The Role of Information and Financial Reporting in Corporate Governance and Debt Contracting

Abstract

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 multi-period contracts among managers, directors, shareholders, and creditors.Keywords: financial accounting; corporate governance; board structure; contracting; executive compensation; debt contracts; informal contracts We thank the following for helpful comments and suggestions:

Does mandatory IFRS adoption facilitate debt financing?

“…For example, Francis et al (2005) show that borrowers with higher accrual quality pay less for debt; Zhang (2008) documents lower interest rates for firms that report more conservatively; and Dhaliwal et al (2011) find that firms with lower disclosure quality are more likely to access the private than public debt market. In summary, prior work suggests that financial reporting attributes are associated with the source and cost of debt (see Armstrong et al 2010, for a recent literature review).…”

“…4 Second, lenders use the book value of assets as a way to determine a firm's ability to service future debt. Asset values are also used by debt holders for collateral purposes (Armstrong et al 2010). Therefore they require current but reliable estimates of asset values (Watts 2003).…”

“…29 To address this issue, we repeat our access to debt tests using our sample firms as well as firms that are likely to be active in the debt markets. Identifying the latter is particularly challenging; Armstrong et al (2010) highlight that there has been relatively little research on the role of financial reporting in determining whether a firm can obtain debt, mainly because of the difficulty of identifying firms that would like to borrow but cannot find a willing lender, and therefore do not participate in the debt markets. 30 A possible solution is to develop empirical models predicting the demand for debt as a function of various firm characteristics and then use the predictions derived from such a model (Armstrong et al 2010).…”

Exploring the Impact of Internal Corporate Governance on the Relation Between Disclosure Quality and Earnings Management in the UK Listed Companies

“…In the UK, the importance of independent boards and audit committees has been stressed by the Cadbury Report (1992) and the Higgs Report on the Combined Code on Corporate Governance (2003). An independent director's role on the board and in the audit committee is expected to mitigate any conflict of interest (Klein 2002a, b;Bédard et al 2004) and be an effective monitoring agent (Armstrong et al 2010), resulting in lower earnings management opportunistic behaviours. Beasley (1996) reveals that firms with a high proportion of outside directors are less likely to be involved in fraud.…”

“…They therefore have less information advantage as compared to internal directors (Adam and Ferreira 2007). It is very unlikely that internal directors will let external directors know that they have been engaged in earnings management (Armstrong et al, 2010), making it nearly impossible for external directors to detect such activity. For that reason, the compliance with audit committee characteristics as recommended by the Smith Report (2003) and the UK Corporate Governance Code (2010) might be, to some extent, useful in helping companies to structure their internal governance system; however, it is only marginally beneficial in constraining earnings management.…”