Keeping Chief Executives in Check

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By David Turner

SMU Office of Research – Money is a powerful incentive, some say the root of all evil. This might explain why experts have struggled to find the balance between giving company managers latitude to innovate and preventing these investments from going up in smoke.

Two global corporate meltdowns in the first decade of the 21st century suggest that the quest is not over. However, the search for such a balance may have become less elusive thanks to the Singapore Management University (SMU) School of Accountancy’s (SoA) research on how corporate governance practices influence the behaviour of company managers.

“How to address managerial myopia is very important for public companies, and good corporate governance is critical to this,” says SoA Dean Professor Cheng Qiang, who, along with SoA Professor Chen Xia, specialise in assessing regulatory and contractual attempts to curb management short-termism.

Two ways CEOs behave badly

Their recent research focused on two practices which had long vexed directors and investors: i) earnings management, i.e., when managers make accounting decisions to make their own performance look good rather than show the company’s true economic situation; and ii) short-termism, i.e., when managers cut expenditure on long-term projects to boost the short-term bottom line.

While both practices severely undermine companies by masking potential risks and resource misallocation, the issue is more complex than one of malfeasance, notes Professor Cheng. “CEOs feel constant pressure from shareholders and directors to deliver high earnings in the current quarter or year, because that is how they are evaluated. If earnings go down, the shareholders and directors will put pressure on them and in extreme cases, fire them. To meet these expectations, CEOs can improve operations and make value-creating investments, but they might also resort to earnings management to report higher earnings,” he says.

Because corporate governance practices can intensify these pressures, it is important to understand how company management respond to new requirements, lest they worsen managerial myopia rather than promote enterprise and long-term growth, which is, after all, the raison d’être of corporate governance.

The regulatory solution – adding independent and informed directors

Two recent studies that were jointly conducted by the two professors investigated the influence of corporate governance initiatives on company management. 

The first study examined the impact of the regulatory requirement for listed companies to have a majority of independent directors on their board. This was a requirement which the Securities and Exchange Commission (SEC) in the United States adopted in 2003 in response to accounting scandals in the early 2000s. The thinking behind this reform was that independent directors would scrutinise management’s assumptions, decisions and financial reports more rigorously, hence deterring managers from engaging in earnings management.

To test this assumption, the two professors teamed up with a colleague from the University of Hong Kong to study the financial statements of 1,587 firms that were released between 2000 and 2006 – the period when the SEC introduced the reform. They found that just under half of those firms needed to add independent directors to their boards in order to comply with the reform, while the others already had a majority of independent directors before the new rule was introduced.

The findings were significant because they threw into strong relief an additional factor at play, which had implications for corporate governance across the board. The study found that the increase in board independence did not by itself drive change: there was no significant difference in the reduction of earnings management between the firms that increased their board independence and the firms that already had majority-independent boards. What made the real difference was the access to company information: among the firms that brought in more independent directors, those with easier access to good information about the company were the most successful at curbing earnings management.

“In some firms, directors and shareholders know little about the firm’s operations, investments and performance, and understandably, CEOs are less forthcoming with directors if they have something to hide, such as earnings management,” explains Professor Cheng.

Agreeing, Professor Chen adds that directors need a richer information environment so that they can rigorously examine and question management accounting decisions and financial reports.

A key to success might be increased public disclosure requirements, suggests Professor Cheng. “Tough regulation and disclosure requirements can force companies to disclose more and this helps the internal information environment as well.”

However, he adds that the answer does not just lie in greater regulation, as directors themselves should be more inquisitive and demand more information from management.

Protecting CEOs encourages innovation

Their second study threw light on an area that has spilt over from the commercial world into the public consciousness since the 2008 financial crisis – CEO remuneration. The dismal failure of financial institutions fuelled public concern about the remuneration and incentives given to CEOs. Similarly, high CEO salaries have become a symbol of global economic inequality, as people start to question the corporate governance objectives of these payouts.

To test whether or not one should be sceptical of these corporate governance objectives, the duo examined contracts that either protect CEOs from or give them financial compensation for early termination. The man in the street may view these provisions, perhaps with some scorn, as ‘golden parachutes’ but, as Professor Cheng points out, there are very real pressures that might force CEOs to focus on the short term.

So does relieving this pressure lead to more innovation and less short-termism?

Both professors looked at whether CEOs with such protections would exercise more freedom to take risks in costly projects such as Research and Development (R&D). Cuts to R&D seemed to be a good indicator of short-termism because expenditure on R&D reduced the ability to meet short-term earnings targets, but led to significant long-term gains.

The research team manually gathered data for the period of 1995 to 2008 on CEO employment agreements, severance pay agreements and R&D expenditure for Standard & Poor’s 500 firms. The findings affirmed the ability of CEO job protection contracts to encourage enterprise and innovation, which ultimately had a bearing on companies’ financial gains (or losses).

Firms with CEO contractual protection were found to be much less likely to cut R&D expenditures to avoid earnings decreases. They were also found to be less likely to engage in real earnings management. Moreover, the research showed that the positive effect of CEO contractual protection increased with longer job security and higher financial cushions.

Conducting research into what works and what does not is very important to getting the corporate governance balance right, explains Professor Cheng. “What works for one company might not work for another. Each company should find the best governance that suits itself.” He plans to extend this research to examine how employment agreements affect a company’s disclosure practices.

Last but not least, the professors’ research findings also showed that a balance between regulatory and market approaches was necessary. Both concur that although contractual and regulation approaches are costly and have their own limitations, the two should be mobilised concurrently to deal with corporate governance issues. 

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