Boarding over the cracks

UK boardrooms have undergone dramatic upheaval since the financial scandals of the late eighties and early nineties cast doubt on accounting’s credibility and integrity.

As a result, UK boards must aspire to a strict list of best practice rules – clear delineation between the roles of chairman and chief executive, non-executive directors, separate sub-committees for audit, remuneration and nomination, with transparent disclosure of board procedures.

But the changes have come at a price.

The costs to companies of upgrading their boardroom culture and complying with best practice have been enormous, particularly in terms of management time.

So, is there any evidence that boards really make a difference? And do boards matter when it comes to the quality and reliability of published financial statements?

An emerging body of research has started to shed light on these questions. Indeed, as part of a major project funded by the ICAEW, Lancaster University has examined the link between board quality and financial reporting.

Using data from the nineties for all UK-based companies on the London Stock Exchange, we have found evidence of a link between board structure and accounting quality.

To measure board quality, we began by examining companies identified by the Financial Reporting Review Panel as having violated UK GAAP. In terms of explaining blatant breeches of accounting standards, boards did indeed make a difference. These companies were significantly less likely to have an audit committee than a control group of non-violation companies. The board of an average company investigated by the FRRP also typically contained a lower proportion of independent non-execs.

For a more subtle approach, we looked at companies that used creative accounting within the constraints of GAAP to see whether that activity was linked to the quality of board monitoring.

Using a statistical model that captures unusual working capital accruals behaviour, we estimated the level of creative accounting activity. We found that the use of income-increasing creative accounting practices was substantially lower for companies whose boards are composed of a higher fraction of non-execs.

Interestingly, this monitoring role of non-execs was only apparent following the adoption in 1993 of the Cadbury’s recommendations on board structure and composition. In the pre-Cadbury regime, we found no evidence of a relation between board quality and the use of income-increasing creative accounting practices aimed at avoiding losses and earnings declines.

In short, this suggests that appropriately structured boards are now more effective at discharging their financial reporting duties than was the case before the good governance bandwagon gained momentum.

An alternative perspective on accounting quality is earnings timeliness. Management often faces incentives to speed up reporting of good news and delay bad news, resulting in a biased view of company performance.

Our study confirmed the link between the timely recognition of bad news and good board quality. In particular, companies whose boards comprise a high fraction of non-execs recognised bad news in earnings significantly quicker than companies with fewer non-execs.

Evidence that director integrity and board structure play a key role in ensuring the quality and reliability of published financial statements is not restricted to the UK. Similar conclusions are starting to emerge from the US, where research shows that board independence, audit committee independence and the financial competence of directors all have an impact on the quality of published numbers.

UK boards have come a long way in the last 15 years, but there is considerable scope for improvement. Both the Higgs and Smith reports, for example, emphasise the ‘people’ aspect of good governance, arguing that effective training, induction and appointment procedures are critical to maximising the governance contribution of non-execs.

This seems particularly relevant to financial reporting, especially in light of the switch to IFRS. The recommendations of the Smith report that at least one member of the audit committee should have significant, recent and relevant financial experience seems particularly appropriate in this context.

Ensuring that board members have sufficient time and energy to devote to their board duties is also central to delivering good governance and higher quality financial reporting. Many companies limit the number of additional non-exec positions that their full-time directors can hold. This seems reasonable and necessary given the ever-increasing demands placed on board members’ time.

At the same time, forcing companies to cast their nets wider when recruiting board members also helps stimulate greater diversity in the director pool – something that has been seriously lacking in many UK boardrooms.

The strategy of appointing ‘figurehead’ non-execs with little sector-relevant expertise and numerous additional board commitments may help to ensure compliance with the letter of the combined code. However, it does little to uphold the underlying principles of good governance on which the code is based.

As with financial reporting, it is substance, not form, that ultimately counts when it comes to effective governance.

Steven Young is senior lecturer in accounting at Lancaster University Management School

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