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Employment Capital, Board Control, and the Problem of Misleading Disclosures *

2007; Pittsburg State University; Volume: 19; Issue: 3 Linguagem: Inglês

1045-3695

William J. Donoher, Richard Reed,

Financial Reporting and Valuation Research

Recent years have witnessed unprecedented levels of accounting irregularities and scandals, leading to a thorough re-examination of governance practices and the institutionalization of mandated governance and accounting standards such as those incorporated in the Sarbanes-Oxley Act. Left unanswered by all of the publicity and legislation is the question whether the phenomenon has been fully and properly understood. Although agency theory (Fama and Jensen, 1983; Jensen and Meckling, 1976) speaks to the issue of monitoring and control of executive discretion, do we know enough about how governance structures operate in different contexts to be confident that we can reduce the incidence of problems such as misleading disclosures? We seek to contribute to our understanding of the dynamics of the disclosure process and effective governance design by examining the response of CEOs to threats to their employment capital and the relationship between the board and the CEO. To date, the majority of published research on misleading disclosures has appeared in the accounting literature and focuses rather narrowly on audit and litigation issues (e.g., St. Pierre and Anderson, 1984; Stice, 1991). More recently, work investigating misleading disclosures has started appearing in the management literature (e.g., Dunn, 2004; Latham and Jacobs, 2000; Reed et al., 2004). Like this emergent research, our work is grounded in management thought rather than accounting theory and practice. We draw primarily on agency theory (e.g., Fama, 1980; Jensen and Meckling, 1976) to focus on the tension between managerial motivations and the ability to control managerial decision making. In short, this research adopts more of a governance perspective than a broad behavioral approach. Although we apply prospect theory (e.g., Kahneman and Tversky, 1979)--a behavioral framework--we do so within the context of the agency relationship. Understanding the framework presented here also necessitates a brief recapitulation of agency theory, particularly as it relates to the problem of misleading disclosures. In the modern corporation, the separation of ownership from management results in an efficient division of labor and differential risk-bearing in which shareholders, as risk-bearing specialists, can reduce their exposure by diversifying their portfolio of securities, while managers, who have skills in formulating and implementing strategy, seek to maximize returns within individual companies (Berle and Means, 1932). This separation of roles implies that the interests and motives of owners and managers can diverge, thereby giving rise to an agency problem (Fama and Jensen, 1983; Jensen and Meckling, 1976). Because they cannot diversify their employment capital (Fama, 1980), managers may have positive incentives to pursue strategies and make decisions that are suboptimal for shareholders (Eisenhardt, 1989; Lee and O'Neill, 2003). The inability of managers to diversify employment capital leads to two critical considerations relevant to the disclosure process. First, any impairment of employment capital necessarily will be borne directly by the managers concerned. Thus, the value of their employment capital will fluctuate with reported results, and disappointing or below-target outcomes will decrease its value. Second, given this relationship between performance and employment capital value, board oversight of the disclosure process is crucial. Indeed, theorists generally advocate strengthening the role and power of the board of directors in order to mitigate the agency problem (e.g., Deutsch, 2005; Fama and Jensen, 1983; Walsh and Seward, 1990; Zahra et al., 2005). In the context of misleading disclosures, the board's proximity to management, and its ability to review strategy and performance on an ongoing basis, gives the board the greatest likelihood of discovering and correcting any misbehavior. (Shareholders, even large ones, are external to the disclosure process and may not be able to uncover problems. …