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Corporate Governance and Disclosure QualityJohn J. Forker

a

aUniversity of Bristol

Version of record first published: 28 Feb 2012.

To cite this article:John J. Forker (1992): Corporate Governance and Disclosure Quality, Accounting and

Business Research, 22:86, 111-124

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Accounting and Business Research Vol. 22. No

6. pp.

1-124, 1992

Corporate Governance

and

Disclosure

Quality

John

J.

Forker*

Abstract-The effectiveness of control exercised over executive remun eration an d the quality of informa tion disclosed

in financial statements have given rise to concern and have led to proposals for the reform of corporate governance.

A model of the optim al disclosure decision is presented in terms of m anagerial incentives and the impac t of corporate

governance structures. An investigation into the quality of share option disclosure in financial statements is used

as the basis for testing hypotheses derived from the model and for assessing alternative policy options. The results

support the need for guidance on the duties and responsibilities of audit committees and non-executive directors

but fall short of providing a basis for deciding whether regulatory action is required. The evidence also supports

the view that a threat to monitoring quality exists where the roles of chief executive and chairman are combined.

Introduction

The quality of information disclosed in financial

statements and the control exercised over executive

remuneration have given rise to concern a nd pu blic

debate in both the United States and the United

Kingdom. Reaction in the US has focused on

extending the regulation of corporate governance.

As

a means of improving internal accounting

control the National Commission on Fraudulent

Financial Reporting (1987), otherwise known as

the Treadway Commission, recommended that the

Securities and Exchange Commission require all

US public companies to establish audit com mittees

composed solely of independent non-executive

directors. This contrasts with

a

preference in the

UK

for the provision of guidance on aspects of

good governance practice. Most recently the

Institutional Shareholders Committee (ISC, 1991)'

*The author is lecturer in accounting at the University of

Bristol. Financial support from the Research Board of the

Insti tute of Chartered Ac countants in England a nd W ales and

the research assistance provided by G eoffrey Elliott and Sa lima

Paul are gratefully acknowledged. The paper was presented at

the Universities of Auckland, Bristol and the Australian Na-

tional University and at the European Accounting Association

Congress at Maastricht in April, 1991 and to the Financial

Accounting and A uditing Research conference at the London

Business School in

July,

1991. I tha nk the part icipants a t these

presentations and am particularly grateful to David Ashton,

Don Egginton, Michael Mumford, Peter Pope (Touche Ross

Fellow visiting Bristol from the University of North Queens-

land) and two anonymous referees for helpful suggestions.

'These recommendations follow publication by the invest-

ment protection committee of the Association of British Insur-

ers

(1990) of a discussion paper on the role and duties of

directors. The establishment of a Committee on Financial

Aspects of Corpora te Governance under the Chairmanship of

Sir Adrian Cadbury (May 1991) reflects the perceived import-

ance of the link between financial reporting and corporate

governance.

recommended that remuneration committees com-

prising independent non-executive directors be re-

sponsible for determining executive remuneration

and the provisions of share option schemes, and

that details of the latter be disclosed in financial

statements. The Committee also acknowledged the

potential threat posed by dominant personalities

an d expressed the view tha t the practice of combin-

ing the roles of chairman and chief executive is

undesirable.

The need for action to influence corporate gov-

ernance structure and accounting disclosure is,

however, challenged by those who view interven-

tion as more likely to hinder than improve gover-

nance.' Th e aim of this paper is to contribu te to the

debate by modelling and empirically investigating

the relationship between governance structure and

the degree of internal control exercised over man-

agerial remuneration as reflected by the quality of

share option disclosure in financial statements. Th e

finding of no association between aud it comm ittees

or non-executive directors and the qu ality of share

option disclosure supports the case for policy

action to enhance control of managerial remunera-

tion. Th e study covers the period 1987/88 when

audit com mittees and non-executive directors were

the main instruments of corporate governance.

'The case supporting this view, based on the operation of a

market in decision control for corporate governance, is pre-

sented in Fama (1980) and Fama and Jensen 1983), and is

applied to a ccounting disclosure by Benston (1982). The incon-

clusive nature of the debate

so

far is illustrated by successive

revisions of the Am erican La w Institute propo sals (1982, 1990)

for the reform of corpor ate governance. A first tentative draft

published in 1982 has to d ate been replaced b y a ten th tentative

draft. A comprehensive review of governance proposals,

to-

gether with a normative based prop osal for refo rm, is provided

in Gilson and K raakm an (1990). Tricker (1984) and Clarkh am

(1989) provide UK-based analyses of c orpora te governance.

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112 A C C O U N T I N G A N D B U S I N E S S R E S E AR C H

During that period only two firms in the sample

disclosed in finan cial statemen ts the existence of a

remuneration committee. The ISC (1991) proposal

that executive remuneration should be the specific

responsibility of a remuneration committee may

improve control and disclosure in financial state-

ments. How ever, this is likely to be conditional on

identification of the duties, and provision of de-

tailed guidance on the discharge of responsibilities

of non-executive directors an d audit a nd remuner-

ation com mittees. The identification of an inverse

relation between dom inant personalities and audit

committees and non-executive directors also war-

rants consideration. The methodology employed

does not, however, extend to providing a basis for

deciding if guidance alone would be sufficient or

whether regulation is also necessary.

Disclosure quality is described by Verrecchia

(1990, footnote 3) as the distributional ch aracter-

istic or variance of a n uncertain event. The event

focused on in this paper is the granting of share

options to employees. Deciding on the quality of

disclosure of share option information allows man-

agem ent to influence the level of uncertainty faced

by investors in estimating share option benefits.

The greater the uncertainty the less effective will be

the monitoring of share option benefits and the

greater will be the potential use of options to

increase rewards beyond levels acceptable to share-

holders.

Williamsons (1985b) analysis of transaction

costs provides a framework linking disclosure

quality to co rporate governance. This is integrated

with the positive theory of agency developed by

Jensen and Meckling (1976) to provide a m odel of

the discloure decision of management. Manage-

ment are assumed to balance potential benefits

from less disclosure against costs in the form of

lower share prices and increased threat of takeover

and to choose the quality of disclosure which

minimises the costs they incur. Adoption of in-

ternal control devices such as aud it comm ittees and

non-executive directors, an d separation of the roles

of chairman and chief executive, enhance m onitor-

ing quality and reduce benefits from withholding

information; a s a consequence disclosure quality in

financial statemen ts is improved.

Corporate Governance: The Policy Debate

Doubts about the adequacy of corporate gover-

nance in the

UK

is evident in matters relating to

executive remuneration and the impact of domi-

nant personalities on the decision making pro-

cedures of boards of directors. On the issue of

executive remuneration. the investment m otection

voting power when shareholder ap proval is sought

for executive share option schemes. A subsequent

discussion paper (ABI, 1990) directed attention

toward improving internal control, and proposed

that non-executive directors assume responsibility

for executive remuneration and the provisions of

share option schemes and that details of option

schemes be disclosed in financial statemen ts. These

proposals are incorporated in the document on

best practice published by the Institutional Share-

holders Committee (1991).

The Bank of England has adopted a wider

perspective and has repeatedly drawn attention to

what it regards as the poor state of corporate

governance in the UK. Bank of England sponsored

surveys (1983, 1985, 1988) highlight as threats to

internal control the generally low proportion of

non-executive directors on company boards, the

likelihood th at non-executive directors ap pointed

will not be independent, and the frequency with

which chief executives also act as chairmen of

boards of directors.

The policy option favoured by the British auth-

orities has been to improve internal me chanism s of

corporate governance through a process of persua-

sion and education of the business commun ity. In

1981 following failure of attempts to obtain statu-

tory backing for a proposal that companies be

required to appoint non-executive directors,

PRONED (Promotion of Non-Executive Direc-

tors) was established under the sponsorship of the

Bank of England and major City institutions, to

promo te and facilitate the appointment of indepen-

dent non-executive directors. The code of conduct

published by PRONED (1987) reflects the

UK

preference for recommendation rather than regu-

lation. This contrasts with the situation in the

US

where the governance structures of listed compa-

nies are subject to regu1ation .j This has been

reinforced by the Treadway Comm ission proposal

that all companies supervised by the SEC be

required to establish aud it comm ittees comprising

independent directors.

Corporate Governance: The Academic Deb ate

Public policy on corporate governance has been

formulated against a background of academic de-

bate abo ut the regulation of corporate governance.

Disagreem ent exists abo ut the disciplinary effect of

comp etition. Those taking a n antago nistic view of

regulation (Watts, 1977; Watts and Zimmerman,

1978; Fam a and Jensen, 1983; Scott, 1983) d o

so

because they regard market discipline as sufficient

to realise benefits associated with governance

committee of the Association of British Insurers

published guidelines (ABI, 1987) setting limits to

the benefits which be

Obtained

from

execu-

tive share o ptions- These guidelines aim to provide

financial institutions with a focus to exercise their

3The statutory and regulatory requirements relating to cor-

porate governance in the

US,

and the governance structures

adopted by

US firms,

are described in the Paris Colloquium on

Corporate Governance (1984) and Birkett (1 986).



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SP RI NG 1992 113

control mechanism s. Regulation is justified only if

it gives rise to net benefits and the onus of proof

is placed on those advocating regulation. Further-

more, different contracting structures across firms

are viewed as having different governance conse-

quences (Watts, 1988). Free choice of governance

structure is therefore considered to be important,

and regulating to impose standard forms of

governance is viewed as unnecessary and poten-

tially harmful.

Fama

(1

980) advances a theoretical explana tion

for a market in decision control. This operates

through the monitoring activities of independent

directors who have incentives to protect and

sus-

tain repu tations as experts in decision control. T he

decision ratification and ex post monitoring role

performed by boards of directors has received

similar development by Fama and Jensen (1983).

The de scriptive validity of these theories is chal-

lenged by those who are sceptical of the effective-

ness of market discipline. In part, this criticism

arose because the composition of boards of direc-

tors in practice is held to militate against effective

monitoring (Mace, 1971). More specifically, the

validity of the agency And contracting analogies

cited in support of these theories has been chal-

lenged by Clark (1985) and Brudney (1985). In

addition, P ratt and Zeckhauser (1 985) cite the

impact of retroactive effects of potential welfare

improvements on agents to explain why it cannot

be taken for granted that observed organisational

forms are op timal. Potential go vernance improve-

ments may be resisted by executives if they lead to

uncompensated reductions in utility.

Opportunism, Disclosure and Governance

Opportunism according to Williamson (1985a,

p. 47)

refers to the incomplete or distorted

disclosure of information, especially to calculated

efforts to mislead, distort, obfuscate or otherwise

confuse. By con trolling the quality of inform ation

disclosed in financial statements management

influence the uncertainty attached to the estimates

that shareholders make of any given variable.

Greater uncertainty reduces the effectiveness of

monitoring procedures, which for share options

rely on estimating costs to allow comparison of

anticipated and actual benefits. Disclosure policies

which reduce the quality of information increase

the scope for opportunistic behaviour. In the case

of share options these may be granted in circum-

stances to which shareholders would object had

more information been available.

Where opportunism is joined with bounded

rationality and asset specificity, implications arise

for the governance of contractual relations. The

need for flexibility dictates that, because of

bounded rationality, not all eventualities are

specified

ex ante

in contracts. The desire to pre-

serve a continuing c ontrac tual relationsh ip because

ABR

22/86B

of asset specificity leads to the setting

up

of gover-

nance structures. These serve to monitor the con-

duct of contracting parties and provide cost

effective means for the resolution of disputes.

The conditions of asset specificity and bounded

rationality apply to executive remuneration and , in

particular, to executive share options. T he substan -

tial investment in human capital undertaken by

executives is highly specific and often takes tim e to

develop . It is, therefore, in the interest o f firms and

their executives to devise reward structures which

incorporate a deferred component. Given uncer-

tainty an d with regard to bounded rationality, reward

structures can be expected to incorporate flexibility

to allow rewards to be related to achievement.

Share option schemes satisfy these requirements.

Share Options: The Constrained Choice Set

of

Management

The im portance of the perceived threat to share-

holders from share options g ranted to employees is

indicated by the existence of a comprehensive set

of constraints on managerial freedom of action.

These aim to assist internal con trol, facilitate exter-

nal m onitoring, set limits on the aggregate value of

options granted and impose upper limits on the

level of benefit obtained by individual executive

directors. Authority for these constraints in the

UK

is provided by the Com panies Acts, the Stock

Exchange and the Inland R e v e n ~ e .~he guidelines

issued by the investment protection committees of

the financial institutions add a private sector di-

mension to the control framework. Following

Watts and Zimmerman (1990), this network of

restrictions can be interpreted as the ex ante delin-

eation of the feasible set

of

choices available to

management. Choices made ex post by manage-

ment with respect to this set can be investigated in

the light of the scope they offer for opportunistic

behaviour. In general, the feasible set of choices

available to management serve to set an upper

bound on the benefits which can be obtained from

share options. This pape r focuses on the disclosure

dimension of managerial choice.

Option Appraisal: Information Requirements

The costs to shareholders of share option

schemes comprise the value of options w hen they

4The requirements of the Companies Acts relate to infor-

mation which must be disclosed to shareholders, and recorded

by the firm regarding options granted to directors. The Stock

Exchange L isting Agreement serves to cover gaps perceived in

the statutory requirements on disclosure, and on shareholders

rights to approve share option schemes. Tax concessions are

available only on those schemes falling within the restrictions

set by the Inland Revenue. Finally, the investor protection

committees of the financial institu tions, particularly the A ssoci-

ation of British Insurers, have issued comprehensive guidelines

imposing limits on the benefits available from option schemes.

These restrictions are summarised in Egginton, Forker and

Tippett (1989).



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114

A C C O U N T I N G A N D B U S I N E SS R E S E A RC H

are granted, the cost of administering the schemes

and the cost of dilution perceived by shareholders

at the date options are granted. The benefits take

the form of an anticipated improvement in share

price performance. Satisfaction of the objectives of

internal control and external monitoring require

determination of these costs to allow comparison

against realised share price performance. Judging

the rate of issue of options and the distribution

across individual executives depends on access to

relevant information. Less disclosure impairs con-

trol and provides scope for opportunism.

The value of options when they are granted

represents the biggest component of the cost of

options to shareholders. Determination of this

requires full information on the number

of

options

granted

N),

the exercise prices X) and the dates

during which they can be exercised T). The Com-

panies Act (1985, Sch. 4, para.

40 2))

requires

disclosure of this information if new shares are to

be issued when options are exercised, but excludes

shares to be purchased in the market. The ostensi-

ble purpose of the statutory disclosure requirement

appears to be to provide shareholders with infor-

mation on dilution rather than to exercise control

over the share option component of employee

remuneration.6 Notwithstanding this difference,

the disclosure requirements of the Companies Acts

serve as a potential benchmark for the purpose of

this study because information on the number of

optional shares, exercise prices and exercise dates

are necessary inputs for estimating the value of

options granted to employees.

lassijkation

of

Option Disclosure

The quality of share option disclosure is

classified according to the fineness of information

provided for

N, X

and

T.

In particular, only the

rule for setting X and T might be disclosed; for

example, it may be stated that exercise prices are

set equal to share prices when options are granted,

and that options may be exercised between three

and five years after the date of grant. A finer

partition is where ranges for all exercise prices and

all exercise dates are provided: for example, the

disclosure that options are exercisable at prices

between 250 and 550p and at dates between 1993

5Employee share options are an alternative to cash

or

other

benefits as a means of obtaining improved performance, and

therefore should be evaluated by comparing costs and benefits.

Where the value of options (warrants) granted equals the

expected benefit receivable, Black an d Scholes (1973) and Galai

and Schneller (1979) show that, under certain assumptions,

options granted do not adversely affect the wealth of sh arehold-

ers. Costs of dilution thus relate only to the prospect of a

reduced proportionate share in the equity capital of the firm.

61t is evident from inspection of the Articles of Association

set out in Table A to the Companies Acts that shareholders

have no direct power over executive remuneration. The C omp a-

nies Act 1989 (Sch. 7 para 2(B)), howev er, extends the disclosure

requirements applicable to options held by directors.

and 1998. The disclosure requirements of the Com-

panies Acts for options to subscribe for shares

represent a still finer partitioning where the num-

bers of options outstanding at each exercise price,

and for each exercise period, are disclosed. Other

aspects by which fineness could be measured relate

to whether disclosure is further partitioned to

reveal the distribution of options across different

schemes, and the split in holdings between options

held by directors and those held by other em-

ployees of the firm for different option schemes.

Modelling the Disclosure Decision

Disclosure quality in financial statements is

modelled as

if

management aim to minimise the

costs they associate with disclosure. The level of

these costs for different levels of disclosure is

determined by variables which include the gover-

nance structure of the firm. The disclosure dimen-

sion of the constrained choice set imposes net costs

if

no information is provided. Improvements in

disclosure quality are associated with higher infor-

mation collection costs and with increases in the

level of opportunistic benefits foregone by manage-

ment. Inversely related to disclosure quality are

costs imposed by auditors for non-compliance and

monitoring costs incurred by investors. Security

returns are assumed to be price protected and fully

to reflect disclosure costs. These costs affect man-

Disclosure

Quality

t

A

D O

CO

Costs

o f Disclosure

Figure 1

Aggregate disclosure costs are given by AA while

OB measures the opportunity

loss

management

associated with disclosure. Increasing disclosure

quality from the origin reduces the net cost of

disclosure from OA. These costs are minimised at

C;

the optimal level of disclosure is Do. For

disclosure quality better than Donet costs rise as

disclosure quality is improved.



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SPRING

1 9 9 2

5

Disclosure Qual i ty

A

Costs

o f Disclosure

Figure 2

For the same data as in Figure

1

the net cost of disclosure is illustrated. This is minimised at Do, he optimal

disclosure quality, and increases for improved disclosure quality beyond

Do.

agerial wealth through the proportion

a)

of

the firm owned by management and via the impact

of lower firm values on the threat of takeover.

These relationships are illustrated schematically

in Figures 1 to

3

where, for illustrative conven-

ience, linear functio nal forms are assume d.

OB

and

AA represent costs positively and negatively re-

lated to disclosure quality. OA measured on the

horizontal axis reflects net costs if no information

is disclosed. This cost falls as disclosure quality

improves and is minimised at Do. Figure 2 re-

flects change in net costs for different levels

of

disclosure.

Higher levels of managerial ownership or in-

creases in the vulnerability of the firm to takeover

or tighter application

of

auditing standards result

in outward shifts of aggregate costs from A oAo o

A,A , in Figure 3 and ceteris paribus increase the

optimal level of disclosure. OB reflects the oppor-

tunity loss perceived by management and is given

by (1 - a ) of the value to management from

withholding information plus a) times the firms

data collection costs. Incremental data costs and

benefits from withholding information will fall as

a result of improved monitoring by audit commit-

tees and non-executive directors and w ill shift

OB,

to OBI. Increases in the proportion of the firm

owned by management will have the same effect.

Conversely, the existence of a dominant personal-

ity increases the cost associated with disclosure

from

OB,

to

OB,

and,

ceteris paribus,

lowers

disclosure quality.

Hypotheses

From the model, the following six relationships

based on the determinants of the cost functions

facing management are hypothesised. The higher

are the costs of collecting information, the lower is

the quality of information disclosed. These costs

are likely to be determined by the number of

schemes operated, the num ber of participants, the

number of executive directors and the proportion

of options held by directors. Firms ar e not required

to identify either the different types of scheme

operated o r the numbe r of participants. Analysis of

disclosure quality in the sample revealed large

firms to b e m ore likely to disclose data agg regated

across schemes and this disclosure is of below

average quality. Firm size may therefore be a

proxy for d ata collection costs. These costs are also

inversely related t o the p roportion of options held

by directors. Firms are required by the Companies

Act (1985, s. 325) to maintain a record of options

granted to directors

so

the incremental collection

cost is lowe r for these options. Firm size measu red

by the value of equity also proxies for the threa t of

takeover. The adverse impact of poo r d isclosure on

share prices,

ceteris paribus,

increases the threat of

takeover (Manne, 1965). This effect is proportion-

ately greater the lower is the market value of the

equity of the firm so that, for a given level of

Aggregate data was provided for some

or

all option schemes

by 89

firms

of which 63 were in the top 100 sample.

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116

A C C O U N T I N G A N D B U S IN E S S R E SE A R C H

Disclosure Qual i ty

t

I

A 0 A 1

Cos ts of Disclosure

Figure 3

Increases

in

aggregate costs from

A,A,

to

A , A ,

(caused for example by increased sensitivity to the threat of

takeover and increased managerial ownership interest

in

the

firm

r reduced opportun ity losses shifting

OB,

to OB,

(caused by improved governance monitoring or a smaller interest in op tions) increases, ceteris paribus,

the optimal level of disclosure from

Do

to

D,.

The dominant personality effect shifts the opportunity loss

function from

OB,

to

OB, and, ceteris paribus,

reduces disclosure quality.

disclosure, the impac t on the threa t o f takeover will

be greater the smaller the firm.

H , Ceteris paribus, the smaller the firm and

the higher the proportion of options held by

directors, th e better w ill be disclosure qua lity.

The

UK

Companies Acts require disclosure in

financial statements of information on share op-

tions granted by the firm. This imposes an obli-

gation on auditors to verify compliance with these

disclosure requirements. Non-compliance warrants

qualification of audit reports. While departures of

this nature may be passed over in practice, poor

disclosure quality relative to statutory require-

ments is assumed to generate tension between

auditors and management. This increases the

probability o f an aud it qualification in the event of

a substantive disagreement with management over

accounting policy. As a negative association has

been identified between audit qualifications and

share price returns (Firth, 1980), it is assumed that

due to auditor pressure aggregate disclosure costs

wiil increase for levels of disclosure below statu tory

requirements. This pressure is assumed to be posi-

tively related to the technical competence of audi-

tors and to exist at

a

uniformly high level for the

homogeneous group of auditors comprising the

big six.

H,

Ceter is paribus, firms audited by the big

six provide a higher optimal level

of

disclos-

ure compared to others.

In the positive theory of agency (Jensen and

Meckling, 1976) an d the mo del presented in this

paper, the proportion

a )

of equity owned by

management plays a centrol role. From the model

three distinct effects of

a)

on disclosure quality

can be identified. Two of these are positive while

the third is negatively related to disclosure quality.

The higher is a) the greater will be the level

of

costs incurred and,

ceteris paribus,

the higher is

disclosure quality. Similarly, the opportunity loss

given by (1

)

is lower and disclosure quality is

higher. However, the burden to management of

information collection costs is positively related to

a )

and this negatively affects disclosure quality.

H, Ceteris paribus,

the proportion of equity

owned by management bears an indetermi-

nate relation to disclosure quality.

The recommendations of the Treadway Com-

mission and the Institutional Shareholders Com-



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S P R I N G 1 9 9 2 117

mittee are based on the view that features of

corporate governance have the potential to en-

hance monitoring a nd internal accounting control.

Any improvement in mon itoring share option ben-

efits associated with audit committees and non-

executive directors reduces the scope management

perceive for acting opportunistically and improves

disclosure quality . Th is effect is reinforced because

monitoring in order to be effective requires infor-

mation. Incremental information collection costs

of disclosure should be lower if internal control is

improved and so disclosure quality will be im-

proved.

Agency theory predicts the setting up of audit

committees and appointment of non-executive di-

rectors as a means of attenuating agency costs.

Disclosure in financial statements is the obvious

means of communicating the existence of these

devices to the market but, paradoxically, not all

firms having audit committees

or

non-executive

directors disclose them.8 It is possible th at disclos-

ure in financial statements enhances monitoring

and for this reason the audit committee and non-

executive variables, based as they are in this p aper

on disclosure rather than existence, may increase

the likelihood of identifying a positive associa tion.

H, Ceteris paribus, the disclosure in financial

statements

of

audit committees and non-ex-

ecutive directo rs is positively associated with

disclosure quality.

There is widespread acknowledgement, typically

based on anecdote, that a dominant personality

commanding a firm may be detrimental to the

interest of shareholders. These fears have been

fuelled in the UK because of difficulties

experienced by prominent firms where the role of

chairman and chief executive were combined. Ball

and F oster (1982, fn. 19) cite do mi nan t personality

as a possible research issue. Fama and Jensen

(1983, p. 319) take a relaxed view of this phenom-

enon. In their opinion any adverse consequences

were eliminated by market discipline; those who

sThis phenom enon is not restricted to the

UK.

N o firms listed

in New Zealand in 1981 with an audit com mittee disclosed the

fact in their financial statements (Bradbury, 1990). Comparing

the data for this study with the findings of a survey

of

the 1985

Times I000

firms (Marrian, 1988) reveals that

10

firms in the

Top

100 firm

sample had a udit committees but did not report

this in their financial statements for 1987/88. It appears,

therefore, that

41

firms in the sample may have had audit

committees althoug h only 31 disclosed this in the acc ounts.

I

am

grateful to Ian Ma rrian a nd Aileen Beatt ie

of

the Institute

of

Chartered Accountants of Scotland for granting access to their

data on au dit committees to establish this point. Of the ten firms

not disclosing an au dit committee, seven had d om ina nt person-

alities and only three were good disclosers. Reliance on

disclosure in financial statements to determine the proportion

of non-executive directors is subject to a similar limitation of

incomplete disclosure across firms. This is particularly

so

for

small

firms

(Bank of England, 1988).

survive do

so

because on balance their special skills

outweigh any costs. The model presented in this

paper assumes that dominant personalities impute

higher op portun ity losses to the disclosure of infor-

mation on sh are option benefits. T o the extent that

governance devices like audit committees and

non-executive directors create pressure for better

disclosure which is resisted by dominant personal-

ities, then it is to be expected that they will be less

inclined to establish audit committees and to ap-

point non-executive directors. Dominance is prox-

ied in this study by the disclosure in financial

statements that the roles of chairman and chief

executive are combined.

H,

Ceteris paribus, the existence of dom inant

personalities is negatively associated with dis-

closure quality, and with the existence of

audit committees and non-executive direc-

tors.

Incentives to reduce disclosure quality depend

on perceived benefits. The greater the use of share

options as a method of remuneration by the firm

the higher is likely to be the p otential benefit. In the

model, the o pportu nity loss will be greater for any

level of disclosure and, ceteris paribus, the optimal

level of disclosure lower. The prop ortion of share

option s outstan ding relative to issued share capital

and the value of options held by directors serve as

proxies for the benefit to all employees and to

directors respectively.

H, Ceteris paribus, the higher is the pro-

portion of option s to issued share capital and

the greater is the value of options held by

directors the lower will be the quality of

disclosure.

Data collection

Annual financial statements were examined for

accounting periods ending between October 1987

and September 1988 for the largest 100 and

smallest 100 UK quo ted co mpan ies in the 1988-89

Times

1000.

Three firms

in

the top 100 and fifteen

firms in the botto m 100 did not have share option

schemes, reducing the samp le available for analysis

to 182 firms. Data on sample firms was also

obtained from Datastream and the London

Business School Risk Assessment Service.

The dependent variable

The quality of share option disclosure in financial

statements was classified by the fineness of the

detail provided. Six discrete mutually exclusive

disclosure classes

A

to F were identified, ranked

from the finest to the coarsest disclosure. Firms

providing full details on the number of options

outstanding, exercise periods and exercise prices

were allocated t o class A. This is the same level of



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ABR 1992Corporate Governance and Disclosure Quality V22N86 111-124 SPRING

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Transcript of ABR 1992Corporate Governance and Disclosure Quality V22N86 111-124 SPRING