The Role of Financial Reporting and Transparency in Corporate Governance

Wayne R. Guay is the Yageo Professor of Accounting at The Wharton School of the University of Pennsylvania. This post is based on a recent article authored by Professor Guay; Chris Armstrong, Associate Professor of Accounting at Wharton; Hamid Mehran, Assistant Vice President at the Federal Reserve Bank of New York; and Joseph Weber, George Maverick Bunker Professor of Management and a Professor of Accounting at MIT Sloan School of Management.

In our article, The Role of Financial Reporting and Transparency in Corporate Governance (Economic Policy Review, 2016), we review the recent corporate governance literature that examines the role of financial reporting in resolving agency conflicts among a firm’s managers, directors, and capital providers. We view governance as the set of contracts that help align managers’ interests with those of shareholders, and we focus on the central role of information asymmetry in agency conflicts between these parties. The general conclusion in this literature is that financial reporting is valuable because contracts can be more efficient when the parties commit themselves to a more transparent information environment.

We first survey the papers that argue that financial reporting can alleviate information asymmetries that would otherwise impair the efficiency of important governance mechanisms. Empirical studies have found that information transparency is positively associated with the proportion of outside directors on the board, the proportion of outside directors on the audit committee, and the proportion of outside directors with financial expertise. One interpretation of these findings is that financial reporting transparency reduces information asymmetry between insiders and outsiders, which is more conducive to outsiders (and directors with financial expertise). Several of the more recent studies in this area attempt to discern the direction of causality in the relation between information transparency and board structure: shareholders may choose to appoint more outside directors when the information environment is more transparent, or outside directors might be able to influence the information environment of the firm. (Note that these two hypotheses are not mutually exclusive and causality might operate in both directions.)

We also highlight the distinction between formal and informal contracting relationships, and discuss how both play an important role in shaping a firm’s overall governance structure and information environment. Formal contracts, such as written employment agreements, are often quite narrow in scope and are typically relatively straightforward to analyze. Informal contracts govern implicit multi-period relationships and allow contracting parties to engage in a broad set of activities for which a formal contract is either impractical or infeasible. For example, the complexity of the responsibilities and obligations of a firm’s chief executive officer make it difficult to draft a complete state-contingent contract with the board. Consequently, although some CEOs have formal employment contracts, these contracts are necessarily incomplete and relatively narrow in scope. Consequently, the board and the CEO develop informal rules and understandings that guide their behavior over time.

Another key theme of our survey is that a firm’s governance structure and its information environment evolve together over time to resolve agency conflicts. That is, certain governance mechanisms and financial reporting attributes work more efficiently within certain operating environments. Consequently, one should not necessarily expect to see every firm converge to a single dominant type of corporate governance structure or compensation contract, or adopt a similar financial reporting system. Instead, one should expect to observe heterogeneity in these mechanisms that is related to differences in firms’ economic characteristics. We argue that the corporate governance literature seems to be unduly burdened by the normative notion that certain governance structures can be categorically identified and labeled as “good” or “bad.”

Next, we extend our discussion to the governance of banks and other financial intermediaries. Unlike the governance of traditional firms, bank governance is likely to differ in important ways due to the existence of certain external monitoring mechanisms (e.g., regulatory oversight and capital constraints), which may either substitute for or complement internal mechanisms, such as the board. In particular, external monitoring mechanisms are likely to serve the interests of various public constituencies who expect safe and sound financial institutions. These objectives do not necessarily coincide with those of investors who demand performance, which necessarily entails taking risks. The incentives for information production are also different in banks. Policies such as living wills, the explicit prohibition against future bailouts, and annual stress testing can encourage voluntary disclosure by banks. However, at the same time, regulations such as the annual stress testing may reduce other parties (e.g., credit analysts) incentives for information production. We argue that closer examination of how managers, analysts and regulators interact to produce information about banks and financial institutions is a ripe area for future research.

Finally, we discuss five governance mechanisms that can facilitate the production of information and enhance the transparency of banks, which may also have implications for other institutions. First, separating the positions of CEO and board chair can improve the accuracy and timeliness of financial reporting, since board chairs have incentives to provide information that may help avert large losses to stakeholders. Second, identifying successors to replace key members of the executive management team, should the need arise, is likely to facilitate effective smoother transition and a more steady flow of credible information. Third, an incentive structure that rewards managers who share information—both good and bad—and cooperate with regulators could be established. Fourth, stronger peer assessment, board evaluation, and sharing this information with regulators might facilitate the replacement of ineffective directors. Fifth, bank creditors could take a more prominent role in demanding timely and accurate information, which could improve not only the efficacy and efficiency of their own monitoring, but also that of other interested stakeholders.

The full article is available for download here.

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