It’s All Roses for Well-Connected Boards
Business deals and professional relationships have always flourished in settings outside the office for instance, charity organizations, college alumni groups, and, certainly, the golf course. Yet research from Professor Gopal Krishnan suggests the social ties that individuals cultivate there have assumed new meaning in the decade since the Sarbanes-Oxley Act of 2002 (SOX).
A recognized expert on auditing and corporate governance, Krishnan studied the effect that social ties between board members and CEOs or CFOs have on earnings management. He found that firms with boards that have more social connections with these C-level executives are more likely to engage in the use of such techniques, which can paint a deceptively rosy picture of the company’s financial position.
“Social ties can undermine board effectiveness, because directors are supposed to provide a monitoring role,” Krishnan said. “If they are buddy-buddy with the CEO or CFO, it would become very difficult for them to strictly control the senior management.”
In corporate governance parlance, that means CEOs could “capture” those board members so as to pursue their own personal agendas.
To reach their conclusions, Krishnan and his co-authors analyzed data from approximately 1,300 firms over a six-year period, assessing variables such as earnings forecasts and biographical information for board members and executives.
Specifically, the researchers sought to measure how social ties affected three types of earnings management:
- To avoid reporting a loss,
- To avoid reporting an earnings decline, or
- To avoid failing to meet or beat analysts’ earnings forecast.
Measures of all three factors confirmed that social ties “undermin[ed] directors’ formal independence, resulting in more earnings management and lower information quality in both the pre- and post-SOX time periods.”
Significantly, they found that SOX appears to be working: post-2002, firms with more social ties showed a greater decline in earnings management. All three types of earnings management declined after SOX, proportionate to the presence of social ties.
The results also suggested that CEOs’ social ties, more than those of CFOs, influence earnings management. That reflects CEOs’ broader governance power, Krishnan said, as well as their larger role in selecting board members.
Of course, social ties do not necessarily mean board members will go so far as to overlook outright fraud. Social connections might, however, increase their reluctance to challenge a CEO’s actions, or their willingness to “play along” when financial reporting tiptoes into a gray area.
“The shared characteristics and life experiences…can also undermine, consciously or unconsciously, the ability of a formally independent director to question or disagree with a CFO/CEO’s attempt at managing earnings,” Krishnan wrote.
Regulations dictate that board members must be independent—that is, they cannot have financial or family ties to a firm or its top executives. Social ties, however, are fair game.
SOX’S SOCIAL EFFECTS
Krishnan found that after SOX was implemented, CEOs and CFOs chose more socially connected board members than before, presumably as a way to circumvent tighter standards for board independence. The social ties he and his co-researchers studied included shared past employers, education at the same institutions, and activities such as golf club or charity memberships.
Social relationships can be a double-edged sword, Krishnan pointed out. These days, students of business and other disciplines are frequently advised to take advantage of social connections—and to network to deepen those connections even further. Young professionals learn early and often that “it’s all about who you know.”
Social ties also may yield business benefits. “The better networks you have, the better you can probably identify new customers, new markets, new products—all those things that may actually be beneficial to shareholders and the company,” Krishnan said. “The downside is that the social ties would somehow weaken the monitoring role of the board.”
Weaker monitoring could translate to more aggressive earnings management, which, in turn, lowers the quality of financial reporting. That quality is critical because investors and analysts use reported earnings to gauge corporations’ financial strength. The problem is that managers have a certain amount of latitude in discretionary reporting. This allows them, if they are so inclined, to “put lipstick on a pig,” leading investors to overly optimistic projections.
Krishnan gives the example of an auto manufacturer reporting estimated expenses for future warranty repairs. “Let’s say earnings are low this year,” he suggested. “You may lower the estimate from 5 percent to 3 percent, and that would boost your earnings because you’re reporting less expense. You can play with the estimate.”
The researchers’ analysis included data from 2000 to 2007 (except 2002, the year of SOX’s enactment, to avoid possible confounding effects). They drew from databases containing firms’ annual financial information, analysts’ earnings forecasts, corporate governance control variables, and biographical data for board members and executives.
They studied board size, board independence, average length of directors’ tenure, average number of other directorships held by board members, and whether the CEO also chaired the board.
Krishnan’s study expanded on previous research in part by examining executives’ social ties with the entire board, not just the audit committee. The findings confirmed the importance of this broader scope, Krishnan said: “If you have a very good audit committee and the board is dysfunctional, the board can choose to ignore the recommendations of the audit committee.”
Born of a scandalous, Wild West era of financial accounting, SOX was designed to improve corporate governance and restore investor confidence. Those outcomes appear to have been achieved, Krishnan said, thanks to a sharp increase in regulatory scru- tiny and the threat of lawsuits against companies that fail to comply.
“I think it had a significant effect on people’s behavior,” he said. “Auditors were under a spotlight and management was subject to more scrutiny, so one would hope the financial reporting quality would improve following SOX.”
Even though Krishnan’s study highlights a potential weakness in the post-SOX environment, he doubts lawmakers will expand regulation of board independence to address social ties. In addition to drawing significant opposition—and bringing out the lobbyists in force—they would find it exceedingly difficult to reach a solution that satisfied all stakeholders, he said.
“You can protect independence in a number of ways, but you don’t want to go too far because then it becomes very difficult for the company to choose its board members,” Krishnan said. “You have to draw your line somewhere.”
When regulators tightened the rules governing who could serve on corporate boards, they likely were aware that social ties remained a potential vulnerability, Krishnan said. They faced a major challenge, however, in how best to define independence.
“The general notion was that if you make the board members independent, that would provide some oversight and increased monitoring, because that’s what directors are supposed to do,” he said. Even if regulators had an eye on social ties, Krishnan speculated, they may have underestimated just how powerful those ties could be.
Currently, Krishnan is researching factors that strengthen audit committees.
“CFO/CEO-Board Social Ties, Sarbanes-Oxley, and Earn- ings Management,” co-authored with K.K. Ramen, Ke Yang, and Wei Yu, was published in Accounting Horizons in 2011.