Corporate Governance and Board Equity Ownership

STRUCTURED ABSTRACT

Purpose: This study empirically tested the relationship between board equity ownership and
corporate governance on earnings quality of for-profit corporations, to help practitioners enhance
corporate governance practices.

Methodology/Approach: The study examined two competing theories of equity ownership

(convergence-of-interests and management entrenchment) to explain how board members react
to owning the firm’s stock and if governance impacts their behavior. In a sample of 499 publicly
traded firms, a governance index was calculated and the relative power of equity ownership and
governance was regressed on reported earnings quality.

Findings: The results supported the management entrenchment theory. Both independent and
insider board members became entrenched, negatively impacting reported earnings quality and
the strength of the governance structure. However, effective governance using a composite of
mechanisms moderated the effects of entrenchment.

Research Limitations: The effect of individual governance variables on earnings quality was
not identified. The reader should not generalize the results of this research to other types of
organizations, such as not-for-profit or governmental entities. We studied for-profit publicly
held firms where directors acted as agents of the stockholders and corporate governance was
tasked with the responsibility to monitor management and improve investor confidence in
reported earnings quality. We acknowledge that in other types of entities, the governance culture
and objectives may be different and our results may not apply.

Practical Implications: The results provide insight regarding the motivations and behavior of
board members and the impact of stock ownership on their actions. Stronger governance
controls are needed within the entrenchment range of stock ownership. Firms should not rely on
oversight by independent board members to control insider board members. A composite of
governance mechanisms can moderate negative behavior.

Originality/value: The results challenge commonly held beliefs that independent board
members and board members who own stock will perform their fiduciary duty. This means that
governance mechanisms should address all board members, not just specific types and that
equity ownership must be very high before it can be relied upon as effective.

Key Words: Corporate governance, entrenchment, earnings quality, insider board members,
research paper

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 Corporate Governance and Board Equity Ownership
1. INTRODUCTION

Recent financial scandals have raised the issue of whether for-profit public companies are
being run in the best interests of shareholders. Management may have too much power and not
enough supervision or accountability, particularly in companies with widely dispersed
ownership. Agency conflicts, conflicts that arise from the separation of ownership and control,
may not be effectively resolved through corporate governance systems.
Corporate governance systems are defined in a variety of contexts. Farinha (2003)
reviews definitions of corporate governance dating back to Berle and Means (1932) through
current researchers and concludes that although the definitions of governance differ, they share
some common elements. All of them refer to conflicts of interest between insiders and outsiders
over the generation of value by a firm that cannot be effectively resolved by contracting. A
corporate governance system then is the system of monitoring devices, internal and external,
specific to each organization, that defines how these mechanisms are set up and how each will
fulfill its monitoring role. It is important to understand that the governance system is specific to
each company, that different ownership structures may result in different structures, cultures, and
outcomes based on their unique governance objectives. The overriding goal is the protection of
outsider stakeholder interests. Stakeholder interests are protected in a variety of ways, i.e., by
ensuring compliance with laws, regulations, and technical standards, by ensuring equitable
allocation of economic rents, by monitoring management decision-making to ensure that
decisions will create long-term value for the entity, and/or by ensuring that information prepared
and provided by management is relevant and objective (of high quality). In this study, we
examine publicly traded companies with diverse ownership structures whose directors act as
agents of stockholders
One of the most important functions of the corporate governance system in this context is
to ensure the quality of the financial reporting process. Board members, acting as agents of
owners, are being held increasingly responsible for controlling the actions of management and
for evaluating and implementing effective systems of controls. Recent legislation and the major
stock exchanges now require boards to have a majority of outside directors and audit committees
to have three independent directors. The intent is to limit the ability of management to engage in
earnings management and opportunistic behavior by increasing the ability of both the board and
audit committee to monitor management (Farinha, 2003).
Earnings management is generally defined as “a purposeful intervention in the external
financial reporting process, with the intent of seeking some private gain…” (Dechow & Skinner,
2000). Earnings management includes fraud, purposeful violations of generally accepted
accounting principles (GAAP), and accounting choices within GAAP that mask true economic
performance and the volatility of earnings. One stream of research has focused on the
relationship between board of director characteristics and fraud (Beasley, 1996; Beasely,
Carcello, Hermanson, & Lapides, 2000; Dechow, Sloan, & Sweeney, 1996), and between
management power and fraud (Dunn, 2004). Others have examined the relationship between
non-fraud earnings management and specific characteristics of boards and audit committees,
such as independence (Klein, 2002b), and meeting frequency (Xie, Davidson III, & DeDalt,

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2003). The findings of the both streams of research are consistent with governance reforms for
independence and accountability. However, evidence suggests that management can overcome
monitoring mechanisms, even those that meet the new legislative and exchange standards. Chief
Executive Magazine (Niskanen, 2003) reports that all major firms charged with accounting
scandals through 2002 were in full compliance with the standards for board and audit committee
independence now required by law. This implies that monitoring by independent directors is not
always sufficient and/or effective in controlling management malfeasance.
So why might independent directors not be effective monitors? The explanation may be
found by examining the power and incentive of board members to perform their fiduciary duties.

2. COMPETING THEORIES

Encouraging stock ownership among directors is often used to align the interest of
directors with those of the shareholders. There are two competing theories about how board of
director members, acting as agents for the stockholders, react to owning stock in the firms they
serve.

Convergence-of-Interests Theory. The first theory, called “convergence-of-interests”,

posits that when managers on the board have no stock ownership, they are self-oriented but they
have little power to overcome corporate controls designed to align their actions for the benefit of
the stockholders. One such corporate governance mechanism is the existence of independent
board members who could influence the managers on the board, which has been shown to result
in less fraud and earnings manipulation (Beasley, Carcello, Hermanson, and Lapides, 2000;
Klein, 2002a). As stock ownership rises, managers on the board will gradually align their
interest with the stockholders and will make good quality decisions that increase the value of the
firm (Jensen and Meckling, 1976; Beasley, 1996). Theoretically, as even small increments of
stock ownership occur, the interests of the manager incrementally become more aligned with the
interests of the stockholders. Visualize a graph with increasing stock ownership on the
horizontal X-axis and increasing quality of decision making on the vertical Y-axis. Under the
convergence-of-interests theory, a straight line would rise from the vertex. Increased quality of
decision making results in better alignment of actual cash flows with profits, that is, increased
earnings quality1. As managers’ interests become more aligned with stockholders’ interest,
managers become increasingly more conscientious, are involved in fewer fraud activities, and
would feel less motivated to intentionally manipulate earnings to make performance appear
better than it actually is. Ultimately, when they own all the stock, they act as sole proprietors
… any action they take against the firm’s interest only hurts themselves. At this extreme, no
governance mechanisms would be needed. If the convergence-of-interests theory is true, the best
strategy for firms is to encourage (or require) stock ownership by managers and board members.
Compensation packages that include stock options or awards of free shares and restrictions that
delay the ability to sell these shares are designed to gradually build ownership. Fewer
governance controls would be needed as stock ownership increases.

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Earnings quality reflects the results of management choices, both intentional misstatements and poor estimates.
Earnings quality is measured as accrual estimation error or the difference between the accrual (estimate) and its
related cash flow. Low earnings quality is represented by earnings that contain high estimation error. If earnings
reflect low quality accruals, then earnings do not reflect economic reality and are not persistence, or predictive of
future earnings. Thus, they are of less use to interested outside parties.

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 Entrenchment Theory. The second theory, called “entrenchment”, has similar
expectations about managers and directors at extremely low and extremely high levels of stock
ownership. At low ownership levels their interests are not aligned with the stockholders, but
they possess so little stock that they have no power to subvert governance mechanisms. At high
stock ownership levels, the managers or directors are the stockholders and inappropriate actions
would only hurt themselves. It is the middle range of the graph that differs. When managers or
board directors obtain relatively large stock ownership (but not extreme ownership levels that
would align their interests with those of the stockholders) they may possess sufficient power to
overcome governance mechanisms (Fama and Jensen, 1983). This would allow managers to act
in their own self interests with little fear of removal or sanctions ... they would have become
“entrenched”. Previous studies have indicated that entrenchment can occur at relatively low
levels of absolute stock ownership (Morck, Shlefier, and Vishny, 1988; Short and Keasy, 1999;
Griffith, Fogelberg, and Weeks, 2002; Peasnell, Pope, and Young, 2003; Warfield, Wild, and
Wild, 1995; Yeo, Tan, and Chen, 2002). If the entrenchment range exists, it should be reflected
in poor earnings quality. Poor earnings quality means that managers intentionally manipulate
earnings, shirk and make poor accrual decisions, or conduct fraud activities that would also
adversely affect earnings. All such activities result in actual cash flows being different from
what profits project that cash flows should be. If the entrenchment theory is true, one strategy
for firms might be to build stock ownership in managers and board members, but increase
governance mechanisms within the entrenchment range. Thus, it becomes important to know
where the thresholds into and out of the entrenchment range exist and whether governance
mechanisms are able to overcome entrenchment.

3. DESIGN OF THIS STUDY

This study investigated which of these two theories can be supported by observation. If the
entrenchment theory is observed, this study investigated whether entrenchment thresholds could
be identified and whether governance mechanisms can be sufficient to reduce the effects of
entrenchment2.

Measures and Statistical Tests. We employed various statistical methods to accomplish

the test of the two theories. To test if the convergence-of-interests theory or the entrenchment
theory existed, we regressed earnings quality against the relative stock ownership by members of
the board who were insiders. By running piecewise linear regressions in increments of 5%
insider ownership we could observe if the slope or its sign changed as relative insider ownership
rose. Under convergence-of-interests, the slope should be constant and positive at all levels of
insider ownership. If the slope or its sign changed, it would imply an entrenchment threshold
existed. To test if governance mechanism contributed to earnings quality, we regressed earnings
quality against the governance index scores. A positive correlation would imply that as the
governance strength rose, earnings quality rose. If an entrenchment range was observed, we

2
In this article the design and results of this empirical study are summarized and presented from a practitioner’s
perspective. For readers desiring a more detailed presentation of the measures, statistical tests, and test results,
please refer to Effects of Corporate Governance and Board Equity Ownership on Earnings Quality in The
International Journal of Accounting and Finance Studies, forthcoming. We also show many of the statistical
tests and results in an appendix to this article.

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designed test to regress earnings quality against the combined effects of both insider ownership
and the strength of governance mechanisms below, within, and above the entrenchment range.
This would indicate if governance mechanisms could overcome the strength of insider
ownership. Each of these measures and tests is discussed below.

The Measure of Decision Quality / Earnings Quality. In this study we measured the
quality of decision making within a firm by computing “earnings quality”. Perfect earnings
quality means that all profits ultimately result in equal cash flows. For example, when a firm
extends credit to customers, it subsequently accrues an estimate of the portion of those accounts
receivable that will not be collected. This estimated bad debts expense reduces the firm’s profits
and reduces net accounts receivable that in turn reduces working capital. Poor management of
customer credit, poor estimation of the amount of bad debts, theft of cash collections, or
intentional manipulation by management to make performance look better would result in
recorded cash collections to differ from the amount that working capital and the profit numbers
lead you to expect. That is, cash flows will not ultimately equal the profits. There are many
different types of accounting accruals and depending on the type of accounting accrual, it could
affect the year before the profit is recognized, the year of the profit, or the year after the profit is
recognized. In fact, the operating cycle of 97.6% of the firms in our sample was less than one
year. Thus, the premise that accruals would turn into cash flows within one year to either side of
the study year was valid.
When profits don’t completely turn into cash flows, it implies that accruals were incorrect
and earnings quality is less than perfect. In general, we measured the size of earnings quality.
We used the Dechow and Dichev model (2002) of accrual estimation errors as a proxy for
earnings quality. The model statistically evaluates the relationship between changes in working
capital accruals (dependent variable) and cash flows from the prior period, current period, and
subsequent periods (independent variables) by regressing cash flows on changes in working
capital. This predicts earnings quality through the error in the accruals (error term from the
regression).3 Past research has shown that the majority of accrual activity is related to current
accruals (Sloan, 1996; Teoh, Welch, and Wong , 1998a, 1998b; Dechow & Dichev, 2002). The
change in current accruals should be the result of prior period accruals reversing that affect
current period income and current period accruals that affect future period income. Both of these
types of accruals can contain estimation errors. If you compare them to the resulting cash flows,
the differences can be used to reflect the accuracy, or quality, of the accruals and thus, the quality
of the earnings. We standardized the residuals to remove industry effects and scaled them by
total assets to address differences in firm size. The absolute value of the residuals was used in
the testing to reflect both over and under estimated accrual estimation errors.

Sample of Firms. We did not limit our investigation to firms that experienced fraud or
financial failure as many previous studies have done because we wanted to observe the theories
in firms across a wide spectrum of financial conditions. Also, entrenchment does not always
lead to fraud or misappropriation of assets. Entrenchment can also be expressed through
shirking or mismanagement that affects the quality of decision making and the resulting
earnings. We were interested in observing many types of firms in many industries. We started
with 1,500 firms comprising the lists of firms from S&P 400 (mid cap), 500 (large cap), and 600
(small cap) for the year 2002. The year 2002 was used because wide-scale accumulation of
3
For the reader who is more interested in the statistical model and statistical tests, we refer you to Appendix A.

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governance data is not available prior to 2002. In addition, 2002 was the year that Sarbanes-
Oxley was enacted, but not fully effective. We wanted to examine earnings quality prior to
governance reform. Because we needed to measure possible industry differences, these firms
were regrouped into 2-digit SIC codes. To obtain sufficient power for a .05 significance level
(Hair et. al. 1998, 165) we eliminated each 2-digit SIC code with less than 30 observations.
Specific firms were eliminated from the sample due to the reasons shown in Table 1. The final
set of firms used were 499 firms in seven 2-digit SIC code groups after eliminating firms for
missing data, SIC groups that were too small to be statistically significant, and other factors.
Statistical test confirmed that our results were not biased by either the industry or the S&P list
from which the firms came.

[ Insert Table 1 about here ]

The Measure of Board Member Stock Ownership. Members of a firm’s board of

directors fall into two groups: independent board members who are totally unaffiliated with the
firm except for serving on the board, and insider board members made up of managers, founders,
and others with a direct financial interests in the firm as defined by the Securities and Exchange
Commission. Theoretically, these two groups have different motivations and serve to provide a
system of checks on each other. This is the thinking behind legislation such as the Sarbanes-
Oxley Act of 2002, which requires certain proportions of independent members on the board and
its sub-committees. In fact, past research has shown that the independence of the full board and
audit committee may contribute to the effectiveness of monitoring (Weisbach 1988;
Archambeault and DeZoort 2001; Dahya et al. 2002; Klein 2002a; Xie et al. 2003; Krishnan
2005). Our interest, however, went beyond simple independence and related to how both of
these groups responded to owning stock in the firm and how the governance structure was
related to the equity allocation between insiders and outsiders4. We measured the relative stock
ownership between these two groups based on data obtained from proxy statements by the
Investor Responsibility Research Center (IRRC). Our primary measure was the proportion of
board stock ownership held by insiders and independent board members. For example, if
insiders held 80% of the stock owned by the board of directors, then the independent board
members owned the remaining 20%. We also measured the absolute total percentage of the
outstanding shares owned by both groups. Using the proportionate ownership as the measure of
board member stock ownership is consistent with the results of earlier research that showed the
corporate governance could be overcome when insiders had a concentration of relative
ownership power (Beasley, 1996; Dechow, Sloan, and Sweeney, 1996; Dunn, 2004).

Earnings quality can be correlated with relative stock ownership by managers (insiders)
and independent board members. If the convergence-of-interests theory is true, earnings quality
should never decrease as stock ownership rises among board members. As relative stock
ownership rises a decrease in earnings quality could result either because of intentional
manipulation of accruals and profits or because of shirking or mismanagement that results in
poor accrual judgments. This would imply that the entrenchment entry threshold has been

4
Caramanolis-Cotelli (1995) posit that corporate governance is determined by the allocation of equity amount
insiders, executives, CEOs, directors, and other individuals, and outside investors. Dunn (2004) found that the
relative power of the two groups had a stronger relationship with the incidence of fraud than did independence.

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passed. Subsequently, when earnings quality no longer decreases, the entrenchment exit
threshold has been passed.

We examined earnings quality across relative board insider ownership (BIO) levels. To
test for entrenchment, we divided BIO into intervals of five percent and ran piecewise linear
regressions at different BIO intervals to estimate the coefficient on BIO. Changes in the slope,
or in its sign, at two different thresholds indicate the range of entrenchment for BIO. The results
of these tests defined the entrenchment and non-entrenchment levels of ownership (See
Appendix A for details of statistical tests performed).

The Measure of the Strength of Governance Mechanisms. Single governance

mechanisms can be compromised, Firms often employ multiple complementary controls. Earlier
researchers (Gompers, Ishii, & Metrick, 2003: Brown & Caylor, 2004) incorporated governance
composite indexes and results showed that higher indexes exhibit higher market returns, higher
firm value (Tobin’s Q), and better operating performance. To measure how strong the
governance mechanisms are for a firm, we employed a commercially available index of
composite governance mechanisms developed by Institutional Shareholder Services (ISS). The
ISS index is comprised of 61 separate variables encompassing the eight corporate governance
categories. Because some of the ISS variables measured characteristics that we were already
assessing in this study, we calculated our own index from 51 of the variables, with each variable
equally weighted by “1” (see Table 2 for the list of variables used in this study). This
governance index composite score was identified as GI. A higher index score implied stronger
governance effectiveness, with a GI of 51 being the highest. We omitted four provisions of
poison pills and six provisions related to the state of incorporation. Poison pills require
shareholder approval and we assumed that shareholders deemed them in their best interests. As
to the state of incorporation, the only consideration is whether the firm is incorporated in a state
with or without stakeholder laws. The specific laws are not necessary for this evaluation and
only served to subdivide the sample needlessly. We eliminated the provision that measures
officer and director ownership because we used a specific measure of director ownership (BIO)
in our models. Consistent with Brown and Caylor (2004), we separated one provision into two
components: poison pill and blank check preferred stock. All these adjustments resulted in
consideration of 51 separate provisions of governance.

[ Insert Table 2 about here ]

In our sample the GI ranged from 13 to 41 with a mean of 25.76 and median of 25.00.
Governance mechanisms are put in place to monitor and control management behavior. If
effective, governance and earnings quality should be positively correlated. We regressed
governance on earnings quality using simple regression to test this premise. From the
entrenchment interval found in the tests described above, we then examined the combined effect
of board insider ownership and the strength of the governance structure on earnings quality using
multiple regression analysis.

4. RESULTS OF THE STUDY

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 Statistical tests showed that the variables acted in the predicted manner and each SIC
grouping showed that the research model was well specified and significant at the .05 level. The
variation in working capital accruals explained by cash flows ranged from an average of 49
percent in the manufacturing industry to 68 percent in the oil and gas industry (See Appendix A,
Table 1). This is consistent with prior researchers’ tests of the model (Dechow and Dichev,
2002), which provides validity for using the model to estimate earnings quality. The relationship
between the strength of governance and estimation errors was inverse, as expected, indicating
that stronger governance resulted in less errors and higher earnings quality. The effect of board
insider ownership on estimation errors was not significant except in the entrenchment range,
where errors increased as ownership increased. The statistical results appear in Appendix A,
Table 2. The results of the statistical tests are discussed in the following paragraphs. During the
discussions that follow, visualize the results as depicted in Figure 1.

[ Insert Figure 1 about here ]

Convergence-of-Interests or Entrenchment? By regressing earnings quality at

different levels of relative insider ownership, we found entrenchment thresholds at 30% and 50%
of relative insider ownership. At the 30% level, the slope of the line representing earnings
quality became negative. At the 50% level, the slope of the line ceased to be negative. This was
inconsistent with the convergence-of-interests theory that predicted a positive slope for earnings
quality over all ranges of insider ownership. The entrenchment theory proved true.

Below the Entrenchment Range. Both below and above entrenchment, there was no
discernable slope to the earnings quality line … it had neither a positive nor negative slope.
Below entrenchment, insider board members had a low relative stock ownership (between 0%–
29%) compared to independent board members (between 71%–100%). Additionally, absolute
stock ownership of insiders was also low (less than 1% of the outstanding shares), while
independent board members owned more absolute stock shares below entrenchment than within
the entrenchment range or above entrenchment. Thus, independent board member had more
motivation and more ability to control the insider board members. It did not seem to matter
whether insiders had a relative 10% ownership or 20% ownership. Obtaining marginal
increments of stock did not materially increase their motivation to act in stockholder interests or
increase their power to subvert controls. Thus, the earnings quality line had no discernable slope
below entrenchment.

Above the Entrenchment Range. Above entrenchment, besides having high relative
stock ownership (between 50%–100%), the absolute stock ownership by insider board member
was also higher than in any other region. Insiders had the motivation and the power to act in the
interests of stockholders. Their ownership levels were so high that obtaining marginal
increments of more stock did not materially change their position. Thus, the earnings quality
line had no discernable slope above entrenchment.

Within the Entrenchment Range. Within entrenchment, we found that earnings quality
fell as insider ownership rose, implying that once insiders became entrenched, the effects of their
entrenchment became stronger as they accumulated more stock ownership. Across the
entrenchment range, both independent board members and insider board members had

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insignificant levels of actual stock ownership (less than 2.5% of the outstanding shares for either
group). Thus, neither group had strong motivation to act in the stockholders’ interests. At the
lower end of the entrenchment range, independent board members had the dominant relative
equity position (approaching 70%), but did not keep insiders from negatively impacting earnings
quality. At the high end of the entrenchment range, insiders had the dominant relative equity
position and the power to subvert governance mechanisms, thus negatively impacted earnings
quality. These findings imply that both groups (insiders and independent board members)
became entrenched, a finding consistent with the very few prior studies that addressed this issue.

The Effectiveness of Governance Mechanisms. Below the entrenchment range firms

had higher governance indexes than for firms above the entrenchment range, implying that firms
acknowledged the need for and implemented greater governance mechanisms when it was
assumed that management’s interests were not aligned with those of stockholders. Within the
entrenchment range we found statistically significant results that firms with higher insider board
ownership had lower governance indexes (Appendix A, Table 4). This indicates that as relative
insider ownership rose, insider board members were able to resist the imposition of additional
governance mechanisms. By using multivariate regression, we were able to show that the impact
of insider ownership on earnings quality was no longer significant when the firms’ governance
indexes were include in the model (Appendix A, Table 4). Thus, effective governance was able
to moderate the negative effect of entrenchment. We further tested if individual governance
mechanisms could be isolated as being particularly beneficial for firms. By dividing the subset
of entrenched firms into two groups (those that had a particular governance mechanism and those
that did not), we applied ANOVA and nonparametric tests (not shown) to determine if earnings
quality was different when the firm did or did not have the governance mechanism. We found
that no individual governance mechanism (other than insider ownership) had a significant effect
on earnings quality. Yet, earlier tests had shown that the total composite set of governance
mechanisms did have an effect on earnings quality (Appendix A, Table 3). From this we
conclude that it was the combination of governance mechanisms that was effective, not any
single variable. That is, the whole was greater than the sum of the parts.

5. CONCLUSIONS

From the above research findings, we make the following conclusions about for-profit
firms and recommendations for those people attempting to manage these issues.

• We feel this research and other related research studies provide sufficient evidence that the
uniform model of convergence-of-interests does not reflect reality. The entrenchment model
seems more reflective of how board members react to equity ownership in the firm they are
serving consistent with earlier research results of Beasley (1996) and Dechow et al., (1996).
Given sufficient equity ownership, board members may become entrenched, whereby their
interests do not reflect the interests of the shareholders and the board members have
sufficient voting power to suppress sanctions on them or their removal. This suggests the
need to have stronger governance mechanisms at higher levels of equity ownership than is
implied by the convergence-of-interests theory. Firms need the strongest controls within the
entrenchment range.

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 • What was particularly surprising, however, was the finding that both insider board members
AND independent outsider board members can become entrenched. In fact, within the
entrenchment range, both sets of board members can be simultaneously entrenched. The
negative effect of insider ownership on earnings quality indicated that neither group was
acting in the owners’ interests i.e., both groups were entrenched. These findings are
consistent with Morck et al. (1988), who found that independent board members with stock
holdings responded to financial incentives in a similar fashion to management and could also
become entrenched. This means that governance mechanisms should not address specific
types of board members, but rather should address the activities of all board members. It also
means that governance mechanisms that rely on the existence of independent board members
to moderate the activities of insider board members may be weaker controls than generally
thought. The Sarbanes-Oxley Act relies considerably on these types of controls. This
finding is especially critical to regulatory bodies and legislators who attempt to address these
issues. Auditors should also note the implied weakness of independence as a control
mechanism when not considered in conjunction with equity allocations.

• We find that while entrenchment exists, effective governance can moderate the effects of
entrenchment. Firms must assess the types of governance mechanisms available and select
those that fit their operation. It is important that firms design and implement their
governance mechanisms before the need for them arises, because we also saw that entrenched
firms’ board members were able to resist adding more governance mechanisms when the
mechanisms seemed to be needed most. Further research is needed to identify those types of
mechanisms that provide the strongest controls over the actions of board members.

• Future research may find that specific individual governance mechanisms may provide
material control, but for now, we suggest that firms and analysts should concentrate on sets of
governance mechanisms. It seems reasonable that governance indexes based on an
assessment of many mechanisms may provide credible criteria for rating or ranking a firm’s
governance strength. While we endorse no specific products, two such indexes are the
Accounting and Governance Risk Rating (AGR®) provided by Audit Integrity Incorporated
(http://www.auditintegrity.com) , and the Corporate Governance Quotient (CGQ®) provided
by Institutional Shareholder Services (http://www.issproxy.com) which is also available via
Yahoo!Finance (http://finance.yahoo.com).

• So far, these discussions beg the issue about whether firms should encourage stock ownership
by managers and board of director members. We know that firms often use stock options as
a means to attract quality managers when large salaries cannot be paid (for example, with
start-up companies). Key managers routinely sit on the board of directors, and more often
than may be desired, they chair the board. However, we see that problems can arise as equity
ownership rises sufficiently to entrench such people. Is the problem avoided entirely if stock
ownership is not encouraged? Future research should address this issue.

One final point needs to be made. The reader should not generalize the results of this research to
other types of organizations, such as not-for-profit or governmental entities. As we stated at the
very start of this article, we studied for-profit publicly held firms where directors acted as agents
of the stockholders and corporate governance was tasked with the responsibility to monitor

10
management and improve investor confidence in reported earnings quality. We acknowledge
that in other types of entities, the governance culture and objectives may be different and our
results may not apply.

Selected References

Archambeault, D., and F.T. DeZoort. 2001. Auditor Opinion Shopping and the Audit Committee: An
Analysis of Suspicious Auditor Switches. International Journal of Auditing 5: 33-52.

Beasley, M.S. 1996. An Empirical Analysis of the Relation between Board of Director Composition and
Financial Statement Fraud. The Accounting Review 71(4): 443-465.

Beasley, M.S., Carcello, J.V., Hermanson, D.R., and Lapides, P.D. 2000. Frudulent Financial Reporting:
Consideration of Industry Traits and Corporate Governance Mechanisms. Accounting Horizons, 14 (4),
441-454.

Berle Jr., A., and G. Means, 1932, The Modern Corporation and Private Property. Macmillan, New York.

Brown, L.D., and M.L. Caylor. 2004. Corporate Governance and Firm Performance. Available at: Social
Science Research Network http://ssrn.com/abstract=586423

Dahya, J., J.J. McConnell, and N.G. Travlos. 2002. The Cadbury Committee, Corporate Performance, and
Top Management Turnover. The Journal of Finance LVII(1): 461-483.

Dechow., P.M., and Skinner, D.J. 2000. Earnings Management: Reconciling the Views of Accounting
Academics, Practitioners, and Regulators. Accounting Horizons, 14 (2), 235-250.

Dechow, P.M., and I.D. Dichev. 2002. The Quality of Accruals and Earnings: The Role of Accrual
Estimation Errors. The Accounting Review 77: 35-59.

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Appendix A: Statistical Tests and Results

Measure of Earnings Quality

We used the Dechow and Dichev model (2002) of accrual estimation errors as a proxy for
earnings quality. The model uses the following equation to measure earnings quality:

∆WCt/TAt = b0[1/TAt] + b1[CFOt-1/TAt] + b2[CFOt/TAt]

+ b3[CFOt+1/TAt]+ et
where:

∆WCt = change in accounts receivable (Compustat #302), plus the change in inventory
(Compustat #303), minus the change in accounts payable (Compustat #304),
minus the change in taxes payable (Compustat #305), plus the change other
assets (Compustat #307) at time t;
CFOt-1 = cash flows from operations for the prior period;
CFOt = cash flows from operations for the current period;
CFOt+1 = cash flows from operations for the next period;
TAt = average total assets for a firm in the current period.

The model captures the extent to which accruals map into cash flow realizations, measuring any
estimation errors using the error term (et). We scaled all variables by average total assets (TAt)
(Compustat #6) to account for differences in firm size. The intercept (b0) was included to
measure positive working capital accruals related to firm growth.

We estimated the model cross-sectionally, using a 3-year period to derive CFOt-1, CFOt, and
CFOt+1. We used the model for t = 2002 because wide-scale accumulation of governance data is
not available prior to 2002. In addition, 2002 was the year that Sarbanes-Oxley was enacted, but
not fully effective. The model was well specified for our sample industries as indicated by the
coefficients of determination and f statistics shown in Table A-1.

Table A-1. Regressions of the Change in Working Capital on Past, Current, and
Future Cash Flow From Operations for the Year 2002

∆WCt/TAt = b0[1/TAt] + b1[CFOt-1/TAt] + b2[CFOt/TAt] + b3[CFOt+1/TAt]+ et

Intercept
SIC b1 b2 b3 Adj R2 F Stat
b0
13 Mean .019 .096 -.489 .168 .678 22.035
(t-statistic) (3.257) (2.443) (-7.904) (4.923)
28 Mean .009 .272 -.562 .242 .525 30.102
(t-statistic) (2.414) (5.873) (-9.392) (6.061)
35 Mean .011 -.021 -.512 .226 .445 20.211
(t-statistic) (2.054) (-.412) (-6.501) (2.698)
36 Mean .005 .095 -.613 .308 .525 38.636
(t-statistic) (.858) (1.963) (-10.501) (6.116)
37 Mean -.001 .196 -.663 .430 .613 18.946
(t-statistic) (-.157) (2.201) (-7.241) (4.621)
38 Mean .009 -.056 -.326 .256 .324 12.356

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 (t-statistic) (1.414) (-1.011) (-4.868) (5.357)
73 Mean .000 .185 -.499 .241 .389 23.112
(t-statistic) (-.022) (3.905) (-8.292) (5.002)

The error term from the model was the proxy for earnings quality. We standardized the error
term to remove industry effects and scaled it by total assets to address differences in firm size.
We used the unsigned standardized error (|SEE|) to reflect both over and under estimated accrual
errors.

Measure of Board Stock Ownership

We examined earnings quality across relative board insider ownership (BIO) levels. To test for
entrenchment, we divided BIO into intervals of five percent and ran piecewise linear regressions
at different BIO intervals to estimate the coefficient on BIO. Changes in the slope, or in its sign,
at two different thresholds indicated the range of entrenchment for BIO.

|SEE|f,t = b0 + b1BIOf,t + ef,t

where:

|SEE|f,t = absolute value of standardized estimation errors found in accruals for firm f at
time t using the Dechow and Dichev Model(2002);
BIOf,t = proportion of insider (management and affiliated directors) equity to total
board equity for firm f at time t;
ef,t = the error term for firm f at time t.

Results, shown in Table A-2, indicate an entrenchment range of 30 – 49% insider ownership.

Table A-2. Descriptive Statistics for BIO Groups

Panel A: Curve Estimation Results for IO Groups

Board Board
Mean Mean Relationship of
Insider Independent n p value
BIO % |SEE| IO to |SEE|
Own % Own %
0-29 71-100 33 12.76 .7992 Flat .8177
30-49 51-70 24 41.66 .7262 Positive .0370*
50-100 0-50 442 85.70 .7682 Flat .1684

Panel B: Total Equity Ownership for BIO Groups

Board Board
Mean Insider % Mean Independent %
Insider Independent
of Total Equity of Total Equity
Own % Own %
0-29 .86 71-100 7.48
30-49 1.38 51-70 2.21
50-100 7.76 0-50 .67
* A positive relationship between errors and ownership indicate that as ownership rises from 30% to
49% of inside ownership, errors also rise indicating that earnings quality falls.

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Measure of the Strength of Governance Mechanisms

We used the following model to examine the effect of governance on earnings quality. Results
follow in Table A-3.

|SEE|f,t = b0 + b1GIf,t + ef,t

where:

GIf,t = a discrete governance index variable indicating the effectiveness of a composite

of governance mechanisms for firm f at time t;
all other variables are as previously defined.

Table A-3. SPSS Curve Estimation of GI on |SEE| for All Firms

Coefficient on GI Significance T F Stat R2 Model
-.265869 .0510 3.82806 .00764 Logarithmic

Combined Effects of BIO and GI on Earnings Quality

We regressed BIO and GI on |SEE| for firms in the entrenchment range to assess the combined
effect of both BIO and GI on earnings quality. The regression results are presented in Table A-4.
We used following multivariate regression model:

|SEE|f,t = b0 + b1BIOf,t + b2GIf,t + ef,t

where all variables are as previously defined.

Table A-4. Regression Results for Entrenched Firms N = 24

Panel A: GI on |SEE|

Variable Expected Sign Coefficient (p-value)

Intercept 2.125 (.003)
GI ─ -.051 (.034)

Panel B: GI and BIO on |SEE|

Variable Expected Sign Coefficient (p-value)

Intercept .445 (.680)
GI ─ -.042 (.066)
BIO + .035 (.071)

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 Table 1. Sample Reconciliation
Initial S&P indices sample for 2002 1,500
There was missing/insufficient Compustat data (7)
Regulated utility firms (SIC code 4900) (91)
Regulated financial service firms (SIC codes 6000 – 6999) (233)
Non-US firms (3)
Firms with a fiscal year change in 2002 (3)
Outliers (42)
Firms with missing governance data (70)
(SIC code 20) due to an inordinately small sample size (30)
Firms with less than thirty observations (522)
Final sample 499

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 Table 2. ISS Governance Mechanisms
Category 1: Board of Directors
Board is controlled by more than 50 % independent directors
Compensation committee is composed solely of independent directors
Nominating committee is composed solely of independent directors
Governance committee exists and meets at least once during the year
Size of the board is at least six but not greater than fifteen members
Shareholder approval is required to change board size
Shareholders have cumulative voting rights to elect directors
Board members are elected annually
CEO serves on no more than two other boards of public companies
Outside directors serve on no more than five additional boards of public companies
No former CEO’s sit on the board
The CEO and chairman duties are separated and a lead director is specified
Board guidelines are published in the firm proxy statement
Managers respond to all shareholder proposals within twelve months of the last shareholder meeting
Directors attend at least 75 % of board meetings or have a valid excuse for non-attendance
Shareholders vote on directors selected to fill vacancies
CEO is not listed as having a related party transaction in the proxy statement
Category 2: Audit
Audit committee consists solely of independent outside directors
Consulting fees paid to auditors are less than audit fees paid to auditors
Company has a formal policy of audit rotation
Auditors were ratified at the most recent shareholder meeting
Category 3: Charter/Bylaws
Company either has no poison pill or a pill that has shareholder approval
A simple majority is required to approve a merger (not a supermajority)
A majority vote is required to amend charter/bylaws (not a supermajority)
Shareholders are allowed to call special meetings
Shareholders may act by written consent and the consent is non-unanimous
Company is not authorized to issue blank check preferred stock (stock over which the board has broad
authority to determine voting, dividend, conversion and other rights)
Board cannot amend bylaws without shareholder approval or can only do so under limited
circumstances
Company has a single class of common stock
Category 4: Director Education
One or more directors have participated in an ISS-accredited director education program
Category 5: Executive and Director Compensation
No interlocks exist among directors on the compensation committee
Non-employees do not participate in the company pension plans
Option re-pricing did not occur within the last three years
Stock incentive plans were adopted with shareholder approval
Directors receive all or a portion of their fees in stock
Company does not provide any loans to executives for exercising options
The last time shareholders voted on a pay plan, ISS did not deem its costs to be excessive
The average options granted in the past three years as a %age of basic shares outstanding did not
exceed 3 % (option burn rate)
Option re-pricing is prohibited
Company expenses stock options

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 Table 2. ISS Governance Mechanisms (continued)
Category 6: Ownership
All directors with more than one year of service own stock
Executives are subject to stock ownership guidelines
Directors are subject to stock ownership guidelines
Category 7: Progressive Practices
Mandatory retirement age for directors exists
Performance of the board is reviewed regularly
A board-approved CEO succession plan is in place
Board has outside advisors
Directors are required to submit their resignation upon a change in job status
Outside directors meet without the CEO and disclose the number of times they meet
Director term limits exist
Category 8: State of Incorporation
Incorporation in a state without any anti-takeover provisions

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Figure 1. Overall Results

High Relative Stock Ownership Proportion of Independent

(And High Actual Ownership) Director Stock Ownership
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Below Entrenchment Above

Entrenchment Range Entrenchment

Earnings
No discernable No discernable
Earnings Quality Quality Earnings Quality
Slope Slope

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Proportion of Insider High Relative Stock Ownership
Director Stock Ownership (And High Actual Ownership)

Independent board members could Insider board members had

control insider board members due higher relative and absolute
to higher relative and absolute equity ownership and their
equity ownership. interests were better aligned
with those of the stockholders.

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