Liang Tan George Washington University Ph: Yanfeng Xue George Washington University Ph:

Transcription

1 Does Stronger Corporate Governance Improve Financial Reporting Quality? Evidence from a Regression Discontinuity Analysis of Shareholder-Sponsored Governance Proposals Liang Tan George Washington University Ph: liangtan@gwu.edu Yanfeng Xue George Washington University Ph: yxue@gwu.edu Yong Yu University of Texas at Austin Ph: Yong.Yu@mccombs.utexas.edu Abstract This study examines whether stronger corporate governance leads to higher quality financial reporting. We use a regression discontinuity method to analyze the effect on financial reporting quality of shareholder-sponsored governance proposals that pass or fail by a small margin of votes in annual meetings. This empirical strategy allows us to overcome the endogeneity problem of governance mechanisms and provide evidence on the causal effect of corporate governance on financial reporting quality. We find that passing proposals related to board of directors and executive compensation leads to an improvement in the quality of financial reporting. We also find that this positive effect on financial reporting is more pronounced for firms with lower quality financial reporting prior to the voting. We find no evidence that passing proposals related to antitakeover provisions affects financial reporting quality. Preliminary draft - Please do not cite or quote. Comments welcome.

2 1. Introduction How corporate governance affects financial reporting is an important question in accounting research. However, despite the large volume of research devoted to this topic, there is limited evidence on the causal effect of corporate governance on financial reporting, primarily because of the joint endogeneity of governance mechanisms and accounting system (Armstrong et al. 2010; Brickley and Zimmerman 2010). As Brickley and Zimmerman (2010) conclude, "Upon more careful reflection, however, most of these results are also consistent with alternative explanations. Moreover, causality often is impossible to infer." The difficulty of establishing a causal relation is further exacerbated by the lack of comprehensive theories that allow researchers to classify a specific governance feature as "good" or "bad." The objective of this study is to provide evidence on the causal effect of corporate governance on financial reporting by applying a regression discontinuity method to analyze a threshold event - shareholder proposals related to corporate governance. Our empirical strategy focuses on examining the effect on financial reporting quality of shareholder-sponsored governance proposals that pass or fail by a small margin of votes in annual meetings (i.e., closecall proposals). For such close-call proposals, the treatment firms (e.g., those with a proposal that just passes with 50.1% of the votes) are, on average, the same as the control firms (e.g., those with a proposal that just fails to pass with 49.9% of the votes) on virtually every dimension (Lee, 2008). However, a proposal is significantly more likely to be implemented and thus lead to changes in corporate governance for the treatment firms than for the control firms (Ertimur et al. 2010). Thus, for the close-call proposals, passing a proposal is a "locally" exogenous event. The estimated effects of passing a proposal on financial reporting quality should not be affected by any observed or unobserved confounding factors, as long as their effects are continuous around 2

3 the majority threshold (which we show is indeed the case for our setting). Therefore, our empirical strategy allows us to overcome the endogeneity problem of governance mechanisms and provide clear evidence of a causal effect of corporate governance on financial reporting. Our research design also allows us to overcome the limitation of having to classify a governance feature as "good" or "bad" arbitrarily. To the extent that shareholders have better information and abilities to detect the weakness of a firm' governance structures, they are likely to request changes that represent improvements in the firm's governance. Consistent with the shareholder proposals improving governance, Cunat et al. (2012) find that passing governancerelated shareholder proposal triggers significant positive market reactions. We use the regression discontinuity method to analyze a large sample of 3,775 governance-related shareholder proposals from 1997 to We gauge financial reporting quality using both the accrual-based measure from the modified Dechow and Dechiv (2002) model and the measures based on accounting restatements and internal control deficiencies. We find that the passing of governance-related shareholder proposals is related to an improvement in the accrual-based measure of reporting quality and a reduction in the likelihood of having internal control deficiencies, suggesting that stronger corporate governance results in higher quality financial reporting. Next, we examine which types of governance mechanisms drive the positive effect on financial reporting quality. We classify all shareholder-initiated governance proposals into three groups that are related to executive compensation, boards of directors, and antitakeover provisions (included in the G-index constructed by Gompers et al. 2003), respectively. 1 We find strong evidence that passing proposals related to board of directors improves the accrual-based 1 We also attempt to identify proposals directly related to auditing. However, there are too few proposals related to auditing issues, making it difficult to estimate the impact of these proposals precisely using our research design. 3

4 measure of reporting quality, and reduces the likelihood of having accounting restatements and internal control deficiencies. We also find some evidence that passing proposals related to executive compensation improves the accrual-based measure of reporting quality. However, we find no evidence that passing proposals related to antitakeover provisions affects financial reporting quality. Further, we conduct cross-sectional analyses to examine whether the effects of passing governance proposals on financial reporting depend on the sponsorship of the proposals and the quality of financial reporting prior to the voting. Prior research shows that shareholder governance proposals are more likely to be implemented when they are sponsored by institutions rather than individuals (Gillian and Starks 2007; Ertimur et al. 2010). Further, improvements in governance mechanisms are likely to lead to a larger increase in financial reporting quality for firms with relatively poorer financial reporting prior to the voting. We find some evidence that passing proposals related to executive compensation and boards of directors leads to a larger increase in financial reporting quality for firms with poorer reporting quality prior to the voting. We find no evidence that the effects of passing shareholder proposals on reporting quality vary with institution sponsorship of the proposals. Furthermore, we find no evidence in any subsample that passing proposals related to antitakeover provisions affects financial reporting quality. Overall, our results suggest that stronger corporate governance leads to an improvement in financial reporting quality, and this positive effect is concentrated in governance mechanisms related to board of directors and, to a lesser extent, executive compensation. Our paper makes two primary contributions. First, it contributes to our understanding of the relation between corporate governance and financial reporting by providing clear evidence on the causal effect of corporate governance on financial reporting. Using the regression 4

5 discontinuity design and the threshold event of shareholder-sponsored governance proposals, we are able to overcome the problem of the joint endogeneity of governance and accounting system as well as the difficulty of lacking theories to classify a governance feature as good or bad. Our results suggest that stronger governance mechanisms, particularly those related to board of directors and executive compensation, lead to improved financial reporting. Second, our study also adds to our understanding of the economic consequences of shareholder-initiated governance proposals. Cunat et al. (2012) examine market reactions to governance proposals and find that passing governance proposals triggers significant positive market reactions, reduces acquisitions and capital expenditures, and improves long-term firm performance. We extend Cunat et al. (2012) by demonstrating that the governance-related shareholder proposals have an important, and previously unidentified, benefit of improving firms' financial reporting. Our results are also relevant to the standing debate on shareholder-sponsored governance proposals. While proponents argue that such proposals can improve governance and enhance firm value, critics raise the concern that shareholders who initiate the proposals can be selfserving and the shareholder voting could be uninformed and disruptive to firm operation (Bainbridge 2006). This debate is especially heated by the recent enactment of the Dodd-Frank Act, which requires firms to put their executive compensation policy under shareholder advisory vote at least once every three years. Our study shed light on the economic consequence of shareholder-sponsored governance proposals by providing evidence on the role of those proposals in improving firms' financial reporting quality. The rest of the paper proceeds as follows. Section 2 reviews prior literature and discusses institutional background. Section 3 describes the regression discontinuity research method, and 5

6 Section 4 describes our sample and empirical measures. Section 5 presents the empirical findings. Second 6 concludes. 2. Prior research and institutional background 2.1 Prior research Although a large body of research has examined whether financial reporting quality is influenced by various governance mechanisms, the empirical evidence is generally mixed (see Armstrong et al. (2010) for a comprehensive review of this literature). For example, research examining how managerial compensation influences financial reporting fails to find consistent results. On one hand, some studies find a negative relation between managerial equity incentives and the quality of financial reporting (e.g., Cheng and Warfield 2005; Bergstresser and Philippon 2006; Efendi et al. 2007); on the other hand, other studies find no relation between the two (e.g., Erickson et al. 2006; Baber et al. 2007) or even a positive relation (e.g., Warfield et al. 1995; Armstrong et al. 2010). The results from the stream of research examining the effects of various features of boards of directors on financial reporting are also mixed. For example, while some studies find that more independent boards are associated with higher quality reporting (e.g., Klein 2002; Efendi et al. 2007), others find little evidence that board independence has a significant impact on financial reporting quality (e.g., Agarawal and Chadha 2005; Larcker et al. 2007). The evidence from examining anti-takeover provisions (G-index) is also inconclusive. For example, Larcker et al. (2007) find no relation between G-index and measures of reporting quality, whereas Baber et al. (2012) document a negative relation between G-index and restatement in part of their sample period and no relation in the rest of the sample period. 6

7 While many factors may contribute to the mixed findings in the extant literature, the joint endogeneity of corporate governance and financial reporting represents perhaps the biggest challenge (Armstrong et al. 2010; Brickley and Zimmerman 2010). A firm s choice of a particular governance mechanism is endogenously determined by many factors including firm fundamental characteristics, information environments, other governance mechanisms, and managerial attributes. And many of those factors are also likely to be important determinants of the firm's financial reporting. This endogeneity problem raises concerns that any association found between corporate governance and financial reporting can be driven by observable or unobservable confounding factors. Recent reviews of the literature (Armstrong et al. 2010; Brickley and Zimmerman 2010) conclude that the extant literature has provided very little evidence on the causal relation between corporate governance and financial reporting and call for more research that better addresses the endogneity problem and provides clearer causal evidence. In addition to this endogeneity problem, the difficulty in providing causal evidence between corporate governance and financial reporting is further exacerbated by the lack of comprehensive theories that allow researchers to classify a feature of corporate governance as "good" or "bad." (Brickley and Zimmerman 2010). A particular governance feature (e.g., more outside directors or smaller board size) is unlikely to be optimal for all firms. Rather, whether a specific governance feature is good or bad for a particular firm likely depends on the firm's fundamental characteristics, information environments, other governance mechanisms, shareholder structure, etc. As such, the same governance feature may be good for some firms, but bad for others. This difficulty forces researchers to rely on some ad hoc classification (e.g., having more outside directors on boards is assumed to be a good governance feature for all 7

8 firms), which can lead to mixed findings, depending on the sample of firms examined, and also make it difficult to interpret the findings. In this study we examine the causal effect of corporate governance on financial reporting by applying a regression discontinuity method to analyze a threshold event - shareholder proposals related to corporate governance. One key advantage of our empirical strategy is to overcome the endogeneity problem of governance and provide clear evidence of a causal effect of corporate governance on financial reporting. In addition, our research design also overcomes the limitation of having to classify a governance feature as "good" or "bad" arbitrarily. 2.2 Institutional background According to Rule 14a-8 of the Securities Exchange Act of 1934, shareholders who continuously own more than $2,000 or 1% of a company for at least one year can initiate a proposal. The shareholder proposal must be placed on the agenda of the next annual meeting and included in the proxy distributed to the shareholders. 2 Shareholder proposals have been used to address all kinds of issues including removing anti-takeover provisions, monitoring management compensation, strengthening shareholder voting rights, promoting corporate social or environmental responsibilities, and advocating corporate charitable contributions. Because we are interested in how corporate governance affects financial reporting, we focus on the shareholder proposals that are directly related to firms corporate governance mechanisms, which comprise the vast majority of all shareholder proposals. Although shareholder proposals are advisory in nature (i.e, the voting results are not binding and the implementation of the proposals are subject to the boards and managers 2 One exception is that if the proposal violates certain conditions, such state law, the company may ask the SEC to approve their exclusion of the proposal from the meeting agenda. 8

9 discretion), the voting results on the proposals have been demonstrated to have significant influences on firm policies, especially when the proposals receive majority support from shareholders. Ertimur et al. (2010) show that among S&P 1500 firms, 40% of proposals receiving majority votes were implemented in 2004, and the proposals receiving majority votes are significantly more likely to be implemented than the ones without majority support. Ferri and Sandino (2009) find that firms that are targeted by shareholder proposals in support of expensing employee stock options are more likely to adopt the accounting practice and this likelihood increases with the voting support for the proposals. Ertimur et al. (2011) document that the likelihood of implementing executive compensation-related proposals increases substantially after receiving majority votes. The shareholder proposals offer a threshold event that allows us to address the endogneity of governance mechanisms and provide causal evidence on the effect of corporate governance on financial reporting. Specifically, we apply a regression discontinuity (RD) method to examine changes in firm s financial reporting quality in response to proposals that pass or fail the shareholder votes by a small margin. The main idea behind the design is that the governance rules adopted can be considered random in those closed-call firms whose proposals pass or fail by a very small margin (Lee 2008). In other words, firms whose proposal passes by a small margin are essentially the same as firms whose proposal fails by a small margin in all dimensions, except for the significant difference in the likelihood of implementing the governance changes requested by the proposal. Thus, a positive association between the voting results and changes in financial reporting quality in the subsequent periods should not be affected by any observed or unobserved confounding factors, as long as their effects are continuous around the majority threshold (which we show is indeed the case). Therefore, this positive 9

10 association can be interpreted as the causal evidence that improvements in corporate governance lead to higher financial reporting quality. Examining shareholder proposals also allows us to overcome the difficulty in classifying a governance feature as good or bad. Instead of classifying a change in a governance mechanism as an improvement or a deterioration arbitrarily, we assume that shareholders are in better position (than researchers) to access a firm's governance structure and they make valuemaximizing decisions in their initiation of and voting on governance proposals, and thus the changes required by the shareholder proposals represent improvements in governance on average. This assumption is supported by recent evidence. Cunat et al. (2012) show that passing governance-related proposal leads to significant positive market reactions, suggesting that shareholder proposals represent governance improvements that enhance firm value. We first examine all governance-related proposals to provide evidence on the average effect of corporate governance on financial reporting. We then examine the effect of specific categories of governance mechanisms. Because there are only limited numbers of shareholder proposals related to each specific governance mechanism, we follow Cunat (2011) to group all governance-related proposals into different categories: 1) proposals related to executive compensation (e..g., putting a cap on executive bonus); (2) proposals related to board of directors (e.g., requiring majority vote for director elections); and (3) proposals related to anti-takeover provisions included in the G-index developed by Gompers, Ishii, and Metrick (2003) (e.g., proposals to eliminate classified board or golden parachute). 3. Identification Strategy A Regression Discontinuity Design 10

11 We use a regression discontinuity (RD) design to examine changes in firms financial reporting quality in response to governance-related shareholder proposals that pass or fail by a small margin (i.e., closed-call proposals). 3 A RD design is a quasi-experimental data design where treatment assignment depends upon an observed assignment variable around certain thresholds (Hahn, Todd, and van der Klaauw, 2001; Lee and Lemieux 2010). Lee (2008) demonstrates that as long as the treatment assignment process cannot be precisely manipulated, all outcome related factors other than the treatment will evolve continuously with respect to the assignment and variations in the treatment will be locally randomized around the cutoff. The treatment effect can, therefore, be causally identified by controlling for a smooth function of the assignment variable and focusing on discontinuous changes in outcomes around the cutoff. In other words, from a regression perspective, even if there exist omitted correlated variables, as long as they do not exhibit precisely the same discontinuity as the treatment does, the treatment effect can be consistently estimated. Such a mild identification condition makes the RD analysis more credible than typical natural experiment strategies, such as difference-in-differences or instrumental variables (Lee and Lemieux, 2010). In the context of governance-related shareholder proposals, the treatment is the impact of the proposed change in a firm s governance structure and the assignment variable is the vote shares for the proposals. Two important features in a shareholder proposal are critical to our identification. First, passing a proposal results in a discrete jump in the probability that this 3 The RD design was first invented in the psychology literature by Thistlethwaite and Campbell (1960) to estimate the impact of merit awards on future academic outcomes. It has gained great popularity in economics and finance research since late 1990s to address endogeneity because its relative mild assumption for causal inference compared to other non-experimental approaches. Lee and Lemieux (2010) provide an excellent introduction and user guide to this design. Related to our study, in financial reporting literature, Tan (2013) adopts the RD design in the covenant violation setting and studies creditors demand for conservatism reporting. In shareholder proposal literature, two papers have adopted the RD design. Cunat et al. (2012) use the RD design to examine market reaction on shareholder proposals that pass or fail by a small margin. Ertimur et al. (2013) focus on a specific type of shareholder proposals adopting majority voting for directors and analyze market reactions to such change in the director election system. 11

12 proposal will be implemented. Ertimur et al. (2010) document that 31.1% of passed proposals were implemented, while only 3.2% of failed proposals were implemented and most of the jump occurs around the passing cutoff (20.7%). Ertimur et al. (2011) show that the likelihood of implementing executive compensation-related proposals increases substantially after the proposals receive majority votes. This discrete jump in the probability of implementation ensures that our quasi-experiment gets a legitimate treatment at the majority threshold. 4 Second, no discontinuity should be observed on vote share distribution around the majority threshold. Recall that the critical identification assumption for a RD design is that the treatment assignment process is not precisely manipulated. A precise manipulation will result in a discontinuous distribution of the assignment variable around the cutoff. First of all, in practice, the vote outcome of a shareholder proposal is not revealed until the meeting date. This mitigates the possibility that someone has superior information about the likely voting outcome and influences the vote to change the result of a close-call proposal. Second, using a shareholder proposal sample similar to ours, Cunat at al. (2012) do not find any discontinuity in distribution around the threshold 5. The standard RD regression model applying to our shareholder proposals setting is the following: Financial Reporting Quality i,t+1 = α 0 + α 1 Pass i,t + P l (X it, β l ) + P r (X it, β r ) + ε it (1) 4 In the RD design literature, this means that we have a fuzzy regression discontinuity setting (Lee and Lemieux 2010). Therefore, a proposal is not required to be binding for identification. 5 The reason that we focus on shareholder proposals instead of management-sponsored proposals is that management-sponsored proposals voting results are likely being influenced by management. Listokin (2008) documents widespread irregularities in the distribution of votes in management-sponsored proposals. He finds that management is overwhelmingly more likely to win votes by a small margin than lose by a small margin. 12

13 where Financial Reporting Quality it+1 is one of our three proxies of financial reporting quality for a firm i in year t+1 after the proposal meeting year t. Pass it is an indicator variable equal to 1 if the shareholder proposal is passed in year t, 0 otherwise. X it is the vote share for the proposal. P(X it,β) is a polynomial in vote shares and represents the smooth function of the assignment variables. We allow the coefficients to differ on either side of the voting cutoff, indicated by superscript/subscript l and r for the polynomial functions. Similar to Cunat et al. (2012), we present our results using a polynomial of order four, though our findings are robust to higherorder polynomials. We correct the standard errors using two-way clustering by firm and by year (Petersen, 2009; Gow, Ormazabal and Taylor, 2010). One complication in the application of the standard RD regression model (i.e. model (1)) to analyze shareholder proposals is that shareholders of a firm may vote on more than one proposal on a particular meeting date. That is, we could have one outcome but multiple treatments. Theoretically, we can create and estimate a Pass dummy and a set of polynomials in vote shares for each individual proposal. However, there are 72 distinct types of governancerelated shareholder proposals according to Risk Metrics classification. The limited number of observations for each type prevents us precisely estimating the governance effect for every proposal, and requires the aggregation of shareholder votes. Let s assume there are J types of proposals voted in a shareholder meeting. Following Cunat et al. (2012) and assuming for all J, α J =α, P J l = P l and P J r = P r, then we can rewrite model (1) as Financial Reporting Quality i,t+1 = α N j=1pass j i,t + P l ( N j=1x j it, β j,l ) + P r ( N j=1x j it, β j,r ) + ε it (2) 13

14 α thus captures the average causal effect of passing a proposal on financial reporting quality. We first estimate the average causal effect among all proposals using model (2). Then, we relax the restriction and let α vary by three major types of proposals (i.e., proposals related to boards of directors, executive Compensation, and anti-takeover provisions (G-index), respectively) and estimate their individual effects jointly using the following regression model: Financial Reporting Quality i,t+1 = α 0 + α 1 Pass G i,t + α 2 Pass B i,t + α 3 Pass C i,t + P G l(x G it, β G,l ) + P r G (X G i,t, β G,r ) + P B l(x B it, β B,l ) + P r B (X B i,t, β B,r ) + P G l(x C it, β C,l ) + P r G (X C i,t, β C,r ) + ε it (3) The key coefficients in model (3) are α 1, α 2 and α 3. Because our three measures of financial reporting quality (to be discussed in section 4.2) are all negatively correlated with reporting quality, we expected the three coefficients α 1, α 2 and α 3 to be negative, consistent with the notion that passing of governance-related shareholder proposals leads to higher reporting quality. 4. Data and Variable Measurement 4.1. Data We obtain shareholder proposals data from Risk Metrics shareholder proposals database, which contains shareholder proposals from all S&P 1500 companies plus an additional 500 widely held firms. It provides information such as company names, meeting dates, a description of the resolution and categorization of the proposal type, the voting percentage in favor of the proposal, an indicator variable showing whether the proposal has received a majority vote and the name of shareholder proponents. We keep only proposals classified as governance-related by the database for nonfinancial firms with available meeting dates and vote share data. Our sample 14

15 contains 3,775 governance-related shareholder proposals from 1997 to Further, we obtain accounting data from Compustat and stock price data from CRSP. We obtain SOX 404 internal control weakness data from the Audit Analytics database, and the accounting restatement data from the Audit Analytics database and the U.S. government accountability office (GAO) database. 6 Figure 1 draws the distribution of vote shares. The figure plots both histograms and kernel density estimation of the distribution. Close-call proposals are not uncommon. In fact, they are more frequent than proposals that are supported overwhelmingly. For example, the number of proposals with supporting vote shares between 40% and 60% (26.68%) are 7.5 times greater than that with supporting vote shares between 80% and 100% (3.58%). We also notice that vote shares are generally distributed smoothly. There is no noticeable kink around the 50% threshold (see formal statistical tests in Section 5.1). Table 1 reports summary statistics of the sample. Panel A shows summary statistics at the proposal level. On average, proposals receive around 37% of the supporting votes and are passed 29% of the time. G-index, Board and Executive Compensation related proposals are the three major types of proposals in the sample. 38.7% of the sample is G-index proposals and they receive the highest shareholder approval (56.36%) than any other types of proposals. These observations are consistent with Cunat et al. (2010). There are only 57 proposals that are related to Audit and 343 other types of proposals. Audit and Other categories are approved in only 5% of the cases. Given the low approval rate for these two types, there are very few observations 6 Unlike Audit Analytics, the GAO data only provide the date when the restatements were issued but not the restatement periods. We examine restatement data from Audit Analytics and find that the median number of days between the start and end dates of the restatement periods are 455 days and the median number of days between the end dates of restatement period and the restatement dates are 167 days. We apply these statistics to estimate the restatement periods for restatements in the GAO database. That is, we assume that the restatement period is from 622 days ( ) to 167 days prior to the restatement date. 15

16 around the majority threshold, which prevents us from estimating their individual effects precisely. As a result, we exclude Audit and Other categories from our analyses. Panel B of Table 1 presents summary statistics at the firm-year level for key variables used in this study. The number of observations varies according to the availability of the data. On average, 44.6% of the sample firms have proposals sponsored by institutional investors. The average number of restatements happening in the three year window after the proposal voting year is and average incidences of internal control weakness in the same window is 0.082, consistent with statistics documented in prior studies Financial Reporting Metrics We use three measures to proxy for financial reporting quality. Our first measure of financial reporting quality is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) (MDD). Following Kothari et al. (2005), we also control for performance in the model. ΔWC i,t = α +β 1 CFO i,t-1 + β 2 CFO i,t + β 3 CFO i,t+1 + β 4 ΔREV i,t + β 5 PPE i,t + β 6 ROA i,t-1 +ε (4) where ΔWC i,t is the change in working capital from year t-1 to year t and calculated as ΔAR + ΔInventory - ΔAP - ΔTP +ΔOther Assets (net), where AR is accounts receivable, AP is accounts payable, and TP is taxes payable. CFO s are operating cash flows from fiscal year t-1, t, and t+1. ΔREV i,t is the change of sales from year t-1 to t. All variables are scaled by average total assets of year t-1 and t. ROA i,t-1 is the net income before extraordinary items in year t divided by average total assets of year t-1 and t. 16

17 Dechow and Dichev (2002) estimate firm-specific time-series regressions and use standard deviation of the residuals over eight years as measures of accrual quality. Our research design makes it hard to estimate accrual quality over a time window as long as eight years. We therefore estimate model (1) cross-sectionally for each industry (two-digit SIC code) and year, and use the absolute value of the residuals as our measure of reporting quality. Jones et al. (2008) shows that the residuals from the cross-sectional regressions based on the Dechow and Dichev (2002) model modified by McNichols (2002) is the best at predicting accounting fraud compared to other measures of accrual quality. Our second measure of financial reporting quality is number of internal control weaknesses (# of ICW) reported under SOX 404 within three years after the proposal meeting year. Sarbanes-Oxley Act Section 404 requires management and auditors to disclose any material internal control weaknesses over financial reporting if detected. Finally, we use number of restatement (# of Restate) within three years after the proposal meeting year as our third measure of financial reporting quality. 5. Empirical results 5.1. Density Discontinuity and Pre Proposal Covariates Before formally testing our hypotheses, we first examine the validity of our RD setting. As discussed before, the local randomization assumption is valid as long as the economic agents cannot precisely manipulate the assignment variable, i.e., vote shares for the proposals. A direct test of it is to examine the density of vote shares. If voting results are not manipulated, then the aggregate distribution of vote shares should be continuous. We use the two-step procedure described in McCrary (2008) to formally test this assumption. In the first step, we partitioned the 17

18 vote shares into equally spaced histogram bins and calculate frequencies within each bin. Then, we run local linear regressions using the frequency counts as dependent variable and midpoints of the histogram bins as independent variable on either side of the 50% cutoff. We test whether the log difference in dependent variable at the cutoff is statistically significant. Figure 2 presents a graphical analysis of the vote share density. The solid line represents the non-parametric local polynomial smoothing on either side of the cutoff. The dashed lines represent the 95% confidence intervals of the estimation. At the cutoff, we do not observe significant shifts in distribution. Table 2 reports the test statistic. The estimated log discontinuity is and is not statistically significant (t-stat = 1.168), which confirms our graphical result. Another key implication of local randomization is that the baseline covariates should be locally balanced on either side of the cutoff before proposal voting. Cunat et al (2012) have examined a variety of baseline variables. We complement their findings by examining our financial reporting quality proxies in year t-1 (i.e., MDD t-1, ICW t-1 and Restate t-1 ). We also examine prior institutional ownership and whether return is negative in t-1. We use these variables in our cross-sectional variation tests. We employ the RD analysis model, but replace the dependent variable with each of the observed baseline covariates in year t-1. Table 3 presents the test results. We do not find any discontinuities for baseline covariates. The Pass variables are not statistically significant across all regressions. Overall, these results provide assurance that the local randomization assumption is valid to our setting. 5.2 Empirical results from regression analysis The regression results of Model (2) are presented in Table 4, where we aggregate all types of governance-related proposals and examine the impact of the passing (>50% approval 18

19 vote) of the proposals on three measures of financial reporting quality. The coefficient on the variable Pass is significantly negative in the first column, indicating that passing of governancerelated proposals leads to an improvement in the accrual-based measure of financial reporting quality. In the second column, we use the incidences of internal control weakness to gauge the quality of a firm s financial reporting system, and the significantly negative coefficient on Pass suggests that passing governance-related shareholder proposals results in fewer incidences of internal control weakness. In column three, we use the incidences of restatement in the subsequent three years as a measure of financial reporting quality and the coefficient on Pass is statistically insignificant. The insignificant result for the restatement test could be driven by the small number of restatements. Specifically, only 11% of our sample has at least one restatement during the three-year window following the year of the proposal. Another possible explanation is that different forms of governance mechanisms may have different impact on firms reporting quality and grouping all governance related proposals together reduces the power of our tests. We next classify shareholder proposals into three types: G-index, board, and executive compensation, examining the impact of each specific category of governance mechanisms on firms financial reporting quality. Table 5 presents the empirical results of Model (3) for the three proposal types. Passing of G-index related proposals do not seem to have any significant impact on our measures of financial reporting quality. However, the proposals aiming to improve board efficiency are found to significantly improve accrual quality (negative coefficient on Pass(Board) in Column (1)), reduce incidences of internal control weakness (negative coefficient on Pass(Board) in Column (2)), and reduce incidences of restatement (negative coefficient on Pass(Board) in Column (3)). For proposals related to executive compensation contracts, we find the passing of this type of proposals improves accrual quality (negative 19

20 coefficient on Pass(Comp) in Column one) but has no significant impact on internal control weakness and restatements. Overall, these results provide evidence that governance improvements related to boards of directors and, to a lesser extent, executive compensation, lead to higher quality financial reporting. In the next set of analysis, we examine whether the impact of passing of shareholder proposal on firms reporting quality is affected by the sponsorship of the proposals and financial reporting quality in prior periods. Table 6 reports the empirical results of these cross-sectional analyses. Panel A shows that institutional sponsorship of the proposals do not have significant impact on the relation between passing of the shareholder proposals and subsequent financial reporting quality. Panel B examines whether firms with worse prior period financial reporting quality witness a bigger improvement after passing of the governance-related proposals. We find some support consistent with the notion that firms with worse financial reporting quality prior to the proposal year experience bigger improvement after the passing of proposals related to executive compensation and board of directors. The coefficient on Pass(Comp) x ICW t-1 is significantly negative, indicating that firms with more incidences of Section 404 internal control weakness (ICW) prior to the voting of the proposal see larger reduction in ICW after passing of proposals targeting at executive compensation contracts. For tests using restatements as the measure of financial reporting quality, the results suggest that the incidence of restatement is significantly reduced by shareholder proposals related to board efficiency and executive compensation when the firm already experienced more restatements in years prior to the voting of the proposal the coefficients on Pass(Board) x Restate t-1 and Pass(Comp) x Restate t-1 in Column 3 are significantly negative. 20

21 6. Conclusions This study examines the causal effect of corporate governance on financial reporting quality. To overcome the endogeneity problem related to corporate governance, we use a regression discontinuity design to analyze a threshold event - passing of governance-related shareholder proposals. This research design explores a unique semi-experimental setting where the shareholder proposals pass or fail the majority vote by a small margin (closed-call proposals). Firms receiving those closed-call proposals should be the same in all aspects except for the likelihood of implementation of the governance proposal, which jumps discretely once the proposal receives majority vote. Thus, passing a proposal represents a locally exogenous shock to firms governance structure, and the estimated effects on financial reporting can be interpreted as causal evidence of the effect of corporate governance on financial reporting quality. Using three measures of financial reporting quality (i.e., accrual-based measure from the modified Dechow and Dechiv model, incidences of internal control weakness, and incidences of accounting restatements), we find that the passing of governance-related shareholder proposals leads to higher quality financial reporting. Further, we find that this positive effect on financial reporting quality is primarily driven by proposals related to boards of directors and to a lesser extent, executive compensation. However, we find no evidence of improved financial reporting quality for proposals in response to the passing of shareholder proposals related to anti-takeover provisions (G-index). Additionally, We find that passing proposals related to boards of directors and executive compensation leads to a greater improvement in financial reporting quality for firms with weaker financial reporting quality prior to the proposal voting Our study contributes to the literature by establishing a clearer causal relation between corporate governance and financial reporting. Our study also adds to our understanding of the 21

22 economic consequences of shareholder-initiated governance proposals by demonstrating that the governance-related shareholder proposals have an important, and previously unidentified, benefit of improving firms' financial reporting. Our results are relevant to the ongoing debate on the effectiveness of the advisory voting on shareholder-initiated proposals, which is intensified by the recent enactment of the Dodd-Frank Act that mandates shareholder advisory vote on firms executive compensation contracts at least once every three years. Our study highlights the important role of those governance-related shareholder proposals in improving firms' financial reporting quality. 22

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25 0.5 Density Figure 1 Vote Shares Distribution Vote Shares Note: This figure presents vote share distribution of shareholder proposals. The horizontal line is Vote Shares for the proposals. 25

26 Figure 2 Graphical Analysis of Density Discontinuity Note: This figure presents a graphical analysis of the density discontinuity of the vote shares distribution. The horizontal line is the margin of victory for passing a proposal. It is defined as the difference between vote shares supporting a proposal and the 50 percent threshold. 26

27 Table 1 Summary Statistics Panel A: Summary Statistics Proposal Level Proposals N % of Proposals Passed Average % of Supporting Vote All Proposals % 37.00% Board % 29.99% Comp % 26.99% G-index % 53.34% Audit % 22.44% Other % 18.05% Panel B: Summary Statistics Firm-Year Level N Mean SD 25th Median 75th MDD # of ICW # of Restate % with Institution Sponsor High MDD t ICW t Restate t Note: This table presents summary statistics of the sample. The sample consists of 3,775 governance related shareholder proposals from 1997 to 2010 for all nonfinancial S&P 1500 companies plus an additional 500 widely held firms. Panel A reports summary statistics at the proposal level. Panel B reports summary statistics at the firmyear level for key variables used in the study. MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1. # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting. # of Restate is the number of restatements within three years after the proposal meeting. Ins Own t-1 is the percentage ownership by institutional investors right before the proposal meeting. Union Fund (G-index) is an indicator variable equal to 1 if the G-index type of proposals is sponsored by union fund, 0 otherwise. Union Fund (Board) is an indicator variable equal to 1 if the Board related type of proposals is sponsored by union fund, 0 otherwise. Union Fund (Comp) is an indicator variable equal to 1 if the Compensation related type of proposals is sponsored by union fund, 0 otherwise. Negret t-1 is an indicator variable equal to 1 if the buy-and-hold abnormal return is negative for the proposal firm one year before the proposal meeting. High MDD t-1 is an indicator variable equal to 1 if a firm s MDD is above median the year before the proposal meeting, 0 otherwise. ICW t-1 is an indicator variable equal to 1 if internal control weakness has been found for a firm one year before the proposal meeting, 0 otherwise. Restate t-1 is an indicator variable equal to 1 if a firm has made restatement one year before the proposal meeting, 0 otherwise. 27