Paper Armstrong: the role of information and financial reporting in

corporate governance and debt contracting

The paper is divided into two main sections: governance contracting and debt contracting.
Governance is viewed as the set of contracts that align the interest of the managers with that of the
shareholders, and the paper focusses on the role information asymmetry plays in agency conflicts
between those two parties. With respect to debt contracting, information asymmetries between
borrowers and lenders are also important. Moreover, this research discusses both formal and
informal contracts.

2. A brief discussion of contracts and their reliance on financial reporting

In this paper, the firms is seen as a nexus of contracts among the various factors of production,
where contracts serve to mitigate agency conflicts between those parties. We consider both formal
and informal contracts:

Formal: tend to be narrow in scope, covering agreements between contracting parties that
specify certain responsibilities, quantities and prices, as well as what to do in the event of
unforeseen contingencies.
Informal: considers a broad set of unwritten or implicit arrangements that allow the firm to
engage in activities where it would be either prohibitively costly or impractical to write a
formal contract.
When thinking about formal and informal contracts, it is important to recognize differences in the
enforcements mechanisms that facilitate viability of the two different contracts. In the case of
formal, parties can often rely on legal and regulatory systems. In the case of informal, contracting
parties are often discouraged to break contract (in a repeated game setting) due to reputational
capital, costly commitment or investment or the threat of retaliation.

2.1 Contracts addressing the agency conflicts among managers, boards, and shareholders
CG is viewed as the subset of a firm's contracts that helps align the actions of managers with the
interests of shareholders. That is, one can think of the hierarchy within the corporation that includes
shareholders, BOD and managers. Shareholders have the most power, but managers are the best
informed party. CG consists of the mechanism by with shareholders ensure that the BOD, in turn,
sees to it that the interest of shareholders and the manager are aligned. Literature focusses on two
types of agency problems:

1. Interest of shareholders and BOD are aligned, but those of managers are not. Examples to
curb this are incentives and monitoring mechanisms.
2. BOD and managers interests are aligned, but not completely aligned with shareholders.
Examples to curb this are examining board independence and shareholders actions to
overturn board decisions (say-on-pay etc).
2.2 Contracts addressing agency conflicts between shareholders and creditors
The conflicts are summarized as: creditors concerns with actions by owner/management that
increase risk or probability that the investors will not see their investment returned. For example
cash-payouts to investors (leaving firm more leveraged). Creditors with rationally anticipate such
actions and will either price protect their claims or choose not to lend. Because shareholders bear
these costs, they have incentives to use contracting mechanisms that reduce the manager to
expropriate wealth from the creditors. When a firm lends money, in engages in a formal contract.
Informal contracts can also be of influence, because in part, lending ability is based on reputation,
risk management etc.

2.3 Contracting role of information and financial accounting reports

This paper highlights the role of information in setting contracts that serve to mitigate governance-
and debt-related agency conflicts. With respect to governance, we consider the important role of
financial accounting (transferring information from managers to shareholders). With respect to debt-
related agency conflicts, the financial reporting (FR) system can play at least two important roles.
First, FR can reduce information asymmetry with existing and future creditors. Second, outputs of FR
can serve as inputs (parameters) of debt contracts. The role is of course dependent on the type on
contract. In formal contracting, the FR is explicitly used. Informal contracts generally rely more on a
commitment to information content and quality.

3. The role of financial accounting information in corporate governance

3.1 The role of information in structuring corporate boards
Most research examines the BOD serving two functions: (1) advising senior management and (2)
monitoring senior management. Fulfilling the first requires a skilled board (knowledge AND firm-
specific!). Fulfilling the second also requires the former, but here we must add independence. The
way this independence is researched is mostly based on two type of directors:

Outside directors; typically experienced professionals (CEOs, politicians etc.), The value is in
the additional knowledge about a topic. Furthermore, they bring the needed independence.
Typically already busy with other stuff, do not have that much time on hand.
Moreover, these outside directors prime source for information is the CEO, although
media etc. may play a moderating role.
Inside directors; often executives of the firm. Since it is costly to transfer information, inside
directors are an efficient way of managing the company. In addition to their advising role,
inside directors are also helpful in educating outside directors.
At the same time, inside directors are conflicted with their incentives to monitor the
CEO. Moreover, insiders might be reluctant to share information with outside
directors if it leads to a loss of power.
It follows that a board with only outside directors is not effective because of limited understanding of
the business, just as that a board of insiders will not be effective for allowing managerial
entrenchment. So what is the perfect mix? Armstrong argues that it depends on the business, using
the following rationale: when outside directors face greater information asymmetry, they are less
likely to be invited on a board. For example, a company with a lot of R&D-activities usually has more
inside directors on the board. However, there is some question if this problem is endogenous (lower
information asymmetry more outside directors? OR more outside directors spur decisions that
lower information asymmetry?).

Another dimension of board structure that deserves attention is the role of the CEO on a board. The
most observed role of CEO on a board is chairman. The literature suggests that the CEO might be
able to develop significant bargaining power over time, with they can use to shape the BOD
themselves.

Before moving on, we point out a trend in board structure that is currently gaining motion: more
outside directors in boards. Why we will not research why, there are four research stated in the
paper:

1. As noted, outside directors require transparent information. It might be that quality of

information has increased, reducing information asymmetry and creating a more open
environment for outside directors.
2. Due to regulatory pressure
3. Certain regulatory actions or other economic forces removed frictions that, for whatever
reason, prevented shareholders from instituting their desired proportion of outside directors
4. Transparency in the corporate information environment has declined (or is perceived as
such), so that the firm adds outside directors to improve monitoring and actively reduce
information asymmetries.
3.2 Mechanisms to commit to a transparent information environment
If we accept that outside directors require high quality information to effectively perform their
monitoring and advisory roles, the next question is: how do managers commit to more fully convey
their private information about the firm? The accounting literature has identified several
commitment mechanisms, including:

1. Committing to timely reporting

2. Making a more specific commitment to report information about losses in a timely manner
(e.g. conservative accounting).
3. Hiring a high-quality auditor and having an independent audit committee.
4. Inviting financial outside experts to sit on the board
5. Maintaining more active investors as monitors
6. Submitting to creditor monitoring by raising debt capital
7. Providing executive incentive structures to resolve information-related agency problems
All these mechanisms are discussed more in detail below. Note on page 25: managers might only
share information with outside directors that is not detrimental for their own position.

1. Committing to timely reporting

Timely reporting aids the outside directors in their task of advising and monitoring, because they can
react earlier. The rest of page 26-30 is all research.

2. Making a more specific commitment to report information about losses in a timely manner
(e.g. conservative accounting).
Basically, conservative accounting is the timeliness of bad news. Managers should be forthcoming
with good news, but are expected to conceal bad news. If managers do commit to reporting BN, this
will lead to lower information asymmetry between insiders and outsiders. Thus, it seems reasonable
that more conservative accounting contributes to more complete and timely corporate disclosure.
The rest of page 30-35 is all research.

3. Hiring a high-quality auditor and having an independent audit committee

High-quality auditors are seen as influencing the financial reporting process better financial
reporting quality. Page 36.

Inviting outside directors on the audit committee increases independence. However, outside
directors in general are expected to require more transparency in the information environment. Page
36-41

4. Inviting financial outside experts to sit on the board

We argue that financial experts have better capabilities than non-financial experts, and thus need to
sit on the board. However, in SOX definitions, almost everybody is a financial expert. Rest of pages
41-45 is research.

Recently, as set of papers explores the notion that in addition to mitigating agency costs between
managers and shareholders, outside directors can also help control agency conflicts between
managers/shareholders and other stakeholders, such as creditors. Outside directors have
reputational capital that may constrain their willingness to participate in ex post opportunistic
reporting actions (thus better reporting, thus stakeholders happy). Moreover, outside directors and
other stakeholders are largely aligned in their demand for high quality information, further increasing
the notion that outside directors can be seen as a bonding mechanism. Page 45-47 is research

5. Maintaining more active investors as monitors

Active investors are those such as blockholders, taking on an active monitoring role. Another variant
may be the market for corporate control, where active investors may choose to acquire a controlling
interest in a firm in an attempt to resolve extreme agency conflicts posing a threat to managers
and thus can serve as a mechanism to discipline management. Page 48-55 is all research.

6. Submitting to creditor monitoring by raising debt capital

As discussed by Scott, creditors require timely financial information to monitor existing capital
investments. Thus, the firm will commit to accounting choices that (ex-ante) convey quality reporting
and (ex-post) reflect the wishes of debtors (e.g. through timeliness, quality or conservatism). Rest of
page 56-57 is research.

7. Providing executive incentive structures to resolve information-related agency problems

Another tool that boards have their disposure to ensure a transparent information environment is
managerial inventive structures. That is, they can give managers economic incentives to provide
reliable and timely information about their activities. This can be either negative (fire manager if
caught being unreliable) or positive (tie compensation to performance measures that are sensitive to
the quality of reporting). Page 57-59.

4. Accounting information and ownership structure

In this section, we discuss agency conflicts between controlling shareholders and minority interest
shareholders. When there are no controlling shareholders, the interesting agency problem are
between shareholders as a whole group and other parties (e.g. management or creditors). However,
if a controlling shareholder has a different objective from that of minority shareholders, the minority
shareholders become more like suppliers of capital (like debtors). Controlling shareholders are
known to have less agency problems with management, due to the little separation between
ownership and control. However, although manager-shareholder conflicts are smaller in firms with
controlling shareholders, there are important agency conflicts between minority shareholders and
controlling shareholders, since the latter have the ability to extract private benefits from control.
Controlling shareholder therefore, could put bonding mechanisms in place to take advantage of
minority shareholders, thus mitigate the price protection reaction minority shareholders would
otherwise show. gebruik slides hiervoor!
5. The role of financial accounting in debt contracting
In this section, we review literature on the role of accounting information in contractual relationships
between debt holders and owners/managers. Three important points are derived from previous
literature. 1. Managers have incentives, ex-post, to engage in actions to further their own actions to
the detriment of outside capital providers. 2. Capital providers are aware of this, and will price
protect their loan. 3. Managers are willing to incur monitoring and bonding costs, ex-ante, to restrict
their ability to engage in such behavior.

5.1 The role of financial accounting in determining the ability and source of debt financing
Before providing access to capital, lenders typically require firms to supply audited FS. The quality of
FS plays an important role. If the lender has a hard time evaluating the financial statements, the firm
will have a hard time to cost effectively access the debt market.

The paper differentiates between two debt markets: private and public. Private debt holder (e.g.)
banks, have access to private information. Public bondholders do not (rating agencies, but who trusts
those?). Firms that decide to access the debt market recognize institutional differences between
various suppliers of debt capital:

Private debt holders; access to private information,

Public debt holders; no access to private information, often has many holders and requires
the approval of two-thirds to renegatioate (= high negotiation costs), public debt is often
underwritten and subject to SEC-regulations.
The difference in information accessible will likely affect the type of information demanded at loan
inception. Public debtholders will probably demand a higher quality of reporting. Companies who
dont reach that level can always try to access private debt (by giving private information to the bank
etc.). Page 111-115 is research.

In addition to the source of financing, firms must also decide whether to enter into a relationship
lending agreement, in which they borrow from the same lender over time (leading the firm to build
reputational capital). While reputational capital is good, there is also a potential downside: a hold-up
problem. In this holdup problem, the lender uses his access to firm-information to extract rents
before he provides additional financing. Rest of page 117-121 is research.

5.2 How do elements of the firms accounting system affect the design of the debt contract?

Financial reporting and interest rates

Creditors are expected to demand higher interest rates as compensation for the agency costs
associated with the managers actions that benefits shareholders at the creditors expense. It has been
argued that elements in a firms FS can exacerbate or mitigate these agency costs, and in turn, that
these elements are therefore likely to be associated with the interest rate charged on the loan.
Summarizing the research on pages 120-125, we see that the quality of a firms FR is related to its
cost of debt.

Association between financial reporting and the design of debt covenants

The financial covenants in debt contracting are designed to reduce a variety of the agency costs
discussed. Because many of these agency conflicts are the result of information asymmetry between
borrowers and lenders, it is natural that elements of the firms financial reporting system are likely to
be associated with the attributes of the covenants. Rest of 127-130 is research

Association between elements of the accounting system and other contracting features
Recent studies have showed that firms with higher quality accounting are able to negotiate a longer
maturity and less restrictive collateral requirements in private debt contracts. Firms may be easier to
monitor. Other features such as cash sweeps and borrowing base restrictions are also likely to be
influence by the quality of the firms accounting system and the accounting choices the firm has
made.

5.3 The effect of debt contracts on accounting choice

The central premise of this line of research is that, conditional on having debt financing, features of
the firm's debt contracts influence managers accounting choices. For example, managers change
accounting methods to avoid covenant violations.

Are covenant violations costly?

Two central assumptions underlie the argument that managers use accounting policies to circumvent
financial contract violation. First, violating the covenant and entering into technical default is costly.
Second, managers have sufficient discretion to avoid violating the covenant. Regarding the first
assumption, there has been a substantial debate whether violation is costly.

Early research showed that violating covenants is costly. One problem with this approach, however,
is that firms are not required to disclose violations that are cured before the financial statements are
released. Thus, disclosed covenant violations are likely being systematically different from
undisclosed violations and per definition more costly. Additionally, technical defaults typically give
rise to indirect costs (hiring a better auditor, replacing CEO etc), that are hard to measure

Another recurring problem is that firms can renegotiate contracts if they anticipate violating a
covenant, and they do not have to disclose the violation. Thus, covenant violations disclosed in
financial statements are most likely to be costly violations, as the firm was unable to fix them any
other way before the FS were released.

The effect of debt contracts on earnings management

As stated by Scott, managers can manage earnings in different ways. Either through accruals or
through real actions (such as cutting R&D). Rest of page 138-140 is research. in slides kijken wat ik
hier dan precies van moet weten?!

The effect of debt contracts on the extent to which firms report conservatively
Research has suggested that firms who report more conservatively enjoy a lower interest rate, have
conservative covenant modifications and are more likely to have a smaller bid-ask spread in the
syndicated debt markets (i.e. a lower cost of capital). Two elements of debt contracting support this
logic:

1. Debt holders have asymmetric pay-offs, providing incentives for lenders to obtain more
timely information about losses
2. Debt contracts often prevent managers from changes accounting policies when these
managers engage in a debt contract.
If these two terms can be met, it is reasonable to think that the debt holder will reward the firm with
more favorable contract terms. Page 141 is research.
6. Conclusion
In this paper, we reviewed the accounting literature on CG and debt contracting. The paper focused
on the firm as a nexus of contracts, and highlighted the role of the accounting system in reducing the
information related agency costs that arise among managers, directors and equity and debt
providers. Here we discuss the important themes of this paper once more.

An important theme that is often overlooked, is the role of informal contracts. Although informal
contracts are not governed by formal written contracts and (in most cases) not subject to law
enforcement, they represent an important mechanism for facilitating a variety of economic
transactions that might otherwise be non-contractible of contractible with lower efficiency.
Consequently, informal contracts are made in an multi-period environment!

Another theme is the interrelationship among various governance statistics, as well as the
interrelationships among various features of debt contracts. Page 152 is all suggestive one point to
make however: endogenous is a problem! See abovementioned issue in this paper.