CLS Blue Sky Blog

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.

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.

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?

REFERENCES

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: https://ssrn.com/abstract=2861206

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.

Exit mobile version