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Do Variations in the Strength of Corporate Governance Still Matter? A Comparison of the Pre- and Post-Regulation Environment

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Abstract

Corporate scandals brought the issue of corporate governance to the forefront of the agendas of lawmakers and regulators in the early 2000s. As a result, Congress, the New York Stock Exchange, and the NASDAQ enacted standards to improve the quality of corporate governance, thereby enhancing the quantity and quality of disclosures by listed companies. We investigate the relationship between corporate governance strength and the quality of disclosures in pre- and post-regulation time periods. If cross-sectional differences in corporate governance policies affect the quality of financial disclosures, the quality of information available to analysts varies with such policies. Specifically, higher quality disclosures, produced as a result of strong corporate governance, should lead to more accurate and less dispersed analysts’ forecasts. Our analysis suggests that voluntary implementation of stronger corporate governance enhanced the quality of disclosures in the pre-regulation period; however, exceeding current corporate governance standards does not appear to result in higher quality disclosures post-regulation. These results suggest that SOX and the stronger regulations enacted by U.S. exchanges were effective in reducing variation in the quality of financial information available to investors.

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Notes

  1. Congress passed the Sarbanes–Oxley Act (SOX) in 2002 and The New York Stock Exchange (NYSE) adopted Section 303A, Corporate Governance Listing Standards, in November 2003 (effective in late 2004). The NASDAQ passed a standard similar to Section 303A in November 2003.

  2. A related line of research examines whether improvements in corporate governance strength are associated with improvements in operating performance, since more strict oversight may encourage management to more efficiently and effectively carry out their duties (e.g., Brown and Caylor 2009; Core et al. 2006; Klein, 1998). While regulations on corporate governance may have additional objectives such as enhancing operating performance, our study examines only the reforms’ objective to improve the quantity and quality of financial reporting disclosures.

  3. A notable exception to these finding is Koehn and Ueng (2005). Their analysis found no relationship between higher governance scores from the Institutional Shareholders Services (ISS) and earnings quality.

  4. In both Chang and Sun (2009) and (2010), the authors used 2002–2003 proxy statements and earnings announcements after the SOX effective date of July 30, 2002 to form their “post-SOX” sample. We define the post-regulation period starting after January 1, 2005. Our definition is cleaner because the NYSE and NASDAQ changes were not effective until 2004 and probably took some time to be fully implemented.

  5. While this study does not examine the relationship between corporate governance and disclosure quality, the evidence provided establishes a context where the positive effects of corporate governance improvements are diminished in the post-regulation period.

  6. Regulation G was adopted in January of 2003 and requires a reconciliation of non-GAAP with GAAP performance measures. This Regulation was passed as a provision of SOX to improve financial disclosures for investors.

  7. The enactment of regulations had far reaching implications for publically traded companies. Specifically, SOX:

    1. 1.

      Increased auditors’ independence by limiting the auditors’ ability to provide outside services (Section 201)

    2. 2.

      Improved internal controls and the assessment of material weaknesses (Section 404)

    3. 3.

      Strengthened the responsibility of executives by requiring CEOs/CFOs to certify financial statements (Sections 302)

    4. 4.

      Enhanced the corporate environment by requiring corporate codes of ethics for senior financial executives (Section 406)

    In addition, all three regulations sought to improve corporate governance by improving the independence of the board of directors and its members’ financial knowledge.

  8. A related line of research examines whether individual analysts’ ability to forecast earnings has a “general” component in addition to a “firm-specific” component (see, for example, Brown and Mohammad 2010). We focus on the relationship between a firm’s information quality and analysts’ forecast accuracy/dispersion since our primary interest is the effect of firm-specific variability in corporate governance pre- and post-regulation.

  9. An analytical study by Beretta and Bozzolan (2008) on the richness of disclosure content showed that the richness component of disclosure quality was positively related with forecast accuracy and negatively related with forecast dispersion. In addition, a recent study by Drake, et al. (2009) identified disclosure quality as an important factor in reducing investor’s mispricing of the accruals and cash flow components of earnings (i.e., the accrual anomaly). Higher disclosure quality may also assist analysts in making more accurate earnings forecasts by reducing their overreaction to the accruals component of earnings. Also see Chan, et al. (2004) for their analysis of current accruals’ impact on future earnings and how the accrual effect can be used to improve forecast accuracy.

  10. Koehn and Ueng (2005) provides a comprehensive overview of the distinction between Governance Metrics International and Institutional Shareholder Services. See Brown and Caylor (2006) for an example of a broad measure of corporate governance strength based on ISS information. Specifically, Brown and Caylor (2006) use ISS information to create a measure called “Gov-Score” that includes both internal and external corporate governance provisions.

  11. The number of observations in the standard deviation regression is slightly smaller as at least two analyst forecasts are necessary to calculate standard deviation.

  12. Variance inflation factors were computed for each regression and suggested that multicollinearity was not a problem.

Abbreviations

SOX:

Sarbanes–Oxley Act of 2002

NYSE:

New York Stock Exchange

NASDAQ:

National Association of Securities Dealers Automated Quotations

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Authors and Affiliations

  1. School of Accounting and Finance, College of Business and Behavioral Science, Clemson University, Clemson, SC, USA

    Nancy Harp

  2. Department of Accounting, Miller College of Business, Ball State University, Muncie, IN, 47306, USA

    Mark Myring

  3. Department of Accountancy, College of Business, Northern Illinois University, DeKalb, IL, USA

    Rebecca Toppe Shortridge

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  1. Nancy Harp
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  2. Mark Myring
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Correspondence to Mark Myring.

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Harp, N., Myring, M. & Shortridge, R.T. Do Variations in the Strength of Corporate Governance Still Matter? A Comparison of the Pre- and Post-Regulation Environment. J Bus Ethics 122, 361–373 (2014). https://doi.org/10.1007/s10551-013-1749-4

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