The Case of France. Board Structure, Board Characteristics and Monitoring Effectiveness

Master's Thesis , 2021 , 64 Pages , Grade: 1.0

Business economics - Business Management, Corporate Governance

This study examines whether a board’s structure and composition are indicative of its monitoring effectiveness in terms of mitigating opportunistic management behavior. French companies may legally choose to operate with a board of directors (One-tier board) or a separate management board and supervisory board (Two-tier board). While the French Corporate Governance Code sets out uniform guidelines on board composition and activity regardless of a given board structure, respective directors face different challenges in establishing adequate management oversight.

Hence, externally prescribed board composition may have varying or unintended consequences. Further, both board structures have been attributed with different conceptual advantages that may influence their practical monitoring performance. Using the occurrence of earnings management as an indicator for poor management supervision, empirical results show that companies with two-tier boards are superior monitors.

More generally for France, I also find that independent boards are associated with less earnings management whereas busy boards are associated with more earnings management. I do not find a measurable impact of director financial expertise. Finally, mixed results are presented on the existence of a moderating effect of board structure on the relationship between board composition and earnings management.

TABLE OF CONTENTS

1 INTRODUCTION

2 LITERATURE REVIEW
2.1 AGENCY THEORY AND OPPORTUNISTIC MANAGEMENT BEHAVIOR
2.2 PRIOR RESEARCH ON EARNINGS MANAGEMENT
2.3 EARNINGS MANAGEMENT AND BOARD MONITORING
2.4 MONITORING IN ONE-TIER AND TWO-TIER BOARD STRUCTURES
2.5 RESEARCH SETTING FRANCE

3 HYPOTHESES DEVELOPMENT
3.1 BOARD STRUCTURE
3.2 DIRECTOR INDEPENDENCE
3.3 DIRECTOR BUSYNESS
3.4 FINANCIAL EXPERTISE
3.5 THE MODERATING EFFECT OF BOARD STRUCTURE

4 METHODOLOGY
4.1 SAMPLE SELECTION AND DATA SOURCES
4.2 MEASURING EARNINGS MANAGEMENT
4.3 MEASURING BOARD MONITORING CHARACTERISTICS
4.4 CONTROL VARIABLES
4.5 MODEL SPECIFICATION

5 DATA ANALYSIS
5.1 DESCRIPTIVE STATISTICS AND CORRELATION
5.2 MULTIPLE LINEAR REGRESSION RESULTS
5.3 ROBUSTNESS ANALYSIS
5.4 LIMITATIONS

6 DISCUSSION & CONCLUSION

7 REFERENCES

8 APPENDIX

ABSTRACT

This study examines whether a board's structure and composition are indicative of its monitoring effectiveness in terms of mitigating opportunistic management behavior. French companies may legally choose to operate with a board of directors (One-tier board) or a separate management board and supervisory board (Two-tier board). While the French Corporate Governance Code sets out uniform guidelines on board composition and activity regardless of a given board structure, respective directors face different challenges in establishing adequate management oversight. Hence, externally prescribed board composition may have varying or unintended consequences. Further, both board structures have been attributed with different conceptual advantages that may influence their practical monitoring performance. Using the occurrence of earnings management as an indicator for poor management supervision, empirical results show that companies with two-tier boards are superior monitors. More generally for France, I also find that independent boards are associated with less earnings management whereas busy boards are associated with more earnings management. I do not find a measurable impact of director financial expertise. Finally, mixed results are presented on the existence of a moderating effect of board structure on the relationship between board composition and earnings management.

The study's contributions are twofold: First, it adds to existing earnings management research from other countries by investigating how board characteristics affect the occurrence of earnings management in the context of France. Second, it is the first to investigate the role that a board's structuring plays in determining its monitoring effectiveness as well as to discuss and test interdependencies of that structure with other board characteristics.

Keywords Earnings management

- Board of directors
- Two-tier board structure
- Board monitoring
- Independence
- Financial expertise
- Busyness
- France

1 INTRODUCTION

The dispersed ownership structure of modern multi-national companies mostly renders the effective monitoring of management through shareholders/owners entirely unfeasible. However, under a lack of adequate monitoring, some management personnel may be more successful in opportunistically exerting its discretion over company processes in pursuit of self­serving goals mutually incompatible with shareholder interests. One currently unraveling example is the large-scale accounting fraud concealing embezzlement by parts of the management board of German electronic financial services provider and index member of the DAX, Wirecard AG. Its discovery in 2020 resulted in Wirecard's insolvency causing extensive financial damage to shareholder investments and resulted in the most recent case in a long line of corporate governance scandals emblematic of severe and persisting shortcomings in the way companies facilitate the monitoring of management. It serves as a reminder of the necessity and importance of establishing and maintaining a solid governance structure with adequate oversight of shareholders over management. Assessing such governance structures, companies' boards of directors tasked with monitoring management and the representation of shareholder interests naturally receive legislative and academic attention.

In this study, I set out to investigate how directors with specific characteristics (namely independence, busyness, financial expertise) may individually or collectively strengthen or weaken a board's monitoring effectiveness, which I expect in turn to be relevant for the occurrence of management opportunism due to improved detecting and disciplining. In doing so, this study is the first to consider the role that a board's structure plays in determining both board monitoring effectiveness itself, as well as the relationship between board monitoring effectiveness and other board characteristics. In the context of this study, board structure refers to the two major organizational oversight structures in use internationally, the one-tier and the two-tier board structure. For the purpose of this study, France presents a particularly suitable research setting as it is one of the very few countries that offer companies an option of choosing between a one-tier and a two-tier board structure instead of mandating one or the other as is the case in most other countries.

In line with contemporary accounting and governance research, I use the degree of accrual­based earnings management measured as the magnitude of abnormal accruals in company financial statements as an indicator for the leeway that management has in opportunistically exerting its discretion, particularly over financial reporting. Relatedly, boards with effective management oversight are expected to restrict earnings management. The study's hypotheses on board monitoring effectiveness are tested using a sample of French publicly listed non­financial companies.

The study contributes to earnings management and corporate governance research by providing additional insights on the relationship between earnings management and board monitoring characteristics from France. It is the first to provide comparative empirical results on the monitoring effectiveness of different board structures, whereas prior research almost exclusively focuses on one-tier boards.

The remainder of the study is organized as follows: Section 2 discusses and assesses the relevant literature by first illustrating the central premise of earnings management from a principal-agent perspective, second elaborating on the objectives that managers follow in managing earnings, third describing the relevance of board monitoring in mitigating earnings management, fourth deriving differences and implications concerning monitoring in different board structures, and finally reflecting on the choice of the country France as this study's subject. Section 3 draws from the research and theory discussed in developing the hypotheses. Section 4 outlines the methodological approach towards testing the hypotheses, section 5 presents the empirical analyses performed, and section 6 discusses results and concludes.

2 LITERATURE REVIEW

2.1 Agency Theory and opportunistic management behavior

The interplay of equity markets and publicly held companies is characterized by a separation of ownership and control. Its shareholders equip a company with the resources required for operations while not being entitled to any particular return other than the net result (residual claims) of those operations (Fama & Jensen, 1983). However, this net result then depends on the actions taken by the person(s) entrusted with the control over these operations. An agency relationship, accordingly, stems from shareholders (principal) employing executives (agent) to adequately control operations on their behalf by delegating some extent of their decision authority (Jensen & Meckling, 1976).

Assuming both agent and principal act rationally in that they are utility maximizers, there is a naturally occurring misalignment of interests regarding the question of what actions constitute adequate control and maximize whose utility (Jensen & Meckling, 1976). An agent's utility maximization may include the aversion of appropriate risks or effort, myopic behaviors, and self-dealing (Lambert, 2001), all of which are conflicting with principal interests.

Further, the shareholders' assessment of whether actions taken by management were self­serving or value-maximizing is tainted by information asymmetries. As shareholders usually only take a passive part in operational decision-making, they are put at an informational disadvantage compared to management which is assumed to have private information on the choices between possible actions and the resulting state of the company (Balago, 2014).

As described information asymmetries alongside conflicts of interests between shareholders and management impede efficient capital allocation and thereby the functioning of capital markets, the disclosure of accurate information through a company's financial reporting is essential (Healy & Palepu, 2001).

In this regard, financial reporting offers two important advantages from a shareholder perspective (Armstrong et al., 2010). First, it is designed to reduce information asymmetry by providing shareholders with financial information that summarizes the combined effect of the actions taken by management with less noise than other performance indicators like stock performance (Bushman & Smith, 2001). Second, it allows contracting with management on financial measures that shareholders value, partially tying management compensation to performance targets and thereby reducing the naturally occurring incentive misalignment (Tosi et al., 1997).

While advantageous, both these aspects of financial reporting also provide management with incentives to act opportunistically and for self-serving purposes.

Specifically, financial reporting introduces the pressures of meeting more elaborate shareholder expectations (Carruth, 2011) and allows for a better outside assessment of both company and management performance. However, in an attempt to meet expectations or conceal unfavorable performance, management may be more inclined to resort to opportunistically (due to their information advantage of the factual situation) influencing financial reporting, thereby manipulating outside perception of the company and, by extension, their managerial aptitude. This is enabled by the application of accounting standards frequently requiring the use of professional judgment. While intended to improve financial reporting, it may be abused to systematically provide information that deviates from economic reality (Healy & Wahlen, 1999).

Further, contracting with management on financial reporting measures, e.g., earnings, inadvertently introduces considerations about the impact on personal compensation into management's decision-making process on accrual and accounting procedures (Healy, 1985). In both cases, management may attempt to influence outcomes through altering information that outsiders have to rely on for their decision-making. The process of doing so is referred to as ‘earnings management' in accounting research and can be seen as one instance of agency costs.

2.2 Prior Research on Earnings Management

As per Schipper (1989), earnings management refers to management intentionally exerting its discretion over financial reporting to extract benefits that could not be obtained by means of unbiased reporting. This paper is mainly concerned with accrual-based earnings management, which opportunistically exploits the use of judgment by management intended to make financial reporting more informative to the users of financial information (Schipper, 1989). Generally, accrual accounting assumes that GAAP earnings (and accruals as a part of it) provide a better estimate of future company cash flows than current cash flows (Barth et al., 2001) due to a stronger connection between the timing of an economic occurrence and its respective financial effect on a company. A part of accruals is non-discretionary and arises naturally from the ordinary course of business whenever there are misalignments between the timing of income or expenses and related cash flows. Discretionary accruals, however, occur whenever firms divert from regular (e.g., based on its industry) accrual choices and create distortions in reported earnings that favor management's underlying objective (Constantatos et al., 2016). While this may happen by mistake, systematic diversions may reflect opportunistic management behavior (Ising, 2014). Hence, it is the discretionary accruals that accounting and earnings management research commonly focuses on when identifying earnings management (Dechow et al., 1995).

There is extensive prior research towards management's specific objectives when managing earnings that can mostly be summarized as influencing the outside perception of management performance and company performance.

Regarding management performance, Guidry et al. (1999) showed earnings management to be applied to maximize management's short-term bonuses by boosting key performance measures. Also, Healy (1985) demonstrated earnings management to be used to decrease earnings during fiscal years during which financial targets are anticipated to be missed in any case and this way ‘taking a bath' to more easily signal a turnaround in the following year. Similar intentions were found surrounding CEO changes, with incoming CEOs attempting to report low earnings for the year of the CEO change (Wells, 2002).

Regarding company performance, DeFond and Jiambalvo (1994) found earnings management to be related to attempts to avoid the violation of debt covenants. Documented earnings management also relates to the practice of concealing exceptionally good performance through building up reserves, such as bad debt reserves (Jackson & Liu, 2010), whose later reduction allows for income-increasing earnings management during fiscal years with worse performance - so-called ‘cookie jar reserves'. Further, Burgstahler and Dichev (1997) found earnings management to be applied to report an increase in earnings instead of a decrease in earnings or a slight gain instead of a slight loss to avoid increased transaction costs with stakeholders. Similar evidence was presented by Das et al. (2009) consistent with earnings management being applied to benefit from the reporting of smoothed income that investors may perceive as less risk-prone than variability in earnings.

While certainly motivated by trying to influence outside perception as outlined above, earnings management can also be seen as a response to outside expectations. The management of public companies faces pressure to improve results continuously. Accordingly, companies that meet or beat external analysts' expectations show higher stock returns than companies that do not (Bartov et al., 2002). Simultaneously, stock markets regularly appear to punish failing to meet earnings expectations more severely than they reward meeting them, which further underlines incentives to manage earnings (Skinner & Sloan, 2002).

Despite the extensive documentation of the objectives of earnings management, research has reached no definitive consensus on whether earnings management is necessarily detrimental to a company and its owners and thereby worth restricting. This is, for example, questioned by a study of Bowen et al. (2008) in which the authors do not find a link between accounting discretion of managers and future poor performance of the company. Also, Jiraporn et al. (2008) do not find a negative association between company value and the extent of earnings management.

[...]

• College: Maastricht University (School of Business and Economics)
• Grade: 1.0
• Author: David Port (Author)
• Publication Year: 2021
• Pages: 64
• Catalog Number: V1119262
• ISBN (eBook): 9783346496621
• ISBN (Book): 9783346496638
• Language: English
• Tags: Earnings Management, Board characteristics, Governance, Monitoring, Management, Two-tier Board, France, One-tier Board, Supervisory Board, Management Board, Board of Directors