Sloan 2001

Journal of Accounting and Economics 32 (2001) 335–347

Financial accounting and corporategovernance: a discussion$

Richard G. Sloan*

School of Business Administration, University of Michigan, 701 Tappan Street,

Ann Arbor, MI 48109-1234, USA

Received 30 October 2000; received in revised form 5 January 2001

Abstract

Bushman and Smith (2001, this issue) provide a useful review of research on the roleof accounting in management compensation contracts and an appealing future researchagenda that builds on recent research using a cross-country approach. This paper

rounds out their discussion by highlighting some limitations of their research agenda,providing a critical review of the contributions of accounting scholars to governanceresearch and highlighting research opportunities on the role of financial accounting ingovernance mechanisms other than managerial incentive contracts. r 2001 Elsevier

Science B.V. All rights reserved.

JEL clasification: M41; G14

Keywords : Corporate governance; Accounting; Contracting

1. Introduction

The study of corporate governance is concerned with understanding themechanisms that have evolved to mitigate incentive problems created by theseparation of the management and financing of business entities. Financial

$I am grateful for the comments of Patricia Dechow, Scott Richardson, Doug Skinner and Jerry

Zimmerman.

*Corresponding author. Tel.: +1-734-764-2325; fax: +1-734-936-0282.

E-mail address: [email protected] (R.G. Sloan).

0165-4101/01/$ - see front matter r 2001 Elsevier Science B.V. All rights reserved.

PII: S 0 1 6 5 - 4 1 0 1 ( 0 1 ) 0 0 0 3 9 - 8

accounting provides financiers with the primary source of independentlyverified information about the performance of managers. Thus, it is clear thatcorporate governance and financial accounting are inexorably linked. Indeed,many of the central features of financial accounting, such as the use ofhistorical costs, the reliability criterion, the realization principle and theconservatism principle are difficult to understand unless one adopts a corporategovernance perspective. Without governance problems, the role of financialaccounting would be reduced to providing investors with the risk and returninformation required to facilitate the optimal portfolio allocation decision. Thereview by Bushman and Smith (2001, B&S hereafter) therefore addresses anarea of fundamental importance in financial accounting.

B&S’s review focuses on two main areas of governance research. First, theyprovide a comprehensive summary and evaluation of research on the role offinancial accounting information in managerial incentive contracts. Second,they propose an agenda for future research that builds on previous researchexploiting cross-country differences in financial reporting and governanceregimes. While B&S provide a useful and thorough analysis in each of thesetwo areas, my task is to identify potential limitations of their review. I identifythree broad limitations. First, their proposed research agenda only analyzes therole of accounting information at a very macro-level. Second, they providelittle in the way of a critical assessment of the contributions of accountingscholars to governance research. Finally, they provide only a superficialdiscussion of the role of accounting in governance mechanisms other thanmanagerial incentive contracts. Below, I discuss these limitations in more detailand suggest additional research opportunities in this area.

2. Limitations of cross-country research agenda

B&S’s most specific and detailed suggestions for future research involve theuse of cross-country research designs to investigate the effects of financialaccounting on economic performance. While appealing and well worthy ofserious consideration, this research agenda is nevertheless subject to somelimitations. First, it is not clear that accounting researchers have a comparativeadvantage in conducting such research. The determinants of national economicperformance are many and varied, with the financial accounting systemrepresenting only one small and interrelated piece. Moreover, such researchonly analyzes the role of accounting information at a macro-level, using crudemeasures of the quality of the accounting system, such as the CIFAR Indexdescribed by B&S. Financial economists have conducted the seminal researchin this area, and are best equipped to conduct this research moving forward.Financial accountants most useful role in this research agenda is in helping todevelop improved measures of the quality of alternative financial accounting

R.G. Sloan / Journal of Accounting and Economics 32 (2001) 335–347336

systems, including the institutional arrangements that support them, such asauditors, analysts and regulators. However, as I will argue in Section 4,accounting researchers are also well equipped to conduct more micro-levelresearch focusing on the role played by accounting information in facilitatingvarious governance mechanisms.

Another major limitation of the cross-country research agenda proposed byB&S is the particularly thorny set of econometric issues that it raises. Whileacknowledged by B&S, these issues are serious enough to warrant additionalemphasis. Problems with correlated omitted variables, multicollinearity,endogeneity and limited degrees of freedom combine to make meaningfulinferences very difficult. One particular example is worthy of mention.Economically developed countries tend to have more highly regulated financialaccounting systems, resulting in a positive correlation between economicperformance and the CIFAR index. However, it would be dangerous toconclude that more accounting regulation leads to improved economicperformance. Economic performance and financial accounting both thrivedin numerous developed countries even before the introduction of extensiveaccounting regulation. In less-developed countries, costly regulation byopportunistic regulators may well hinder economic development.

3. Evaluation of accounting scholars’ contribution to governance research

Governance research is truly interdisciplinary in nature, drawing heavily onthe fields of economics, finance, law and management. Accounting also has apotentially important role to play in governance research since, as I will discusslater in this review, accounting provides the information required for mostgovernance mechanisms to operate efficiently. Indeed, some have attributed thetremendous success of US capital markets to the sophistication of the USfinancial reporting system.1 It is therefore worth reflecting on the contributionsof accounting scholars to governance research. As with any critical assessmentof research, an evaluation of this nature is inherently subjective, but isnevertheless useful for evaluating past contributions and guiding futureresearch efforts.

The basic method by which I propose to provide some perspective onaccounting scholars’ contribution to the governance literature is to examine therelative frequency with which research in accounting journals is referenced in arecent survey article on corporate governance. Of course, this approach has itslimitations. In particular, the individual biases of the authors will influence thereferenced articles, and there is no obvious benchmark against which to judge

1 See, for example ‘‘The Numbers Game’’, remarks by Arthur C. Levitt, Chairman of the SEC,

September 28, 1998.

R.G. Sloan / Journal of Accounting and Economics 32 (2001) 335–347 337

the relative frequencies of references across disciplines. Nevertheless, I believethe analysis provides some useful insights.

The survey article used is Shleifer and Vishny (1997). This is, to the best ofmy knowledge, the most recent general survey article published in a top tierjournal. The fact that this survey is published in a finance journal by twofinancial economist’s raises concerns that it probably has a bias towardresearch in finance and economics. For comparative purposes, I also conductan analysis of the references in the B&S review paper. Recall that the explicitfocus of B&S is financial accounting information and corporate governance.As such, we expect that paper to have a significant accounting bias whencompared to a general survey paper. However, an analysis of the B&Sreferences should nevertheless provide corroborative evidence on the relativecontributions of the non-accounting disciplines.

Results of the reference analysis are reported in Table 1. I classify allreferenced articles by the primary areas of the journals in which they arepublished. In cases where a journal title refers to two areas (e.g., Journal ofAccounting and Economics), I classify the article according to the areaappearing first (i.e., Accounting). Books, monographs and working papers areleft unclassified.

As expected, the vast majority of the references in Shleifer and Vishny are topublications in the Economics (31%) and Finance (29%) literature. However,we also see that the economics and finance journals feature prominently in theB&S review with 17% and 15% of the references, respectively, despite the factthat this review has an explicit focus on financial accounting. It seems clear thatthe majority of the academic contributions to governance research have beenmade in economics and finance. Law comes in third with 10% of thereferences, while Accounting comes in a distant fourth with 3%, trailed only byManagement with 2%.

Table 1

References in governance survey papers classified according to journal areasa

Panel A: References in Shleifer and Vishny (1997)

Area ECON FIN LAW ACC MNGT UNC Total

Freq. 73 68 23 8 5 60 237

% 31 29 10 3 2 25 100

Panel B: References in Bushman and Smith (2001)

Freq. 59 34 6 79 4 43 225

% 17 15 3 35 2 19 100

a Key: ECONFEconomics Journal, FINFFinance Journal, LAWFLaw Journal, ACCFAc-

counting Journal, MNGTFOther General Management Journal, UNCFUnclassified (book,

monograph or unpublished manuscript).


The fact that only 3% of the papers referenced in a general survey ofcorporate governance are published in accounting journals seems disappoint-ing at first glance. Accounting information undoubtedly plays an importantrole in corporate governance and most business schools expend significantresources on accounting research. However, if one digs a little deeper into thereferenced accounting papers, the situation becomes even more disturbing.Panel A of Table 2 lists the papers appearing in accounting journals that arereferenced by Shleifer and Vishny. Panel B of Table 2, lists the papersreferenced in Shleifer and Vishny that I was able to identify as including asubstantive analysis of accounting-related phenomena. While some subjectivityis required to construct this list, I doubt that anyone going through the sameexercise would disagree with the general spirit of my findings. Of the eightpapers published in accounting journals, only one makes both lists. That is,only one of the papers published in accounting journals involves a non-trivialanalysis of accounting-related phenomena. This paper is Palepu’s (1986)‘‘Predicting Takeover Targets’’ paper. Palepu shows, among other things, thatfinancial accounting data are useful in predicting takeover targets. Thus,Palepu’s research highlights the role of accounting data in facilitatingcorporate takeovers. The remaining seven papers cover such issues as therelation between executive compensation and stock price performance,executive deaths, golden parachutes, executive stock ownership and board

Table 2

Accounting-related research referenced by Shleifer and Vishny (1997)a

A: Research published in Accounting Journals

Benston (1985) ‘‘The self-serving management hypothesis’’ JAE

Coughlan and Schmidt (1985) ‘‘Executive compensation, management turnover and firm

performance’’ JAE

Johnson et al. (1985) ‘‘An analysis of the stock price reaction to sudden executive deaths’’ JAE

Lambert and Larcker (1985) ‘‘Golden parachutes, executive decision making and shareholder wealth’’

JAE

Lewellen et al. (1985) ‘‘Merger decisions and executive stock ownership in acquiring firms’’ JAE

Murphy (1985) ‘‘Corporate performance and managerial remuneration’’ JAE

Palepu (1986) ‘‘Predicting takeover targets’’ JAE

Shivdasani (1993) ‘‘Board composition, ownership structure and hostile takeovers’’ JAE

B: Research involving a substantive analysis of the role of accounting in governance

Asquith and Wizman (1990) ‘‘Event risk, covenants, and bondholder returns in leveraged buyouts’’

JFE

Palepu (1986) ‘‘Predicting takeover targets’’ JAE

Smith and Warner (1979) ‘‘On financial contracting: an analysis of bond covenants’’ JFE

Teoh et al. (1998) ‘‘Earnings management and post-issue under-performance of seasoned equity

offerings’’ JFE

a Note: JAE=Journal of Accounting and Economics, JFE=Journal of Financial Economics.


composition. None of these seven papers, however, contain a substantiveanalysis of the role of financial accounting in corporate governance.

Fortunately, panel B of Table 2 does consist of more than one paper. Thereare several papers containing a substantive analysis of the role of financialaccounting in corporate governance. However, these papers are not publishedin accounting journals. For example, Smith and Warner (1979) provide adetailed analysis of the role of accounting information in bond covenants,including the purposes of the various covenants and the importance of GAAP.There are also many other papers referenced by Shleifer and Vishny that makeextensive use of accounting data in their empirical tests, but panel B of Table 2lists only those that contain a substantive analysis of accounting-relatedphenomena.

In summary, the analysis in this section highlights two key points:

1. There is a dearth of influential research published in accounting journalsthat contains a substantive analysis of the role of financial accounting incorporate governance.

2. Accounting research has the potential to play an important role ingovernance research, as evidenced by the impact of several influentialpapers on the role of accounting in corporate governance that are publishedin non-accounting journals.

In the next section, I provide a framework for summarizing the moreimportant roles played by accounting in corporate governance and highlightrelated opportunities for research involving a substantive analysis ofaccounting-related phenomena.

4. Overview of the roles played by accounting in corporate governance

Fig. 1 provides an overview of the relation between financial accounting andthe various corporate governance mechanisms that facilitate the separation ofmanagement and financing. The basic agency problem resulting from theseparation of management and financing is that the managers will haveincentives to take actions to increase their own utility, but not to maximize thereturns on capital invested by the financiers. This problem may manifest itselfin numerous ways, including direct wealth transfers from the financiers to themanagers, sub-optimal allocation of capital and managerial perquisiteconsumption. The financial accounting system provides an important sourceof information to governance mechanisms that help alleviate the agencyproblem described above. The use of accounting information in thesegovernance mechanisms can be either explicit or implicit. The use ofaccounting-based covenants in bond contracts is an example of the explicituse of accounting information. The use of accounting information in the


selection of takeover targets is an example of the implicit use of accountinginformation. This section provides an overview of the explicit and implicit usesof accounting information in governance mechanisms.

In addition to constituting an important input to the governance process,financial accounting information is itself a product of the governance process.Financial accounting information is produced by management, and manage-ment knows that this information will be used as an input to the governanceprocess. As such, a series of governance mechanisms have evolved to ensurethat the accounting information supplied by management is not undulycompromised. We begin with a brief discussion of these mechanisms.

4.1. Financial accounting information as a product of the governance process

The process through which accounting information is supplied frommanagers to investors is summarized at the bottom of Fig. 1. While Fig. 1focuses on the US environment, it is broadly applicable to other countries. Thefinancial reporting process for public entities is typically regulated through thegovernment and the legal system, with the Securities and ExchangeCommission (SEC) serving as the primary regulatory body in the USDetermination of the generally acceptable set of accounting principles (GAAP)is delegated to the accounting profession, which has its own oversight structure(FASB, AICPA, etc.). The financial statements supplied by management are

Fig. 1. Illustration of the role of financial accounting and corporate governance mechanisms in

facilitating the separation of management and financing.


subject to external audit to certify that they are prepared in accordance withthe applicable statutory and professional principles. Finally, firms typicallyappoint an audit committee from the board of directors, which exercisesoversight over the preparation of the financial statements and communicateswith the auditors on behalf of investors.

The nature and extent of the mechanisms described above differs widelyacross different countries and companies. Yet only recently have researchersstarted to conduct research in this area. B&S summarize research investigatinghow the quality of the financial reporting system relates to the nature andextent of other governance mechanisms (e.g., La Porta et al., 1998; Bushmanet al., 2000). There is also a body of developing literature investigating otherissues relating to the quality of the financial reporting system. This literaturecan be categorized into three broad areas. The first area is research examiningthe relation between the overall quality of financial disclosures and the cost ofcapital (e.g., Lang and Lundholm, 1996; Botosan, 1997; Botosan and Plumlee,2000). The second area consists of research on the effectiveness of specificmechanisms monitoring the financial reporting process. This area includesresearch on audit quality (e.g., Becker et al., 1998; Francis et al., 1998) andboard of directors/audit committee quality (e.g., Beasley, 1996; Dechow et al.,1996; Carcello and Neal, 2000; Peasnell et al., 2000). The final area consists ofresearch on the causes and consequences of failures in the financial reportingprocess. This research focuses on the determinants and effects of earningsmanagement (e.g., Rangan, 1998; Teoh et al., 1998) and earnings manipulation(e.g., Feroz et al., 1991; Dechow et al., 1996).

The research summarized above is recent and evolving and requires a goodunderstanding of the financial reporting process. Thus, there are richopportunities for accounting research in this area. The recent debate overconflicts of interest for auditors created by the joint provision of consultingservices provides a representative opportunity.

4.2. Explicit uses of accounting information in corporate governance

The explicit use of accounting information in contracts between manage-ment and financiers represents perhaps the most visible use of accountinginformation in governance mechanisms. In particular, the use of accounting-based performance measures in managerial compensation contracts representsperhaps the best known and most heavily researched governance role ofaccounting information. B&S provide an excellent and comprehensive reviewof this research, and I have little to add. The one point that I would like toemphasize is that accounting-based compensation accounts for just a smallproportion of the incentives for a typical top executive. Incentives provided bystock and option holdings tend to dominate (e.g., Murphy, 1985; Core et al.,


2000). Thus, the incredible amount of research in this area is perhaps overkill,given the relative insignificance of this particular role of accounting earnings.

In contrast to the compensation literature described above, the explicit roleof accounting information in debt contracts is extensive, but there is a relativelittle research in this area. Early research by Smith and Warner (1979) andLeftwich (1983) documents the existence and function of accounting-basedcovenants in public debt contracts. Subsequently, what little research has beendone in this area tends to focus on the implications of accounting covenants foraccounting choice (e.g., Press and Weintrop, 1990; Sweeney, 1994). Yet the roleof accounting information in financial contracting has continued to developand flourish, particularly in private placements of debt and private lendingagreements. For example, the use of performance pricing (grid-pricing) inprivate lending agreements is now commonplace. Performance pricing involveslinking the interest rate that is charged on debt to measures of financialstrength that are based on accounting data. Performance pricing represents aninteresting development for two reasons. First, the return to investors, andhence the pricing of the debt is explicitly tied to accounting information.Second, unlike debt covenants that are only violated in extreme circumstances,performance-pricing bounds are frequently triggered in the normal course ofbusiness.

Despite the pervasiveness of performance pricing and its heavy reliance ofaccounting-based ratios, there is little research to date. The only research paperof which I am aware is a recent working paper by Beatty and Weber (2000).More generally, there has been little research on the role of accountinginformation in financial contracting, and the little research that has been donehas often not been done by accountants (e.g., Gilson and Warner, 1998;Kaplan and Stromberg, 1999). This represents a missed opportunity foraccounting researchers. Many accounting researchers are well-trained infinancial economics and frequently engage in governance-based research thathas little to do with accounting. Accounting researchers could make moresignificant contributions to governance research if they exploited theircomparatively strong knowledge of accounting to help explain observedfinancial contracting practices.

4.3. Implicit uses of accounting information in corporate governance

The implicit use of accounting information in corporate governancemechanisms probably represents the most important role of accountinginformation. In this context, the valuation and governance roles of accountingbecome intertwined. The terms on which investors are willing to part with theircapital are a function of the informational efficiency and liquidity of the capitalmarkets in which they will subsequently trade their claims. Thus, any capitalmarkets research focussing on the role of accounting information in the


formation of security prices has potential governance implications. However,rather than focussing on the governance role of accounting through its role infacilitating the informational efficiency of stock prices, I focus on situationswhere accounting information appears to directly facilitate the operation ofspecific governance mechanisms.

Empirical research suggests that accounting information be implicitly usedin a variety of governance mechanisms. Following the structure laid out inFig. 1, I organize this research into the two categories of ‘legal protection’ and‘large investors’. In the legal protection category, a large body of research hasillustrated the role of accounting information in the enforcement of investors’legal rights against management. Investors cannot bring lawsuits againstmanagers simply because the managers did a bad job or because the stock pricedeclined. A common avenue for litigation in the US is to allege a violation ofRule 10b-5 of the Securities Exchange Act of 1934. This rule requires investorsto have relied upon a material misstatement or omission when purchasing orselling a security. Since the financial reporting system is the primary regulatorymechanism through which management communicates with investors, mostinvestor lawsuits brought under Rule 10b-5 allege a material misstatement oromission in the financial statements. Research has demonstrated thataccounting and disclosure problems are most frequently associated withstockholder litigation and that management act as if they take steps to managetheir reporting strategy in order to mitigate the costs associated with thislitigation (e.g., Kellogg, 1984; Francis et al., 1994; Skinner, 1994; Skinner,1996). Accounting information also plays an important role in the enforcementof creditors rights in the event of default and/or bankruptcy. However, whilethis particular role of accounting information is of great practical significance,it has attracted almost no research (an exception is Lehavy, 1999).

The second category of research where accounting information implicitlyfacilitates the operation of governance mechanisms is large investors. Largeinvestors can affect management’s actions through the board of directors,which has the authority to hire and fire top management. Academic researchconfirms that the board uses accounting earnings performance as an input intotheir firing decisions (Weisbach, 1988). However, in many cases, a largeinvestor may not have a clear voting majority on the board, and may have totake more drastic action, such as a takeover or a proxy contest to wrest controlof the board and discipline management. In this respect, preliminary researchalso shows that measures of accounting performance are related to takeovers(Palepu, 1986), proxy contests (DeAngelo, 1988), and institutional investoractivism (Opler and Sokobin, 1998). Yet there are clearly opportunities formore detailed research in this area.

In summary, accounting information provides an important input into themajor corporate governance mechanisms. Accounting information is implicitlyused both to indicate whether governance actions against management are


required and to help determine the payoffs to different stakeholders in the caseof legal disputes and financial distress. Yet current research only provides asuperficial analysis of accounting information in these respective roles.

5. Concluding comments

Financial accounting is a key ingredient in the corporate governance process.A complex set of institutions and rules have evolved to facilitate the financialreporting process, and the information provided by this process is an importantinput to major governance mechanisms. Indeed, it is no surprise that the USfinancial reporting system is often cited as an important factor in thetremendous success of US capital markets. In this review, I have sought tohighlight the many and varied links between financial accounting andcorporate governance mechanisms. However, in doing this, I have also soughtto highlight the limited contribution of accounting researchers in this area.Accounting researchers have over-invested in certain areas of governanceresearch at the expense of other areas, and have failed to probe very deeply intothe characteristics of financial accounting information that make it useful inspecific governance mechanisms. The managerial compensation researchreviewed by B&S provides a good illustration of my concerns in this respect.An enormous amount of accounting research has focussed on the topic ofmanagerial compensation. This is despite the fact that a relatively insignificantproportion of top management incentives are tied to accounting-basedperformance measures. Moreover, this research has not moved much beyondviewing accounting earnings as a generic noisy signal of firm performance. Incontrast, while detailed accounting information is used extensively in corporatelending agreements, there is relatively little research in this area.

In summary, despite the undeniable importance of financial accounting incorporate governance, the current body of research is modest, and non-accountants have made many of the most significant advances. As a result,there are tremendous opportunities for future accounting-based research in thisarea. These research opportunities call for us to exploit our comparativeadvantage as accountants in understanding the many and varied roles ofaccounting numbers in corporate governance mechanisms. Accounting journaleditors can help to encourage accounting researcher to take advantage of theseopportunities by resisting the temptation to serve as an overflow outlet forfinance papers that have little to do with accounting. For their part, accountingresearchers should move beyond thinking about accounting information asproviding generic noisy signals of firm performance, and instead focus onidentifying the unique structure and characteristics of accounting informationthat make it useful in specific governance mechanisms.


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