for both Eqs. (1) and (2) to have degree of freedom of at least 6, which requires at least 9 years of observations for estimating Eq. (1) and 8 years for Eq. (2).

11 The use of a composite involving percentile ranks can mitigate potential measurement error in the timeliness metrics (Greene, 2000). Using the ranks of the timeliness metrics mitigates measurement error in the metrics only if the rank is determined by ``timeliness'' rather than the measurement error in metrics. In sensitivity analysis we also conduct our estimations using the first principal component of the earnings timeliness metrics. These analyses are discussed in Section 5.2.

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