Voluntary Reporting on Internal Control Systems and ... - EBSCOhost

JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010: 383-408

Voluntary Reporting on Internal Control Systems and Governance Characteristics: An Analysis of Large U.S. Companies1* Stephen Owusu-Ansah

Associate Professor of Accountancy University of Illinois at Springfield

Gouranga Ganguli

Professor of Accounting The University of Texas-Pan American It has been hotly debated for decades in the U.S. whether management should be required to report on internal controls over financial reporting, and whether independent auditors should be required to attest to such reports. It was only recently that the U.S. Congress was provoked by high profile corporate failures in the country to pass the Sarbanes-Oxley Act of 2002 (SOX)21 to mandate management report on internal control systems (U.S. House of Representatives, 2002). However, in spite of the absence of mandatory reporting requirements on internal control systems, several companies did voluntarily include a report on internal control systems in their annual reports.23 1*

The authors appreciate the comments by Titus Oshagbemi, Dwight Owsen, and Haiyan Zhou on earlier drafts of this article. They also wish to thank Jaime Carrillo, Chowdhury Kibria, Veronica Lopez, Tejinder Sethi, Adil Suliman, and Jorge Vidal for research assistance in data collection. Further, they wish to thank the reviewers for their insightful comments. An earlier version of this paper was presented at the International Academy of Business and Public Administration Disciplines Conference in 2008. 21 The Sarbanes-Oxley Act is named after its Congressional sponsors, Senator Paul Sarbanes (Democrat-Maryland) and Representative Michael Oxley (Republican-Ohio). President George W. Bush signed the Act into law on July 30, 2002, but its provisions took effect in differing periods. For example, large U.S. listed companies (with more than $75 million in market capitalization) were required to comply with Section 404 of the Act for the first fiscal year ending on or after November 15, 2004, while compliance date for foreign companies listed in the U.S. stock markets and small U.S. listed companies (with less than $75 million in market capitalization) was pending at the time of writing. Section 404 of the Act requires companies to include a report on internal control over financial reporting in their annual reports. 32 However, since 1991 banks with more than $500 million in total assets in the country have been required under the U.S. Federal Deposit Insurance Corporation Improvement Act (FDICIA) to JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010 (383)

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Internal Control Systems and Governance Characteristics

Given that reporting on internal control systems entails both out-of-pocket and indirect costs, one wonders why some companies voluntarily chose to do so before SOX made it a mandatory requirement. This article seeks to investigate this issue using 2001 data of a sample of Fortune 500 companies as the unit of analysis. While there has been considerable research on the determinants and capital market effects of voluntary disclosure (see, e.g., Jorgensen and Kirschenheiter, 2003; Ronen et al., 2003; Clement et al., 2003; Lundholm and Van Winkle, 2006; Lim et al., 2007), only Bronson et al. (2006) investigate the relationships between some corporate governance variables and management voluntary reporting on internal control systems of 397 midsized U.S. companies. Using 1998 data, they analyze the nature and content of voluntary management reports on internal control systems, and characteristics of companies issuing such reports. Since extant literature suggests that the frequency of voluntary reporting on internal control systems varies widely depending on whether a company is large, medium-sized, or small (Raghunandan and Rama, 1994; McMullen et al., 1996; Bronson et al., 2006), the present study contributes to the extant literature by examining a cross-sectional data of 198 Fortune 500 companies—the largest U.S. public companies.34 3Generally, public policy decisions are based on the experiences of such large companies, as they are industry leaders and pacesetters. Importantly, this study examines 2001 data—the last year in which the companies could effectively report on their internal control systems voluntarily.54 Unlike Bronson et al. (2006), the present study investigates the effects of both board and audit committee characteristics. The inclusion of the board characteristics in the model of this study is justified for two reasons. First, while an audit committee has an oversight responsibility for internal control system and related financial reporting matters, it is accountable to the main board, as the latter has the ultimate responsibility.56 The audit committee has a delegated oversight responsibility. Like the nomination and compensation committees, the audit committee is just one of the standing subcommittees of the main board. Second, an audit committee derives its characteristics from those of the main board. In fact, the effectiveness of the oversight function of the audit committee depends on the attitude, philosophy, and practices of the main board. Raghunandan and Rama (2007) hypothesize and find a positive relationship between the number of audit committee meetings and the number of board meetings, suggesting that the assiduousness of the main board is reflected in the activities of its report on their internal control systems to the U.S. Federal Deposit Insurance Corporation (FDIC). A report on internal control effectiveness is also required of banks with more than $1 billion in total assets. The FDICIA even required attestation by external auditors of the assertions by banks’ managements. 43 The criterion for inclusion in the Fortune 500 list is based on a company’s total revenues for a particular year. The largest (Wal-Mart Stores) and smallest (New York Times) companies on the 2002 list reported total revenues of $219.8 and $3.0 billion, respectively. The median (250th) company on the 2002 list was Alltel with total revenues of $7.6 billion (http://money.cnn.com/magazines/fortune/ fortune500_archive/full/2002/401.html). 54 Though the study relates to section 404 of SOX, which took effect on or after November 15, 2004, section 302 that includes some internal control-related requirements was effective at the end of August 2002, and effectively made 2001 the last year that a company could voluntarily report on its internal control system. 65 It must also be pointed out, however, that with audit committees’ increased responsibilities for financial reporting and auditing-related matters following the enactment of SOX, characteristics of the main board may become less relevant when examining issues that come under the purview of audit committees. JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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sub-committees. Using a sample of 198 Fortune 500 companies, this study analyzes whether corporate governance characteristics systematically relate to the incidence of management voluntarily reporting on internal control systems in annual reports prior to the passage of SOX. Holding constant the effects of company size, corporate performance, leverage, industry, sales growth, and external financing needs, this study finds that companies that voluntarily report on their internal control systems are more likely to have a smaller proportion of their ownership interest held by insiders, have audit committees that meet frequently, and are dominated by independent non-executive directors. In addition, it finds that companies that report on their internal control systems before SOX tend to have small-sized, independent boards with members not having directorships in other companies. However, the analysis fails to document any statistically significant relationships between voluntary internal control reporting and CEO/chair duality, auditor-type, and institutional ownership. This study contributes to the literature by providing empirical evidence on the role played by internal governance mechanisms in the decisions of large U.S. companies to report voluntarily on their internal control systems in annual reports prior to the passage of SOX. In particular, it documents that while not all board characteristics are relevant in a large company’s decision to voluntarily report on its internal control system, board independence, board size, and multiple directorships are, and as such, these characteristics should not be ignored in any future research. The rest of the article is organized as follows. The first section theorizes the relationships between corporate governance variables and voluntary reporting on internal control systems. It is followed up in section two with a description of the data collection procedures and research design. The empirical results are reported and discussed in section three. Section four presents the conclusions and suggestions for future research. HYPOTHESES DEVELOPMENT A review of the literature shows that voluntary disclosure is driven by several managerial incentives. Studies identify such incentives as: (1) to signal good news in company performance (Verrecchia, 1983; Dye, 1985; Lev and Panman, 1990); (2) to reduce the risk of litigation (Skinner, 1994; Kasznik and Lev, 1995); (3) to facilitate access to capital market thereby reducing cost of capital (Frankel et al., 1995; Healy et al., 1999; Lang and Lundholm, 2000); and (4) to signal managerial talent (Trueman, 1986). In this study, it is contended that a company would voluntarily issue a report on its internal control system to signal that it is a well run, efficient, effective, and lawabiding corporate citizen.76 Thus, one form of such publicity would be demonstrated through voluntarily reporting on internal control systems as an indicator of compliance, transparency, and accountability to a company’s universe of stakeholders. Further, in the absence of an active disclosure policy, outside investors would not be able to recognize the true value of a company’s other activities such as investment, production, and marketing (Lev, 1992) because of the creation of an information asymmetry between insiders and outsiders. Agency theory supports such a contention 76Hermanson (2000) provides empirical evidence consistent with this assertion. She reports that her survey respondents strongly agreed that voluntary management reporting on internal control system provides a better indicator of a company’s long-term viability. JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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by focusing on the conflict of interest between principals (stockholders and lenders) and agents (managers), its adverse consequences, and the steps that can be taken to mitigate them (Jensen and Meckling, 1976). Thus, according to agency theory, companies are permanently undervalued because of the cost of monitoring managers’ opportunistic behavior and self-serving financial and operating decisions. While such agency cost affects all public companies, the magnitude of such cost (and the consequent depression of market values) depends largely on the difficulties encountered by outsiders in monitoring and evaluating management performance. In this context, a voluntary disclosure policy, including reporting on internal control systems, is a cost-effective way for outsiders to evaluate a company and its management by narrowing the information asymmetry, which in turn, increases stockholder value by decreasing agency cost. Further, transparency about the effectiveness of a company’s internal control system discourages managers from engaging in opportunistic behavior and reassures its stockholders, employees, and the public that they have a level playing field in which to invest. Accordingly, the effects of variables that capture different dimensions of corporate governance87 on voluntary reporting on internal control systems are investigated. The variables are insider ownership, frequency of audit committee meetings, audit committee independence, board size, board independence, multiple directorships, CEO/chair duality, institutional holdings, and auditor-type. The relational conjectures are developed in the following sub-sections. Insider Ownership (INSOWN) Jensen and Meckling (1976) note that as the proportion of a company’s equity shares held directly or indirectly by insiders increases, the likelihood to undertake “excessive” perquisite consumption decreases, thereby aligning the interests of management and stockholders. Therefore, it is reasonable to expect that the monitoring role of the board would be less critical for companies with greater proportion of insider share ownership. Thus, companies with a large insider equity ownership stake should have lower agency conflict and lower agency cost. Therefore, it is hypothesized that: H1: Ceteris paribus, a company with greater proportion of its equity held by insiders is less likely to voluntarily report on its internal control. Frequency of Audit Committee Meeting (FACMT) It is expected that a company whose audit committee meets more frequently is likely to voluntarily report on its internal control. This expectation is based on an argument advanced by Kalbers and Fogarty (1993) that establishing an audit committee is one 87Instead of this, a composite index consisting of provisions of corporate governance codes and guidelines of best practices issued by public sector organizations such the Organization for Economic Cooperation and Development (OECD) could have been created or ratings generated for public companies by private sector organizations such as the GovernanceMetrics International (www.gmiratings.com) could have been used. For examples of the use of corporate governance index, see Gompers et al. (2003) and Tsipouri and Xanthakis (2004). A corporate governance index is not used in the present study because most constituent items of such index would be irrelevant in managerial decision to voluntarily report on internal control systems. JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010


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thing, establishing an effective audit committee is quite another. Prior literature upholds the view that key attributes of audit committees such as independence of members, members’ expertise in accounting and finance,98 and frequency of meeting (rather than the audit committees’ mere existence) critically impact their ability to effectively execute their mandate (Abbott and Parker, 2000, 2001; Beasley et al., 2000; Raghunandan et al., 2001; Carcello and Neal, 2003). Menon and Williams (1994), Collier and Gregory (1999), and Vafeas (1999) suggest that board and audit committee meetings are important events for monitoring financial reporting. Krishnan and Visvanathan (2007), however, find that companies reporting weaknesses in their internal control systems in the post-SOX period tend to have audit committees that meet more frequently. Krishnan and Visvanathan’s (2007) study reports on the content of management report on internal control system, while the current study investigates the act of reporting without analyzing the content. Taken into consideration the fact that Krishnan and Visvanathan (2007) examines post-SOX data and current study examines pre-SOX data, it is posited that: H2: Ceteris paribus, a company having an audit committee that meets frequently is more likely to voluntarily report on its internal control. Audit Committee Independence (ACIND) An audit committee composed of independent directors is better situated to assess objectively the quality of a company’s financial disclosure and the adequacy of internal controls than a committee that is affiliated with management. Thus, an independent audit committee with adequate resources helps to overcome management perquisites consumption and opportunistic behavior. This is because any occurrence of an incidence involving audit failure, earnings restatement, and earnings management entails greater reputational damage to independent audit committee members. Klein (2002) hypothesizes and finds a negative relation between audit committee independence and the extent of earnings management. Krishnan (2005) also documents a negative association between the proportion of independent members of audit committee and the existence of internal control problems. Based on the above line of reasoning and empirical evidence, it is hypothesized that: H3: Ceteris paribus, greater independence of an audit committee increases the likelihood of a company voluntarily reporting on its internal control. Board Size (BDSIZE) The size of a company’s board of directors affects the board’s effectiveness in its monitoring function and decision-making processes. The effectiveness is compromised if the size of the board is too large or too small. Thus, having more members on a board 98The effect of financial expertise of audit committee members is not examined in this study because of unavailability of data for the period studied. Public companies were not required to provide this information in their annual reports, proxy statements, and/or Form 10-K until the end of their fiscal years ending on or after July 15, 2003 (visit: http://www.sec.gov/news/press/2003-6.htm). Because there is no mandatory requirement for the provision of this information, the available data may not be reliable (for why the data on this variable might not be reliable prior to SOX, see Beresford, 2005). JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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provides a broader experience base, which can be valuable given a broad scope of a board’s mandate, but it can also be unwieldy and difficult to keep its meetings focused (Gladstein, 1984). It may also reduce the responsibility individual members feel, as one member might presume another will address a troubling issue. Organizational theory suggests that large groups take relatively more time to make decisions (Steiner, 1972). Similarly, having too few members in a group hampers it from effectively achieving its mandate. Though there is no theoretical prescription for the optimum number of members that should serve on a board, the number of members should allow active participation of all members, while keeping the size manageable. Empirical research shows that large board size negatively correlates with both profitability and market valuation of companies (Yermack, 1996; Eisenberg et al., 1998). Persons (2006) also reports that smaller board size decreases the likelihood of non-financial fraud reporting. While the size of a particular board must be appropriate for a company and its circumstances, it is hypothesized that: H4: Ceteris paribus, large board size decreases the likelihood of a company voluntarily reporting on its internal control. Board Independence (OUTDIR) A board dominated by independent non-executive (outside) directors is expected to be associated with voluntary reporting on internal control. The role of the board of directors is to monitor management decisions and protect stockholders’ interests (Fama and Jensen, 1983). Having a greater proportion of outside non-executive directors on a board would most likely result in better monitoring of management activities and curbing of managerial opportunism (Fama, 1980; Fama and Jensen, 1983). Evidence of the power and effectiveness of non-executive directors in disciplining executive (inside) directors exists in the literature. Weisbach (1988) finds that the association between poor performance and CEO resignation is stronger for companies with outsider-dominated boards compared to companies with insider-dominated boards, suggesting that outside board members enhance independence and monitoring power over CEOs. Brickley et al. (1994a) also document a positive association of average abnormal stock return with the announcement of poison pills and companies with outsider-dominated boards. Furthermore, Beasley (1996) finds that companies without financial reporting problems have a greater proportion of outside directors than those with such problems. These empirical evidences support the contention that greater proportion of outside directors, by being more independent of management, may be more inclined to encourage the practice of good governance and transparency. Recently, Lim et al. (2007) also find that boards of Australian-listed companies composed largely of independent directors voluntarily disclose more forward-looking, quantitative, and strategic information in annual reports. Hence, the following hypothesis is tested: H5: Ceteris paribus, a company whose board is dominated by independent directors is more likely to voluntarily report on its internal control. Multiple Directorships (MDIR) An effective board is one whose members have sufficient time and dedication to JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010


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their job. Holding multiple directorships affects the time a board member devotes to the individual companies on whose boards he/she serves. However, there are two opposing viewpoints on multiple directorships. On one hand, Fama (1980) and Fama and Jensen (1983) argue that multiple board appointments signal director quality. Vafeas (1999) also suggests that the number of directorships held by a director might proxy for reputational capital, with such individuals viewed as high quality directors. Moreover, serving on multiple boards can provide a director with greater diversity of experience, which is likely to enhance his/her effectiveness. On the other hand, Morck et al. (1988) contend that individuals who hold directorships in multiple companies are incapable of effectively monitoring the management of the individual companies they serve. Lipton and Lorsch (1992) report lack of time as the most commonly shared complaint among such board members. Over-committed and over-worked directors might serve less frequently on important board standing committees such as audit or compensation committees, let alone review the audit process and internal controls. Following the alternative line of argument, it is hypothesized that: H6: Ceteris paribus, multiple directorships decrease the likelihood of a company voluntarily reporting on its internal control. CEO/Chair Duality (DUALITY) Perhaps the ultimate threat to the independence of a board occurs when a CEO concurrently serves as the board chairperson (i.e., CEO/chair duality). Defenders of the practice argue that the appointment of CEO as chair eliminates the possibility of the board not receiving the same information as the executives. Holding both positions helps to avoid an inherent disjunction of information between the board and top management. Hence, proponents argue that the sharing of information can unify the management and directors (Sanders and Carpenter, 1998). However, a chair’s service in both capacities may also create monitoring problems. If a board’s role is to monitor (and potentially override) the decisions of management, it is difficult to believe that the CEO would be inclined to disagree with his or her own decisions. By sharing the role, a CEO can influence a board. It will be harder for a board to reject one of its own, making the monitoring function increasingly difficult to the extent that management will not expend resources on internal control reporting. Indeed, Forker (1992) hypothesizes and finds that CEO/chair duality poses a threat to monitoring quality and is detrimental to the quality of stock option disclosure. Dechow et al. (1996) also find that the likelihood of earnings manipulation increases if the dual role is not separated. Hence, it is hypothesized that: H7: Ceteris paribus, a company that combines the roles of CEO and chairperson is less likely to voluntarily report on its internal control. Institutional Holdings (INSTHLD) Generally, institutional investors have both resources and incentives to monitor more closely the actions of management and board of directors than their smaller counterparts (Shleifer and Vishny, 1986). As Stiglitz (1985) argues, individual stockholders owning relatively small proportions of a company’s equity capital have little or no incentive to gather and bear the costs of collecting information to enable them to monitor and JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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control the behavior of the board. Despite the potential influence of large institutional investors on corporate governance, they are historically known to pursue an “exit” strategy (i.e., selling their holdings) when dissatisfied with the performance of a company in which they own shares. However, such strategy is often costly due to the large size of their portfolios, as dumping of their holdings on the market would depress stock prices. Consequently, such investors are now increasingly attempting to control managerial behavior through such means as board representation, addition of non-executive directors to boards, or removal of directors by direct action. Institutional investors consider recent corporate governance initiatives essential if they aim at monitoring the principal/agent problem (Solomon et al., 2000). Empirical evidence on the role of institutional investors in monitoring board of directors is mixed. By investigating proxy contests, Pound (1988) concludes that institutional stockholders are not efficient monitors, and as such, are more likely to vote in favor of management. Alternatively, Brickley et al. (1988, 1994b) investigate institutional voting patterns in management-initiated anti-takeover amendments and find institutional opposition to be greatest when proposals reduce stockholder wealth. Research also shows that institutional stockholder activism leads to positive changes in governance structure and stockholder wealth (Nesbitt, 1994; Smith, 1996; Akhigbe et al., 1997; Gompers et al., 2003). These evidences support the emerging role of institutional investors as active monitors of corporate management. Accordingly, it is hypothesized that: H8: Ceteris paribus, a company with greater proportion of its equity shares held by institutional investors is more likely to voluntarily report on its internal control. Auditor-type (AUDT) The external audit function plays an important role in corporate governance by lending credibility to published financial statements. It does this by auditing the financial statements and providing reasonable assurance that they conform to the contractual relation between the principal (investors and creditors) and the agent (top management), and are free of material misstatement caused by errors and fraud. Financial statements are perceived to be more credible and legitimate when they are accompanied by an independent audit report. In a competitive market of brand-name producers such as the Big-5 audit firms, product differentiation in that group might be a distinguishing feature among them, and because external auditors of all the companies in the sample are Big-5, a nondirectional hypothesis is formulated: H9: Ceteris paribus, the identity of the external audit firm of a company has an influence on whether the company voluntarily reports on its internal control. Control Variables Apart from the governance variables, prior literature suggests that certain companyJOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010


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specific characteristics associate with voluntary disclosure, and are therefore controlled for in this study. They are company size, profitability, leverage, industry, sales growth, and external financing needs. Company Size (COSIZE). Financial reporting entails both direct and indirect costs. Voluntary reporting on internal control systems is not free. Companies incur preparation costs (e.g., time spent on establishing and evaluating the internal control system and determining report content) as well as potential costs of additional legal exposure resulting from such act of reporting. Because of the costs involved, only large companies are more likely to undertake such voluntary reporting, as they tend to have more employees and greater resources. Usually, large companies have strong internal control systems. Ge and McVay (2005) find a negative relation between disclosure of material weakness in internal control system and company size. Raghunandan and Rama (1994), McMullen et al. (1996), and Bronson et al. (2006) find a positive relation between company size and voluntary reporting on internal control. Hence, COSIZE is expected to have a positive effect on voluntary reporting on internal control. Profitability (PROFT). Prior literature suggests a positive relation between profitability and voluntary disclosure. Cerf (1961) argues that management discloses more information about their performance to support the continuance of their positions and performance-related compensatory schemes that may be due to them. This reasoning leads to an expectation of a positive association between PROFT and voluntary reporting on internal control. This expectation is consistent with Krishnan’s (2005) finding that the existence of loss is positively associated with the reporting of an internal control problem in companies that change auditors. Ashbaugh-Skaife et al. (2007) also find that poor financial performance positively relates to internal control weaknesses. These empirical evidences suggest that loss-making companies may not adequately invest in internal control systems, let alone voluntarily report on their effectiveness. Hence, a positive relationship is expected between PROFT and voluntary reporting on internal control. Leverage (LEVG). Voluntary reporting on internal control is associated with agency cost of debt. Jensen and Meckling (1976) suggest that the need to monitor management arises from the conflicting interests of management and contributors of capital. Particularly, agency cost increases as the proportion of fixed portion of a company’s capital structure increases because the tendency of wealth transfers, either from debtholders to stockholders or from stockholders to managers, increases with leverage. Hence, the need to monitor management by debtholders increases when the fixed return portion of a company’s capital increases. As with the case of equity, management has incentive to control agency cost of debt through voluntary reporting. An alternative view is that companies in poor financial condition may not be able to withstand the initial negative consequences that are needed to derive any benefits from more extensive disclosure. Hence, such companies may not voluntarily disclose information (see, e.g., Cormier and Magnan, 2003). Therefore, the direction of the relationship between LEVG and voluntary reporting on internal control cannot be predicted. Industry (IND). Sprouse (1967) states that accounting policies and techniques, and by implication the voluntary internal control reporting vary, by industry. The relationship between industry and voluntary disclosure is confirmed in the extant literature (e.g., Meek et al., 1995). Beasley et al. (2000) find that the likelihood of fraud varies across industries JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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and that there is a positive association between weak internal control environment and incidence of fraud (Bell and Carcello, 2000). Hence, the direction of the relationship between IND and voluntary reporting on internal control cannot be predicted. Sales Growth (GROWTH). Bronson et al. (2006) find that companies with rapid sales growth are less likely to voluntarily issue reports on their internal control systems. Therefore, this variable is controlled for in the model and it is expected to have a negative association. External Financing (EFINt-1). Dechow et al. (1996) state that a company’s need to raise additional financing on more favorable terms could be an incentive for its management to engage in earnings manipulation. However, the incentive to manipulate earnings may be constrained by an effective internal control system. Therefore, the demand for external financing (EFINt-1) is explicitly controlled for, and it is expected to have a negative effect on voluntary internal control. CHARACTERISTICS INTERNAL CONTROLreporting SYSTEMSon AND GOVERNANCE RESEARCH DESIGN Empirical Model Empirical Model To test the relationship between the governance characteristics and voluntary To test the relationship between the governance characteristics and voluntary reporting on internal control system (VRICS), a simultaneous equation (two-stage) reporting on internal control system (VRICS), a simultaneous equation (two-stage) system of two cross-sectional models is estimated. The use of this estimation technique system of two cross-sectional models is estimated. The use of this estimation technique is is justified justified by by prior prior literature literature (see, (see, e.g., e.g., Lim Lim et et al., al., 2007), 2007), which which suggests suggests that that one one of of this this study’s study’s independent independent variables, variables, board board independence independence (OUTDIR), (OUTDIR), may may be be endogenously endogenously determined. determined. That That is, is, the the OUTDIR OUTDIR variable variable becomes becomes stochastic stochastic and and correlates correlates with with the the error term of the equation in which it appears as an explanatory variable. Indeed, error term of the equation in which it appears as an explanatory variable. Indeed, the the result ofaaWald Wald of exogeneity (Chi-squared = 18.65, p = 0.0000) the result of testtest of exogeneity (Chi-squared = 18.65, p = 0.0000) suggests suggests the presence presence of endogeneity situation VRICS and OUTDIR are of endogeneity problem—aproblem—a situation where VRICSwhere and OUTDIR are determined by determined by the same company-specific characteristics. Consequently, to and include the same company-specific characteristics. Consequently, to include OUTDIR the OUTDIR and the company-specific characteristics onanthe right-hand side biased of an company-specific characteristics on the right-hand side of equation would yield equation would yield biased and inconsistent estimates (Pindyck and Rubinfeld, 1991; and inconsistent estimates (Pindyck and Rubinfeld, 1991; Gujarati, 1995). Gujarati, 1995). This endogeneity endogeneity problem problem is is dealt dealt with with by by adopting adopting aa two-stage two-stage regression regression This estimation methodology. In the first stage, an equation depicting the relationship estimation methodology. In the first stage, an equation depicting the relationship between OUTDIR and the company-specific characteristics is estimated. This equation between OUTDIR and the company-specific characteristics is estimated. This equation has as its independent variables all the characteristics that determine both VRICS and has as its independent variables all the characteristics that determine both VRICS and OUTDIR as per prior literature.109 Thus, the following ordinary least-squares model is OUTDIR as per prior literature.9 Thus, the following ordinary least-squares model is estimated in the first stage: estimated in the first stage: OUTDIR = δ00 + δ1INSOWN + δ2FACMT + δ3ACIND + δ4BDSIZE + 12 δ5MDIR + δ6DUALITY + δ7INSTHLD + 12 + δ5MDIR + δ6DUALITY + δ7INSTHLD + +  j AUDT j j 8



δ13COSIZE + δ14PROFT + δ15LEVG +

24

  j IND j + δ GROWTH + 25

The problem, described by Lim et al. (2007), of the jlack 16 of well-established theoretical underpinning or empirical evidence to guide which company-specific characteristics influencing board inδ26EFINt-1 + δ27VRICSt-1 + ν (1) dependence should be chosen is encountered. Bhagat and Black (2002) state that the factors that influence board independence are not well understood. 9

In the second stage, an equation that has the same independent variables as the JOURNAL OF MANAGERIAL ISSUES 1) Vol.isXXII Number 3 Fall 2010 first-stage regression (i.e., Equation estimated. However, the two equations differ in two instances. First, the second-stage equation (i.e., Equation 2) does not have the incidence of voluntary reporting on internal control system in the prior year (VRICSt-1) as one of its independent variables. Second, the second-stage equation uses the fitted

OUTDIR = δ0 + δ1INSOWN + δ2FACMT + δ3ACIND + δ4BDSIZE + 12 + δ5MDIR + δ6DUALITY + δ7INSTHLD +  j AUDT j Owusu-Ansah and Ganguli j 8



δ13 COSIZE + δ14 PROFT + δ15 LEVG + 13 14 15

393

24 24

  j IND j + δ GROWTH + 25 25

j16 δδ26EFIN + VRICSt-1 + + ν ν EFINt-1 + δδ27 VRICS 26 t-1 27 t-1

(1) (1)

In the second secondstage, stage,ananequation equation that same independent variables the In the that hashas thethe same independent variables as theasfirstfirst-stage regression (i.e., Equation 1) is estimated. However, the two equations differ stage regression (i.e., Equation 1) is estimated. However, the two equations differ in two in two instances. First, the second-stage (i.e., Equation 2) have does the not incidence have the instances. First, the second-stage equationequation (i.e., Equation 2) does not incidence of voluntary oncontrol internal control in year the prior year)(VRICS as one t-1of) of voluntary reporting reporting on internal system in system the prior (VRICS t-1 O WUSU -A NSHA AND G ANGULI as one of its independent variables. Second, the second-stage equation uses the fitted its independent variables. Second, the second-stage equation uses the fitted values of the values of the board (OUTDIR) independence (OUTDIR) labeled asinstead FIT_ OUTDIR, board independence variable, labeledvariable, as FIT_ OUTDIR, of the raw instead the raw the data on OUTDIR. Thederived fitted values are first-stage derived the first-stage regression. Thus, following maximum-likelihood model from isregression. estimated in the data onof OUTDIR. The fitted values are fromprobit the Thus, second stage: maximum-likelihood probit model is estimated in the second stage: the following Prob (VRICS = 1) = β0 + β1INSOWN + β 2FACMT + β 3ACIND +

0 The problem, described by Lim et 1al. (2007), of 2 the lack of 3 well-established theoretical underpinning or empirical evidence to guide which company-specific characteristics influencing β44BDSIZE + β55FIT_OUTDIR β66MDIR + Bhagat β77DUALILY + + (2002) state that the board independence should be chosen is + encountered. and Black 13 factors that influence board13 independence are not well understood. 9



β8INSTHLD + + β14COSIZE + β+15β PROFT + 14COSIZE + β15PROFT +

AUDT

j XXII Number 3 Fall 2010 j JOURNAL OF MANAGERIAL ISSUES Vol. j 9

25 25 + β26βGROWTH+ EFINt-1 + ε β27EFINt-1 + ε β16 16LEVG + + β26GROWTH+ 27 



j17

j IND j

(2)

Though a simultaneous equation system of two models is estimated, only the results Though a simultaneous equation system two models is estimated, only the results of of Equation 2 are of primary interest. In of addition, the first nine independent variables Equation 2 are primary interest. In addition, nine independent variables in in Equation 2, of which measure different aspectsthe of first governance characteristics of the Equation 2, constitute which measure of governance characteristics of the companies, the testdifferent variables.aspects The remaining six variables in Equation 2 companies, constitute the test variables. The remaining six variables Equation 2 control for company-specific characteristics, identified in prior literature,inthat relate to control fordisclosure. company-specific characteristics, identified in prior literature, that relate to voluntary voluntary disclosure. Sampling Design and Data Collection Sampling Design and Data Collection The sample consists of non-financial, U.S. domestic companies that were on the 2002The Fortune 500 consists list. Fortune 500 companies aredomestic regardedcompanies as the largest sample of non-financial, U.S. thatpublicly were onheld the companies in 500 the U.S. Only 419 companies list publicly are included 2002 Fortune list. Fortune 500non-financial companies are regardedonasthe the2002 largest held in the sample because FDIC419 requires banks and other financial institutions report companies in the U.S. Only non-financial companies on the 2002 list are to included on their internal control systems. Further, to and ensure homogeneity, only U.S. to domestic in the sample because FDIC requires banks other financial institutions report companies are analyzed. to Further, avoid thetoproblems of confounding the results, four on their internal control Thus, systems. ensure homogeneity, only U.S. domestic foreign companies are excluded. This is because their financial reporting practices companies are analyzed. Thus, to avoid the problems of confounding the results, four may be influenced home countries’ reporting requirements. For datapractices recency foreign companies by aretheir excluded. This is because their financial reporting purposes, a requestby fortheir hardhome copies of 2001110reporting annual reports and Form 10-Ks sent may be influenced countries’ requirements. For data was recency 10 purposes, a request for hard copies of 2001 annual reports and Form 10-Ks was sent 10 11 was the last year in which the companies could voluntarily report on Asthe indicated earlier, 2001 to remaining 368 non-financial, U.S. domestic companies on the 2001 list. Two their internal control systems because 302responded of SOX, which some internal controlhundred thirty-two companies (63 section percent) withincludes the requested materials. related requirements, became effective at the end of August 2002, though the provisions of section From the 232 non-financial, U.S. domestic companies, two sets of samples were 404, which relates more closely to the study, took effect on or after November 15, 2004. drawn. The first set, labeled the experimental group, consists of those companies that voluntarily reported on their internal control in their 2001 annual reports. The second JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010 set, labeled the control group, consists of those that did not. A sample of 198 10

As indicated earlier, 2001 was the last year in which the companies could voluntarily report on

394


to the remaining 3681211 non-financial, U.S. domestic companies on the 2001 list. Two hundred thirty-two companies (63 percent) responded with the requested materials. From the 232 non-financial, U.S. domestic companies, two sets of samples were drawn. The first set, labeled the experimental group, consists of those companies that voluntarily reported on their internal control in their 2001 annual reports. The second set, labeled the control group, consists of those that did not. A sample of 198 companies (110 experimental and 88 control companies) remains after excluding those companies that lacked data on many of the governance characteristics.1312 Table 1 presents the industry distribution of the companies. The companies are not evenly represented in either the experimental or the control group. Companies in the consumer services industry (IND_3) are most represented, accounting for about 25 percent of the sample. They are followed by those in the “industrials” (IND_5) sector, and then by those in the consumer goods (IND_2) industry, with each accounting for about 20 and 18 percent of the sample respectively. Companies in the telecommunications sector (IND_8) are least represented, constituting only three percent. The data on board and audit committee characteristics and other governance variables were hand collected from 2001 proxy statements of the companies published online by the Lexis-Nexis, SEC’s Edgar, and Mergent’s databases. In addition, 2001 data on insider and institutional shareholdings were hand collected from various hard copies of Standard and Poor’s Stock Reports and Mergent’s Handbook of Common Stocks. Further, the financial data were collected from companies’ annual reports and Form 10-Ks except the free cash flow per share data, which were obtained from the Lexis-Nexis online database. As explained later, the data on the free cash flow per share were based on the companies’ financial years ending in 2000. Measurement of Independent Variables Insider ownership (INSOWN) is measured by the proportion of outstanding equity shares owned by insiders (executive management and directors). The frequency of audit committee meeting (FACMT) is measured by the number of times it met in 2001. For the audit committee independence (ACIND) variable, a dummy coded one if a company’s audit committee meets the independence criteria of the New York Stock Exchange (NYSE), zero otherwise.1413 The independence of directors is defined by NYSE in terms of directors having “no relationship to the company that may interfere with the exercise of their independence from management and the company” (NYSE Listed Company Manual §303.01[B][2][a]). Thus, an audit committee is independent only if all members are non-executive directors, where non-executive directors are defined as the non-salaried members of a board who have no business or other relationships with the company in any material way other than being a board member. Board size (BDSIZE) is measured by the number of directors serving on the board of a company.

12

Of the remaining 415 non-financial U.S. domestic companies on the 2002 Fortune 500 list, 47 companies were deleted because they were not on the 2001 list. 12 Statistically, the size of the control group need not be the same as that of the experimental group. 1413This requirement is applied to all the companies regardless of the U.S. stock market in which they are listed. The NYSE independence criteria are accessible at http://www.nyse.com/pdfs/section303A_final_rules.pdf. 11

JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

IND_4

IND_5

IND_6

IND_7

IND_8

IND_9

Healthcare

Industrials

Oil and Gas

Technology

Telecommunication

Utilities

Excess due to rounding-off.

IND_3

Consumer Services

†

IND_2

IND_1

Variable Notation

Consumer Goods

Basic Material

Type of Industry

Commodity and specialty chemicals, forestry and paper, metals, and mining. Automobiles and parts, food and beverage, food producers, household, leisure and personal goods, and tobacco. Food and drug retailers, general retailers, media, and travel and leisure. Health care, health care equipment and services, pharmaceuticals, and biotechnology. Construction and materials, industrial goods and services, electronic and electrical equipment, industrial engineering and transportation, and support services. Oil and gas producers, oil equipment, service and distribution. Software and computer services, and technology hardware and equipment. Fixed line telecommunications, and mobile telecommunications. Electricity, gas, water, and multi-utilities.

Nature of Business

7 88

110

2

8

2

19

6

22

18

4

9

3

7

9

20

10

27

17

8

No. of Companies Experimental Control

Table 1 Industrial Composition of Sample Companies (n = 198)

100.2†

8.1

2.5

7.6

5.6

19.7

8.1

24.8

17.7

6.1

% of Sample

Owusu-Ansah and Ganguli 395


396


Board independence (OUTDIR) is operationally defined as the proportion of non-executive independent directors on the board. Multiple directorships (MDIR) is measured by the proportion of directors on a board with directorships in other companies. The CEO/chair duality (DUALITY) effect is measured by a dummy coded one if a company’s CEO is the same as the chair of its board, zero otherwise. Institutional investors’ stockholdings (INSTHLD) is measured by the proportion of outstanding equity shares owned by institutional stockholders. A dummy is used to capture the auditor-type (AUDT) effect. The dummy is coded one if a company was a client of either PricewaterhouseCoopers (PWC), KPMG, Deloitte and Touche (DT), Ernst and Young (EY), or the now defunct Arthur Andersen (AA), zero otherwise. Measurement of Control Variables Company size (COSIZE) is measured by the natural logarithm of total assets. Profitability (PROFT) is operationally defined as the ratio of net income before interest and taxes to total assets. Leverage (LEVG) is measured by the ratio of long-term liabilities to total assets. The industry (IND) effect is captured with a dummy coded one if a company operates in a sector represented in the Industry Classification Benchmark (ICB), except for the “financials,”1514 zero otherwise. Sales growth (GROWTH) is measured by the percentage increase in net revenue over previous year’s figure. Lastly, 2000 data on free cash flow per share is used as a proxy for ex-ante demand for external financing (EFINt-1). Free cash flow per share is defined as net operating cash flow less capital expenditure and dividends scaled by outstanding number of shares. EMPIRICAL RESULTS AND DISCUSSION Univariate Analysis Table 2 reports the descriptive statistics for both the test and control variables. On average, the companies in the experimental group are larger in size (COSIZE), have small-sized boards (BDSIZE), have experienced greater growth in sales (GROWTH), and are more profitable (PROFT). In addition, the experimental companies have more directors holding multiple directorships in other companies (MDIR) and more CEOs concurrently serving as board chairpersons (DUALITY) than companies in the control group. Further, institutional investors (INSTHLD) hold relatively greater proportion of equity shares in companies in the experimental group than in the control group. However, on average, the proportion of insider shareholdings (INSOWN) is higher for control companies than for companies in the experimental group. Table 2 also presents the results of a two-sample mean-comparison test (based on parametric t-test statistics) and a two-sample median-comparison test (based on nonparametric Wilcoxon rank-sum test statistics). The primary focus here is to examine whether there are significant differences in the governance variables. The results show that there are several significant differences in the governance characteristics of the 1514The Industry Classification Benchmark (ICB) is proprietary to the FTSE International Limited and Dow Jones & Company, and has been licensed for use by the NYSE. The ICB, which comprises 10 industries, 18 supersectors, 39 sectors, and 104 sub-sectors provides accurate and globally accepted industry and sector classifications (www.nyse.com/about/listed/industry.shtml?ListedComp=All). Except for the “financials” category, the rest of the industry classification by ICB is shown in Table 1. Recall that companies in the finance industry were excluded in selecting the sample. JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

*p < 0.10; **p < 0.05; ***p < 0.01 (based on two-tail test). † Two-sample t-test with equal variances. †† Two-sample Wilcoxon rank-sum test.

0.016 6.000 1.000 11.000 0.882 0.481 1.000 0.685 0.000 0.000 0.000 0.000 0.000 23.222 0.082 0.331 2.201 0.675 1.000

0.057 6.882 0.927 11.427 0.840 0.502 0.764 0.646 0.364 0.173 0.209 0.218 0.027 23.262 0.092 0.357 10.276 -0.970 0.873

INSOWN FACMT ACIND BDSIZE OUTDIR MDIR DUALITY INSTHLD PWC KPMG DT EY AA COSIZE PROFT LEVG GROWTH EFINt-1 VRICSt-1

0.097 2.504 0.261 2.518 0.123 0.221 0.427 0.217 0.483 0.380 0.409 0.415 0.164 1.151 0.113 0.194 47.806 8.408 0.335

Experimental Group (n = 110) Mean Std. Dev. Median

Variable 0.092 7.466 0.591 11.011 0.827 0.506 0.705 0.630 0.205 0.250 0.330 0.284 0.011 22.650 0.043 0.312 8.281 0.670 0.125

0.139 3.227 0.495 2.620 0.095 0.206 0.459 0.250 0.406 1.009 0.473 0.454 0.107 1.089 0.210 0.214 67.175 3.731 0.333

0.031 7.000 1.000 10.000 0.857 0.500 1.000 0.710 0.000 0.000 0.000 0.000 0.000 22.663 0.067 0.273 0.077 0.835 0.000

Control Group (n = 88) Mean Std. Dev. Median

Table 2 Descriptive Statistics of Independent Variables (n = 198)

2.062** 1.434 -6.147*** -1.135 -0.707 0.128 -0.936 -0.491 -2.469** 0.741 1.922* 1.066 -0.788 -3.810*** -2.123** -1.523 -0.244 1.699* -15.661***

3.414*** 1.263 -5.797*** -1.270 -1.340 0.318 -0.937 0.031 -2.438** -0.218 0.909* 1.065 -0.789 -3.417*** -1.894* -1.797* -1.624 0.900 -10.464***

z-statistic††

Tests of Differences t-statistic†

Owusu-Ansah and Ganguli 397


= = = = = = = = = = = = =

=

MDIR DUALITY INSTHLD PWC KPMG DT EY AA COSIZE PROFT LEVG GROWTH EFINt-1

VRICSt-1

Variable definition: INSOWN = FACMT = ACIND = BDSIZE = OUTDIR =

the proportion of outstanding shares owned by insiders (executives and directors); the number of audit committee meetings in 2001; 1 if a company’s audit committee has only non-executive directors, 0 otherwise; the number of directors serving on a board of a company; the proportion of non-executive (outside) directors’ make up of a board of a company, where non-executive directors are defined as the non-salaried members of a board who have no business or other relationships with the company in any material way other than being a board member; the proportion of directors on a board with directorships in other companies; 1 if a company’s CEO is also the chair of its board of directors, 0 otherwise; the proportion of outstanding shares owned by institutional investors; 1 if a company is audited by PriceWaterhouseCoopers, 0 otherwise; 1 if a company is audited by KPMG, 0 otherwise; 1 if a company is audited by Deloitte and Touche, 0 otherwise; 1 if a company is audited by Ernst and Young, 0 otherwise; 1 if a company is audited by Arthur Andersen, 0 otherwise; the natural logarithm of total assets at year-end; return on capital employed defined as net income before interest and taxes to total assets; the ratio of long-term liabilities to total assets; percentage increase in net revenues over previous year’s; free cash flow per share defined as 2000 net operating cash flow less capital expenditure and dividends scaled by outstanding number of shares; and 1 if a company voluntarily reports on its internal control system in 2000, 0 otherwise.

Table 2 (con’t) Descriptive Statistics of Independent Variables (n = 198)

398 Internal Control Systems and Governance Characteristics



399

companies based on whether they choose to voluntarily report on their internal control or not. Companies that voluntary reported on their internal control systems have relatively smaller proportion of their shares held by top management and directors (INSOWN) than their counterparts that did not do so. For example, the z-statistic of the Wilcoxon rank-sum test for this variable is statistically significant (p < 0.01). A significant difference is also found in the independence of the audit subcommittee (ACIND), but not of the main board (OUTDIR) between companies in the experimental and control groups. Further, significant differences are documented in the type of auditors between companies in the experimental and control groups. More PWC-audited companies in the experimental group significantly chose to voluntarily report on their internal control systems than their counterparts in the control group. A similar inference can also be drawn for companies audited by DT. However, no significant differences between the experimental and control companies are found with respect to frequency of audit committee meeting (FACMT), the number of directors holding multiple directorships in other companies (MDIR), proportion of equity shares held by institutional investors (INSTHLD), and whether a CEO also wears the hat of a chair of the board (DUALITY). Bivariate Analysis Table 3 presents the Pearson product-moment correlation matrix of the governance and control variables. While there are several statistically significant pairwise correlation coefficients, none of them has a magnitude large enough to warrant multicollinearity concerns. Gujarati (1995) recommends a correlation coefficient of 0.800 as the threshold for multicollinearity concerns. The highest correlation coefficient is 0.504 between BDSIZE and MDIR (see Table 3), suggesting that companies having boards with many members tend to have most of them also holding directorship positions in other companies. Though multicollinearity, as measured by the pairwise correlation coefficients reported in Table 3, is not problematic, the existence of certain degree of collinearity is still possible since one independent variable may be an approximate linear function of a set of several other independent variables. Consequently, a post-estimation variancecovariance of the estimators (VCE) of Equation 2 is performed. Like the results of the Pearson product-moment correlation procedure, the VCE (the matrix of which is not tabulated) suggests that the degree of multicollinearity is not severe. Multivariate Analysis Since univariate analyses provide limited information about the relationships between the governance characteristics and VRIC, it is important to determine whether such relationships continue to exist when other company-specific characteristics that could also be associated with VRIC are controlled. Hence, a multivariate simultaneous equation system of a linear and a maximum-likelihood probit model is estimated. The first-stage linear regression, which tests the relationships between board independence (OUTDIR) and company-specific characteristics associated with VRIC, has a good fit with an adjusted R-squared of 39 percent. The untabulated results also show that OUTDIR has a significant positive association with audit committee independence JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010


1.000 -0.054 -0.045 0.177** -0.137 0.032 -0.003 -0.075 -0.054 -0.005 -0.131* -0.053 0.012 -0.013 0.033 -0.066 -0.044 0.165** 0.007 -0.065 -0.008 -0.054 -0.004 -0.025 -0.064 -0.034 0.041 -0.187***

INSOWN FACMT ACIND BDSIZE OUTDIR MDIR DUALITY INSTHLD PWC KPMG DT EY AA COSIZE PROFT LEVG IND_1 IND_2 IND_3 IND_4 IND_5 IND_6 IND_7 IND_8 IND_9 GROWTH EFINt-1 VRICSt-1

1.000 -0.003 -0.096 -0.022 0.137* -0.152** -0.016 -0.102 0.037 0.019 0.009 -0.083 0.184*** -0.336*** 0.152** -0.065 -0.135* 0.033 0.083 -0.114 0.034 0.033 0.207*** 0.096 0.027 0.063 -0.107

FACMT

1.000 -0.080 0.176** 0.047 0.084 -0.038* -0.157** -0.132* -0.068 -0.031 -0.010 0.182** 0.1120 0.194*** -0.017 -0.039 0.025 -0.020 0.051 0.077 -0.122* 0.009 0.025 0.090 -0.045 0.360***

ACIND

1.000 0.172** 0.504*** 0.110 -0.215*** -0.018 -0.005 -0.099 0.019 0.099 0.272*** 0.147** 0.023 -0.066 0.129 -0.012 0.047 -0.076 0.015 -0.221*** 0.161** -0.057 0.004 -0.005 0.155***

BDSIZE

1.000 0.249*** 0.024 0.047 0.025 0.023 -0.010 -0.053 -0.023 0.095 -0.021 0.002 0.038 0.021 -0.017 -0.061 -0.030 0.071 -0.106 0.120*** 0.044 0.015 -0.026 0.154** 1.000 0.100 -0.089 0.056 0.054 0.011 -0.138* 0.055 0.380*** -0.051 0.121 0.107 -0.017 -0.123 -0.024 -0.103 0.013 0.011 0.170** 0.067 -0.028 -0.022 0.033

OUTDIR MDIR

1.000 0.016 0.009 0.050 0.009 -0.134* 0.004 0.031 -0.176** -0.060 0.071 -0.161** -0.069 -0.007 0.006 0.057 0.057 -0.123* 0.135 0.098 -0.036 0.071 1.000 0.002 -0.149* -0.058 0.050 0.008 -0.105 -0.019 -0.067 0.038 -0.116 0.047 0.183* 0.033 -0.009 -0.017 -0.043 -0.127* 0.076 0.063 0.095 0.033 -0.111 0.087 -0.089 0.095 1.000 -0.033 0.210*** 0.015 -0.135* -0.021 0.024 -0.142* 0.064 0.077 0.231*** -0.130* 0.083 -0.072 0.292***

DUALITY IHOL COSIZE

0.071 -0.021 -0.086 0.077 0.035 -0.033 1.000 -0.089 -0.055 0.218*** 0.082 0.098 -0.106 -0.010 -0.095 -0.269*** -0.074 0.004 0.059 0.131*

PROFT

-0.023 -0.136 -0.183** -0.088 0.083 0.210** -0.089 1.000 0.158* 0.155* -0.131* -0.106 -0.033 0.022 -0.224*** 0.146* 0.121* 0.038 -0.204*** 0.131*

LEVG

*p < 0.10; **p < 0.05; and ***p < 0.10 (based on a two-tail test). † We do not report the pairwise correlation coefficients between the auditor-type and industry dummies because no meaningful inference can be drawn. †† We define the variables as in Table 2.

INSOWN

Variable††

Table 3 Pearson Correlation Matrix for Independent and Control Variables† (n = 198)

-0.100 -0.032 0.078 0.0382 -0.006 0.083 0.004 0.038 0.141** -0.053 -0.028 -0.015 -0.027 0.002 -0.109 -0.010 0.159** 1.000 0.012 -0.000

-0.062 -0.026 0.055 0.087 -0.012 -0.072 0.059 -0.204*** -0.204*** 0.006 0.050 0.042 0.014 -0.006 0.063 -0.015 -0.021 0.012 1.000 -0.107

GROWTH EFINt-1

400 Internal Control Systems and Governance Characteristics


401

(ACIND), multiple directorship (MDIR), institutional holdings (INSTHLD), and the auditor-type dummies, except PWC. Further, the results indicate that OUTDIR negatively relates to the frequency of audit committee meetings (FACMT), board size (BDSIZE), CEO/chair duality (DUALITY), company size (COSIZE), leverage (LEVG), sales growth (GROWTH), need for external financing (EFINt-1), and the industry dummies, except for those in the consumer services (IND_3), healthcare (IND_4), industrials (IND_5), and technology (IND_7) sectors. Table 4 presents the results of the second-stage regression, a probit model with an endogenous regressor (Equation 2), which tests the relationships between nine governance characteristics and VRICS. The model’s Wald chi-square statistic of 357.59 is statistically significant (p < 0.01), suggesting that the coefficients on the variables in the model are significantly different from zero. As predicted, the coefficient on INSOWN is negative and significantly related to the probability of a company voluntarily reporting on its internal control system (p < 0.10). This is consistent with the expectation that companies with greater proportion of insider equity share ownership have lower agency conflict and agency cost, and consequently, do not need to be effectively monitored by the board. Bronson et al. (2006) fail to document any significant relationships between insider holding and voluntary reporting on internal control. Also consistent with expectations, the coefficients on both FACMT and ACIND are positive and statistically significant, suggesting that an audit committee that meets frequently and is dominated by independent members is crucial if a company will voluntarily report on its internal control system. As in this study, Bronson et al. (2006) find a significant positive relationship between frequency of audit committee meeting and VRICS, but fail to find any significant relationship between audit committee independence and VRICS. Except for the CEO/chair duality (DUALITY) variable, the other three characteristics of the main board (i.e., BDSIZE, OUTDIR {actually the fitted values of OUTDIR [FIT_ OUTDIR]} and MDIR) are all statistically significant (p < 0.01) and have their predicted signs. Documenting that independent-dominated boards (FIT_OUTDIR) positively influence management voluntary reporting decisions than management-dominated boards is consistent with prior studies (see, e.g., Laksmana, 2008). Though the effect of INSTHLD on VRICS is positive, it is not statistically significant at any conventional level. While this result is inconsistent with the efficient monitoring hypothesis, it affirms Pound’s (1988) view that institutional investors are not efficient monitors and are more likely to vote in favor of management. Short and Keasey (2005) explain the inefficiency in monitoring management by institutional investors by saying that institutional investors either face conflicts of interest because of current or potential business relationships with companies they invest in or find it worthwhile strategically to align themselves with management on certain issues. Bronson et al. (2006), on the other hand, find institutional ownership (INSTHLD) to be a significant predictor of a company voluntarily issuing a report on its internal control system. Further, as reported in Table 4, all the coefficients on the auditor-type dummies have positive signs, but none is statistically significant. Thus, none of the companies audited by PWC, KPMG, DT, or EY fares better in terms of VRICS than those companies in the sample audited by the now defunct AA, which serves as the base category. It appears that all public accounting firms were concerned about minimizing their exposure to legal suits in the wake of public concerns about the quality of financial reporting and transparency JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

402

Internal Control Systems and Governance Characteristics Table 4 Estimates of Probit Model with Endogenous Regressor† (Equation 2 [n = 198])

Prob (VRICS = 1) = +

6

+

15

MDIR +

0

+

INSOWN +

1

DUALITY +

7

PROFT +

FACMT +

2

ACIND +

3

INSTHLD +

+

8

LEVG +

16

Variable Hypothesis Constant INSOWN Test variable (H1) FACMT Test variable (H2) ACIND Test variable (H3) BDSIZE Test variable (H4) FIT_OUTDIR Test variable (H5) MDIR Test variable (H6) DUALITY Test variable (H7) INSTHLD Test variable (H8) PWC Test variable (H9) KPMG Test variable (H9) DT Test variable (H9) EY Test variable (H9) COSIZE Control variable PROFT Control variable LEVG Control variable IND_1 Control variable IND_2 Control variable IND_3 Control variable IND_4 Control variable IND_5 Control variable IND_6 Control variable IND_7 Control variable IND_8 Control variable GROWTH Control variable EFINt-1 Control variable Log likelihood statistic Wald chi-squared statistic Prob > chi-squared

BDSIZE +

4

+

COSIZE

14

GROWTH +

26

Predicted Sign +/+ + + + +/+/+/+/+ + +/+/+/+/+/+/+/+/+/-

FIT_OUTDIR

5

EFINt-1 +

27

(2)

Coefficient z-statistic -9.114 -4.83*** -0.643 -1.85* 0.128 2.76*** 0.037 1.81** -0.206 -2.91*** 9.585 18.17*** -0.107 -3.15*** -0.400 -0.23 0.332 0.98 0.040 0.15 0.150 0.87 0.225 0.75 0.015 0.05 0.772 3.54*** 0.282 0.53 0.712 1.67* -0.030 -1.78* -0.112 -2.52** 0.262 1.89* 0.462 1.18 0.147 2.41** -0.456 -2.37** 0.508 1.04 -1.608 -2.64*** -0.005 -2.13** -0.002 -0.19 114.38 357.59 0.0000

*p < 0.10; **p < 0.005; and ***p < 0.01 (based on a one- or two-tail test as appropriate). † We exclude the dummies for both Arthur Andersen accounting firm (AA) and utilities industry (IND_9) from the model to avoid the “dummy variable trap” problem (Gujarati, 1995: 504). Thus, AA and IND_9 respectively serve as the base categories against which the estimated coefficients for both the remaining dummies for the auditor-type (i.e., PWC, KPMG, DT, and EY), and industry classification (i.e., IND_1 through IND_8) are measured.



403

due to the heightened interest in corporate governance issues in the media during the period examined. Therefore, it is not surprising that there is no significant difference among the companies audited by the then Big-5 public accounting firms in terms of their voluntary reporting practices on internal control systems. A plausible explanation for this observation might be that, though there is “product differentiation” in the audit market, the then Big-5 firms appear to equally provide high quality service in certain areas such as being instrumental in their client companies’ decision to voluntarily report on their internal control systems. As Table 4 reports, the coefficient estimates for four of the six control variables are statistically significant. Company size (COSIZE) is significantly positive (p < 0.01; onetailed test), corroborating Bronson et al. (2006). The LEVG variable is also positively significant (p < 0.10; two-tailed test), suggesting that management has incentive to voluntarily report on internal control system, as a bonding activity to assure debtholders that their investments are safe. As in this study, Bronson et al. (2006) also find a positive effect for LEVG but not statistically significant. Apart from being negatively related to VRICS, the GROWTH variable is also statistically significant (p < 0.05; one-tailed test). Bronson et al. (2006) also report a similar result for mid-size U.S. companies. Of the industry dummies, VRICS negatively relates to four and the relationships are statistically significant, namely, basic materials (IND_1), consumer goods (IND_2), oil and gas (IND_6), and telecommunication (IND_8). The consumer services (IND_3), healthcare (IND_4), industrials (IND_5), and technology (IND_7) sectors positively relate to VRICS, but two of them are not statistically significant (i.e., IND_3 and IND_5). Thus, compared to the base category (utilities [IND_9]), the companies in the consumer services and industrials fare better in voluntarily reporting on internal control systems, while those in the basic materials, consumer goods, oil and gas, and telecommunication did worse. Though they have the predicted signs, the estimated coefficients on both PROFT and EFINt-1 are of no statistical significance in managements’ decision to voluntarily report on internal control systems. CONCLUSIONS This study attempts to identify and explain the role played by internal governance mechanisms, particularly the characteristics of the main board of directors, in the decision of U.S. large companies to voluntarily report on their internal control systems in annual reports prior to the enactment of the Sarbanes-Oxley Act. Using a simultaneous equation analysis to address an endogeneity problem, and controlling for company-specific characteristics identified in prior literature as affecting managerial voluntary disclosure, this study finds that there are positive, significant relationships between management voluntary reporting on internal control systems and frequent audit committee meetings, audit committee independence, and board independence (fitted values). Negative significant relationships are also found to exist between voluntary reporting on internal control system and insider stockholdings, board size, and multiple directorships. However, no significant relationships are documented between voluntary internal control reporting and CEO/chair duality, institutional stockholdings, and auditor-type. This study contributes to the existing voluntary disclosure literature by providing empirical evidence on the role of governance characteristics in the decision of JOURNAL OF MANAGERIAL ISSUES Vol. XXII Number 3 Fall 2010

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management of large U.S. companies to voluntarily report on their internal control systems. In particular, this study shows for the first time that while not all board characteristics are relevant in a large company’s decision to voluntarily report on its internal control system, board independence, board size, and multiple directorships are, and as such, these board characteristics should not be ignored in any future research. The results of this study suggest the need for further inquiry into the economic consequences of voluntary reporting on internal control system (such as its impact on securities’ prices, trading volume, volatility of prices, bid-ask spreads, and the overall profitability of a company). Krishnan and Visvanathan’s (2007) study indicating that more management reports reveal weaknesses in internal control systems where the frequency of audit committee meetings is high should be noted in this context. This suggestion is also relevant because many public companies have privatized just to escape the mandatory reporting on internal control pursuant to SOX (see Engel et al., 2007). In addition, the results suggest that future research should pay more attention to board characteristics that affect a company’s decision to voluntarily report on its internal control system. The results of this study must be interpreted with caution, as it has several limitations. First, the content and quality of the reports on internal control systems are not measured. The study focuses primarily on the presence of such reports, which provides no information about their content and the quality of information disclosed therein. Second, regression analysis does not resolve causality issues. Consequently, the estimated coefficients on the significant governance variables should not be interpreted as elasticities that predict how much the dependent variable will change following a change in any of those governance variables. Third, since the results of the study are based on an analysis of large companies, their generalizability to other types of companies, notably, small-sized companies is limited. Fourth, a number of potential governance characteristics such as directors’ age, block shareholders’ equity ownership, financial expertise of audit committee members, tenure of the CEO/chair, and existence of internal audit function are not considered in this study because of either lack of data, unreliability of the available data, and/or the intensity of time involved in hand collecting governance data. Notwithstanding the above limitations, the results are sufficiently interesting to have implications for corporate financial reporting in other developed economies. Those significant governance characteristics identified in this study may be incorporated in many of today’s corporate governance codes and guidelines being considered in these economies. The results may also be extended to companies in emerging economies, where the existing literature has documented earnings management problems as a contributing factor to the lack of transparency in corporate financial reporting (see, e.g., Aharony et al., 2000; Ball et al., 2000; Chen and Yuan, 2004). Consequently, policy-makers in these economies may benefit from the results of this study by reinforcing their corporate governance codes and guidelines in such a manner that internal control over financial reporting may be strengthened to provide accounting information that is more transparent. References



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