The role of information and financial reporting in corporate governance and debt contracting

Abstract

We review recent literature on the role of financial reporting transparency in reducing governance-related agency conflicts among managers, directors, and shareholders, as well as in reducing agency conflicts between shareholders and creditors, and offer researchers some suggested avenues for future research. Key themes include the endogenous nature of debt contracts and governance mechanisms with respect to information asymmetry between contracting parties, the heterogeneous nature of the informational demands of contracting parties, and the heterogeneous nature of the resulting governance and debt contracts. We also emphasize the role of a commitment to financial reporting transparency in facilitating informal multiperiod contracts among managers, directors, shareholders, and creditors.

Introduction

Financial capital is a key factor of production that gives rise to an array of complex contracting relationships among owners, managers, and creditors. When structuring these contracting arrangements, divergent interests among managers, boards, equity investors, and lenders create a demand for monitoring and bonding mechanisms that help alleviate various agency conflicts (Jensen and Meckling, 1976). The information environment plays a central role both in determining the extent of these conflicts and in designing the mechanisms to mitigate them. Specifically, the fact that certain contracting parties possess superior firm-specific information at various times before and/or during the contracting relationship either create or exacerbate a wide range of agency conflicts. Further, even when all contracting parties are equally informed, more efficient contracts can be written when there is less uncertainty about current and future business conditions. We review recent literature on the role of financial reporting in resolving agency conflicts among a firm's managers, directors, and capital providers.¹

We divide our survey into two main sections: governance contracting and debt contracting. We view governance as the set of contracts that help align the actions of managers with the interests of shareholders, and we focus on the role information asymmetry plays in agency conflicts between these parties. In terms of the firm-specific information hierarchy, the literature typically views management as the best informed, followed by outside directors, followed by shareholders. We discuss the large volume of research that predicts and finds that financial reporting helps mitigate these information asymmetries, and that the role financial reporting plays in this regard depends on how firms choose to structure monitoring and bonding mechanisms (the role of outside directors, active investors, management incentives, etc.). With respect to debt contracting, information asymmetries between borrowers and lenders are important, both at the time of the lending decision and at the point of technical or cash-flow default, when lenders must decide whether to exercise their state-contingent control rights. Even in the absence of information asymmetry, information uncertainty poses problems in debt contracting. That is, even when managers and lenders enter into contacts with the same information, the incomplete nature of debt contracts creates a demand for mechanisms that allocate decision rights in the future, conditional on the realization of certain events, both foreseen and unforeseen.

Our review discusses both formal and informal contracting relationships. Although formal, explicit contracts, such as written employment contracts or debt contracts, are relatively straightforward to research, these contracts are often quite narrow in scope. Informal contracts, on the other hand, comprise implicit multiperiod relationships that allow contracting parties to engage in a broad set of activities where a formal contract is not practical or feasible. As an example, consider the contracting relationship between the CEO and the board of directors. The CEO’s duties, abilities, and incentives are extremely complex, and it is impractical to construct a state-contingent contract that specifies appropriate actions under every possible scenario the firm could face. As a result, although some CEOs do have formal employment contracts, these contracts are necessarily incomplete and relatively narrow in scope, allowing the board and the CEO to develop informal rules and understandings that guide the behavior of both parties over time.

In the context of financial reporting research, considering informal contracts allows for a much richer analysis of governance-related working relationships among executives, directors, and shareholders. If one were to consider only formal contracts involving these parties, one might conclude that financial reporting plays a relatively limited role in governance-related contracts. As we discuss, however, researchers have uncovered a wide array of important contracting roles for financial reporting. With respect to governance, much of the literature emphasizes informal contracting based on signaling, reputation, and certain incentive structures, whereas in the debt-contracting literature, research is more balanced across formal and informal contracts. The general conclusion in this literature is that financial reporting is useful because more efficient contracts are possible when contracting parties commit to a more transparent information environment.

Another key theme of our review is the notion that a firm’s contractual arrangements and its corporate information environment evolve together over time to resolve agency conflicts. That is, certain contractual arrangements and financial reporting choices work more efficiently within certain business environments. As a result, one does not expect to see firms converging to a single dominant type of corporate governance structure, compensation contract, debt contract, or financial reporting system. Instead, one expects to observe heterogeneity in these mechanisms that is a function of firms’ economic characteristics. Although the literature on debt contracts tends to accept this notion, the governance literature seems more burdened by the idea that some governance structures are unconditionally “good” or “bad” (for example, governance structures frequently asserted as unconditionally “bad” include a board with a high proportion of inside directors, a CEO that also serves as chairman of the board, a CEO with relatively low equity incentives, and a firm with relatively weak shareholder rights).

Our review builds on the surveys of Bushman and Smith (2001), Lambert (2001) and Fields et al. (2001), and we strive to limit our overlap with those papers by focusing on research that has evolved since the time of those surveys. Specifically, in the governance area, papers have begun to explore how a commitment to financial reporting quality influences both board structure and ownership structure, although the causality of this relation is likely to go in both directions. In the executive compensation area, although literature on the role of accounting-based performance measures has noticeably waned, a large literature on the relation between executives’ equity incentives and financial reporting quality has emerged. Finally, in large part because of increased data availability, empirical research on the role of financial reporting in debt contracting has grown rapidly in recent years. Throughout our discussion, we critique various aspects of these literatures, as well as provide ideas for future research.

In Section 2, we briefly discuss the firm as a nexus of contracts, the general nature of contracts related to governance and debt, and properties of the information environment and financial reports that are relevant to various contracting settings. Section 3 discusses the role of information asymmetry and a commitment to transparent financial reporting in corporate governance, with an emphasis on corporate boards and executive compensation arrangements. In Section 4, we discuss the relation between financial reporting and ownership structure, with an emphasis on agency conflicts between majority and minority shareholders. In Section 5, we discuss the role of financial reporting in the design of debt contracts. Section 6 provides a synthesis of the main themes in our review and a discussion of what we consider to be fruitful areas for future research.