Transparency, Financial Accounting Information, and Corporate Governance

Robert M. Bushman and Abbie J. Smith
Transparency, Financial
Accounting Information,
and Corporate Governance
1. Introduction
sophisticated financial disclosure regime is not cheap.
Countries with highly developed securities markets devote
ibrant public securities markets rely on complex systems
substantial resources to producing and regulating the use of
of supporting institutions that promote the governance
extensive accounting and disclosure rules that publicly traded
V
of publicly traded companies. Corporate governance structures
firms must follow. Resources expended are not only financial,
serve: 1) to ensure that minority shareholders receive reliable
but also include opportunity costs associated with deployment
information about the value of firms and that a company’s
of highly educated human capital, including accountants,
managers and large shareholders do not cheat them out of the
lawyers, academicians, and politicians.
value of their investments, and 2) to motivate managers to
In the United States, the SEC, under the oversight of the U.S.
maximize firm value instead of pursuing personal objectives.1
Congress, is responsible for maintaining and regulating the
Institutions promoting the governance of firms include
required accounting and disclosure rules that firms must
reputational intermediaries such as investment banks and
follow. These rules are produced both by the SEC itself and
audit firms, securities laws and regulators such as the Securities
through SEC oversight of private standards-setting bodies such
and Exchange Commission (SEC) in the United States, and
as the Financial Accounting Standards Board and the Emerging
disclosure regimes that produce credible firm-specific
Issues Task Force, which in turn solicit input from business
information about publicly traded firms. In this paper, we
leaders, academic researchers, and regulators around the
discuss economics-based research focused primarily on the
world. In addition to the accounting standards-setting
governance role of publicly reported financial accounting
investments undertaken by many individual countries and
information.
securities exchanges, there is currently a major, well-funded
Financial accounting information is the product of
effort in progress, under the auspices of the International
corporate accounting and external reporting systems that
Accounting Standards Board (IASB), to produce a single set of
measure and routinely disclose audited, quantitative data
accounting standards that will ultimately be acceptable to all
concerning the financial position and performance of publicly
countries as the basis for cross-border financing transactions.2
held firms. Audited balance sheets, income statements, and
The premise behind governance research in accounting is
cash-flow statements, along with supporting disclosures, form
that a significant portion of the return on investment in
the foundation of the firm-specific information set available to
accounting regimes derives from enhanced governance of
investors and regulators. Developing and maintaining a
firms, which in turn facilitates the operation of securities
Robert M. Bushman is a professor of accounting at the University of North
The authors thank Erica Groshen, James Kahn, and Hamid Mehran for useful
Carolina’s Kenan-Flagler Business School; Abbie J. Smith is the Marvin Bower
comments. Robert Bushman thanks the Kenan-Flagler Business School for
Fellow at Harvard Business School and the Boris and Irene Stern Professor of
financial support; Abbie Smith thanks Harvard Business School. The views
Accounting at the University of Chicago’s Graduate School of Business.
expressed are those of the authors and do not necessarily reflect the position
<bushmanr@bschool.unc.edu>
of the Federal Reserve Bank of New York or the Federal Reserve System.
<asmith@hbs.edu>
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markets and the efficient flow of scarce human and financial
theory in supplying testable predictions of relations between
capital to promising investment opportunities. Designing a
performance measures and optimal compensation contracts.
system that provides governance value involves difficult trade-
Researchers also have examined the role of accounting
offs between the reliability and relevance of reported
information in the operation of other governance mechanisms.
accounting information. While the judgments and
Examples include takeovers, proxy contests, board of director
expectations of firms’ managers are an inextricable part of any
composition, shareholder litigation, and debt contracts, among
serious financial reporting model, the governance value of
others. We distill major research findings and suggest ideas for
financial accounting information derives in large part from an
future research.
emphasis on the reporting of objective, verifiable outcomes of
In Section 4, we discuss a developing literature using cross-
firms. An emphasis on verifiable outcomes produces a rich set
country research designs to examine links between financial
of variables that can support a wide range of enforceable
sector development and economic outcomes. Within-country
contractual arrangements and that form a basis for outsiders to
research holds most institutional features of a country fixed,
monitor and discipline the actions and statements of insiders.3
precluding investigation of interactions across institutions.
A fundamental objective of governance research in
By exploiting cross-country differences in political structures,
accounting is to investigate the properties of accounting
legal regimes, property rights protections, investors’ rights,
systems and the surrounding institutional environment
regulatory frameworks, and other institutional characteristics,
important to the effective governance of firms. Bushman and
researchers can empirically explore connections between
Smith (2001) provide an extensive survey and discussion of
institutional configurations, including disclosure regimes, and
governance research in accounting and provide ideas for future
economic outcomes. At the heart of theories connecting a well-
research. In this paper, we synthesize major research findings
developed financial sector with enhanced resource allocation
in the accounting governance literature and extend Bushman
and growth is the role of the financial sector in reducing
and Smith to consider corporate transparency more generally,
information costs and transaction costs.4 Despite the central
which includes financial accounting information as one
role of information costs in these theories, until recently little
element of a complex information infrastructure.
attention has been given by empirical researchers to the role of
We begin our discussion of governance research in Section 2
the information environment per se in explaining cross-
with a framework for understanding the operation of
country differences in economic growth and efficiency.
accounting information in an economy. This framework
Preliminary results from this emerging literature provide
isolates three channels through which financial accounting
encouraging new evidence of a positive relation between the
information can affect the investments, productivity, and
quality of financial accounting information and economic
value-added of firms. These channels involve the use of
performance. This evidence suggests that future research into
financial accounting information: 1) to identify promising
the governance role of financial accounting information has
investment opportunities, 2) to discipline managers to direct
the potential to detect first-order economic effects.
resources toward projects identified as good and away from
Finally, in Section 5, we present a conceptual framework for
projects that primarily benefit managers rather than owners of
characterizing and measuring corporate transparency at the
capital, and to prevent stealing, and 3) to reduce information
country level introduced in Bushman, Piotroski, and Smith
asymmetries among investors. An important avenue for future
(2001), hereafter BPS. Corporate transparency is defined as the
research is the development of research designs to isolate the
widespread availability of relevant, reliable information about
impact of accounting information through the individual
the periodic performance, financial position, investment
channels and facilitate direct examination of the differential
opportunities, governance, value, and risk of publicly traded
properties of the accounting system and institutional
firms. BPS develop a measurement scheme for corporate
infrastructure important for each channel.
transparency that is more comprehensive than the index of
In Section 3, we discuss the direct use of financial
domestic corporate disclosure intensity used in prior cross-
accounting information in specific corporate governance
country studies. Corporate transparency measures fall into
mechanisms. The largest body of governance research in
three categories: 1) measures of the quality of corporate
accounting examines the use of financial accounting
reporting, including the intensity, measurement principles,
information in the incentive contracts of top executives of
timeliness, and credibility (that is, audit quality) of disclosures
publicly traded firms in the United States. This emphasis
by firms listed domestically, 2) measures of the intensity of
derives from the ready availability of top executive
private information acquisition, including analyst following,
compensation data in the United States as a result of existing
and the prevalence of pooled investment schemes and of
disclosure requirements, and from the success of contracting
insider trading activities, and 3) measures of the quality of
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information dissemination, including the penetration and
other firms. Financial accounting systems also support the
private versus state ownership of the media. We describe the
informational role played by stock price. As argued by
BPS framework to stimulate further thought on the
Black (2000) and Ball (2001), a strong financial accounting
measurement of corporate transparency and to illustrate
regime focused on credibility and accountability is a
promising directions for future research into the economic
prerequisite to the very existence of vibrant securities markets.
effects of corporate transparency, and into the economics of
Efficient stock markets in which stock prices reflect all public
information more generally.
information and aggregate the private information of
individual investors presumably communicate that aggregate
information to managers and current and potential investors.
Recent papers by Dow and Gorton (1997) and Dye and Sridhar
(2001) explicitly model a strategy-directing role for stock
2. Channels through Which
prices. In these models, stock price impounds private,
Financial Accounting Information
decision-relevant information not already known by managers,
Affects Economic Performance
managers’ investment decisions respond to this new
information in price, and the market correctly anticipates
A corporation can be viewed as a nexus of contracts designed
managers’ decision strategies in setting price.
to minimize contracting costs (Coase 1937). Parties
The second channel through which we expect financial
contracting with the firm desire information both about the
accounting information to enhance economic performance is
firm’s ability to satisfy the terms of contracts and the firm’s
its governance role. The identification of investment
ultimate compliance with its contractual obligations. Financial
accounting information supplies a key quantitative
representation of individual corporations that supports a wide
range of contractual relationships. Financial accounting
Three Channels through Which Financial Accounting
information also enhances the information environment more
Information Affects Economic Performance
generally by disciplining the unaudited disclosures of managers
and supplying input into the information processing activities
of outsiders.5 The quality of financial disclosure can impact
Economic performance
firms’ cash flows directly, in addition to influencing the cost of
capital at which the cash flows are discounted. We posit three
channels through which financial accounting information
Reduced cost of
1A
improves economic performance, as illustrated in the exhibit.6
2A
external financing
First, financial accounting information of firms and their
competitors aid managers and investors in identifying and
evaluating investment opportunities. An absence of reliable
1B
2B
3
and accessible information in an economy impedes the flow of
human and financial capital toward sectors that are expected to
Channel 1
Channel 2
Channel 3
have high returns and away from sectors with poor prospects.
Better identification
Discipline on
Reduction in
Even without agency conflicts between managers and
of good versus bad
project selection and
information
projects by managers
expropriation by
asymmetries
investors, quality financial accounting data enhances efficiency
and investors
managers
among investors
(project
(governance role
by enabling managers and investors to identify value creation
identification)
of financial
accounting
opportunities with less error. This leads directly to more
information)
accurate allocation of capital to highest valued uses, as
indicated by arrow 1A in the exhibit. Lower estimation risk can
1
2
3
also reduce the cost of capital, further contributing to
Financial accounting information
economic performance, as indicated by arrow 1B.7
Financial accounting systems clearly supply direct
information about investment opportunities. For example,
Unaudited disclosures
Stock price
Information collection
by firms
by private investors
managers or potential entrants can identify promising new
and intermediaries
investment opportunities, acquisition candidates, or strategic
Information environment
innovations on the basis of the profit margins reported by
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opportunities is necessary, but not sufficient to ensure efficient
A major component of liquidity is adverse selection costs,
allocation of resources. Given information asymmetry and
which are reflected in the bid-ask spread and market impact
potentially self-interested behavior by managers, agency
costs. Firms’ precommitment to the timely disclosure of high-
theories argue that pressures from external investors, as well as
quality financial accounting information reduces investors’
formal contracting arrangements, are needed to encourage
risk of loss from trading with more informed investors, thereby
managers to pursue value-maximizing investment policies (for
attracting more funds into the capital markets, lowering
example, Jensen [1986]). Objective, verifiable accounting
investors’ liquidity risk (see Diamond and Verrecchia [1991],
information facilitates shareholder monitoring and the
Botosan [2000], Brennan and Tamarowski [2000], and Leuz
effective exercise of shareholder rights under existing securities
and Verrecchia [2000]). Capital markets with low liquidity risk
laws; enables directors to enhance shareholder value by
for individual investors can facilitate high-return, long-term
advising, ratifying, and policing managerial decisions and
(illiquid) corporate investments, including long-term
activities; and supplies a rich array of contractible variables for
investments in high-return technologies, without requiring
determining the financial rewards from incentive plans
individual investors to commit their resources over the long
designed to align executives’ and investors’ financial interests.
term (Levine 1997).9 Hence, well-developed, liquid capital
Ball (2001) argues that timely incorporation of economic losses
markets are expected to enhance economic growth by
in the published financial statements (that is, conservatism)
facilitating corporate investments that are high-risk, high-
increases the effectiveness of corporate governance,
return, long-term, and more likely to lead to technological
compensation systems, and debt agreements in motivating and
innovations, and high-quality financial accounting regimes
monitoring managers. He argues that it decreases the ex-ante
provide important support for this capital market function.
likelihood that managers will undertake negative net present
In summary, we expect financial accounting information to
value (NPV) projects but pass on their earnings consequences
enhance economic performance through at least three
to a subsequent generation, and it increases the incentive of the
channels, one of which represents the governance role of
current generation of managers to incur the personal cost of
financial accounting information. The impact of a country’s
abandoning investments and strategies that have ex-post
information infrastructure on the efficient allocation of capital
negative NPVs.
is an important topic for future research.
The governance role of financial accounting information
contributes directly to economic performance by disciplining
efficient management of assets in place (for example, timely
abandonment of losing projects), better project selection, and
reduced expropriation of investors’ wealth by the managers
3. Direct Use of Accounting
(exhibit, arrow 2A). We also allow for the possibility that
Information in Specific
financial accounting information lowers the risk premium
Governance Mechanisms
demanded by investors to compensate for the risk of loss from
expropriation by opportunistic managers (arrow 2B).
The roots of corporate governance research can be traced back
However, we caution that the impact of improved governance
to at least Berle and Means (1932), who argued that effective
on the rate of return required by investors is subtle. Lombardo
control over publicly traded corporations was not being
and Pagano (2000) argue that the effect of improved
exercised by the legal owners of equity, the shareholders, but by
governance on the required stock return on equity depends on
hired, professional managers. Given widespread existence of
the nature of the improvement. For instance, improved
firms characterized by this separation of control over capital
governance can manifest in a reduction of the private benefits
from ownership of capital, corporate governance research
that managers can extract from the company or in a reduction
generally focuses on understanding mechanisms designed to
of the legal and auditing costs that shareholders must bear to
mitigate agency problems and support this form of economic
prevent managerial opportunism. These two changes can have
organization. There are of course a number of pure market
opposite effects on the observed equilibrium stock returns, and
forces that discipline managers to act in the interests of firms’
the size of these effects depends on the degree of international
owners. These include product market competition (Alchian
segmentation of equity markets.
1950; Stigler 1958), the market for corporate control (Manne
The third channel through which we expect financial
1965), and labor market pressure (Fama 1980). However,
accounting information to enhance economic performance is
despite the existence of these powerful disciplining forces, there
by reducing adverse selection and liquidity risk (arrow 3). As
evidently remains residual demand for governance
documented in Amihud and Mendelson (2000), the liquidity
mechanisms tailored to the specific circumstances of individual
of a company’s securities impacts the firm’s cost of capital.
firms. This demand is documented by a large body of research
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examining boards of directors, compensation contracts,
mean percentage of annual bonus determined by financial
concentrated ownership structures, debt contracts, and
performance measures is 86.6 percent across the whole sample,
securities law in disciplining managers to act in the interests of
and 62.9 percent for the 114 firms that put nonzero weight on
capital suppliers (see Shleifer and Vishny [1997] for an
nonfinancial measures. Wallace (1997) and Hogan and Lewis
insightful review of this literature).
(1999) together document adoption of residual income-based
Governance research in accounting exploits the role of
incentive plans (for example, EVA) by about sixty publicly
accounting information as a source of credible information
traded companies. Numerous studies have also documented
variables that support the existence of enforceable contracts,
that both the earnings and shareholder wealth variables load
such as compensation contracts with payoffs to managers
positively and significantly in regressions of cash compensation
contingent on realized measures of performance, the
on both performance measures (for example, Lambert and
monitoring of managers by boards of directors and outside
Larcker [1987], Jensen and Murphy [1990], and Sloan [1993];
investors and regulators, and the exercise of investor rights
Bushman and Smith [2001] thoroughly review this evidence).
granted by existing securities laws. The remainder of Section 3
Poor earnings performance is also documented to increase
is organized as follows. Section 3.1 discusses evidence
the probability of executive turnover. Studies finding an
documenting widespread use of financial accounting measures
inverse relation between accounting performance and CEO
in determining bonus payouts and dismissal probabilities for
turnover include Weisbach (1988), Murphy and Zimmerman
top executives, and in supporting the allocation of control
(1993), Lehn and Makhija (1997), and DeFond and Park
rights and cash-flow rights in financing contracts between
(1999), while Blackwell, Brickley, and Weisbach (1994)
venture capitalists (VCs) and entrepreneurs. Section 3.2
document a similar relation for subsidiary bank managers
describes recent trends in the compensation contracts of top
within multibank holding companies.9 Weisbach (1988) and
U.S. executives, including shifts in the relative importance of
Murphy and Zimmerman (1993) include both accounting and
accounting numbers for determining compensation payouts,
stock price performance in the estimation of turnover
and discusses potential implications. Section 3.3 reviews
probability. Weisbach finds that accounting performance
research examining how characteristics of accounting
appears to be more important than stock price performance in
information systems interact with the firms’ observed choices
explaining turnover, while Murphy and Zimmerman find a
of governance configurations. Finally, Section 3.4 discusses
significant inverse relation between both performance
evidence concerning the use of financial accounting
measures and turnover.
information in corporate control mechanisms other than
This phenomenon has also been found to hold outside of
compensation contracts.
the United States. Kaplan (1994a, b) finds that turnover
probabilities for both Japanese and German executives are
significantly related to earnings and stock price performance.
Estimates of turnover probability in both countries indicate
3.1 Prevalence of Financial Accounting
that stock returns and negative earnings are significant
Numbers in Top Executive
determinants of turnover.10 Regressions using changes in cash
Incentive Contracts
compensation of Japanese executives document a significant
impact for pretax earnings and negative earnings, but not for
The extensive use of accounting numbers in top executive
stock returns and sales growth. Kaplan (1994a) compares
compensation plans at publicly traded firms in the United
results for Japanese executives with U.S. CEOs and finds
States is well documented. Murphy (1999) reports data from a
turnover probabilities for Japanese executives more sensitive to
survey conducted by Towers Perrin in 1996-97. Murphy
negative earnings. This relative difference is suggestive of a
reports that 161 of the 177 sample firms explicitly use at least
significant monitoring role for a Japanese firm’s main banks
one measure of accounting profits in their annual bonus plans.
when a firm produces insufficient funds to service loans.
Of the sixty-eight companies in the survey that use a single
Kaplan documents that firms are more likely to receive new
performance measure in their annual bonus plan, sixty-five use
directors associated with financial institutions following
a measure of accounting profits. Ittner, Larcker, and Rajan
negative earnings and poor stock price performance.
(1997) collect data on actual performance measures used in the
Finally, Kaplan and Stromberg (2000) document an
annual bonus plans of 317 U.S. firms for the 1993-94 time
important disciplining role for accounting information in
period. Ittner et al. document that 312 of the 317 firms report
private equity transactions. They examine actual financing
use of at least one financial measure in their annual plans.
contracts between venture capitalists and entrepreneurs. They
Earnings per share, net income, and operating income are the
document that VC financings allow VCs to separately allocate
most common financial measures. They also report that the
cash-flow rights, voting rights, board rights, and other control
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rights. The allocation of cash-flow rights and control rights is
Why is the market share of accounting measures shrinking,
frequently contingent on verifiable, observable financial and
and can cross-sectional differences in the extent of shrinkage be
nonfinancial performance measures. The financial measures
explained? Has the information content of accounting
appear to comprise standard measures from the financial
information itself deteriorated, or should we look to more
accounting system, including earnings before interest and
fundamental changes in the economic environment? For
taxes, operating profits, net worth, and revenues. Control
example, Milliron (2000) documents a significant shift over the
rights are allocated such that if the company performs poorly,
past twenty years in board characteristics measuring director
the VCs take full control, while entrepreneurs obtain control as
accountability, independence, and effectiveness consistent with
performance improves. They argue that this is supportive of
a general increase in directors’ incentive alignment with
theories that predict shifts of control to investors in bad
shareholders’ interests. A number of environmental changes
outcome states, such as Aghion and Bolton (1992) and
are candidates for explaining the observed evolution in
Dewatripont and Tirole (1994).
contract design and boards.
For example, the emergence of institutional investor and
other stakeholder activist groups in the 1980s created pressure
on firms to choose board structures designed to facilitate more
3.2 Trends in the Use of Accounting Numbers
active monitoring and evaluation of managers’ performance.
for Contracting with Managers
In addition, new regulations were instituted by the Securities
and Exchange Commission and the Internal Revenue Service in
While the evidence documents significant use of accounting
the early 1990s to require that executive pay be disclosed in
numbers in determining cash compensation, both the
significantly more detail and be approved by a compensation
determinants of cash compensation and the importance of cash
committee composed entirely of independent directors. The
compensation in the overall incentive package exhibit
nature of the firm itself may have changed. Recent research
significant time trends. Bushman, Engel, Milliron, and Smith
notes that conglomerates have broken up and their units spun
(1998) document that over the 1971-95 period, firms have
off as stand-alone companies, that vertically integrated
substituted away from accounting earnings toward other
manufacturers have relinquished direct control of their
information in determining top executives’ cash
suppliers and moved toward looser forms of collaboration, and
compensation.
that specialized human capital has become more important
It has also been documented that the contribution of cash
and also more mobile (for example, Zingales [2000] and Rajan
compensation to the overall intensity of top executive
and Zingales [2000]).
incentives has diminished in recent years. Recent studies
In closing this section, we note that caution should be used
construct explicit measures of the sensitivity of the value of
in concluding from this recent shift away from explicit
stock and option portfolios to changes in shareholder wealth
accounting-based incentive plans toward equity-based plans
(Murphy 1999; Hall and Liebman 1998). These studies show
that accounting information has become less important for the
that the overall sensitivity of compensation to shareholder
governance of firms. There are a number of issues to consider
wealth creation (or destruction) is dominated by changes in the
in this regard. First, as discussed in our introduction and by a
value of stock and stock option holdings, and that this
number of other scholars (for example, Ball [2001] and Black
domination increases in recent years. For example, Murphy
[2000]), the existence of a strong financial accounting regime is
(1999) estimates that for CEOs of mining and manufacturing
likely a precondition for the existence of a vibrant stock market
firms in the S&P 500, the median percentage of total pay-
and in its absence the notions of equity-based pay and diffuse
performance sensitivity related to stock and stock options
ownership of firms become moot.
increases from 83 percent (45 percent options and 38 percent
Second, while executive wealth clearly has become more
stock) of total sensitivity in 1992 to 95 percent (64 percent
highly dependent on stock price, managerial behavior is
options and 31 percent stock) in 1996. In addition, Core, Guay,
impacted by executives’ and boards’ understanding of how
and Verrecchia (2000) decompose the variance of changes in
their decisions impact stock price. Under efficient markets
CEOs’ firm-specific wealth into stock-price-based and
theory, stock price is a sufficient statistic for all available
nonprice-based components. They find that stock returns are
information in the economy with respect to firm value, which
the dominant determinant of wealth changes, documenting
implies that stock price is a good mechanism for guiding
that for 65 percent of the CEOs in their sample, the variation in
investors’ resource allocation decisions, as they only need to
wealth changes explained by stock returns is at least ten times
look at price to get the market’s informed assessment of value.
greater than the component not explained by stock returns.
But is stock price also a sufficient statistic for operating
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decisions and performance assessments within firms? That is,
from Hewitt Associates’ annual compensation surveys of large
can managers and boards rely on stock price as their sole
U.S. companies. This data set provides the percentage of a
information source? We observe analysts pouring over the
CEO’s annual bonus determined by individual performance
details of financial statements, such as margin analyses,
evaluation (IPE). IPE is generally a conglomeration of
expense ratios, and geographic and product line segment data.
performance measures including subjective evaluations of
In addition, market participants expend real resources
individual performance. For firms with significant growth
privately collecting and trading on detailed firm-specific
opportunities, expansive investment opportunity sets, and
information that is ultimately aggregated in price. Given that
long-term investment strategies, it is conjectured that current
market participants whose trading decisions drive stock price
earnings will poorly reflect future period consequences of
formation are heavily influenced by detailed accounting and
current managerial actions, and thus exhibit low sensitivity
other performance data, why should we believe that managers
relative to important dimensions of managerial activities. This
and boards ignore the details and are guided solely by stock
should lead firms to substitute toward alternative performance
price?
measures, including IPE. Bushman et al. (1996) proxy for the
Lastly, stock price possesses other potential limitations as a
investment opportunity set with market-to-book ratios, and
measure of current managerial performance. In particular, the
the length of product development and product life cycles.
fact that stock price is forward-looking can limit its usefulness
They find that IPE is positively and significantly related to both
because it anticipates possible future actions. For example,
measures of investment opportunities, implying a substitution
when a firm is in trouble, its current stock price may reflect the
away from accounting information.
market’s expectation that the current CEO will soon be
Ittner, Larcker, and Rajan (1997) follow a similar research
replaced, thus limiting its usefulness in assessing the current
strategy focused on the use of nonfinancial performance
CEO’s performance. This may lead to reliance on accounting
measures. Using a combination of proprietary survey and
measures, as documented in the literature on CEO dismissal
proxy statement data, they estimate the extent to which CEO
probabilities discussed in Section 3.1 (see also the discussion in
bonus plans depend on nonfinancial performance measures.
Section 3.4 on the role of accounting information in proxy
The mean weight on nonfinancial measures across all firms in
contests).
their sample is 13.4 percent, and 37.1 percent for all firms with
a nonzero weight on nonfinancial measures. They construct
a measure of investment opportunities using multiple
indicators, including research and development (R&D)
3.3 Properties of Accounting and Choice
expenditures, market-to book ratio, and number of new
of Governance Configurations
product and service introductions. They find that the use of
nonfinancial performance measures increases with their
In this section, we discuss research investigating relations
measure of investment opportunities.
between properties of financial accounting information and
Substitution away from publicly reported accounting data
governance mechanism configurations. The premise behind
likely leads to the use of performance measures in contracts
this research is that when current accounting numbers do a
that are not directly observable by the market. Hayes and
relatively poor job of capturing information relevant to
Schaeffer (2000) extend Bushman et al. (1996) and Ittner et al.
governance, firms substitute toward alternative, more costly
(1997) by investigating the relation between executive
governance mechanisms to compensate for inadequacies in
compensation and future firm performance. If firms optimally
financial accounting information. This research is based on the
use unobservable measures of performance that are correlated
premise that financial accounting systems represent a primary
with future observable measures of performance, then
source of effective, low-cost governance information. The
variation in current compensation that is not explained by
research discussed next uses various proxies to capture the
variation in current observable performance measures should
governance relevance of accounting numbers. Developing
predict future variation in observable performance measures.
more refined measures of information quality is an important
Further, compensation should be more positively associated
goal for future research.
with future earnings when observable measures of
Consider first the portfolio of performance measures
performance are noisier and, hence, less useful for contracting.
chosen by firms to determine payouts from CEOs’ annual
They test these assertions using panel data on CEO cash
bonus plans. Bushman, Indjejikian, and Smith (1996) study the
compensation from Forbes, and show that current
use of “individual performance evaluation” in determining
compensation is related to future return-on-equity after
annual CEO bonuses. They use managerial compensation data
controlling for current and lagged performance measures and
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analyst consensus forecasts of future accounting performance,
represents the average number of ninety items included in the
and that current compensation is more positively related to
annual reports of a sample of domestic companies. They
future performance when the variances of the firm’s market
document that the concentration of stock ownership in a
and accounting returns are higher. They detect no time trend
country is significantly negatively related to both the CIFAR
in the relation between current compensation and future
index and an index of how powerfully the legal system “favors
performance. This stability is noteworthy given the significant
minority shareholders against managers or dominant
increases in the use of option grants documented by Hall and
shareholders in the corporate decision-making process,
Liebman (1998) and Murphy (1999). Boards of directors
including the voting process” (1995, p. 1127), after controlling
apparently have not delegated the complete determination of
for the colonial origin of the legal system and other factors.
CEO rewards to the market, and still fine-tune rewards using
These results are consistent with their prediction that in
private information.
countries where the accounting and legal systems provide
Bushman, Chen, Engel, and Smith (2000) extend this
relatively poor investor protection from managerial
research to consider a larger range of governance mechanisms.
opportunism, there is a substitution toward costly monitoring
The governance mechanisms considered include board
by “large” shareholders.
composition, stockholdings of inside and outside directors,
ownership concentration, and the structure of executive
compensation. They conjecture that to the extent that current
earnings fail to incorporate current value-relevant
3.4 Financial Accounting Information
information, the accounting numbers are less effective in the
and Additional Corporate Control
governance setting. The authors develop several proxies to
Mechanisms
measure earnings “timeliness” based on traditional and reverse
regressions of stock prices and changes in earnings. Consistent
In this section, we expand our discussion of the role of financial
with the hypothesis that limits to the information provided by
accounting information in the operation of specific governance
financial accounting measures are associated with a greater
mechanisms. An important example in this respect is
demand for firm-specific information from inside directors
DeAngelo’s (1988) study of the role of accounting information
and high-quality outside directors (Fama and Jensen 1983),
in proxy fights. She documents a heightened importance of
Bushman et al. find that the proportion of inside directors and
accounting information during proxy fights by providing
the proportion of “highly reputable” outside directors are
evidence of the prominent use of accounting numbers. She
negatively related to the timeliness of earnings, after
presents evidence that dissident stockholders typically cite poor
controlling for R&D, capital intensity, and firm growth
earnings performance as evidence of incumbent managers’
opportunities. They also find a negative relation between the
inefficiency (and rarely cite stock price performance), and that
timeliness of earnings and the stockholdings of inside and
incumbent managers use their accounting discretion to portray
outside directors, the extent of ownership concentration, the
a more favorable impression of their performance to voting
proportion of incentive plans granted to the top five executives
shareholders. DeAngelo suggests that accounting information
that are long-term plans, and the proportion that are equity-
may better reflect incumbent managerial performance during
based.
proxy fights because stock price anticipates potential benefits
Finally, La Porta, Lopez-De-Silanes, Shleifer, and Vishny
from removing underperforming incumbent managers.11
(1998) argue that protection of investors from opportunistic
It is also important to recognize that the governance of firms
managerial behavior is a fundamental determinant of
is exercised through a portfolio of governance mechanisms,
investors’ willingness to finance firms, of the resulting cost of
and so it is important to understand potential interactions
firms’ external capital, and of the concentration of stock
between mechanisms. Consider product market competition
ownership. They develop an extensive database of the laws
and the use of accounting information in governance.
concerning the rights of investors and the enforcement of these
Aggarwal and Samwick (1999) argue that in more competitive
laws for forty-nine countries, from Africa, Asia, Australia,
industries (higher product substitutability), wage contracts are
Europe, North America, and South America. Interestingly, one
designed to incorporate strategic considerations and create
of the regimes that they suggest affects enforcement of
incentives for less aggressive price competition. DeFond and
investors’ rights is the country’s financial accounting regime.
Park (1999) and Parrino (1997), examining CEO turnover
They measure quality of the accounting regime with an index
probabilities, posit that in more competitive industries, peer
developed for each country by the Center for International
group comparisons are more readily available, creating
Financial Analysis and Research (CIFAR). The CIFAR index
opportunities for more precise performance comparisons.
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Jagannathan and Srinivasan (1999) examine whether product
allocation of decision rights, task allocation, divisional
market competition, as measured by whether a firm is a
interdependencies, and subjective performance evaluation.
generalist (likely to have more comparable firms) or a specialist
Lambert, Larcker, and Weigelt (1993) present evidence that
(few peers), reduces agency costs in the form of free cash-flow
observed business unit managers’ compensation across the
problems. If increased competition reduces agency costs and
hierarchy exhibits patterns consistent with both agency
creates more peer comparison opportunities (including the
theory and tournament theory. Baker, Gibbs, and Holmstrom
supply of potential replacement executives), how is the design
(1994a, b) and Gibbs (1995) analyze twenty years of
of incentive contracts impacted? Competition can impact the
personnel data from a single firm and illustrate the complex
relative value of own-firm and peer-group accounting
relations that can exist among the hierarchy, performance
information as a function of competitiveness. It is also possible
evaluation, promotion policies, wage policies, and incentive
that the extent of competition influences the costs to disclosing
compensation. Baker, Gibbons, and Murphy (1994)
proprietary information, impacting the amount of private
theoretically isolate economic tradeoffs between objective
information and the relative governance value of public
and subjective performance evaluation in the design of
performance measures.
optimal contracting arrangements. Ichniowski, Shaw, and
Bertrand and Mullainathan (1998) illustrate the potential
Prennushi (1997), using data on thirty-six steel mills, find
power of designs that consider interactions across governance
that mills that adopt bundles of complementary practices (for
mechanisms. They examine the impact on executive
example, incentive compensation, teamwork, skills training,
compensation of changes in states’ anti-takeover legislation.
and communications) are more productive than firms that
Adoption of anti-takeover legislation presumably reduces
either do not adopt these practices or that adopt practices
pressure on top managers. They attempt to distinguish
individually rather than together.
between optimal contracting and skimming theories in
explaining observed contracting arrangements. Do share-
holders, observing weakening of one disciplining mechanism,
respond by strengthening another, say, pay-for-performance?
Or do CEOs facing reduced threat of hostile takeover exploit
4. Effects of Financial Accounting
this reduced pressure to skim more resources by increasing
Information on Economic
their mean pay? They find that pay-for-performance
Performance
sensitivities (especially for accounting measures of perform-
ance) and mean levels of CEO pay increase after adoption of
A growing body of evidence indicates that the development of
anti-takeover legislation. They further separate their sample
a country’s financial sector facilitates its growth (for example,
into two groups based on whether the firm has a large
King and Levine [1993], Jayaratne and Strahan [1996], Levine
shareholder (5 percent blockholder) present or not. They
[1997], Demirguc-Kunt and Maksimovic [1998], and Rajan
find that firms with a large shareholder increased pay-for-
and Zingales [1998]). Levine (1997) presents a framework
performance, while firms without a large shareholder increased
whereby a well-developed financial sector facilitates the
mean pay. They also empirically examine the responsiveness of
allocation of resources by serving five functions: to mobilize
pay to luck, using three measures of luck. First, they perform a
savings, facilitate risk management, identify investment
case study of oil-extracting firms where large movements in oil
opportunities, monitor and discipline managers, and facilitate
prices tend to affect firm performance on a regular basis.
the exchange of goods and services. At the heart of these
Second, they use changes in industry-specific exchange rates
theories is the role of the financial sector in reducing
for firms in the traded goods sector. Third, they use year-to-
information costs and transaction costs in an economy. In spite
year differences in mean industry performance to proxy for the
of the central role of information in these theories, until
overall economic fortunes of a sector. For all three measures,
recently little attention has been given by empirical researchers
they find that CEO pay responds to luck. However, similar to
to the information environment per se in explaining cross-
the takeover results, they find that the presence of a large
country differences in economic growth and efficiency.
shareholder reduces the amount of pay for luck. These results
In this section, we discuss research that explicitly examines
raise important questions about the optimality of observed
the role of a country’s corporate disclosure regime in the
governance configurations in the United States.
efficient allocation of capital. Preliminary results from this
Finally, complex interactions can exist between incentive
literature provide encouraging evidence of a positive relation
contracts written on objective performance measures and
between the quality of a country’s corporate disclosure regime
features of organizational design such as promotion ladders,
and economic performance. Cross-country analyses are one
FRBNY Economic Policy Review / April 2003
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promising way to assess the effects of corporate disclosure on
measure of financial development, Rajan and Zingales
economic performance for several reasons. First, there are
document a significant positive coefficient on the interaction
considerable, quantifiable cross-country differences in
between industry-level demand for external financing and the
corporate disclosure regimes.12 Second, there are dramatic
country-level CIFAR index. This result supports the prediction
cross-country differences in economic efficiency. Rajan and
that the growth is disproportionately higher in industries with
Zingales (2001), Modigliani and Perotti (2000), and Acemoglu,
a strong exogenous demand for external financing in countries
Johnson, and Robinson (2000) argue that inefficient institutions
with high-quality corporate disclosure regimes, after
can be sustained in a given country due to political agendas other
controlling for fixed industry and country effects. They also
than efficiency. Hence, the possibility of observing grossly
find that growth in the number of new enterprises is
inefficient financial accounting and other regimes in the cross-
disproportionately high in industries with a high demand for
country sample is not ruled out. In contrast, within the United
external financing in countries with a large CIFAR index.
States, where market forces and explicit and implicit
Using a similar design, Carlin and Mayer (2000) find that
compensation contracts powerfully discipline managers,
the growth in industry GDP and the growth in R&D spending
inefficiencies are more difficult to isolate in the data.
as a share of value-added are disproportionately higher in
However, there are also limitations to this approach. The
industries with a high demand for external equity financing in
explanatory variables in these studies are highly correlated and
countries with a large CIFAR index. Together, the results of
measured with error, impeding interpretation of results. This is
Rajan and Zingales, and Carlin and Mayer are consistent with
a significant issue for interpreting results on the basis of the
high-quality disclosure regimes promoting growth and firm
CIFAR index (described above), which is commonly used to
entry by lowering the cost of external financing. However, as
measure the “quality” of accounting information within a
illustrated in the exhibit, corporate disclosure can also impact
country. The CIFAR index is highly correlated with numerous
economic performance directly through the project
other country characteristics. Furthermore, given the
identification and governance channels. For example, future
crudeness of the CIFAR index, the quality of countries’
research can focus on the governance channel by developing
financial accounting regimes is probably measured with
proxies for the relative magnitude of inherent agency costs
considerable error. A second limitation is that causal inferences
from shareholder-manager conflicts for each industry,
are problematic. It is plausible that both measures of financial
regardless of where the industry is located. Measures of
development, such as the CIFAR index, and measures of
economic performance for each industry within each country
economic performance are caused by the same omitted factors.
can be regressed against the interaction of the inherent agency
It is also plausible that economic performance stimulates
costs for the industry and the quality of the corporate
development of extensive financial disclosure systems. These
disclosure regime in the country.
limitations of cross-country designs are well recognized in the
Love (2000) examines the hypothesis that financial
economics literature. Levine and Zervos (1993) conclude that
development affects growth by decreasing information and
these studies can be “very useful” as long as empirical
contracting related imperfections in the capital markets, thus
regularities are interpreted as “suggestive” of the hypothesized
reducing the wedge between the cost of external and internal
relations. Lack of cross-country relations can at a minimum
finance at the firm level. Estimating a structural model of
cast doubt on hypothesized relations.
investment using firm-level data from forty countries, the
Rajan and Zingales (1998) argue that if financial institutions
paper finds that financial development decreases the sensitivity
help firms overcome moral hazard and adverse selection
of investment to the availability of internal funds, which is
problems, thus reducing the cost of raising money from
equivalent to a decrease in financing constraints and
outsiders, financial development should disproportionately
improvement in capital allocation. Love’s main indicator of
help firms more dependent on external finance for their
financial development is an index combining measures of stock
growth. They measure an industry’s demand for external
market development with measures of financial intermediary
finance from data on U.S. firms. If capital markets in the
development. Although the paper’s main result is that this
United States are relatively frictionless, this allows them to
indicator of financial development is negatively related to the
identify an industry’s technological demand for external
estimated measure of capital market imperfection, it is
financing. Assuming that this demand carries over to other
interesting to note that the CIFAR index loads negatively over
countries, they test whether industries that are more dependent
and above the main financial development indicator, while
on external financing grow relatively faster in countries that are
separate measures of the efficiency of the legal system,
more financially developed. Using the CIFAR index as a
corruption, and risk of expropriation do not.
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