Accounting discretion, corporate governance, and firm performance – what’s the link?

Do self-interested opportunistic managers systematically exploit lax governance structures and abuse accounting discretion allowed under GAAP in a bid to increase their wealth at the expense of shareholders? Or do managers, in general, exercise accounting discretion in an efficient manner consistent with long-run shareholder value maximization? This academic study by Robert M. Bowen and Shivaram Rajgopal of the University of Washington and Mohan Venkatachalam of Duke University set out to examine this subject.

Although anecdotes such as Enron and WorldCom can suggest that managerial opportunism is commonplace, we investigate multiple types of accounting discretion in a large sample study. In particular, we investigate whether poor governance quality is associated with greater accounting discretion and whether firms with weaker governance structures report poorer future performance as a consequence, ceteris paribus.

However, “similar to prior research, in the firststage, we find significant associations between accounting discretion and proxies for weak governance structures — for example, greater short-run managerial compensation, balance of power tilted in favor of managers over shareholders, chief executive officer (CEO)–chair duality, and closer relations between the executive team and the board,” say the authors. Much of the prior literature stops at this stage and interprets the association between accounting discretion and poor governance quality as evidence that lax governance structures encourage managerial opportunism. We argue that such an interpretation is premature unless one can show that excess accounting discretion has negative consequences for shareholders’ wealth. In particular, the observed relation between accounting discretion and poor governance quality could represent (a) managerial opportunism unexpected by the contracting parties — for example, as an outcome of unresolved agency problems; or (b) an indication that we have not adequately specified a model for the equilibrium level of accounting discretion — for example, variables included as economic determinants in the first stage are incomplete.

The authors also find some evidence that discretion due to poor governance is positively associated with future operating cash flows and return on assets(ROA), consistent with shareholders benefiting from earnings management, on average. However, it is important to point out that in our tests (a) accounting discretion is estimated, not empirically observed, and (b) governance quality is proxied by observable attributes of the firm’s governance structure. Thus, our inferences are subject to the standard caveats regarding inherent measurement error in our surrogates for accounting discretion and governance quality despite measures of accounting discretion and governance quality being (a) state-of-the-art and (b) used by prior research. Regardless, our second-stage results call into question the widely held view that accounting discretion is driven by opportunistic managers.

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