Does proximity to corporate headquarters enhance directors' monitoring effectiveness? A look at financial reporting quality

• Author: Maryam Firoozi,Steve Fortin,Michel Magnan
• DOI: http://doi.org/10.1111/corg.12264
• Date: 01 March 2019
• Published date: 01 March 2019

ORIGINAL ARTICLE

Does proximity to corporate headquarters enhance directors'

monitoring effectiveness? A look at financial reporting quality

Maryam Firoozi

1

|Michel Magnan

2

|Steve Fortin

3

1

Sprott School of Business, Carleton

University, Ottawa, ON, Canada

2

John Molson School of Business, Concordia

University, Montréal QC, Canada and from

CIRANO, Montreal, Canada

3

School of Accounting and Finance, University

of Waterloo, Waterloo, ON, Canada

Correspondence

Maryam Firoozi, Sprott School of Business,

Carleton University, 1125 Colonel By Drive,

1015 Dunton Tower, Ottawa, ON K1S 5B6,

Canada.

Email: maryam.firoozi@carleton.ca

Funding information

Carleton University, Sprott School of Business;

Institute for the Governance of Public and

Private Organizations; S.A. Jarislowsky Chair

in Corporate Governance (Concordia);

Concordia University

Abstract

Research question/issue: In this study, using a unique Canadian setting that relies

on a principle‐based corporate oversight environment and that has access to a large

pool of U.S. directors, we investigate how directors' proximity to a firm's headquarters

influences its financial reporting quality.

Research findings/insights: Our results show that financial reporting quality is

higher for firms whose boards (audit committees) consist of a greater proportion of

independent directors who reside close to a firm's headquarters than for firms whose

boards consist of directors who are more geographically dispersed. However, among

nonlocal directors, the effect of nonlocal domestic directors on financial reporting

quality is similar to the effect of local directors. In contrast, compared with local direc-

tors, the presence of U.S. directors has a negative impact on financial reporting quality.

Theoretical/academic implications: Our results suggest that directors' proximity to

corporate headquarters extends beyond geographical proximity and also reflects

directors' familiarity with a firm's institutional environment. Institutional familiarity

helps domestic nonlocal directors reduce information costs associated with low geo-

graphical proximity, thus providing them with access to a wider range of information

sources and enhancing their monitoring ability, at least for financial reporting. In con-

trast, foreign directors face information costs arising from both low geographical

proximity and less familiarity with the institutional environment.

Practitioner/policy implications: Firms should take into consideration the conse-

quences of nominating nonlocal directors on the monitoring of financial reporting

quality. In addition, regulators should take a more comprehensive approach if they

impose regulations such as board diversity initiatives, as regulatory pressures often

imply appointing directors farther away from headquarters.

KEYWORDS

corporate governance, board of directors, geographical proximity, financial reporting quality,

foreign directors

1|INTRODUCTION

Our study investigates the impact of proximity on a key aspect of

boards of directors' decision making, that is, financial reporting quality.

Within the context of our paper, proximity is defined as the directors'

geographical location compared with corporate headquarters. Finan-

cial reporting quality relates to abnormal accruals management and

accounting restatements. Our paper represents an extension of Alam,

Chen, Ciccotello, and Ryan (2018), who find that the requirements

imposed by the Sarbanes–Oxley Act (SOX) have increased directors'

Received: 20 April 2017 Revised: 13 October 2018 Accepted: 29 October 2018

DOI: 10.1111/corg.12264

98 © 2018 John Wiley & Sons Ltd Corp Govern Int Rev. 2019;27:98–119.wileyonlinelibrary.com/journal/corg

geographical distance to corporate headquarters and that this, in turn,

has caused higher earnings management in these firms. We extend

their paper by examining the effect of directors' proximity on financial

reporting quality in Canada, an institutional setting that differs from

the United States on several fronts. We contend that these differ-

ences may affect directors' responsibilities for monitoring financial

reporting quality, as well as their information acquisition costs.

First, directors' responsibilities in a Canadian context differ from

those faced by directors in the United States. In this regard, recent

rulings of the Supreme Court of Canada indicate that directors of

Canadian firms bear broader responsibilities toward a firms' stake-

holders (e.g., BCE Inc. v. 1976 Debentureholders, 2008; Cormier &

Magnan, 2017). Moreover, the regulatory oversight environment in

Canada emphasizes compliance rather than enforcement, as is the

case in the United States (United Nations Conference on Trade and

Development [UNCTAD], 2014). More importantly, Canada's corpo-

rate governance regime is principle based, whereas in the United

States, it is rule based. The Canadian principle‐based approach may

give firms a better opportunity to adapt their governance mechanisms

to meet the needs of the firms (Li & Broshko, 2006). Thus, in Canada,

firms may have more freedom to evaluate the costs, such as informa-

tion acquisition costs, and benefits of appointing nonlocal directors.

Therefore, when appointing a nonlocal director, there is a better

opportunity for Canadian firms to take into consideration the informa-

tion needs of directors for monitoring and advising managers.

Second, Canada is neighbor to the United States, which has a

well‐developed directors' market. Canadian firms have access to a

deep pool of U.S. directors with a wide range of expertise and experi-

ence. Therefore, the nonlocal directors' mix on corporate boards is dif-

ferent from the one found in the United States, because nonlocal

directors in Canada can be domestic or foreign. Alam et al. (2018) do

not investigate this dimension. Our setting allows us to investigate

the effect of low proximity of domestic and foreign independent

directors, compared with local directors, on financial reporting quality.

When Canadian firms are not able to find qualified directors in the

proximity of their headquarters, they can nominate directors from

other parts of Canada, the United States, or other countries. Due

to institutional differences between Canada and the United States

(e.g., governance mechanisms and the regulatory oversight environ-

ment), firms may prefer to explore the Canadian directors' market first

(even though some U.S. cities may be geographically closer to the

firms' headquarters). The reason is that, for nonlocal domestic direc-

tors, institutional familiarity may help them mitigate information asym-

metry and the information acquisition costs associated with their low

geographical proximity. For example, nonlocal domestic directors have

access to soft information at the country level, as well as access to

other national information channels, such as the Institute of Corporate

Directors.

1

Therefore, in terms of monitoring financial reporting

quality, nonlocal domestic directors in Canada may behave similarly

to local directors because of their familiarity with the institutional

environment, which, in turn, helps mitigate the information costs

associated with low geographical proximity.

In Canada, foreign directors are mainly recruited from one neigh-

boring country, the United States. The literature on the impact of

foreign directors on financial reporting quality is limited, and results

so far are mixed (e.g., Du, Jian, & Lai, 2017; Masulis, Wang, & Xie,

2012). Foreign directors face higher information‐gathering costs

compared with domestic nonlocal directors who are residents of the

country where the firm's headquarters are located. First, foreign direc-

tors have a disadvantage in gathering firm‐specific information, and

second, they also face costs in gathering information about the econ-

omy, business practices, and financial reporting models (including

accounting standards) of the country where the firms' headquarters

are located (Masulis et al., 2012). In addition, in terms of institutional

context, the duties and responsibilities of directors are different in

Canada compared with the United States. Canadian directors have

broader responsibilities to all stakeholders. Therefore, U.S. directors

face both a low geographical proximity and a low level of familiarity

with the institutional environment compared with local directors in

Canada. Hence, we anticipate that, compared with local directors,

the presence of U.S. directors on a firm's board has a negative impact

on financial reporting quality.

Our sample comprises 1,050 firm‐year observations from

Canadian firms during the period between 2008 and 2012. In the next

step, we measure financial reporting quality using abnormal accruals,

as well as restatements. Controlling for other director attributes and

firm‐specific dimensions, results of the multivariate analysis show that

the higher the proportion of independent local directors (audit com-

mittee members), the lower the level of absolute abnormal accruals,

which implies higher financial reporting quality. In addition, the likeli-

hood of restatement is lower for firms with a higher percentage of

independent local directors (local audit committee members). We also

measure directors' dispersion by using a Herfindahl index, which takes

into consideration where directors from the same board are located

compared with each other. Results based on the Herfindahl index

show that more dispersed boards (audit committees) are associated

with lower financial reporting quality.

Nonlocal directors in Canada are mainly chosen from other prov-

inces or from the United States, and a small portion (6%) are from

other countries. In this regard, the presence of U.S. directors is associ-

ated with lower financial reporting quality when compared with local

directors. However, the presence of directors from other provinces

(i.e., nonlocal domestic) does not have a different effect on financial

reporting quality than the presence of local directors. Therefore, U.S.

directors' low geographical proximity and their low level of familiarity

with Canada's institutional context seem to drive our main results. The

information acquisition cost originated from both low geographical

proximity and low institutional familiarity still negatively affects U.S.

directors' monitoring abilities. Our results hold after controlling for

endogeneity and alternate explanations.

We consider that the study contributes to three streams of

research. First, this study provides evidence regarding a dimension

of boards of directors, their geographical origins, that has rarely

been explored (Alam et al., 2018; Alam, Chen, Ciccotello, & Ryan,

2013, 2014). More specifically, we investigate the relationship

between the geographical proximity of directors and corporate

transparency in a country with a different oversight environment

over financial reporting quality. Prior research mostly focuses on the

statutory diversity of directors (directors' independence) or individual

attributes (expertise and gender) and their effects on the information

FIROOZI ET AL.99