Exploring the Moderating Role of Growth Options on the Relation between Board Characteristics and Management Earnings Forecasts

• Author: Arifur Khan,Howard Chan,Robert Faff,Paul Mather
• Published date: 01 July 2013
• DOI: http://doi.org/10.1111/corg.12027
• Date: 01 July 2013

Exploring the Moderating Role of Growth

Options on the Relation between Board

Characteristics and Management

Earnings Forecasts

Howard Chan, Robert Faff, Arifur Khan, and Paul Mather*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines whether director independence, reputation, and f‌inancial expertise are

related to managementearnings forecast (MEF) activity. In particular, we examine whether such a relationshipis moderated

by f‌irms’ growth options.

Research Findings/Insights: Using Australian archival data for 1,928 f‌irm-years between 1999 and 2006, we f‌ind several

board characteristics have a signif‌icant positive relationship with: (1) the likelihood of f‌irms issuing MEFs; (2) their

specif‌icity; (3) their accuracy; and (4) a negative relationship with their bias. For (1), (2), and (3) we show that these

relationships are accentuated for f‌irms with high growth options.

Theoretical/Academic Implications: While the theory of voluntary disclosure suggests f‌irms will disclose information that

is favorable to them or their managers, well-governed f‌irms issue informative MEFs that potentially reduce information

asymmetries in capital markets. We extend the prior literature by showing that such a relation is enhanced in the presence

of information asymmetry and moral hazard associated with growth options.

Practitioner/Policy Implications: Our results have strategic implications for nomination committees by showing that

independent directors and those with strong reputations and f‌inancial expertise enhance the governance of high growth

f‌irms. We also inform the regulatory debate by showing that good corporate governance enhancing disclosure quality is

context-specif‌ic – it is not a case of “one size f‌its all”.

Keywords: Corporate Governance, Management Earnings Forecasts, Growth Options

INTRODUCTION

This study examines the linkage between director

attributes (such as independence, reputation, and f‌inan-

cial expertise) and management earnings forecast (MEF)

behavior, with a particular focus on whether such a relation-

ship is moderated by f‌irms’ growth options. In essence, our

argument is based on the simple idea that internal corporate

governance (CG) mechanisms (centered around corporate

boards) which require enhanced management disclosures,

can particularly assist in reducing acute agency problems

(including information asymmetries and moral hazard) that

are exacerbated in f‌irms with high growth options (see Fama

& Jensen, 1983). Our evidence shows that once the impact of

growth options is properly modeled, a much clearer picture

emerges of the MEF/CG linkage. Wealso explore its broader

implications for the literature and the associated regulatory

debate.

One important set of regulatory requirements in Austra-

lia, imposed by a unique combination of Australian Securi-

ties Exchange (ASX) listing rules and the Corporations Act,

requires companies to continuously disclose information to

the ASX that is likely to be security price sensitive.1Allied to

this has been an on-going debate about the identif‌ication

and implementation of corporate governance principles and

structures designed to ensure that corporate resources are

*Address for correspondence: PaulMather, La Trobe Business School, La Trobe Uni-

versity,Vic 3086 Australia. Tel: 61 3 9479 5264; Fax: 61 3 9479 3669; E-mail: p.mather@

latrobe.edu.au

314

Corporate Governance: An International Review, 2013, 21(4): 314–333

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12027

managed in the best interests of all stakeholders, in particu-

lar, the ASX Principles of Good Corporate Governance and

Best Practice Recommendations (PGCG) established in 2003

(and subsequent amendments). Levering off this as our

broad motivation, we provide an empirical assessment of the

effect of corporate governance mechanisms across several

important dimensions of a f‌irm’s disclosure policy, namely,

the likelihood, specif‌icity, accuracy, and bias of management

earnings forecasts.

Managers know more about the f‌irm and its future pros-

pects than do shareholders. However, managers have incen-

tives (e.g., insider trading opportunities) not to meet their

continuous disclosure obligations. Notwithstanding such

incentives, governance features such as director indepen-

dence should increase the likelihood of companies disclos-

ing more informative (more accurate, less biased) earnings

news to shareholders. Notably, the PGCG recommends that

a majority of the board and the audit committee be indepen-

dent directors. Independent directors are considered more

effective in monitoring senior management and thus help

mitigate agency problems associated with managing such

companies (Fama & Jensen, 1983). The economics of the

managerial labor market also provides incentives for inde-

pendent directors to be effective monitors (Fama, 1980).

There has been some prior research in the area. In the US,

Ajinkya, Bhojraj, and Sengupta (2005) investigate the effects

of institutional holdings and outside directors on the prop-

erties of management forecasts, while Karamanou and

Vafeas (2005) examine how corporate boards and audit com-

mittees are associated with management earnings forecasts.

Truong and Dunstan (2011) examine the inf‌luence of three

external corporate governance mechanisms (continuous dis-

closure regulatory reform, analyst following and ownership

concentration), as well as board structure on the likelihood,

frequency, horizon, precision, and accuracy of management

earnings forecasts in New Zealand.

While all three studies above broadly f‌ind an association

between some board characteristics and management earn-

ings forecast behavior, the specif‌ic f‌indings vary – to such an

extent that drawing clear-cut insights is diff‌icult. For

example, neither Ajinkya et al. (2005) nor Karamanou and

Vafeas (2005) f‌ind the hypothesized positive association

between forecast precision and outside directors. In fact,

Karamanou and Vafeas (2005) f‌ind that more precise fore-

casts are made by US f‌irms with a lower percentage of

outside directors. Similarly, Karamanou and Vafeas (2005)

f‌ind limited association between governance variables and

forecast bias and Truong and Dunstan (2011), contrary to

their hypothesis, report positive associations between

several governance variables and forecast error.

The sole Australian study in this area tests and f‌inds a

signif‌icant positive relationship between the likelihood and

frequency of f‌irms issuing management earnings forecasts

and measures of audit committee independence and inde-

pendent director reputation but not director independence

(Chan, Faff, Mather, & Ramsay, 2008). However, due to

sample size constraints, Chan et al. (2008) do not examine

the relation between corporate governance and the accuracy

or bias associated with managementearnings forecasts (for a

more general examination ofAustralian disclosures, see also

Beekes & Brown, 2006).

We argue that the mixed results reported in the prior

literature point to the need to better contextualize the poten-

tial governance-forecast relation. That is, we contend thatby

recognizing the moderating effect of growth options, we can

uncover evidence of a conditional linkage that is much more

persuasive than achieved by this literatureto date. The sepa-

ration of ownership and control in publicly listed f‌irms

results in information asymmetries between managers and

shareholders that give rise to agency problems and costs

resulting from the inability of shareholders to perfectly

monitor managerial behavior (Jensen & Meckling, 1976). If

both managers and shareholders are utility maximizers, it

cannot be safely assumed that managers will always work in

the best interests of shareholders. This creates incentives for

shareholders to engage costly monitoring mechanisms to

limit any aberrant managerial behavior and for the manag-

ers to incur “bonding” costs to facilitate such monitoring.

Firms with high growth options are associated with greater

information asymmetries and are more diff‌icult to monitor

(Core, 2001).

Informative management earnings forecasts potentially

reduce information asymmetries in capital markets and are

particularly useful to monitor managers in the presence of

increased moral hazard associated with growth options. We

argue that reputable independent directors with appropriate

expertise will recognize the increased information asymme-

tries and moral hazard associated with high growth f‌irms.

Hence, such directors will endeavor to mitigate such infor-

mation asymmetries through appropriate disclosures,

including high quality management earnings forecasts.

Our f‌inal sample consists of 1,928 f‌irm-year observations

drawn from the top 500 Australian Stock Exchange listed

companies (by market capitalization) during the period

1999–2006. We f‌ind several board characteristics have a sig-

nif‌icant positive relationship with: (1) the likelihood of f‌irms

issuing MEFs; (2) the specif‌icity of MEFs; (3) the accuracy of

MEFs; and (4) a negative relationship with MEF bias. Most

notably, we extend the extant literature by showing that the

aforementioned relations (with the exception of bias) are

considerably accentuated in f‌irms with high growth options

and the results are robust to alternative empirical methods to

control for issues of endogeneity and reverse-causality. We

also inform practitioners and the regulatory debate by

showing that the benef‌its of board monitoring in this impor-

tant area of information disclosure appears to be context

specif‌ic. Finally, we elaborate the contextual patterns in the

paper.

The remainder of the paper is structured as follows: the

next section reviews the literature, followed by a section that

develops the hypotheses. This is followed by a section that

outlines our research methods, variable def‌initions, and

sample. The results are then discussed followed by a section

on further robustness checks. The last section presents the

conclusions.

A BRIEF LITERATURE REVIEW

Board Characteristics

The board of directors is the apex of the internal governance

system and assists in reducing agency problems associated

BOARD CHARACTERISTICS AND EARNINGS FORECASTS 315

Volume 21 Number 4 July 2013© 2013 John Wiley & Sons Ltd