Determinants and Accounting Consequences of Forming a Governance Committee: Evidence from the United States

• DOI: http://doi.org/10.1111/j.1467-8683.2009.00769.x
• Author: Jian Zhou,Gerald J. Lobo,Henry Huang
• Published date: 01 November 2009
• Date: 01 November 2009

Determinants and Accounting Consequences of

Forming a Governance Committee: Evidence

from the United States

Henry Huang*, Gerald J. Lobo, and Jian Zhou

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the determinants of forming a governance committee and whether such a

committee constrains managerial opportunism.

Research Findings/Insights: This study examines a sample of S&P 1,500 f‌irms over the period of 1996 to 2002. It f‌inds that

f‌irms with a larger, more independent, and more active board, higher agency costs (as indicated by lower managerial

ownership and lower takeover vulnerability), and past occurrence of class-action lawsuits are more likely to voluntarily

form a governance committee. This study also provides evidence that having a governance committee brings real conse-

quences in that it constrains managerial opportunism by reducing aggressive f‌inancial reporting.

Theoretical/Academic Implications: Consistent with substitution theory, this study documents that a f‌irm is more likely to

form a governance committee to compensate for its severe agency problems. It also demonstrates that delegating some

corporate governance duties to a specif‌ic board committee could improve the effectiveness of board monitoring.

Practitioner/Policy Implications: This study provides insights to regulators who are interested in regulating board struc-

ture. It suggests that whether a f‌irm needs to form a governance committee is endogenously determined by the f‌irm’s

characteristics when the f‌irm has an independent board. In addition, this study documents that a voluntarily formed

governance committee is able to mitigate agency costs in the form of constraining managerial accounting discretion.

Keywords: Corporate Governance, Governance Committee, Accounting Accruals, Sarbanes-Oxley Act

INTRODUCTION

On November 4, 2003, the Securities and Exchange Com-

mission (SEC) approved the New York Stock Exchange

(NYSE) proposal that companies listed on the NYSE have a

nominating/governance committee composed entirely of

independent directors (SEC, 2003a).1The major objective of

this proposal is to strengthen the corporate governance prac-

tices of listed companies. In addition to the traditional duty

of nominating executives and directors, the new responsi-

bilities of the nominating/governance committee under the

NYSE proposal include: (1) conducting the board’s annual

governance review; (2) monitoring compliance with the

NYSE’s corporate governance guidelines; (3) establishing

and implementing a process for the board’s self-assessments

(including board and committee self-assessments and

director assessments); and (4) recommending director com-

pensation (SEC, 2003a). Theseduties of overseeing the board

and corporate governance were either nonexistent or

handled by the full board if the f‌irm did not have such

a governance committee (Mahoney & Shuman, 2003). By

forming a governance committee, the board can explicitly

delegate some specif‌ic or selected governance duties to a

focused and independent subcommittee. It is clear from the

NYSE proposal and the SEC’s endorsement that having a

governance committee is viewed as essential to good corpo-

rate governance in public companies.

Given the perceived importance of a governance commit-

tee by the NYSE and SEC in directing and monitoring a

f‌irm’s activities, it is surprising that less than 50 per cent of

the Standard & Poor’s (S&P) 1,500 f‌irms had governance

committees as recently as 2001.2Whysome f‌irms established

a governance committee and whether having such a com-

mittee improves monitoring are clearly questions worthy of

research. We address these questions by investigating the

*Address for correspondence: College of Business, Prairie View A&M University,

Prairie View, Texas 77446, USA. Tel: 936-261-9210; Fax: 713-583-9749; E-mail:

hhuang@pvamu.edu

710

Corporate Governance: An International Review, 2009, 17(6): 710–727

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00769.x

underlying determinants of a f‌irm’s choice to voluntarily

form a governance committee prior to the SEC’s mandatory

requirement and examining whether such a committee

improves boardmonitoring from the perspective of manage-

ment’s accounting discretion. Given that a board relies on its

subcommittees to carry out its monitoring function, it is

important to understand the determinants of board commit-

tee formation. Such an understanding will also shed light on

whether f‌irms can optimally design their board structure

and whether a legislative mandate on board structure is

justif‌ied. Meanwhile, examining whether having a gover-

nance committee affects accounting discretion provides evi-

dence on whether such a committee brings real benef‌its to

the f‌irm. Thus, the resultsof this study have important impli-

cations for regulatory theory and practice even after adop-

tion of the governance committee requirement by various

listing authorities.

Using a sample of S&P 1,500 companies from1996 to 2002,

we f‌ind that board characteristics, agency problems, and

past governance failures are related to forming a governance

committee. Specif‌ically, we f‌ind that the likelihood of having

a governance committee is: (1) positively associated with

board size, boardindependence, and number of board meet-

ings; (2) negatively associated with insider ownership and

takeover vulnerability; and (3) positively associated with

past occurrence of securities class-action lawsuits. We obtain

these results after controlling for differences in f‌irm charac-

teristics including f‌irm size and leverage, differences in

exchange listing, and differences in industry characteristics,

such as being in regulated or litigious industries.

Prior research presents evidence that good governance is

related to less earnings management (e.g., Klein, 2002a; Xie,

Davidson, & DaDalt, 2003). If the governance committee is

effective in enhancing governance quality, we should

observe lower accounting discretion for f‌irms with a gover-

nance committee. Our results, based on the sample period

before the NYSE mandatory requirement, support this pre-

diction. Firms with a governance committee have signif‌i-

cantly lower levels of discretionary accruals, even after

controlling for audit committee characteristics and other

accrual-related f‌irm characteristics. In change analysis, we

also f‌ind that f‌irms employ lower levels of discretionary

accruals after adoption of a governance committee.

Our study contributes to the literature on determinants

and effectiveness of board structure by analyzing board

structure before the mandatory legislative intervention of

Sarbanes-Oxley Compliance (SOX). Thus our data allow us

to examine how f‌irms decide whether to establish a board

subcommittee. There have been some concerns about

whether SOX has overburdened companiesby imposing sig-

nif‌icant implementation costs. Our study provides some evi-

dence on whether SOX’s intervention on board structure is

benef‌icial. Our f‌indings indicate that board independence

makes it easier for further board improvement, thus justify-

ing SOX’s mandatory requirement that a majority of board

members are independent. Our resultsalso establish the link

between board diligence and board committee formation.

Prior research (e.g., Bradbury, 1990; Collier, 1993; Premuroso

& Bhattacharya, 2007) focuses on the impact of board char-

acteristics and economic factors on the decision to form a

board committee. We extend this line of research by exam-

ining the impact of a f‌irm’s agency costs on forming a board

committee. In addition to insider ownership, we introduce a

new aspect of agency cost – takeovervulnerability – and f‌ind

that f‌irms are more likely to form a governance committee

when they have severe agency problems as indicated by

lower takeover vulnerability and lower insider ownership.

These results suggest that f‌irms optimally set up their gov-

ernance structure by using stronger board monitoring as a

compensating factor for other weak governance mecha-

nisms. The evidence also suggests that imposing a manda-

tory requirement that all f‌irms havea governance committee

might not be necessary as long as boards are independent

enough to design the board structure to meet the company’s

need. For example, once a board has a suff‌icient level of

independence, it can decide whether to establish a gover-

nance committee based on the severity of the f‌irm’s agency

problem. Wealso demonstrate that f‌irms with past securities

litigations are more likely to form a governance committee.

This suggests that litigation in the US acts as a monitoring

mechanism to prompt a f‌irm to take corrective actions to

address its governance def‌iciency. Our study also provides

insights into the effectiveness of forming a board committee

specializing in corporate governance. It has been suggested

that forming a board committee may be merely a political

move to conform to perceived good governance practice

without any real f‌inancial purpose (Menon & Williams,

1994; Zajac & Westphal, 2004). Our results indicate that

having a governance committee is associated with less

earnings overstatement even after controlling for audit com-

mittee independence. This suggests that various board com-

mittees have differential effects on constraining managerial

accounting discretion.

The remainder of this paper is organized as follows.

Section 2 presents the rationale for the hypotheses. Section 3

describes the sample selection and research design. Section

4 discusses the results of the empirical analysis and Section

5 discusses and concludes the paper.

BACKGROUND AND HYPOTHESES

DEVELOPMENT

Responsibilities of the Governance Committee

Some f‌irms had formed governance committees before

the SEC’s mandatory requirement for establishing a

nominating/governance committee. Firms could either form

a stand-alone governance committee or add new duties to

the nominating committee to make it a nominating/

governance committee. In either case, that committee is

charged with the new responsibilities of reviewing matters

related to corporate and board governance, which are

similar to those promulgated in the NYSE proposal as we

discussed earlier. For example, Kimberly-Clark, a premier

global health and hygiene company with annual sales of

$18.3 billion in 2007, set up a stand-alone governance com-

mittee during f‌iscal year 2000, which “monitors and recom-

mends improvements to the practices and procedures of the

Board, recommends the nature and duties of Committees of

the Board, and reviews stockholder proposals and other

proxy materials relating to corporate governance and

GOVERNANCE COMMITTEE 711

Volume 17 Number 6 November 2009© 2009 Blackwell Publishing Ltd