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University of Bristol
To cite this article: John J. Forker (1992): Corporate Governance and Disclosure Quality, Accounting and
Business Research, 22:86, 111-124
To link to this article: http://dx.doi.org/10.1080/00014788.1992.9729426
Accounting and Business Research, Vol. 22. No. 86. pp. I11-124, 1992
John J. Forker*
Abstract-The effectiveness of control exercised over executive remuneration and the quality of information disclosed
in financial statements have given rise to concern and have led to proposals for the reform of corporate governance.
A model of the optimal disclosure decision is presented in terms of managerial incentives and the impact of corporate
governance structures. An investigation into the quality of share option disclosure in financial statements is used
as the basis for testing hypotheses derived from the model and for assessing alternative policy options. The results
support the need for guidance on the duties and responsibilities of audit committees and non-executive directors
but fall short of providing a basis for deciding whether regulatory action is required. The evidence also supports
the view that a threat to monitoring quality exists where the roles of chief executive and chairman are combined.
Introduction
The quality of information disclosed in financial
statements and the control exercised over executive
remuneration have given rise to concern and public
debate in both the United States and the United
Kingdom. Reaction in the US has focused on
extending the regulation of corporate governance.
As a means of improving internal accounting
control the National Commission on Fraudulent
Financial Reporting (1987), otherwise known as
the Treadway Commission, recommended that the
Securities and Exchange Commission require all
US public companies to establish audit committees
composed solely of independent non-executive
directors. This contrasts with a preference in the
UK for the provision of guidance on aspects of
good governance practice. Most recently the
Institutional Shareholders Committee (ISC, 1991)'
*The author is lecturer in accounting at the University of
Bristol. Financial support from the Research Board of the
Institute of Chartered Accountants in England and Wales and
the research assistance provided by Geoffrey Elliott and Salima
Paul are gratefully acknowledged. The paper was presented at
the Universities of Auckland, Bristol and the Australian National University and at the European Accounting Association
Congress at Maastricht in April, 1991 and to the Financial
Accounting and Auditing Research conference at the London
Business School in July, 1991. I thank the participants at these
presentations and am particularly grateful to David Ashton,
Don Egginton, Michael Mumford, Peter Pope (Touche Ross
Fellow visiting Bristol from the University of North Queensland) and two anonymous referees for helpful suggestions.
'These recommendations follow publication by the investment protection committee of the Association of British Insurers (1990) of a discussion paper on the role and duties of
directors. The establishment of a Committee on Financial
Aspects of Corporate Governance under the Chairmanship of
Sir Adrian Cadbury (May 1991) reflects the perceived importance of the link between financial reporting and corporate
governance.
recommended that remuneration committees comprising independent non-executive directors be responsible for determining executive remuneration
and the provisions of share option schemes, and
that details of the latter be disclosed in financial
statements. The Committee also acknowledged the
potential threat posed by dominant personalities
and expressed the view that the practice of combining the roles of chairman and chief executive is
undesirable.
The need for action to influence corporate governance structure and accounting disclosure is,
however, challenged by those who view intervention as more likely to hinder than improve governance.' The aim of this paper is to contribute to the
debate by modelling and empirically investigating
the relationship between governance structure and
the degree of internal control exercised over managerial remuneration as reflected by the quality of
share option disclosure in financial statements. The
finding of no association between audit committees
or non-executive directors and the quality of share
option disclosure supports the case for policy
action to enhance control of managerial remuneration. The study covers the period 1987/88 when
audit committees and non-executive directors were
the main instruments of corporate governance.
'The case supporting this view, based on the operation of a
market in decision control for corporate governance, is presented in Fama (1980) and Fama and Jensen (1983), and is
applied to accounting disclosure by Benston (1982). The inconclusive nature of the debate so far is illustrated by successive
revisions of the American Law Institute proposals (1982, 1990)
for the reform of corporate governance. A first tentative draft
published in 1982 has to date been replaced by a tenth tentative
draft. A comprehensive review of governance proposals, together with a normative based proposal for reform, is provided
in Gilson and Kraakman (1990). Tricker (1984) and Clarkham
(1989) provide UK-based analyses of corporate governance.
112
A C C O U N T I N G A N D BUSINESS RESEARCH
During that period only two firms in the sample voting power when shareholder approval is sought
disclosed in financial statements the existence of a for executive share option schemes. A subsequent
remuneration committee. The ISC (1991) proposal discussion paper (ABI, 1990) directed attention
that executive remuneration should be the specific toward improving internal control, and proposed
responsibility of a remuneration committee may that non-executive directors assume responsibility
improve control and disclosure in financial state- for executive remuneration and the provisions of
ments. However, this is likely to be conditional on share option schemes and that details of option
identification of the duties, and provision of de- schemes be disclosed in financial statements. These
tailed guidance on the discharge of responsibilities proposals are incorporated in the document on
of non-executive directors and audit and remuner- best practice published by the Institutional Shareation committees. The identification of an inverse holders Committee (1991).
The Bank of England has adopted a wider
relation between dominant personalities and audit
committees and non-executive directors also war- perspective and has repeatedly drawn attention to
rants consideration. The methodology employed what it regards as the poor state of corporate
does not, however, extend to providing a basis for governance in the UK. Bank of England sponsored
deciding if guidance alone would be sufficient or surveys (1983, 1985, 1988) highlight as threats to
internal control the generally low proportion of
whether regulation is also necessary.
Disclosure quality is described by Verrecchia non-executive directors on company boards, the
(1990, footnote 3) as the distributional character- likelihood that non-executive directors appointed
istic or variance of an uncertain event. The event will not be independent, and the frequency with
focused on in this paper is the granting of share which chief executives also act as chairmen of
options to employees. Deciding on the quality of boards of directors.
The policy option favoured by the British authdisclosure of share option information allows management to influence the level of uncertainty faced orities has been to improve internal mechanisms of
by investors in estimating share option benefits. corporate governance through a process of persuaThe greater the uncertainty the less effective will be sion and education of the business community. In
the monitoring of share option benefits and the 1981 following failure of attempts to obtain statugreater will be the potential use of options to tory backing for a proposal that companies be
increase rewards beyond levels acceptable to share- required to appoint non-executive directors,
PRONED (Promotion of Non-Executive Direcholders.
Williamsons (1985b) analysis of transaction tors) was established under the sponsorship of the
costs provides a framework linking disclosure Bank of England and major City institutions, to
quality to corporate governance. This is integrated promote and facilitate the appointment of indepenwith the positive theory of agency developed by dent non-executive directors. The code of conduct
Jensen and Meckling (1976) to provide a model of published by PRONED (1987) reflects the UK
the discloure decision of management. Manage- preference for recommendation rather than regument are assumed to balance potential benefits lation. This contrasts with the situation in the US
from less disclosure against costs in the form of where the governance structures of listed compalower share prices and increased threat of takeover nies are subject to regu1ation.j This has been
and to choose the quality of disclosure which reinforced by the Treadway Commission proposal
minimises the costs they incur. Adoption of in- that all companies supervised by the SEC be
ternal control devices such as audit committees and required to establish audit committees comprising
non-executive directors, and separation of the roles independent directors.
of chairman and chief executive, enhance monitoring quality and reduce benefits from withholding Corporate Governance: The Academic Debate
information; as a consequence disclosure quality in
Public policy on corporate governance has been
financial statements is improved.
formulated against a background of academic debate about the regulation of corporate governance.
Corporate Governance: The Policy Debate
Disagreement
exists about the disciplinary effect of
Doubts about the adequacy of corporate governance in the UK is evident in matters relating to competition. Those taking an antagonistic view of
executive remuneration and the impact of domi- regulation (Watts, 1977; Watts and Zimmerman,
nant personalities on the decision making pro- 1978; Fama and Jensen, 1983; Scott, 1983) do so
cedures of boards of directors. On the issue of because they regard market discipline as sufficient
executive remuneration. the investment motection to realise benefits associated with governance
committee of the Association of British Insurers
published guidelines (ABI, 1987) setting limits to
3The statutory and regulatory requirements relating to corthe benefits which
be Obtained from execu- porate
governance in the US, and the governance structures
tive share options- These guidelines aim to provide adopted by US firms, are described in the Paris Colloquium on
financial institutions with a focus to exercise their Corporate Governance (1984) and Birkett (1986).
SPRING 1992
113
of asset specificity leads to the setting up of governance structures. These serve to monitor the conduct of contracting parties and provide cost
effective means for the resolution of disputes.
The conditions of asset specificity and bounded
rationality apply to executive remuneration and, in
particular, to executive share options. The substantial investment in human capital undertaken by
executives is highly specific and often takes time to
develop. It is, therefore, in the interest of firms and
their executives to devise reward structures which
incorporate a deferred component. Given uncertainty and with regard to bounded rationality, reward
structures can be expected to incorporate flexibility
to allow rewards to be related to achievement.
Share option schemes satisfy these requirements.
Share Options: The Constrained Choice Set of
Management
The importance of the perceived threat to shareholders from share options granted to employees is
indicated by the existence of a comprehensive set
of constraints on managerial freedom of action.
These aim to assist internal control, facilitate external monitoring, set limits on the aggregate value of
options granted and impose upper limits on the
level of benefit obtained by individual executive
directors. Authority for these constraints in the
UK is provided by the Companies Acts, the Stock
Exchange and the Inland R e v e n ~ eThe
. ~ guidelines
issued by the investment protection committees of
the financial institutions add a private sector dimension to the control framework. Following
Watts and Zimmerman (1990), this network of
restrictions can be interpreted as the ex ante delineation of the feasible set of choices available to
management. Choices made ex post by management with respect to this set can be investigated in
the light of the scope they offer for opportunistic
behaviour. In general, the feasible set of choices
available to management serve to set an upper
bound on the benefits which can be obtained from
share options. This paper focuses on the disclosure
dimension of managerial choice.
Option Appraisal: Information Requirements
The costs to shareholders of share option
schemes comprise the value of options when they
4The requirements of the Companies Acts relate to information which must be disclosed to shareholders, and recorded
by the firm regarding options granted to directors. The Stock
Exchange Listing Agreement serves to cover gaps perceived in
the statutory requirements on disclosure, and on shareholders
rights to approve share option schemes. Tax concessions are
available only on those schemes falling within the restrictions
set by the Inland Revenue. Finally, the investor protection
committees of the financial institutions, particularly the Association of British Insurers, have issued comprehensive guidelines
imposing limits on the benefits available from option schemes.
These restrictions are summarised in Egginton, Forker and
Tippett (1989).
114
A C C O U N T I N G A N D BUSINESS RESEARCH
and 1998. The disclosure requirements of the Companies Acts for options to subscribe for shares
represent a still finer partitioning where the numbers of options outstanding at each exercise price,
and for each exercise period, are disclosed. Other
aspects by which fineness could be measured relate
to whether disclosure is further partitioned to
reveal the distribution of options across different
schemes, and the split in holdings between options
held by directors and those held by other employees of the firm for different option schemes.
Disclosure Quality
A
DO
0
5Employeeshare options are an alternative to cash or other
benefits as a means of obtaining improved performance, and
therefore should be evaluated by comparing costs and benefits.
Where the value of options (warrants) granted equals the
expected benefit receivable, Black and Scholes (1973) and Galai
and Schneller (1979) show that, under certain assumptions,
options granted do not adversely affect the wealth of shareholders. Costs of dilution thus relate only to the prospect of a
reduced proportionate share in the equity capital of the firm.
61t is evident from inspection of the Articles of Association
set out in Table A to the Companies Acts that shareholders
have no direct power over executive remuneration. The Companies Act 1989 (Sch. 7 para 2(B)), however, extends the disclosure
requirements applicable to options held by directors.
CO
Costs of Disclosure
Figure 1
SPRING 1992
115
Disclosure Quality
Costs of Disclosure
Figure 2
For the same data as in Figure 1 the net cost of disclosure is illustrated. This is minimised at Do, the optimal
disclosure quality, and increases for improved disclosure quality beyond Do.
Hypotheses
From the model, the following six relationships
based on the determinants of the cost functions
facing management are hypothesised. The higher
are the costs of collecting information, the lower is
the quality of information disclosed. These costs
are likely to be determined by the number of
schemes operated, the number of participants, the
number of executive directors and the proportion
of options held by directors. Firms are not required
to identify either the different types of scheme
operated or the number of participants. Analysis of
disclosure quality in the sample revealed large
firms to be more likely to disclose data aggregated
across schemes and this disclosure is of below
average quality. Firm size may therefore be a
proxy for data collection costs. These costs are also
inversely related to the proportion of options held
by directors. Firms are required by the Companies
Act (1985, s. 325) to maintain a record of options
granted to directors so the incremental collection
cost is lower for these options. Firm size measured
by the value of equity also proxies for the threat of
takeover. The adverse impact of poor disclosure on
share prices, ceteris paribus, increases the threat of
takeover (Manne, 1965). This effect is proportionately greater the lower is the market value of the
equity of the firm so that, for a given level of
Aggregate data was provided for some or all option schemes
by 89 firms of which 63 were in the top 100 sample.
116
Disclosure Quality
. BI
A0
A1
Costs of Disclosure
Figure 3
Increases in aggregate costs from A,A, to A,A, (caused for example by increased sensitivity to the threat of
takeover and increased managerial ownership interest in the firm)or reduced opportunity losses shifting OB,
to OB, (caused by improved governance monitoring or a smaller interest in options) increases, ceteris paribus,
the optimal level of disclosure from Do to D,. The dominant personality effect shifts the opportunity loss
function from OB, to OB, and, ceteris paribus, reduces disclosure quality.
S P R I N G 1992
117
H, Ceteris paribus, the higher is the proportion of options to issued share capital and
the greater is the value of options held by
directors the lower will be the quality of
disclosure.
Data collection
Annual financial statements were examined for
accounting periods ending between October 1987
and September 1988 for the largest 100 and
smallest 100 UK quoted companies in the 1988-89
Times 1000. Three firms in the top 100 and fifteen
firms in the bottom 100 did not have share option
schemes, reducing the sample available for analysis
to 182 firms. Data on sample firms was also
obtained from Datastream and the London
Business School Risk Assessment Service.
Hypothesis Variable"
1. 1 < 2 Size
Mean
Median
SD
LSIZE Mean
Median
SD
One-tail p-value t-test
2. 1 > 2 PDO
Mean
Median
SD
One-tail p-value t-test
4. 1 > 2 DINT
Mean
Median
SD
LDINT Mean
Median
SD
One-tail p-value r-test
F'
2089
1190
2679
7.175
7.082
0.969
0.153
0.101
0.134
0.033
0.003
0.093
3.339
4.268
2.713
1014
119
2089
5.417
4.779
1.868
0.3
0.2 13
0.26
0.107
0.013
0.179
3.0457
2.7181
2.259
m=83
Full Disclosure
Yes= Ib
L
39
0.172
0.083
0.21 1
2.786
2.488
1.756
0.43 1
0.387
0.277
61
53
47
3.859
3.97
0.736
44
1315
584
2299
5.979
6.369
1.737
0.017
0.199
0.141
0.158
0.001
0.073
0.009
0.141
2.901
2.830
2.338
0.337
F
m = 99
2171
1204
2692
7.259
7.093
0.85
0.326
0.143
0.101
0.109
0.291
0.0 16
0.001
0.037
3.0342
3.41 1
2.714
0.230
Full Disclosure
No=2
L
58
Table 1
The relation between continuous explanatory variables and full disclosure of numbers of options, exercise prices and exercise dates
94
63
143
4.168
4.143
0.79
0.031
0.278
0.284
0.182
0.001
0.155
0.114
0.187
2.714
2.063
1.682
0.424
S
41
Mean
Median
SD
Mean
Median
SD
1 < 2 OPPIE
1 > 2 PNE
2.55
1.97
2.68
0.031
0.028
0.022
0.314
0.33
0.177
3.37
2.9
2.36
0.024
0.022
0.013
0.353
0.36
0.159
0.903
0.531
1.214
0.0377
0.033
0.026
0.28
0.25
0.189
0.33
0.31
0.164
0.264
0.038
0.027
0.052
0.127
3.09
1.5
4.27
0.000
0.359
0.33
0.155
0.401
0.026
0.024
0.014
0.166
4.806
3.267
4.603
0.007
0.289
0.27
0.168
0.410
0.054
0.031
0.076
0.090
1.135
0.587
1.77
0.240
"Definitions: SIZE, market value of equity shares; PDO, proportion of options held by directors; DINT, proportion of equity capital controlled
by directors; PNE, proportion of non-executive directors on board of directors; OPPIE, options outstanding as a proportion of issued equity capital;
VOD, value of options held by directors; LSIZE is the natural log of size and LDINT is the natural log of DINT.
bt-tests were carried out to ascertain if significant differences existed between the means of full disclosure and less than full disclosing firms of the
full, large and small firm sub-samples.
'F = full sample (N = 182).
L = large firm sub-sample (N = 97).
S = small firm sub-sample (N = 85).
6.
6.
5.
Table 1-continued
h)
120
A C C O U N T I N G A N D BUSINESS RESEARCH
disclosure as that required by the Companies Act transformations were applied where necessary to
for options to be serviced by the issue of new reduce skewness prior to the computations of these
shares. Firms failing to disclose the start of period tests. As a second stage, multivariate analysis was
exercise date but otherwise matching statutory carried out to control for interaction effects and to
disclosure requirements for the new issue method assess the marginal explanatory power of different
of service were allocated to class B. Firms substi- variables. The ordering of the dependent variable
tuting ranges for exercise prices and dates, rather into discrete disclosure classes allows the use of
than specific prices and dates, were allocated to limited dependent variable models such as logit or
intermediate disclosure classes. Firms disclosing probit. The full sample of 182 firms and separate
only a general rule for setting exercise prices or samples of 97 large firms and 85 small firms were
exercise dates were allocated to lower disclosure investigated.
classes. Of the 182 firms in the sample with options
schemes, 46% were allocated to Class A, 11YO to Univariate Analysis of Continuous Explanatory
By 12% to C, 21% to D, 4% to E, and 6% to F. Variables
In these tests, the Companies Act disclosure
requirements on options to subscribe for new
The independent variables
shares were used as a benchmark to provide a
The following independent variables were identdichotomous classification of disclosure quality.
ified:
Firms providing disclosure quality at least equal to
1. The proportion of options held by directors the statutory requirement (good disclosers) were
(PDO) is the total number of options outstanding allocated to one group, and those failing to attain
held by directors at the end of the year divided by this level (poor disclosers) were allocated to the
the total number of outstanding options.
other. This classification separates firms providing
2. Size of the firm (MVEQ) is the market value precise data for the determination of options benof the firm.
efits from those which do not, and is of particular
3. The proportion of non-executive directors relevance for this study.
(PNE) is the number of non-executive directors
As the distributions for the variables measuring
divided by the total number of director^.^
size of firm (SIZE) and directors' interest in the
4. Audit committee (AC) is a dummy variable firm (DINT) were skewed, a logarithmic transcoded 1 if the firm disclosed the existence of an formation was applied prior to significance testing.
audit committee in its financial statements; 0 other- The model predicts that disclosure quality will be
wise.
positively related to the proportion of options held
5. The existence of a dominant personality (DP) by directors (PDO), the proportion of the firm
is a dummy variable coded 1 if the chief executive owned by the directors (LDINT) and the prois also chairman of the board of directors; 0 portion of non-executive directors (PNE), and
otherwise.
inversely related to the size of the firm (LSIZE), the
6. The interest of the directors in the equity of reliance of the firm on share options (OPPIE) and
the firm (DINT) is the number of shares in which the value of options held by directors (VOD). The
the directors are interested divided by the issued signs of the differences in the mean values of these
share capital of the firm.
variables for good disclosers and poor disclosers
7. Big 6 is a dummy variable coded 1 if the firm are in the predicted direction for all variables with
is audited by a big 6 auditor; 0 otherwise.
the exception of the proportion of non-executive
8. The interest directors have in withholding directors (PNE), and statistically significant at
information on options (VOD) is the number of levels better than 5% for firm size (LSIZE), prooptions held by directors divided by issued shares portion of options owned by the directors (PDO)
times the market value of issued shares.
and value of options owned by the directors
9. The potential gain from withholding infor- (VOD).
mation on share options (OPPIE) is the number of
options outstanding divided by issued equity Univariate Analysis for Dichotomous Variables
shares.
Table 2 reports summary statistics for the dichotomous dependent and independent variables.
Small firms on average provided better quality
Data analysis
disclosure than large firms: 52% of small firms
Univariate descriptive statistics" and bivariate
were good disclosers compared to 40% of large
tests of association were computed. Logarithmic
firms. No small firms in the study reported the
existence of an audit committee, while only 32% of
9Not all firms identify non-executive directors. Where no large firms reported having them. The dominant
identification was provided the PNE variable was coded zero.
I0The univariate data analysis in this paper follows that personality phenomenon occurred evenly across
applied in Pincus, Rusbarsky and Wong (1989). I am grateful large and small firm sub-samples and was in the
to Tony van Zijl for drawing my attention to this paper.
region of 47%.
S P R I N G 1992
121
Table 2
Summary statistics for dichotomous variables
Variablea
D(A)
DP
AC
BIG6
F b
L
S
F
L
S
F
L
S
F
L
S
Number
Mean
Standard
Deviation
182
97
85
182
97
85
182
97
85
182
97
85
0.456
0.402
0.518
0.467
0.453
0.482
0.170
0.320
0
0.813
0.9 17
0.690
0.499
0.493
0.503
0.500
0.500
0.502
0.377
0.469
0
0.391
0.276
0.463
Counts
0
I
99
58
41
97
53
44
151
66
85
34
8
26
83
39
44
85
44
41
31
31
0
148
89
59
122
Table 3
Bivariate measures of association'
Variables2
F
L
S
AC
F
L
D(A)
5.364b
2.357
3.366'
0.003
0.465
N/A
0.907
0.348
0.065
DP
s
3
BIG6
F
L
S
DP
AC
6.Sb
7.029"
N/A
1.415
1.458
4.412
3.679
0.194
-
'Chi-square statistics.
2The variables are defined in Table 2.
3No firms in the small sample disclosed the existence of an audit
committee.
'Significant at the 0.01 level.
bSignificant at the 0.05 level.
'Significant at the 0.10 level.
Table 4
Pearson correlations among the continuous explanatory variables
Variables '
PDO
F
L
S
PNE
F
L
S
VOD
F
L
S
OPPIE
F
L
S
LSIZE
F
L
S
LDINT F
L
S
'The variables
'Significant at
bSignificant at
'Significant at
PDO
1 .oo
1 .oo
1.oo
-0.213b
-0.189'
-0.101
0.048
0.395"
0.285b
0.142'
-0.134'
0.048
-0.54"
-0.444a
-0.207'
-0.204b
-0.128
-0.058
PNE
VOD
OPPIE
LSIZE
LDINT
1 .oo
1 .oo
1.oo
0.007
- 0.402"
0.025
- 0.09
-0.288
-0.014
0.248"
0.019
0.250b
-0.019
0.056
-0.091
1.oo
1 .oo
I .oo
0.099'
0.395"
0.723"
0.065
0.184
0.341"
-0.009
0.017
-0.146'
1 .oo
1.oo
1 .oo
-0.256'
-0.250b
- 0.06 1
0.022
0.037
-0.015
1 .oo
1 .oo
1.oo
- 0.023
0.252b
-0.155'
1 .oo
1 .oo
1 .oo
123
SPRING 1992
n
0
k+
Conclusions
4
a
124
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