One of management’s many important roles is to provide information to market participants. However, this information may be self-serving rather than beneficial to the market, especially in the case of voluntary disclosure. To curb this possibility, boards of directors are responsible for monitoring management to provide confidence in the credibility of these disclosures. To date, however, there has been no clear evidence of a link between director monitoring and the credibility of voluntary disclosure.
Recent studies do suggest directors can influence aspects of firm disclosures. In particular, Karamanou and Vafeas (2005) and Ke, Li, and Zhang (2020) document that director characteristics have significant impacts on the form and accuracy of guidance issued by firms. Although this evidence suggests that director characteristics can influence the content of the management guidance, it is unclear whether those characteristics affect the credibility of that disclosure. In other words, it is clear from prior literature that board monitoring affects what managers are saying, but we seek to investigate whether that same monitoring affects if the market is listening and how market participants react. We hypothesize that, when directors provide more effective monitoring, market participants will view the guidance as more credible and, in response, react more strongly to the information the guidance conveys.
To explore the link between director monitoring and the credibility of management guidance, we identify two channels through which a director’s monitoring effectiveness could vary: independence and attention. Directors who are independent from management have a greater incentive to validate a firm’s disclosures. Similarly, directors who are able to pay more attention to their monitoring duties are better able to effectively assess management guidance. We consider two measures of independence: the percentage of directors classified as independent by stock exchange standards and the percentage of directors who are not co-opted by the current CEO (have a tenure longer than the current CEO, Coles et al., 2014). We also include two measures of attention: the percentage of directors that sit on three or more public boards (i.e., busy directors, Fich and Shivdasani, 2006) and the percentage of monitoring-intensive directors that sit on at least two out of the three main board committees (audit, compensation, and nominating/governance committees, Faleye, Hoitash, and Hoitash, 2011).
In a broad sample of management guidance issued between January 2001 to June 2017, we find that both channels – director independence and director attention – affect analysts’ perceptions of the credibility of management guidance. In particular, analysts react more strongly to guidance disclosed by firms with improved monitoring. These results suggest that analysts incorporate director characteristics in their assessment of the credibility of management guidance. There are, however, potential endogeneity concerns with our analysis that links the reactions of market participants to firm governance characteristics. In particular, it could be that “better” firms simply have more effective directors and issue more credible forecasts. Or, it could be that firms with more credible voluntary disclosures attract higher quality directors, suggesting a reverse causality issue. To address these endogeneity concerns, we conduct several empirical tests to mitigate the possibility of alternative explanations.
First, we use modifications to exchange listing requirements of the NYSE/NASDAQ in 2003 and the Sarbanes-Oxley Act of 2002 (SOX) as exogenous shocks to director independence (percentage of directors classified as independent) and to director attention (monitoring intensity). We find that analysts view guidance as more credible following exogenous increases in both board independence and attention. Second, we evaluate changes in board independence (non-co-option) related to director deaths. We find that decreases in board independence due to deaths of non-co-opted directors (i.e., the loss of an effective monitor) lead to significantly weaker analyst reactions to subsequent management guidance. This result suggests that, when a strong monitor is exogenously removed from serving as a director, analysts view subsequent guidance as less credible. Third, we examine an exogenous increase in director attention through a decrease in a director’s workload as a result of the acquisition of a separate firm where an individual also serves as a director (Hauser, 2018). We find that, when a director’s attention is exogenously increased, subsequent management guidance is viewed as more credible. This result again suggests that analysts view management guidance conditional on the monitoring structures that are in place when that guidance is issued.
Finally, we explore settings where board monitoring is expected to have a particularly strong impact on the credibility of management guidance. For instance, research has found that market participants view negative earnings news as more credible than positive earnings news. In this way, there is a larger potential role for board monitoring to validate good news guidance, as these forecasts are viewed more skeptically by users. Similarly, there may be specific settings where users will benefit more from external validation due to a relative lack of information about the firm (e.g, low analyst following). Our empirical evidence suggests that increased monitoring appears to have a greater impact in both of these settings: when firms issue good news guidance and when firms have low analyst following. These findings corroborate our earlier results that analysts appear to find guidance more credible when disclosed in firms with more effective board monitoring by documenting that these results are especially prevalent in the settings where external monitoring is particularly necessary.
It is possible that the stronger analyst reaction to more effective director monitoring is a function of improved accuracy, as prior studies show that more effective monitoring helps managers provide more accurate guidance. We find, however, that the positive relation between credibility and monitoring exists for only the least accurate management guidance. Thus, the benefits of external validation through effective monitoring is found when managers likely face more difficult forecasting environments, where managers may more easily misrepresent their forward-looking information. Effective monitoring provides a signal of credibility, particularly in more difficult forecasting environments.
Overall, our results suggest that corporate governance significantly affects the credibility of management guidance. In particular, analysts appear to find management guidance more credible when corporate boards include directors who are more independent and pay more attention to monitoring efforts, especially in settings where external validation is needed. We extend prior work on management guidance by showing that, in addition to affecting the frequency and accuracy of management guidance, directors’ characteristics also influence how that guidance is perceived. In sum, our results improve our understanding of how voluntary disclosures are viewed by market participants and help illuminate the complex interplay among firm governance, managers, and analysts.
REFERENCES
Coles, J., N. Daniel, and L. Naveen, 2014. Co-opted boards. Review of Financial Studies 27:1751-1796.
Faleye, O., R. Hoitash, and U. Hoitash, 2011. The costs of intense board monitoring. Journal of Financial Economics 101: 160-181.
Fich, E., and A. Shivdasani, 2006. Are busy boards effective monitors? Journal of Finance 61:689-724.
Karamanou, I., and N. Vafeas, 2005. The association between corporate boards, audit committees, and management earnings forecasts: An empirical analysis. Journal of Accounting Research 43: 453-486.
Ke, R., M. Li, and Y. Zhang, 2020. Directors’ informational role in corporate voluntary disclosure: An analysis of directors from related industries. Contemporary Accounting Research 37: 392-418.
Hauser, R., 2018. Busy directors and firm performance: Evidence from mergers. Journal of Financial Economics 128: 16-37.
Rogers, J., and P. Stocken, 2005. Credibility of Management Forecasts. The Accounting Review 80:1233-1260.
This post comes to us from professors Tyler Jensen at Iowa State University’s Ivy College of Business, Marlene Plumlee at the University of Utah’s David Eccles School of Business, and Jared I. Wilson at Indiana University’s Kelly School of Business. It is based on their recent article, “Does More Effective Director Monitoring Make Management Guidance More Credible?” available here.