Separation of powers: Active, independent boards enhance credibility

Research team discovers an unintended benefit of the 2002 Sarbanes-Oxley Act: Aside from tightening controls on corporate misbehavior, the law creates better board governance which, in turn, improves a corporation's credibility with the market.

The Sarbanes-Oxley Act of 2002 was created to counter the string of corporate and accounting scandals that rocked the business world around the turn of the millennium.

Unfortunately, some chief executives didn't get the message, because in spring 2005 another major corporation, insurance giant American International Group, was going through the now familiar rounds of investigation, removal of chief executive and restatement of earnings.

Yet the Sarbanes-Oxley Act, while controversial, managed to accomplish a number of important things — especially in regard to corporate governance issues. In particular, the law addressed and remedied transparency, board independence, final rules for pro forma statements and audit committee requirements.

The changes were made to prevent corporate abuse of established procedures and penalize companies that trampled on Securities and Exchange Commission (SEC) regulations. Also, improved corporate governance has other unintended consequences. According to a trio of researchers, better board governance has a positive effect on market response to corporate communication.

The three professors — Daniel Deli and Stuart Gillan at the W. P. Carey School of Business and Kirsten Anderson at Georgetown University — all worked for a time at the SEC's Office of Economic Analysis in Washington, D.C. This is a group of about a dozen academics on leave from universities to provide internal consulting for the rule makers, looking at the consequences arising from a change in regulations.

Their research examines the relationship between board and audit committee structures and whether the market believes the earnings information issued by the companies. Perhaps if Maurice "Hank" Greenberg, ex-chairman and chief executive officer of AIG, had looked at the work of these professors, he wouldn't be carrying the attribution "former."

The study shows that firms in which the chief executive officer is a separate position from chairman of the board are given greater credence by the markets. The research also observes a correlation between informative earnings and greater independence and activity of the full board, and that audit committee characteristics influence the information content of earnings.

"We were just trying to make a general point — and not trying to influence the likes of Hank Greenberg," says Deli, an assistant professor of finance at W. P. Carey. "Accounting information or accounting numbers issued in an environment where boards look a certain way, or where they tend to be more active, are believed more and given more credence by the markets than similar numbers issued by firms where the boards are less independent and active."

The assumption is not mere intuition. The authors of the study compared market responses to earnings reports among different publicly traded companies. Basically, they narrowed their study to what is called the "earnings surprise." For example, take the case of a company that reports a $0.10 per share earnings surprise — the earnings are either $0.10 per share more or less than the market expected prior to the announcement. If the market finds the numbers believable, there will be a greater stock price reaction to the earnings surprise, says Deli.

The authors focused on earnings response coefficients (the relationship between earnings surprise and the stock increase or decrease on the day of the announcement) as a function of board and audit committee characteristics, including independence, size, activity and the separation of CEO and board chair positions.

Among the findings were:

• Earnings response coefficients increase as corporate boards become more independent.
• Active boards are associated with higher earnings response coefficients.
• The effects of board independence and activity are contingent upon one another. For example, the "bang for the buck" of making a board more independent depends on how active the board is — increasing independence will increase the credibility of the earnings numbers the most when board activity is low.
• Firms which have separate CEO and chairman positions have more informative earnings.
• The audit committee plays a role in determining the information content of the earnings. (Independent and active audit committees are associated with more informative earnings.)

Deli warns that "we are not addressing in any way, shape or form the potential cost that might be associated with more independent boards, so it would be a mistake to look at our research and say, all right, every company's boards should be 100 percent independent."

While more independence would probably result in more credible accounting numbers, going 100 percent independent might result in poorer operational oversight. "There is a kind of balance that exists between internal knowledge and independence," Deli explains. "If you didn't have any employees or former employees of the firm on the board, operational functions might suffer. You would be giving up what might be called internal knowledge for complete independence."

Still, Deli reiterates, the key point to remember is, "the more independent the board, the more credible and meaningful are the accounting numbers to the market. Also, the board should be more active in terms of meetings. It shouldn't just meet three or four times a year; it should meet more often."

Deli's advice to a CEO on ways to increase transparency — to make the numbers more credible to the marketplace — would be to increase the independence of the board.

"The more independent the board, the more credible are the accounting numbers to the market," he says.

Past studies of earnings have scrutinized the quality of earnings, but this study narrows the debate to earnings credibility. Earnings may be of low quality in the sense that they deviate substantially from cash flows, but still convey value-relevant information to the market. The study's central issues are:

• How well do accounting numbers inform the financial markets with respect to the economic condition of the firm, irrespective of how much they deviate from actual cash flows; and
• The market's reaction reflects the credibility of the reported earnings number.

The study focused on a second, tangential issue as well: the audit committee and its role in regard to earnings credibility. The findings here were a mirror image of the larger results. The study concluded that the information content of earnings increases with audit committee independence and activity. As an aside, they also find that small audit committees are associated with more informative earnings.

The last finding of the research deals with the independence of the audit committee relative to that of the full board. Historically, audit committees have been more independent than boards. Sarbanes-Oxley codified the difference with a requirement of completely independent audit committees.

The professors find that the independence of audit committees above and beyond that of the full board does not increase the credibility of the earnings numbers. Their result suggests that it is the character of the full board, and not the makeup of the audit committee, that ultimately determines the credibility of the earnings numbers.