We posit that limited transparency of firms’ operations to outside investors increases
demands on governance systems to alleviate moral hazard problems. We investigate how
ownership concentration, directors’ and executive’s incentives, and board structure vary with:
(1) earnings timeliness, and (2) organizational complexity measured as geographic and/or
product line diversification. We find that ownership concentration, directors’ and executives’
equity-based incentives, and outside directors’ reputations vary inversely with earnings
timeliness, and that ownership concentration, and directors’ equity-based incentives increase
with firm complexity. However, board size and the percentage of inside directors do not vary
significantly with earnings timeliness or firm complexity.
In the U.S. and in other economies with strong legal protection of outside
shareholders’ rights, transparency of a firm’s operations and activities to outside
investors disciplines managers to act in shareholders’ interests.1 Wepos it that limited
corporate transparency increases demands on corporate governance systems to
alleviate moral hazard problems resulting from a more severe information gap
between managers and shareholders, ceteris paribus. We consider two factors that
limit corporate transparency to varying degrees across large public U.S. companies:
(1) relatively uninformative financial accounting systems characterized by the
inability of firms’ GAAP earnings to explain changes in shareholder value in a timely
fashion (low earnings timeliness) and, (2) firm complexity due to extensive
geographic and/or line of business diversification.
We develop and test two sets of hypotheses concerning how corporate governance
systems vary with the diversification of firms and the timeliness of their earnings. Our
first set of hypotheses predicts that corporate governance systems of diversified firms
and firms with relatively low earnings timeliness are characterized by a relatively
strong link between stock price performance and the wealth of executives and
directors, and by high ownership concentration, to provide incentives to increase
shareholder value through monitoring and other costly activities. Our second set of
hypotheses concerns how the composition of the board of directors varies with the
diversification of firms and the timeliness of their earnings. We predict that, in order
to enable highly effective board monitoring, the boards of diversified firms and firms
with low earnings timeliness have a relatively high percentage of outside directors
with (1) a strong reputation as an outside director, and (2) expertise in the firm’s
main industry. We also explore how board size and the percentage of directors who
are insiders vary with diversification and the timeliness of earnings, but make no
directional predictions.
Our hypotheses build on prior research concerning the determinants of corporate
governance structures. In a seminal paper, Demsetz and Lehn (1985) conjecture that
the scope for moral hazard is greater for managers of firms with more volatile
operating environments. They document that ownership concentration is increasing
in stock return volatility, consistent with the idea that benefits of ownership
concentration increase in response to the difficulty of monitoring managers in
volatile environments. Himmelberg et al. (1999) extend Demsetz and Lehn (1985) by
considering additional firm attributes that proxy for the scope of managerial
discretion, such as research and development, advertising, and intangible asset
intensities. In related research, Smith and Watts (1992) document that firms’ growth
opportunities, as measured by book-to-market ratios, are associated with benefits to
imposing risk on managers via bonus plans and stock option grants.
Consistent with this literature, we adopt the perspective that observed governance
structures represent optimal contracting arrangements endogenously determined by
firms’ contracting environments.2 We extend this literature by expanding the
characterization of the scope for moral hazard to explicitly consider monitoring
technology and organizational complexity. This extension flows naturally from
Himmelberg et al. (1999). Using panel data, they document that a significant fraction
of the cross-sectional variation in managerial equity ownership is explained by
unobserved firm heterogeneity not captured by their proxies for the scope of moral
hazard. We posit monitoring technology and organizational complexity as two
important components of the scope for moral hazard that can be extracted from this
‘‘unobserved’’ firm heterogeneity and studied independently, while controlling for
components considered in previous research.
With respect to monitoring technology, we conjecture that inherent limitations of
firms’ information systems in generating information relevant for monitoring
managerial behavior influence governance structure formation by affecting the costbenefit
trade-off underlying governance mechanism configurations. Financial
accounting systems are a logical starting point for investigating properties of
information systems important for addressing moral hazard problems. Audited
financial statements prepared under Generally Accepted Accounting Principles
(GAAP) produce extensive, credible, low cost information that forms the foundation
of the firm-specific information set available for addressing agency problems. In
monitoring top managers, boards and outside investors cannot simply rely on stock
price changes to provide necessary information about the source of changes to firm
value. For example, agency models generally imply that managers should be held
accountable for controllable events and not uncontrollable events, while stock
returns aggregate the implications of all events. The accounting system facilitates
boards’ efforts to separate controllable from uncontrollable events. As an
illustration, managers often submit budgets to the board and then make periodic
reports explaining variances from budget, presumably aiding boards in separating
controllable from uncontrollable events (e.g., Zimmerman, 2002, Chapter 6).
We proxy for the intrinsic governance usefulness of accounting information with
earnings timeliness, which, paralleling Basu (1997) and Ball et al. (2000), wede fineas
the extent to which current GAAP earnings incorporate current economic income or
value-relevant information. While accounting reports used internally to monitor
managers may utilize methods that differ from GAAP, our premise is that earnings
timeliness proxies for inherent limitations of any transactions-based accounting
system to capture relevant information in a timely fashion, and that the usefulness of
these internal financial reporting systems to the board depends on earnings
timeliness. We predict that where the timeliness of financial accounting information
is relatively low, firms will substitute towards relatively more costly monitoring and
specific information gathering activities to at least partially compensate for low
timeliness of the accounting information.3
While we posit earnings timeliness as an inherent property of firms’ information
systems that impacts governance choices, it is important to ask whether timeliness
really is a distinct characteristic, rather than simply a byproduct determined by the
set of fundamental firm characteristics examined in previous research as governance
determinants. We examine this directly and conclude that timeliness is a distinct
characteristic. We find that a small portion of the cross-sectional variation in our
timeliness metric is explained by firm characteristics found to be linked with
governance structures in prior work including firms’ growth opportunities, return
volatility, size, the number of years a firm is public, CEO tenure, industry and
geographic diversification, and past performance.
We also investigate the relation between organizational complexity and governance
structures. While the construct ‘‘organizational complexity’’ could encompass a
wide range of organizational design features (see, e.g., Brickley et al., 1997, Chapters
8–10), we operationalize it with two measures of diversification. We utilize segment
revenue information to compute Hirfindahl-Hirschman indices measuring with-in
firm industry and geographic concentration. Our premise is that firms competing in
multiple industries and/or multiple geographic regions face more complex
operational and informational environments, and therefore, benefit more from
costly monitoring activities and specific information than firms with tighter industry
and geographic focus.
On thebasis of a cross-section of 784 firms in the Fortune 1000, wefind substantial
support for the predicted negative relation between the ‘‘strength’’ of corporate
governance systems and the timeliness of earnings, after controlling for other factors,
including growth opportunities, return volatility, firm size, the number of years a
firm is public, CEO tenure, whether the CEO or Chairman of the Board is the
founder, past performance, and membership in the banking or utility industries. As
predicted, we find that concentrated shareholdings, and the stock price-wealth link
of inside directors and the top five executives vary inversely with the timeliness of
earnings. We also document the predicted negative relation between the reputation
of outside directors and the timeliness of earnings. However, we fail to document a
significant negative relation between the stock price-wealth link of outside directors
and the timeliness of earnings unless we exclude the dummy variables for banks and
utilities, and fail to find that the percentage of outside directors with expertise in the
firm’s main industry, the percentage of directors who are insiders, or board size vary
significantly with the timeliness of earnings.
Our results concerning the predicted positive relation between the ‘‘strength’’ of
corporate governance systems and firm diversification are mixed. We document that,
as predicted, the stock price-wealth link of inside and outside directors increases with
line of business diversification, and the stock-price wealth link of specific outside
shareholders (i.e., ownership concentration) increases with geographic diversification.
The other predicted relations between diversification and the stock price wealth
links and thecomposi tion of the board arenot supported.
The remainder of this paper is organized as follows. Section 2 further discusses the
role of earnings timeliness and organizational complexity in influencing governance
mechanism choices. Section 3 describes our governance variables and develops
hypotheses concerning their sensitivity to the timeliness of accounting numbers and
organizational complexity. Section 4 describes control variables, sample, and data.
Section 5 describes our empirical design, results and sensitivity analyses. Issues
relating to the possibility of reverse causality in our model are discussed in Sections 6
and 7, presents a summary and discussion of implications of the paper.
