Making Sense of Corporate Governance in U.S. Firms

Corporate governance has become even more important since the collapse of major firms in the 1990s and the global financial crisis of 2007-2008, and the relationship between financial reporting and the capital markets is a big reason why. The debate has continued over the unreliability of reported earnings as the magnitude and frequency of non-GAAP earnings, earnings restatements, earnings management, and fraud have grown. Additionally, major market players disagree about the value of corporate governance codes to U.S. firms.

In my recent article, “Corporate Governance and U.S. Firms over the Last Three Decades,” published in the Journal of Accounting, Ethics and Public Policy, I synthesize the last three decades of research on corporate governance and U.S. firms. The article attempts to answer several basic but important questions: What is corporate governance; what are the best corporate governance practices; what are the theories underpinning corporate governance; what is the value of corporate governance to U.S. firms; and, finally, how can we get the most out of corporate governance codes?

What is corporate governance?

Jensen and Meckling (1976) state that: “Managers who own less than 100 percent of the residual cash flow rights of the firm are more than likely to have a potential conflict of interest with the firm’s shareholders.This misalignment of interests between shareholders (owners) and managers (agents) ultimately creates information asymmetry that produces agency costs (e.g., audit fees, board of directors’ remuneration). Corporate governance is, therefore, any mechanism that attempts to resolve such information asymmetry and align the interests of managers and shareholders. The critical importance of strong corporate governance codes to the U.S. system arises from the fact that it is the world’s richest, largest, and fastest-growing dispersed ownership system. The U.S. is also a contractarian system in which the primary purpose of the firm is to maximize the shareholders’ value as residual claimants.

What are the best corporate governance practices?

In the U.S., the best corporate governance practices are largely set forth in the Sarbanes-Oxley Act of 2002 and promoted by the Securities and Exchange Commission (SEC), the Public Company Accounting Oversight Board (PCAOB) and other financial regulators. The academic literature has focused discussion on boards of directors and various governance committees (e.g., the nominating committee, compensation committee, and audit committee), and the expertise, independence, structure, and composition of the governance committees are good indicators of the quality of corporate governance. In general, corporate governance mechanisms can be either internal or external. Internal ones include management incentive plans, shareholder and debt-holder monitoring, board monitoring, corporate bylaws and charters, and the internal managerial labor market. External mechanisms include the market for corporate control, the external managerial labor market, the legal system, product market competition, the threat of corporate takeover, product market competition, managerial labor market, financial analysts,  and management reputation.

What are the theories underpinning corporate governance?

Although there is heavy reliance on the Agency Theory to explain corporate governance constructs in business research, there are many other competing or complementary theories that, if used simultaneously with the Agency Theory, would help explain some of the mixed results in research on the usefulness of corporate governance codes. Among these theories are the Contingency Theory, the Stewardship Theory, the Stakeholders Theory, and the Resource Dependence Theory.

  • The Agency Theory. Under this theory, effective corporate governance is expected to lower monitoring, auditing, and other private agency costs. The Agency Theory, however, falls short of providing a reasonable explanation for the failure of corporate governance systems during the collapse of large firms in the early 1990s and the 2007-2008 financial crisis.
  • The Contingency Theory. Under this theory, the effectiveness of corporate governance codes is contingent upon the business environment, which is determined by board of directors’ expertise, firm configuration, information uncertainty, environmental factors, market conditions, firm credit risk and the probability of default, country specific factors (recession or expansion), and time factors.
  • The Stewardship Theory. This theory contends that managers are inherently trustworthy and might perceive their future as dependent on their companies’ success. Such success will increase managers’ value in the job market and might also increase their pension rights.
  • The Stakeholders Theory. This theory holds that conflicts of interest do not exist only between managers and shareholders but extend to various stakeholders. The stakeholders have intrinsic value, and their interests might not be in line with those of the firm.
  • The Resource Dependence Theory. This theory suggests that the firm’s performance is expected to improve and that the conflict of interest between management and shareholders is expected to be narrowed by employing resourceful and knowledgeable managers. The majority of the research still focuses on the monitoring and controlling roles of the board of directors and underestimates the board’s own expertise and knowledge, both of which could be used to improve the firm’s financial-reporting transparency and promote more efficient operations.

What is the value of corporate governance to U.S. firms?

Does Wall Street appreciate corporate governance? That depends on the incremental value corporate governance adds to shareholder wealth before and after the implementation of a certain governance provision. A review of the literature on corporate governance and U.S. firms can be divided into two research categories:  corporate governance and firm performance, and corporate governance and financial reporting quality.

  • Corporate governance and firm performance. Anecdotal and empirical evidence suggest that corporate governance is not always directly associated with stock price performance or returns. This could be interpreted as follows. First, the corporate governance mechanisms may simply not affect stock performance. Second, the governance mechanisms might be interacting with some firm value measures that result in an invalid conclusion on the association between corporate governance and firm performance. Third, different governance codes and structures may work for some organizations but not others..  A review of corporate governance and operating performance suggests that certain corporate governance mechanisms may or may not improve operating performance. In general, though, better corporate governance has been shown to be highly correlated with better operating performance, higher firm value, higher stock returns, and higher market valuation.
  • Corporate governance and financial reporting quality. Research on the association between corporate governance and earnings management suggests that earnings management might be systematically reduced by a number of firm-level and national corporate governance mechanisms. For example, boards that are independent of the CEO provide a stronger corporate governance environment for the firm. Nevertheless, independence of the board members is not necessarily a sign of good governance. Other factors should be taken into consideration such as independent board incentives to protect shareholders wealth and maximize firm value. Additionally, research suggests that strong corporate governance enhances the reliability of voluntary disclosure of management earnings forecasts and results in fewer errors and less variation in analysts’ earnings forecasts.

What can be done to get the most out of corporate governance?

The last three decades of research suggest the following areas for future study:

  1. Compare the various measures of “strong” corporate governance and “weak” corporate governance to determine which are most useful in making research findings applicable in a wide variety of settings. Such research might lead to a corporate governance index or measure that could bring consensus on the association between corporate governance codes and stock price performance.
  2. Control for endogenous governance performance – the question of whether, say, strong governance causes firms to perform better, or better performing firms select strong governance codes – and conduct research on its antecedents, characteristics, and consequences for the governance-performance relationship. That would be important in enhancing the governance-performance model and increasing our understanding of the association between corporate governance and firm performance.
  3. Study the effect of voluntary versus mandatory governance mechanisms on firm value. Research on the optimal composition (and characteristics) of boards and audit committees might also be fruitful.
  4. Examine the effect of firm-level versus national corporate ethics codes (as a form of governance) on firm value (both inter-country and intra-country).
  5. Use technology that enhances the reliability and accuracy of financial information such as the eXtensible Business Reporting Language (XBRL). The XBRL is a form of digital reporting that makes it easier to report different types of information more frequently. It can be used in conjunction with strong corporate governance mechanisms in order to increase the reliability of financial statements and curb earnings management.
  6. Explore the types and extent of earnings management in companies (intra-country and inter-country) that have adopted the XBRL technology for reporting financial information. The expectation is that the increased transparency of company information would be negatively and significantly associated with earnings management.
  7. Evaluate various accounting treatments that could be considered earnings management (or earnings smoothing). The literature on earnings management predominantly focuses on discretionary accruals as a proxy for earnings management. Are other treatments as or more useful in predicting earnings management? Which corporate governance mechanisms are significantly associated with these various accounting treatments, i.e, which corporate governance mechanisms are most useful in mitigating earnings management?


ElMahdy, Dina F. 2016.  Corporate Governance and U.S. Firms Over the Last Three Decades (October 29, 2016). Journal of Accounting, Ethics and Public Policy 17 (4):899 –942. Available at SSRN:

Jensen, M. and W. Meckling. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3: 305–360.

This post comes to us from Professor Dina F. El Mahdy of Morgan State University. It is based on here recent article, “Corporate Governance and U.S. Firms Over the Last Three Decades,” available here.