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1 September 2016 CFA Institute Journal Review

Industry Expertise of Independent Directors and Board Monitoring (Digest Summary)

  1. Marc L. Ross, CFA

The presence of independent board directors with relevant industry experience can meaningfully reduce companies’ earnings management and excessive CEO compensation.

What’s Inside?

Independent board directors with knowledge pertinent to the industries they oversee are better able to conduct their oversight function with objectivity and to bring about good corporate stewardship.

How Is This Research Useful to Practitioners?

High-level corporate malfeasance revealed in the early 2000s led to an emphasis on the importance of both board director independence and board members’ ability to monitor effectively by having the requisite knowledge to do so. The egregious events of the global financial crisis only increased academics’ and policymakers’ interest in understanding the extent to which independent directors’ (lack of) experience may have helped ruin various financial institutions through questionable governance practices.

Under the “expert monitor” hypothesis, independent directors knowledgeable about the industry they oversee can be effective in mitigating worst practices, such as earnings management (“smoothing”) and the granting of excessive pay packages to CEOs. Under the “compromised monitor” hypothesis, there is the risk that directors’ prior experience in the industry they monitor may compromise the very objectivity they are supposed to exercise because they may empathize with the travails of the company and its senior management.

The authors evaluate these two conflicting hypotheses in the context of how boards oversee corporate financial reporting. They also consider whether the presence of independent expert directors (IEDs) on corporate boards meaningfully curtails a firm’s propensity to manipulate reported financial results for personal benefit.

Using a sample of firms in the S&P 500 Index, the authors perform a robust and multifaceted analysis of the data, which confirms that an increased presence of IEDs can mitigate earnings manipulation from both an ex ante and an ex post perspective. The increased presence of board experts also curtails excessive CEO pay, heightens CEO turnover-performance sensitivity, and improves acquirer returns in diversifying acquisitions.

Those interested in best practices of corporate governance—including compensation experts, accountants, and students of behavioral finance at senior management levels—should find the authors’ conclusions relevant to their work.

How Did the Authors Conduct This Research?

The relevant literature informs the authors’ thinking and serves as the basis for their research. The dataset is taken from the universe of S&P 500 firms over 2000–2007. Using the BoardEx database, the authors focus on independent directors’ career paths. Upper-management positions include CEO, chief operations officer, chief financial officer, and the upper and divisional levels as well as chair, president, and vice president at both public and private firms. Compustat provides corporate financial data; CRSP provides stock price and return data. Financial firms and utilities are excluded because they are regulated. Sample size in the analyses is a function of the firm policy examined and the model specification used. The authors use regression analysis to gauge the effect of board member independence and knowledge on variables regarding company operations material to earnings and performance.

The authors create variables to measure such things as firms’ incentives to manipulate earnings, auditors’ degree of specialization in a particular industry, the presence of IEDs on the board, and the percentage of independent directors with financial expertise on a firm’s audit committee. These measures accompany firm book value, age, leverage, Tobin’s q, and return on assets.

The authors test the expert monitor and compromised monitor hypotheses to ascertain whether IEDs’ presence improves board oversight effectiveness and reduces earnings management. To do so, they estimate regressions of the absolute values of abnormal accruals against measures of audit committee IED presence, controlling for other firm financial and corporate governance characteristics as well as endogeneity. The authors’ results support the expert monitor hypothesis. In similar exercises, they consider how IEDs’ presence can reduce the propensity for financial misconduct; the results support the same conclusions. The authors also test whether the impact of IED presence varies across firms, industries, and CEO traits. Additional tests look at how certain industry experience may be more relevant to IEDs’ ability to curtail earnings management, including the relevance of the source of industry expertise, such as accounting-related positions. Accounting experience proves more effective in controlling earnings manipulation practices. Regressions to control for endogeneity confirm the positive influence of IEDs on the audit committee.

Finally, the authors consider the value of IEDs in the board-monitoring process vis-à-vis CEO compensation, acquisitions, and CEO turnover. Their regression analysis relates variables for these items to IEDs’ board presence and confirms their value in reining in excessive compensation practices, enhancing the value of acquisitions, and avoiding entrenched senior management.

Abstractor’s Viewpoint

Both knowledge and independence are critical to corporate board members’ ability to discharge their duties in the service of shareholders and society. The authors’ rigorous analysis of company financials and board oversight of firms reveals that board directors who maintain objectivity and keep current on industry developments are better positioned to create an environment of effective corporate governance, resulting in sounder acquisitions, properly remunerated CEOs, and greater financial transparency. Such actions benefit the bottom line. To what extent corporate cultures in other developed countries aspire to similar best practices would be an interesting topic for future research.

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