The Role of Financial Reporting and Transparency in Corporate Governance

1. INTRODUCTION We review the recent corporate governance literature that examines the role of financial reporting in resolving agency conflicts among a firm's managers, directors, and capital providers. We view governance as the set of contracts that help align managers' interests with those of shareholders, and we focus on the central role of information asymmetry in agency conflicts between these parties. In terms of the firm-specific information hierarchy, the literature typically views management as the most informed, followed by outside directors, then shareholders. We discuss research that examines the role of financial reporting in alleviating these information asymmetries and the role that financial reporting plays in the design and structure of incentive and monitoring mechanisms to improve the credibility and transparency of information. Most of this research is large-sample and does not pay particular attention to industry-specific characteristics that may influence a firm's governance structure. For example, the firm-specific governance structure and financial reporting systems of financial institutions and other regulated industries are expected to be endogenously designed. The design is also expected to be conditional on (in other words, take into account) the existence of certain external monitoring mechanisms (for example, regulatory oversight and constraints), which may either substitute for or complement internal mechanisms, such as the board. Similarly, the rationale for regulation in certain industries (for example, the existence of natural monopolies) is also expected to influence firms' governance structures. These and other differences between firms in different industries suggest that inferences drawn from studies spanning multiple industries may not necessarily hold for specific industries or research settings. (2) The same point can also be made about extrapolating inferences drawn from U.S. firms to their international counterparts. Different countries have their own (often unique) laws, regulations, and institutions that influence the design, operation, and efficacy of a firm's governance mechanisms as well as the output of its financial reporting system. We also highlight the distinction between formal and informal contracting relationships, and discuss how both play an important role in shaping a firm's overall governance structure and information environment. Formal contracts, such as written employment agreements, are often quite narrow in scope and are typically relatively straightforward to analyze. Informal contracts, govern implicit multiperiod relationships that allow contracting parties to engage in a broad set of activities for which a formal contract is either impractical or infeasible. For example, the complexity of the responsibilities and obligations of a firm's chief executive officer make it difficult to draft a complete state-contingent contract with the board that specifies appropriate actions under every possible scenario the firm could face. Consequently, although some CEOs have formal employment contracts, these contracts are necessarily incomplete and relatively narrow in scope. As a result, the board and the CEO develop informal rules and understandings that guide their behavior over time. Much of the governance literature emphasizes informal contracting based on signaling, reputation, and certain incentive structures. The general conclusion in this literature is that financial reporting is valuable because contracts can be more efficient when the parties commit themselves to a more transparent information environment. Another key theme of this article is that a firm's governance structure and its information environment evolve together over time to resolve agency conflicts. That is, certain governance mechanisms and financial reporting attributes work more efficiently within certain operating environments. Consequently, one should not necessarily expect to see every firm converge to a single dominant type of corporate governance structure or compensation contract, or to adopt a similar financial reporting system. …