In this paper we evaluate and propose additional economics-based empirical
research concerning the governance role of financial accounting information.
We define the governance role of financial accounting information as the use of
externally reported financial accounting data in control mechanisms that
promote the efficient governance of corporations.
We adopt the classic agency perspective that the separation of corporate
managers from outside investors involves an inherent conflict. Corporate
control mechanisms are the means by which managers are disciplined to act in
the investors’ interest. Control mechanisms include both internal mechanisms,
such as managerial incentive plans, director monitoring, and the internal labor
market, and external mechanisms, such as outside shareholder or debtholder
monitoring, the market for corporate control, competition in the product
market, the external managerial labor market, and securities laws that protect
outside investors against expropriation by corporate insiders.
Financial accounting information is the product of corporate accounting and
external reporting systems that measure and publicly disclose audited,
quantitative data concerning the financial position and performance of publicly
held firms. Financial accounting systems provide direct input to corporate control
mechanisms, as well as providing indirect input to corporate control mechanisms
by contributing to the information contained in stock prices. A fundamental
objective of governance research in accounting is to provide evidence on the
extent to which information provided by financial accounting systems mitigate
agency problems due to the separation of managers and outside investors,
facilitating the efficient flow of scarce human and financial capital to promising
investment opportunities. We believe that governance research is important for
developing a complete understanding of the impact of financial accounting
information on the allocation and utilization of resources in an economy.
The largest body of governance research in accounting concerns the role of
financial accounting information in managerial incentive contracts. The heavy
emphasis on managerial compensation derives from the widespread use of
compensation contracts in publicly traded U.S. corporations, the availability
of top executive compensation data in the U.S. as a result of existing disclosure
requirements, and the success of principal–agent models in supplying testable
predictions of the relations between available performance measures and
optimal compensation contracts.
In Section 2, we review and critique the existing compensation literature in
accounting, including the literature examining the role of accounting
information in determining managerial turnover. Our discussion develops the
theoretical framework underlying much of this work and evaluates existing
empirical evidence. We also provide an historical overview to trace the
economic roots of compensation research in accounting, discuss empirical
research concerning the prevalence and trends in the use of financial
accounting numbers in managerial compensation plans, and offer suggestions
for future compensation research.
While Section 2 focuses on one particular control mechanism, managerial
compensation plans, researchers also have examined the role of accounting
information in the operation of other governance mechanisms. Examples include
takeovers (Palepu, 1986), proxy contests (DeAngelo, 1988), boards of directors
(Dechow et al., 1996; Beasley, 1996), shareholder litigation (Kellogg, 1984; Francis
et al., 1994; Skinner, 1994), debt contracts (Smith and Warner, 1979; Leftwich,
1981; Press and Weintrop, 1990; Sweeney, 1994), and the audit function (Feltham
et al., 1991; DeFond and Subramanyam, 1998).1 A detailed review of this extended
literature is beyond the scope of this paper. However, in Section 3, we provide
examples of such research and suggest ideas for direct extensions. These suggestions
include a more comprehensive investigation of the use of financial accounting
information in a variety of control mechanisms, the consideration of interactions
among control mechanisms, and the impact of limitations of financial accounting
information on the structure of control mechanisms.
The research discussed in Sections 2 and 3 suggests that the governance use of
financial accounting information likely affects the allocation and utilization of
resources in an economy. In Section 4, we propose empirical research to investigate
more directly the effects of financial accounting information on economic
performance, with an emphasis on the governance effects of accounting.
We begin Section 4 by discussing three channels through which financial
accounting information can affect the investments, productivity, and value
added of firms. The first channel involves the use of financial accounting
information to identify good versus bad projects by managers and investors
(project identification).2 The second channel is the use of financial accounting
information in corporate control mechanisms that discipline managers to direct
resources toward projects identified as good and away from projects identified
as bad (governance channel). The third channel is the use of financial
accounting information to reduce information asymmetries among investors
(adverse selection).
The research proposed in Section 4 concerns four issues. The first issue is
the aggregate economic effects of financial accounting information through
all three channels. The second issue is the economic effects of financial
accounting information specifically through the governance channel. The third
issue is how the economic effects of financial accounting information through
all channels, and through the governance channel alone, vary with other
factors, including the auditing regime, communication networks, financial
analyst following, relative importance of financing from capital markets
relative to banks, legal environment and other corporate control mechanisms,
the concentration of production within versus across firms, political influence
over business activities, and human capital. The fourth issue is how the
economic effects of financial accounting data through the governance channel,
and in total, vary with specific properties of financial accounting systems.
Cross-country designs represent a powerful setting for investigating the four
issues proposed in Section 4 because of significant cross-country differences in
both financial accounting regimes and economic performance. In addition, vast
cross-country differences in the legal protection of investors’ rights, communication
networks, and other institutional characteristics enable researchers to
explore how the economic effects of financial accounting information vary with
other factors.
Recent research in economics has laid important groundwork for the
research proposed in Section 4. Economic and finance theories linking
information, financial development, and economic growth motivate investigation
of the relation between financial accounting information and economic
performance. And recent empirical research in economics and finance has
developed designs and databases for testing the cross-country relation between
a variety of institutional characteristics and economic performance.
Furthermore, this emerging literature in economics and finance has
generated new evidence that the protection of investors against expropriation
by corporate insiders is an important economic issue. La Porta et al. (1997,
1998) document substantial cross-country differences in the protection of
investors against expropriation by insiders from laws and their enforcement.
Beginning with these influential papers, there has been a surge of empirical
research concerning the economic effects of the differential legal protection of
investors’ rights from country to country.3 Collectively, this research
documents a significant relation between a country’s protection of investors
against expropriation by corporate insiders and the domestic development and
efficiency of financial markets, costs of external capital, and economic growth
and efficiency. Such evidence supports the La Porta et al. (1997, 1998) view that
the protection of investors against expropriation by insiders has important
economic effects. Together this evidence, along with new evidence of a positive
relation between financial accounting information and economic performance
(Rajan and Zingales, 1998a; Carlin and Mayer, 2000), suggest that the
governance role of financial accounting information is likely to generate firstorder
economic effects.
We expect the research proposed in Section 4 to generate new evidence on
the significance of the economic effects of financial accounting information
from all sources, and from the governance role of financial accounting
information specifically. We also expect the proposed research to identify
institutional factors that influence the total economic effects of financial
accounting information, as well as the factors that influence the economic
effects of financial accounting information through its governance role.
Finally, we expect the proposed research to generate new evidence on the
properties of high- versus low-quality financial accounting systems from the
standpoint of the total economic effects, and from the standpoint of the
economic effects of financial accounting information through the governance
function.
In Section 5, we describe the relation between governance research and
other economic-based research in accounting. We argue that future research
on the connection between the governance use and capital markets
use of financial accounting information is important for developing a
more complete understanding of the effects of financial accounting information
on economic performance, and make suggestions for exploring
this connection. In Section 5, we also make further suggestions for
future capital markets research that naturally emerge from our consideration
of the channels through which financial accounting information
affects the economy, and from consideration of the potential
interactions between financial accounting regimes and other institutional
characteristics.
In Section 6, we provide a summary, and an important caveat to help put
our suggestions for future research in perspective. As we indicate there, we do
not intend that our suggestions for future research be viewed as complete in
terms of either the hypotheses or empirical designs that can be used to
investigate the governance role of financial accounting information. Nor are
we certain that our suggestions will stand up to scrutiny. Our hope is that
our suggestions will stimulate other accounting researchers to reflect on
new possibilities for testing the efficiency effects of financial accounting
information.
