The Downside to Limiting Manager Entrenchment

Critics often argue that firms and financial standard setters fail to understand fully the implications of their corporate governance policies. The general belief is that stronger governance almost necessarily leads to better firm outcomes. This idea rests on the assumption that stronger governance better aligns the interests of managers with the interests of shareholders – limiting manager opportunism or unethical behaviors and incentivizing managers to focus on shareholders’ best interests. In a forthcoming academic article entitled, “Are Entrenched Managers’ Accounting Choices More Predictive of Future Cash Flows?” we examine whether stronger governance, specifically limits to manager entrenchment, necessarily translates to better firm outcomes; in this case, higher financial reporting quality.

Entrenched managers are sheltered from external influences, can be less engaged in providing shareholders with useful information, or may exhibit greater opportunism. As a result, many experts view recent moves to limit manager entrenchment as an important governance mechanism by which shareholders can discipline or remove underperforming or opportunistic managers. We believe that those promoting such limits also assume that entrenched managers are more likely to make financial reporting decisions that result in lower quality financial statements. While we agree that manager entrenchment can pose certain risks, we do not agree that necessarily results in lower quality financial statements. Given existing pressures on policy makers to decrease manager entrenchment, we believe it is important to examine the potential consequences on financial reporting behavior.

Limits to manager entrenchment likely serve a traditional governance role by addressing agency issues within the firm and (potentially) may reduce information asymmetry between managers and shareholders. However, the greater monitoring and demand for more private information associated with limits to manager entrenchment also prompt greater expectations and pressures. Research has shown that when faced with capital market pressures to meet short-term performance goals, managers may use financial reporting discretion to meet financial performance benchmarks. Thus, limits to entrenchment could encourage self-interested reporting behavior, increasing accrual manipulation and lowering financial reporting quality rather than improving it.

To test this reasoning, we examine whether firms with entrenched managers use their permitted discretion more liberally and make accounting choices that lead to more predictive (higher quality) accruals than do firms that do not have entrenched managers. Importantly, we use a broad sample of public firms for our analysis and find that firms with entrenched managers exhibit less accrual manipulation compared with firms that do not have entrenched managers – i.e., limits to manager entrenchment are associated with greater financial reporting discretion.  While potentially unexpected, this finding does not completely address the larger notion of financial reporting quality. In other words, greater discretion does not equate to lower quality in and of itself.

The Financial Accounting Standards Board (FASB) identifies the ability of earnings to predict future cash flows as a primary metric when evaluating financial reporting quality. Managers may use their reporting discretion to provide more predictive information, or may alternatively use their discretion opportunistically which may lead to less predictive information. We test this more precise measure of financial reporting quality and find that entrenched managers’ financial reporting discretion is more predictive of future cash flows when compared with firms that do not have entrenched managers. In short, while limits to manager entrenchment may provide economic benefits to the firm, our results suggest that these limitations are unlikely to improve financial reporting quality and may actually lead to lower financial reporting quality.

One might conclude that a cost of stronger governance is poor financial reporting quality. However, we do not believe the discussion is so clear-cut. The fact is that not all financial reporting situations are the same. In other words, financial reporting discretion may have different consequences depending on the context of the financial report. More specifically, financial reporting quality is most important when manager (or shareholder) self-interest is higher. To address this additional nuance, we further examine our primary result in three contexts where manager (or shareholder) self-interest may be elevated or opportunistic accounting choices are likely to be more significant to various stakeholders. Specifically we examine the role of manager entrenchment (1) when firms just beat an earnings benchmark, (2) when firms face debt covenants through private loan arrangements, and (3) when firms subsequently hold a seasoned equity offering. We find that firms with entrenched managers and firms with limits to manager entrenchment exhibit similar financial reporting quality in situations with elevated financial reporting consequences. In less significant situations, entrenched managers provide higher quality financial reports. In other words, the cost of poor financial reporting quality that accompanies limits to manager entrenchment seems to arise only during less significant financial reporting situations.

Our results have important implications for many interested parties. Accounting researchers generally agree that governance mechanisms should play a direct role in reporting outcomes, but this research has not provided consistent conclusions. Governance mechanisms arise from various sources (such as boards, auditors, shareholders, and regulators), and the incentives of these parties and the extent to which they can influence reporting vary. We provide an example to illustrate how this mixed evidence can occur. Researchers have developed measures of good governance, but they should be aware that these measures might rationally produce results in a direction opposite of initial expectations.

Implications for regulators, managers, and shareholders are less straightforward. In a broad sense, we find evidence that limits to manager entrenchment may generally degrade financial reporting quality. While related research consistently documents economic benefits in limiting manager entrenchment, those limits may come at the cost of lower financial reporting quality. This presents a potential conundrum for those in a position to dictate the governance of an individual firm, industry, or economy. However, firms or regulators may be willing to absorb those costs if they are concentrated in particular settings, especially in less significant settings, as we find in our study.

The timing of our results is beneficial as regulators consider limits to manager entrenchment as a mechanism to improve corporate governance and more recently entertain revisiting previous regulatory actions. Interest in limiting manager entrenchment seemed to have gained steam during the last decade. In part, a weak economy, the financial crisis of 2008, the seemingly high incidence of corporate mismanagement, and the growing disparity between CEO compensation and the average worker’s compensation motivated a move toward greater limits to manager entrenchment over the last decade. Examples of actions focused on such limits include the Dodd-Frank Wall Street Reform and Consumer Protection Act and recent shareholder activism at Citigroup, Goldman Sachs, Target, and Bank of America. As regulators, shareholders, and managers consider limits to manager entrenchment, the underlying contextual relation to financial reporting quality is an important component to the broad role of manager entrenchment in the governance of firms.

This post comes to us from Professor Gregory Martin at the University of North Carolina at Charlotte and Professor Bradley Lail at Baylor University. It is based on their recent article, “Are Entrenched Managers’ Accounting Choices More Predictive of Future Cash Flows?,” available here.

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