The Expanding Role of the CFO: Do Outside Directorships ...

The Expanding Role of the CFO: Do Outside Directorships Facilitate Strategic Learning?

By

Sarfraz Khan Department of Accounting University of Louisiana, Lafayette

skhan@louisiana.edu

Elaine Mauldin Trulaske College of Business

University of Missouri Columbia MO 65211

573-884-0933 mauldin@missouri.edu

February 2018

The manuscript is partially based on the first author's dissertation at the University of Texas at San Antonio. We thank Sharad Asthana, James Groff, Stewart Miller, Emeka Nwaeze and John Wald for valuable suggestions. We also thank Sung-Jin Park, Juan Manuel Sanchez, Sarah Shonka and workshop participants at University of Arkansas, Florida Atlantic University, and University of Texas at San Antonio for helpful comments on ealier versions of the manuscript.

The Expanding Role of the CFO: Do Outside Directorships Facilitate Strategic Learning?

ABSTRACT We study the association between chief financial officer (CFO) outside board directorships and their home firm strategic financing and investment policies. Using a sample of firms from 2003-2014, we find only about nine percent of CFOs sit on outside boards. We find evidence of strategic learning because CFO outside directorships are associated with greater home firm financial flexibility, as reflected in faster adjustment toward target debt ratios, fewer underinvestment problems, and lower sensitivity between cash holdings and cash flows. We also distinguish CFO ouside director from CEO outside director effects and find that CFOs more likely transfer strategic learning to their home firm. Our findings support the argument that outside directorships provide CFOs an opportunity to network with and learn from other executives and directors, enabling these CFOs to improve strategic financing and investing practices in their home firm. Our findings suggest that CFO outside directorship is not merely an outside time commitment that detracts from the CFO's primary responsibilities for their home firm.

Keywords: Chief financial officer; Board of directors; Financial policies; Knowledge transfer

Data Availability: Data are available from public sources.

1. Introduction We examine the association between Chief Financial Officer (CFO) service on an outside board and their home firm's strategic financing and investing policies. The Chief Executive Officer (CEO) and the board of directors increasingly expect the CFO to excel beyond budgeting and financial reporting by focusing on strategy and optimizing investments (KPMG 2017). Yet, it is far from clear how CFOs develop appropriate skills for these expanded roles. We suggest that outside board service provides one potential channel to alter the skill-set and perspectives of the CFO, benefiting home firm policies tied to strategic finance and investments. However, prior research finds outside directorships increase executives' financial, status, and other individual perquisites and suggests that executives focus on personal benefits from outside directorships rather than on transferring knowledge to the home firm (Yermack 2004, Geletkanycz and Boyd 2011, Boivie, Graffin, Oliver, and Withers 2016). Thus, the relationship between CFO outside directorhips and home firm policies is an empirical issue.

We use CEOs as a baseline and compare CFO to CEO outside directorships. Theory suggests that individual directors carry information across firms, yet we know little about how functional experience affects such knowledge transfer (Shropshire 2010). Prior research finds CFOs respond differently to risktaking incentives than CEOs suggesting that functional experience could also differentially affect knowledge transfer from outside directorships (Chava and Purnanandam 2010). CFOs may more likely transfer knowledge because, relative to CEOs, knowledge transfer could facilitate future promotion opportunities and their minority representation on an outside board (due to relative scarcity of active CFO board members) increases transfer of knowledge (Shropshire 2010). On the other hand, CEOs may more likely transfer knowledge because, relative to the CFO, their depth of knowledge provides a more nuanced understanding of information that facilitates knowledge transfer (Shropshire 2010). Thus, the relationship between home firm policies and CFO, compared to CEO, outside directorships is also an empirical question.

To test our hypotheses, we use a panel of US firms from 2003-2014 and three different models commonly used in finance related to strategy and optimizing investments, supplemented with our CFO

and CEO outside director variables of interest as well as other home firm board characteristics from prior research. In our main analyses, we find that CFO, but not CEO, outside directorships are associated with strategic capital structure decisions as evidenced by a greater adjustment speed toward home firms' target market debt ratio (Flannery and Rangan 2006). Second, we find that home firms with CFO outside directorships exhibit fewer underinvestment problems, typically attributed to knowledge transfer while home firms with CEO outside directorships exhibit more overinvestment problems, typically attributed to agency problems (Fazzari et al. 1988). Finally, we find that firms with CFO, but not CEO, outside directorships exhibit less sensitivity of cash holdings to cash flow from earnings, consistent with better management of financial constraints (Almeida et al. 2004). Together, our evidence is consistent with greater CFO outside director knowledge transfer than that from CEO outside directorships. To support our primary findings, we also explore cross-sectional differences in CFO outside directorships. We find more pronounced learning effects when the CFO outside directorship is in the same industry as the home firm or when the CFO has longer tenure on the outside board. These cross-sectional results are consistent with greater learning from related industry boards and from more years of service on an outside board.

Since outside boards likely ask CFOs with better financial policies to join their board due to reputational benefits, our analyses likely suffer from endogeneity. Though our comparison of CFOs to CEOs somewhat mitigates these concerns because if the results are driven by unobserved industry, business, or selection concerns, there should be no difference between CEO and CFO outside board service. Nevertheless, we perform a number of robustness tests to further address endogeneity. First, we use a pre-post, change, analyses comparing effects when the CFO (or CEO) is or is not an outside director. One advantage of pre-post analyses is that the events of CFO (CEO) directorships are staggered over time, thereby differentiating the directorship events from other economic factors. As discussed in greater detail later in the paper, results for all three dependent variables are generally consistent with the primary analyses.

Next, we use propensity score matching (PSM) developed separately for each dependent variable (and for CFO versus CEO). Our results for CFO outside directorship are consistent with the primary

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analyses. However, the PSM results show some evidence of CEO transfer of knowledge to their home firm for adjustment speed to target debt ratio only. Finally, for the CFO outside director analyses of investment efficiency and cash flow sensitivity, we use an instrumental variable (IV) approach.1 For the instrumental variable, we use the annual demand for directors with accounting expertise in the four-digit SIC code since higher demand for directors with accounting expertise should increase the likelihood of a CFO obtaining an outside directorship, but external board hiring practices are unlikely to influence the home firm financial policies. We find results consistent with our main analyses for both CFO and CEO outside directorships. Overall, we conclude our results are robust to tests addressing endogeneity.

We provide several contributions to the literature. First, our results consistently find a positive relationship between CFO outside directorships and better strategic financing and investing decisions at the home firm. Thus, our results are consistent with knowledge transfer from CFO outside directorships providing a channel to alter the skill sets of the CFO. The expanding role of CFOs over the last decade expose current-generation CFOs to a more challenging environment, including the need to utilize scarce resources more efficiently (EY 2012; Dobbs et al. 2009). Prior research finds some CFOs are associated with more conservative financial policies, such as higher underinvestment (Hoitash et al. 2016). Our findings suggest that wider exposure to a variety of business practices through outside board experience may offset this conservative tendency. Understanding the sources of knowledge creation around strategic financing and investment policies helps practice identify outside directorships as a possible untapped source of strategic-oriented knowledge for CFOs.

Further, organizations increasingly seek CFOs to serve on the board as an outside director, most commonly on the audit committee (Spencer Stuart 2014, EY 2012). Yet, acting CFOs rarely sit on outside boards, often because of concerns about additional time commitments; almost 60 percent of large firms restrict their CFOs from serving on outside boards (Spencer Stuart 2014, Murphy and Chasan 2013). Prior research finds CFO outside board service does not diminish home firm financial reporting quality even

1 We do not use an additional IV regression for MDR since all MDR regressions are IV.

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