We review recent literature on the role of financial reporting in resolving agency conflicts in corporate governance and debt contracting settings. We define corporate governance and debt contracting in a broad sense to encompass the complex set of formal and informal agreements among shareholders, managers, boards and creditors. Similarly, we define financial reporting quite broadly to include all of the information in firms financial reports that influences transparency in the information environment that encompasses the contracting parties.
A key theme of our review is the notion that a firm's contractual arrangements and its corporate information environment evolve together over time to resolve agency conflicts. That is, certain contractual arrangements work more efficiently with certain information and financial reporting choices. As a result, one does not necessarily expect to observe firms converging to a single dominant type of corporate governance structure, compensation contract, debt contract, or financial reporting system, but rather one expects to observe heterogeneity in these mechanisms that is a function of firms economic characteristics. Although this notion appears to be more widely accepted in the literature on debt contracts, the governance literature seems more burdened by the idea that some governance structures are unconditionally “good” or “bad”.
Another important aspect of our review is an emphasis on both formal and informal contracting relationships. Although formal contracts, such as written employment contracts or debt contracts, are relatively straight-forward to research due to their explicit nature, such contracts are often quite narrow in scope. Informal contracts, on the other hand, comprise implicit multi period relationships that allow the firm to engage in a broad set of activities where a formal contract is not practical or feasible. Examples of informal contracts include terms of the working relationships between managers, directors, shareholders, much of which is not covered by formal written contracts, and long-term relationships with lenders, a portion of which is built upon reputation in a repeated game setting. As we note below, the attributes of financial reporting play a key role in both formal and informal contracts, in large part because more efficient contracts (of both types) can be established when contracting parties are able to commit to a more transparent information environment.
Our review builds upon the surveys of Bushman and Smith (2001) and to some extent Lambert (2001) and Fields, Lys and Vincent (2001), and we strive to limit the overlap with those papers. Towards that end, we focus on several interesting bodies of research that were in their infancy at the time of those earlier surveys, but have since matured. Specifically, in the governance area, papers have begun to explore how a commitment to financial reporting quality influences both board structure and ownership structure (although the causality of this relation is likely to go in both directions). In the executive compensation area, although literature on the role of accounting-based performance measures has noticeably waned, a large literature on the relation between executive equity incentives and financial reporting quality has emerged. Finally, due in large part to increased data availability, empirical research on the role of financial reporting in debt contracting has grown rapidly in recent years. Throughout our discussion, we critique various aspects of these literatures, as well as provide ideas for future research.
In Section 2, we briefly discuss the firm as a nexus of contracts, the general nature of contracts related to governance and debt, and properties of the information environment and financial reports that are relevant to various contracting settings. Section 3 discusses the role of information in corporate governance, with an emphasis on corporate boards and executive compensation arrangements. In Section 4 we discuss the role of accounting information in ownership structure with an emphasis on agency conflicts between majority and minority shareholders. In Section 5, we discuss the role of financial reporting in the design of debt contracts. Section 6 very briefly discusses other parties in the firm's nexus of contracts that potentially play a role in determining its information environment. Section 7 provides a synthesis of the main themes in our review and a discussion of what we consider to be fruitful areas for future research.
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The Role of Information and Financial Reporting In Corporate Governance and Debt Contracting
