Accounting 300 words. 3hrs

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ScienceDirect The International Journal of Accounting 48 (2013) 318–323

Discussion

The Effects of Compensation and Board Quality on Non-GAAP Disclosures in Europe

Peter Fiechter⁎

University of Zurich, Department of Business Administration, Plattenstrasse 14, CH-8032 Zürich, Switzerland

1. Introduction

Reported performance measures that do not follow Generally Accepted Accounting Principles (GAAP) are labeled as “non-GAAP” figures. Non-GAAP reporting is subject to intense debate. On the one hand, extant research shows that non-GAAP measures convey relevant information (e.g., Bhattacharya, Black, Christensen, & Larson, 2003; Brown & Sivakumar, 2003). On the other hand, firms may opportunistically use non-GAAP figures for impression management (e.g., Black & Christensen, 2009; Bowen, Davis, & Matsumoto, 2005; Doyle, Lundholm, & Soliman, 2003).

The study of Isidro and Marques (2013–this issue) investigates whether specific corporate mechanisms (i.e., compensation contracts and corporate governance) are associated with opportunistic non-GAAP reporting. To the extent that non-GAAP information has an impact on share prices (Bhattacharya, Black, Christensen, & Mergenthaler, 2007), managers with share-based compensation have incentives to report opportunistic non-GAAP measures. However, strong corporate governance mechanisms may mitigate opportunistic reporting behavior (Beekes & Brown, 2006; Frankel, McVay, & Soliman, 2011).

Consistent with this theory, Isidro and Marques (2013–this issue) find that share-based compensation of directors is positively associated with the following opportunistic non-GAAP reporting practices: probability of non-GAAP disclosure, number of adjustments for recurring items, probability of non-GAAP figures in the title of the press release, and avoidance of reconciliation. In addition, Isidro and Marques (2013–this issue) find that effective corporate governance structure—as measured by a score for board quality—is negatively correlated with the probability of non-GAAP disclosure and the emphasis given to them.

⁎ Tel.: +41 44 634 28 01; fax: +41 44 634 49 12. E-mail address: [email protected].

0020-7063/$ - see front matter © 2013 University of Illinois. All rights reserved. http://dx.doi.org/10.1016/j.intacc.2012.07.009

319Discussion

The findings of the study add to the literature on non-GAAP reporting and corporate governance. In particular, the hand-collected data of non-GAAP disclosure from European firms' press releases provides opportunities to extend related literature predominantly based on U.S. data. Furthermore, as the topic is both timely and relevant (e.g., concerns expressed by EFRAG, 2009), the research of Isidro and Marques (2013–this issue) has the potential to inform regulators and standard setters on the important question whether the reporting of non-GAAP figures should be regulated more strictly.

My discussion focuses on three issues. First, I discuss the link between share-based payment and incentives to report opportunistic non-GAAP figures in Section 2. In Section 3, I analyze the role of varying institutional environments in determining opportunistic non-GAAP reporting. In Section 4, I comment on the issue on how to disentangle opportunistic from informative non-GAAP reporting. Section 5 concludes and identifies directions for future research in the area of non-GAAP disclosures.

2. Share-based contracts and opportunistic non-GAAP reporting

Hypothesis H1 predicts a positive association between share-based compensation of directors and opportunistic non-GAAP reporting. The mechanism behind this hypothesis is that the disclosure of a favorable non-GAAP measure motivates market participants to buy the stock, in turn increasing the share price, and thus maximizing managers' wealth. This hypothesis contains two implicit assumptions: (1) share-based payment induces short-term interests of the management, and (2) the market positively reacts on disclosure of non-GAAP earnings.

Although extant literature (Aboody & Kasznik, 2000) shows that CEOs maximize their own wealth by making opportunistic voluntary disclosures, recent findings by Black, Black, Christensen, and Waegelein (2011) point out the importance of distinguishing between short-term and long-term incentive plans. They find that short-term compensation schemes drive opportunistic non-GAAP reporting, whereas long-term performance plans mitigate opportunistic non-GAAP reporting. The distinction seems to be important because share-based payment is not something “bad”; rather, it is an instrument to align incentives of management and shareholders and to reduce agency conflicts. The compensation literature usually finds undesirable outcomes associated with short-term compensation plans. Therefore, without distinguishing between short-term and long-term compensation, it is difficult to make clear predictions linked to agency theory.

Unfortunately, the data from Institutional Shareholder Services (ISS) does not distinguish between short-term and long-term compensation contracts. It would be interesting to see whether varying compensation schemes have a different influence on opportunistic non-GAAP reporting in a non-U.S. setting. I therefore encourage future research to collect more detailed data on European firms' compensation plans (e.g., value of options granted or amount of non-restricted shares).

Second, previous literature usually focuses on management, particularly the CEO, whereas the ISS data uses compensation of the board of directors (BOD). As Isidro and Marques (2013–this issue) point out, the little evidence on how director compensation affects reporting decisions indeed provides new research opportunities. However, the question arises whether the incentives of the CEO and the BOD are comparable, and thus

320 Discussion

whether the findings from research based on CEO data can be translated into a BOD setting. It would be interesting to further explore any differences in incentives of CEO versus BOD compensation and their consequences on opportunistic non-GAAP reporting.

3. Variation in the institutional environment

When testing corporate governance hypotheses, the use of a European setting potentially has an advantage compared to a U.S. setting because non-GAAP reporting is not strictly regulated. Accordingly, company-specific factors can play a more important role in determining firms' reporting practices. Indeed, previous literature shows that firm-specific governance can overcome weak country-level regulation (Durnev & Kim, 2005; Klapper & Love, 2004).

However, the study of Isidro and Marques (2013–this issue) does not exploit differences in the institutional environment across the sample countries, although these differences are likely to have an impact on opportunistic non-GAAP reporting beyond firm-specific

Table 1 Institutional factors and corporate governance across Europe.

Country Institutional factors Corporate governance characteristics

N Regulatory quality

Supervisory power

Index CGQ

Industry CGQ

Independent outsider

Director compensation

Austria 19 1.62 10.50 43.03 40.26 1.00 0.00 Belgium 25 1.46 12.50 25.28 27.00 0.56 0.08 Denmark 22 1.88 10.00 25.45 24.20 1.00 0.09 Finland 31 1.67 9.00 60.02 59.81 0.81 0.52 France 83 1.17 9.00 57.15 56.74 0.36 0.66 Germany 85 1.48 9.00 54.94 54.42 0.82 0.01 Greece 44 0.81 10.00 30.86 29.98 0.11 0.00 Ireland 16 1.88 13.00 82.52 85.08 0.38 0.50 Italy 71 0.87 7.50 47.58 46.38 0.24 0.06 Luxembourg 3 n.a. n.a. 13.97 14.60 1.00 0.00 Netherlands 47 1.76 8.00 47.39 46.59 0.91 0.00 Norway 21 1.38 9.00 25.73 21.77 0.95 0.19 Portugal 14 1.07 14.00 26.03 25.51 0.50 0.00 Spain 54 1.18 11.50 26.56 25.49 0.43 0.28 Sweden 43 1.62 6.00 37.29 38.42 0.77 0.35 Switzerland 58 1.55 14.00 70.68 69.62 0.81 0.59 United Kingdom 530 1.84 9.00 84.13 83.06 0.35 0.61 Total 1166 1.45 10.13 63.67 62.84 0.49 0.41

This table presents country mean statistics for both country-level institutional factors and firm-level corporate governance characteristics of European firms as of 31 December 2005. Regulatory_Quality is an index variable constructed as in Kaufmann et al. (2009) using World Bank data. Supervisory_Power is an index variable ranging from 0 to 14 that captures the power of supervisors to demand information, take legal action against auditors, to restructure or reorganize troubled banks, and to require banks to provision for potential losses (Barth et al., 2004). Data on corporate governance is provided by the Institutional Shareholder Services (ISS). Index_CGQ is the index-adjusted corporate governance quotient by ISS comprising 61 variables. Industry_CGQ is the industry-adjusted corporate governance quotient by ISS. Independent_Outsider equals 1 if the board is controlled by a majority of independen outsiders. Director_Compensation equals 1 if directors with more than one year of service own stock.

t

321Discussion

governance. Recent international accounting research shows that institutional factors vary across European countries. Different institutional factors have two important implications for this study: (1) they directly affect the accounting quality (e.g., Ball, Kothari, & Robin, 2000; Leuz, Nanda, & Wysocki, 2003), which might be associated with opportunistic non-GAAP reporting; and (2) institutional factors shape the country-specific rules for corporate governance, thereby changing the average firm-specific governance score. Next, I illustrate these arguments with selected descriptive statistics on institutional factors and country mean values of corporate governance characteristics.

For 17 European countries, Table 1 reports country-level institutional factors and firm-level corporate governance characteristics. First, the descriptive statistics in Table 1 show that the institutional environment is indeed not homogenous across Europe. For example, the regulatory quality index by Kaufmann, Kraay, and Mastruzzi (2009) for Italy of 0.87 is substantially lower than the regulatory quality of 1.84 for the United Kingdom. The supervisory power index by Barth, Caprio, and Levine (2004) also varies across countries.

Second, the country mean values of firm-specific corporate governance characteristics as of 31 December 2005 differ across countries. For example, the mean value of director compensation for Austria is 0.00, indicating that an average BOD of an Austrian company does not own stock of the respective company. On the contrary, in the United Kingdom, the majority of BOD own stock, as documented by the country mean value of 0.61. These differences are likely attributable to different country-level rules on corporate governance. For example, Switzerland introduced the “Directive Corporate Governance” for all listed firms in 2002, and the United Kingdom tightened its rules for corporate governance reporting in 2004. These country-level differences are reflected in higher mean aggregate corporate governance scores (Index_CGQ) of 70.68 and 84.13 for Switzerland and United Kingdom, respectively, compared to countries without mandatory rules on corporate governance reporting like Austria, which has a mean score of 43.03.

Taken together, these descriptive results document that both the institutional environment and the average corporate governance substantially vary across European countries. As firms from country i have systematically different corporate governance scores than firms from country j, it is difficult to isolate the firm-specific corporate governance effect from a general country-level effect on non-GAAP reporting behavior. In addition, institutional factors (e.g., regulatory quality) can directly affect non-GAAP reporting. Therefore, I recommend further exploiting the role of institutional factors on opportunistic non-GAAP reporting. One possible research question is whether the mitigating effect of firm-level corporate governance on opportunistic reporting is more pronounced in weak regulatory environments.

4. Opportunistic versus informative reporting

The main part of the paper separately investigates four proxies that are usually employed in the literature to measure opportunistic non-GAAP reporting. In Section 6 of Isidro and Marques (2013–this issue), they seek to better distinguish opportunistic and informational non-GAAP reporting by combining their proxies. However, the empirical evidence on share-based compensation is not very strong, particularly because the sign of the coefficient is positive irrespective of whether the intention is opportunistic or informational. As the distinction between intentions is important, I suggest emphasizing this issue to allow further

322 Discussion

insights in entities' reporting strategy. For example, a firm reports a non-GAAP measure exceeding the GAAP measure in the title of the press release without providing any reconciliation. These reporting practices are likely to be driven by opportunistic reasons, so we should find even stronger positive (negative) correlations with compensation structure (board quality).

Related to that argument, Isidro and Marques (2013–this issue) use consensus beating and avoid losses as explanatory variables. Both variables equal 1 if the non-GAAP figure helps to beat the consensus and avoid reporting a loss, respectively. As expected, the authors find that these variables are positively related with the decision to disclose a non-GAAP earnings figure. While supporting the use of these variables to control for other firm incentives for non-GAAP reporting, I suggest further exploiting the underlying constructs of the two variables to disentangle opportunistic and informative non-GAAP reporting. Again, I suggest combining these variables with the other dependent variables to increase the likelihood that the firm's reporting is driven by opportunistic reasons instead of information purposes. If a firm prominently discloses a non-GAAP figure without reconciliation that exceeds the analyst consensus forecast, the firm's reporting strategy is most likely opportunistic. Using such a combined dependent variable would possibly increase confidence in the inferences drawn from the study.

Apart from their analysis in Section 6, I also acknowledge the attempt of Isidro and Marques (2013–this issue) to check whether EBIT figures in the press release differ from the EBIT in the audited financial statements (see information on data collection in Section 3). This procedure is a possible way to rule out the alternative explanation that the reported non-GAAP figure is simply a key number for internal control and thus relevant to investors. If this is the case, the reporting of such a non-GAAP figure is driven by informational rather than opportunistic reasons. Therefore, the additional tests of Isidro and Marques (2013–this issue) are important steps towards identifying opportunistic non-GAAP reporting.

5. Conclusion

The study of Isidro and Marques (2013–this issue) finds a positive relationship between opportunistic non-GAAP reporting and share-based payment of the directors. In addition, the authors find that better board quality can help mitigating two out of four non-GAAP disclosure practices, namely the disclosure decision itself and the emphasis given to the non-GAAP figure in the press release. Although the research design controls for other firm-specific determinants of opportunistic non-GAAP reporting (e.g., ownership structure), we should draw conclusions cautiously, because other not identified factors may also play a role in determining opportunistic non-GAAP reporting. Therefore, a more powerful test would be to examine whether a change in the corporate governance structure also leads to changes in the reporting behavior.

Nevertheless, the study of Isidro and Marques (2013–this issue) helps to show the link between corporate governance and opportunistic reporting of non-GAAP earnings figures. As this research area is of importance to standard setters and regulators, I encourage future research to further explore some of the issues raised in this discussion. In particular, I encourage an examination of the role that different institutional environments across countries play in determining opportunistic non-GAAP reporting.

323Discussion

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