Center for Financial Markets and Policy
Corporate Governance Mandates and Firm Outcomes
Reena Aggarwal
aggarwal@georgetown.edu
Jason D. Schloetzer
jds99@georgetown.edu
Rohan Williamson
williarg@georgetown.edu
December 2011
http://finpolicy.georgetown.edu
Corporate Governance Mandates and Firm Outcomes*
Reena Aggarwal
aggarwal@georgetown.edu
Jason D. Schloetzer
jds99@georgetown.edu
Rohan Williamson
williarg@georgetown.edu
ABSTRACT
Regulators and stock exchanges have recently responded to perceived corporate governance
failures by mandating certain governance attributes across all firms. There has been considerable
debate whether this public policy approach achieves the desired goal even for firms that have the
weakest governance structure and are most affected by the mandates. While SOX-related
regulatory actions required all firms to adopt certain corporate governance attributes, not all
firms were equally affected. This paper identifies a unique sample of firms that were more
affected by the new corporate governance regulations compared with relatively less affected
firms. Using a propensity-score trimmed sample, we find affected firms had significantly lower
pre-regulation valuations. After affected firms adopt governance mandates, there is an increase in
affected firm post-regulation firm value compared with relatively less affected firms. This
relative increase for affected firms is not related to post-regulation differences in investment,
earnings quality, or operating performance. Rather, affected firms experience a decrease in CEO
compensation and an increase in the likelihood of CEO turnover in the post-regulation period
compared with relatively less affected firms. Overall, the evidence suggests that corporate
governance mandates enhanced firm value and improved board monitoring of firms most
affected by the regulatory action.
*
McDonough School of Business, Georgetown University. We are grateful for comments from Lee
Pinkowitz, Jason Sturgess, and workshop participants at Georgetown University. Financial support of the
Center for Financial Markets and Policy is gratefully acknowledged. Aggarwal acknowledges financial
support from the Robert E. McDonough endowment.
Corporate Governance Mandates and Firm Outcomes
ABSTRACT
Regulators and stock exchanges have recently responded to perceived corporate governance
failures by mandating certain governance attributes across all firms. There has been considerable
debate whether this public policy approach achieves the desired goal even for firms that have the
weakest governance structure and are most affected by the mandates. While SOX-related
regulatory actions required all firms to adopt certain corporate governance attributes, not all
firms were equally affected. This paper identifies a unique sample of firms that were more
affected by the new corporate governance regulations compared with relatively less affected
firms. Using a propensity-score trimmed sample, we find affected firms had significantly lower
pre-regulation valuations. After affected firms adopt governance mandates, there is an increase in
affected firm post-regulation firm value compared with relatively less affected firms. This
increase for affected firms is not related to post-regulation differences in investment, operating
performance, or earnings quality. Rather, affected firms experience a decrease in CEO
compensation and an increase in the likelihood of CEO turnover in the post-regulation period
compared with relatively less affected firms. Overall, the evidence suggests that corporate
governance mandates enhanced firm value and improved board monitoring of firms most
affected by the regulatory action.
JEL Classification: G3, G32, K22, L51
Keywords: Monitoring; SEC Regulations; Executive Compensation; CEO Turnover
I. INTRODUCTION
Corporate governance continues to receive a great deal of interest from policy makers
and market participants in response to recent financial scandals and economic crises. In the U.S.,
policy makers and stock exchanges have mandated governance changes to address perceived
weaknesses in firm oversight, with an aim to protect investors, restore confidence in the financial
system, and prevent future financial crisis. It remains an important question as to whether
mandated governance changes can improve managerial decision-making and board monitoring at
firms that are most affected by regulatory mandates. We extend the literature that examines the
relation between mandated corporate governance and firm outcomes by focusing on postregulation changes among those firms most affected by the governance mandates. Specifically,
we examine pre- and post-regulation differences in firm value, board monitoring, and managerial
decision-making, between U.S. firms that were most affected by the regulatory mandates and a
control sample of U.S. firms that were already meeting a majority or all of the mandated
governance provisions.
There is little theoretical work on the potential impact of governance mandates on firm
value. The related question posed by the current theoretical literature is whether mandates can
move firms closer to some optimal governance structure and what are the possible consequences
of mandates. Generally, mandates that move firms closer to an optimal governance level will
enhance firm value while those that move firms further away would destroy value. Harris and
Raviv (2008) use the importance of inside and outside information to analyze board composition.
The study suggests that the mix varies as relative information costs change for the respective
firm and the relation between board independence and firm value is not straightforward. The
paper argues that if insiders have important information relative to outsiders, then forcing
1
independence may be costly. Conversely, if agency costs are large then the model predicts that
that more board independence would be optimal. Therefore, regulations that mandate more
independence would be optimal. Hermalin and Weisbach (2011) focus on the optimal level of
disclosure and argue that more information disclosure can be a double-edged sword. More
disclosure which allows principals to make better decisions can increase rather than decrease
agency problems between corporate boards/shareholders and firm management. They argue that
firm value declines after some optimal level of disclosure because corporate governance reforms
that mandate more regulation could generate unintended costs, including higher CEO
compensation and higher CEO turnover.
This effect occurs because in the case of mandates
where there is no bargaining, managers would be adversely affected and hence managerial
compensation would rise to compensate. Also, the increased monitoring could rise to a point
such that costs outweigh benefits, leading to a decrease in firm value. Our study directly
examines whether firms that are more affected by recent governance mandates related to
Sarbanes-Oxley Act of 2002 (SOX) led to higher firm value relative to the control group, and the
channels through which firm value is impacted.
Our main results show that recently mandated corporate governance provisions enhanced
firm value for those firms that were most affected by the provisions. Specifically, we find that
firms that were more affected by the governance provisions included in SOX-related regulation
experience an increase in Tobin’s Q following the implementation of the provisions compared
with Tobin’s Q for control firms. One area of focus of the SOX regulation was on board
independence. The view is that more independence would enhance monitoring. Consistent with
this view, we find that affected firms had significantly lower CEO compensation in the postregulation period compared with control firms, which is consistent with boards playing a more
2
active and direct role in monitoring top management. In addition, we find that affected firms had
a higher likelihood of CEO turnover in the post-regulation period compared with control firms
supporting the notion of higher board monitoring that was intended by the legislation.
Most of the related empirical work on mandated governance changes is focused on the
overall impact of the SOX legislation. One view of the overall impact is that the SOX legislation
has taken firms away from an optimal governance structure. Consistent with this view, Zhang
(2007) provides evidence that the cumulative raw and abnormal returns around key SOX events
are significantly negative, suggesting that SOX in its entirety imposes significant net costs on
firms. Litvak (2006) assesses the impact of SOX on foreign firms that are cross-listed on U.S.
exchanges relative to foreign firms provides evidence that suggests SOX in its entirety imposed
net costs on firms. Engel, Hayes, and Wang (2006) argue that the increase in going-private
decisions suggests that firms engage in post-regulatory avoidance strategies in response to the
passage SOX. Bargeron, Lehn, and Zutter (2009) argue that the passage of SOX led to a
reduction of risk taking by managers which could lead to lower U.S. firm value compared to
U.K. firms. More directly related to SOX governance mandates, Romano (2005) argues that
requiring independent audit committees and restricting non-audit services would likely adversely
affect firm value. These studies, among others, broadly support the notion that corporate
governance mandates might not enhance firm outcomes.
On the other hand, there is a steadily growing body of research that indicates SOX and its
provisions have increased the scrutiny of public firms which, in turn, has had a positive influence
on firm outcomes. In contrast to Zhang (2007), studies by Reazee and Jain (2006) and Li, Pincus,
and Rego (2008) select different SOX-related event days and find that the cumulative event
return to SOX is significantly positive, suggesting that SOX in its entirety was beneficial to
3
firms. Cohen, Dey, and Lys (2008) find a decline in accrual-based earnings management postSOX. Hochberg et al. (2007) find that firms that lobbied against a strict implementation of SOX
experience significantly positive abnormal returns over the passage of SOX relative to firms that
did not lobby, suggesting that SOX improves the disclosure and governance of lobbying firms
and provides benefits to shareholders. Ashbaugh-Skaife et al. (2006) find cost of equity benefits
from resolving internal control deficiencies. Berger et al. (2006) show that stock market
reactions to SOX are more positive for foreign firms from countries with weaker enforcement of
investor rights, suggesting that SOX in its entirety could improve the protection of outside
investors in such firms. These studies, among others, broadly suggest that SOX and its
provisions mitigate unresolved agency problems between corporate insiders and outside
investors (Leuz 2007).
We contribute to this on-going debate indirectly by investigating the relation between
SOX provisions that mandate certain corporate governance attributes across firms, postregulatory firm value, and board monitoring. The legislation addressed many aspects of firm
reporting, managerial responsibility and governance, our goal is not to address whether the
overall SOX legislation was value increasing or decreasing but a more focused question of
whether governance mandates improve firm value and outcomes for firms most affected by the
changes.
We measure corporate governance in a large sample of firms using data from
Institutional Shareholder Services (ISS) from 2000 through 2009. We then construct a firm-level
governance score from 41 governance attributes that are consistently measured throughout the
period. Of these 41 governance attributes, we identify ten that were affected by SOX-related
regulatory mandates passed in 2002. We use these ten attributes to define “affected firms” as
those firms that were forced to make more changes to their governance structures post-SOX due
4
to regulatory mandates compared with a sample of “control firms.” These control firms were
already in compliance with a majority or all of the regulatory mandates in 2002 having
voluntarily adopted the governance attributes that were later mandated by regulation. Hence the
control firms required fewer or no changes to their governance structures. We study the affected
and control firms over the period 1996-2009 in order to examine changes over the pre- and postregulation time period. We follow developments in the econometrics literature (Crump, Hotz,
Imbens, and Mitnik 2009; Imbens and Wooldridge 2009) and use propensity score trimming to
select a subsample of affected and control firms that display covariate balance, facilitating a
comparison of affected and control firms pre- (1996 through 2002) and post-regulation (2005
through 2009). We then focus on measures of firm value and board monitoring to assess the
consequences of corporate governance mandates for the sample of affected firms relative to
control firms.
Our empirical analysis proceeds as follows. First, we analyze whether there are general
differences in corporate governance between affected and control firms during the postregulatory period. We document that affected firms continue to have lower governance scores
compared with control firms throughout the post-regulatory period. However, the gap between
governance scores reduces considerably, with affected firms (control firms) adhering to 68
percent (74 percent) of the 41 governance attributes in 2009 compared with 41 percent (62
percent) in 2002. This suggests that control firms continued to adopt stronger governance
voluntarily in the post-regulation period.
Further, affected firms also voluntarily adopted
additional governance measures in the post-regulatory period. Thus, the corporate governance
mandates imposed by SOX-related regulation likely had a relatively more important influence on
5
corporate governance for affected firms relative to control firms and thereby could yield different
implications for firm value and board monitoring between the two samples.
Our main contribution establishes that recently mandated corporate governance
provisions enhanced firm value for those firms most affected by the regulation. Specifically, we
find that firms that were more affected by the governance provisions included in SOX-related
regulation experience an increase in Tobin’s Q following the implementation of the provisions
compared with Tobin’s Q for control firms. We document that the value of affected firms was
significantly lower than that of control firms before the regulatory mandates, however, in the
post-regulatory period, the difference in valuation of the two groups is not significantly different
even after controlling for other firm characteristics. Further, we show that the relative increase
in firm value occurs between 2004 and 2007, the period immediately after the implementation of
the regulatory mandates. Overall, this evidence is consistent with the findings of Chhacochharia
and Grinstein (2007) that less compliant firms exhibited positive abnormal returns at the time the
rules were announced.
We extend this contribution by providing new insight about the potential path through
which governance mandates could affect firm value. A key feature of SOX-related governance
provisions was to increase board independence, suggesting that the prevailing view among
regulators is that it is in the interest of investors for corporate boards to be dominated by
independent directors (Harris and Raviv 2008). This view is partly driven by agency
considerations; only independent directors can effectively curtain agency problems. Hence, the
governance mandates were expected to enhance board monitoring, including the board’s
willingness to discipline underperforming managers. Consistent with this view, we find that
affected firms had significantly lower CEO compensation in the post-regulation period compared
6
with control firms, which is consistent with boards playing a more active and direct role in
monitoring top management. In addition, we find that affected firms had a similar likelihood of
CEO turnover in the post-regulation period compared with control firms. We also document that
the likelihood of CEO turnover is not significantly different between affected and control firms
in the post-regulation period, suggesting that turnover rates in the post-regulation period between
the two samples has become similar. This is consistent with the view that SOX-related
governance provisions have enhanced the scrutiny of public firms which, in turn, has had a
positive influence on firm outcomes.
An alternative path through which governance mandates could affect firm value is by
changing important business decisions. We examine several managerial decisions and show that
firms maintained the same level of investments and the same level of accounting performance as
before the initiation of the mandates. Managerial decisions pertaining to accruals did not change
in the post mandate period for the affected firms.
This finding is consistent with mandated
governance provisions improving monitoring and disclosure resulting in reduced asymmetric
information costs and increases in firm value. However, the regulatory mandates did not result
in differences in managerial decision-making between affected and control firms.
Section II reviews the methodological approach. Section III discusses the data and
variables. Section IV examines the governance mandates and their impact on firm value, and
Sections V and VI report the results on mandates and board monitoring. Section VI concludes.
II. METHODOLOGICAL APPROACH
Since the passage of the Sarbanes-Oxley Act of 2002, a growing body of research has
attempted to evaluate the impact of regulatory mandates on firms. In particular, several studies
use an event study approach that identifies various event dates involving the passage and
7
implementation of SOX-related legislation in its entirety to examine short-window market
reactions around such events (Rezaee and Jain 2006; Chhaochhaira and Grinstein 2007; Zhang
2007; Li, Pincus, and Rego 2008). The key problem for event studies is that SOX applies to all
exchange-listed and SEC-registered firms (Leuz 2007). Without a natural control group of
comparable, but unaffected U.S. firms, it is difficult to remove market-wide effects that are
unrelated to SOX but occur in SOX-related event windows. For example, Leuz (2007)
demonstrates that SOX-related event windows frequently include major political and economic
news and overlap with changes in NYSE and Nasdaq listing requirements.
To address the identification concern, studies have used foreign firms as a benchmark in
an attempt to remove confounding news events that influence U.S. market returns around SOXrelated event dates. Zhang (2007) subtracts foreign market returns from the U.S. market return,
which substantially reduces the cumulative abnormal return around SOX-related events. Litvak
(2007) finds that foreign firms that are listed in the U.S. and subject to SOX react more
negatively than either matched cross-listed foreign firms that are not subject to SOX or noncross-listed foreign firms. Bargeron, Lehn, and Zutter (2009) present evidence that the passage of
SOX led to a reduction in risk taking by managers, which could lead to lower firm value among
U.S. firms compared with U.K. firms. However, using foreign firms may not entirely control for
country-specific news and general market conditions.
An alternative approach is to identify firms that a priori are likely to be differentially
affected by specific SOX-related provisions. This identification strategy relies on the ability to
identify firms that are differentially affected by specific SOX provisions (e.g., varying
compliance with mandated corporate governance provisions) and, at the same time, are not also
differentially affected by other SOX-related provisions (e.g., Section 404 material weaknesses).
8
This study adopts this approach and identifies a sample of firms that are likely to be differentially
affected by SOX-related corporate governance mandates as our treated group and compares them
to firms that are likely to be relatively less affected by the governance mandates. We follow
recent developments in the econometrics literature (Crump et al. 2009; Imbens and Wooldridge
2009) and use propensity score trimming to select a subsample of affected and control firms that
display covariate balance, facilitating a comparison of affected and control firms pre- (1996
through 2002) and post-regulation (2005 through 2009). This approach enables us to isolate the
impact of governance mandates on firm outcomes while mitigating endogeneity concerns that are
generally prevalent in corporate governance research.
III. SAMPLE, DATA, AND VARIABLE DESCRIPTIONS
3.1 Corporate Governance and SOX-related Governance Mandates
We measure corporate governance at the firm-level using data from Institutional
Shareholder Services (ISS). We exclude Finance and Insurance firms (two-digit NAICS of 52)
and firms with dual-class structures because several of the new regulations do not apply to
controlled firms with concentrated voting rights. Consistent with Bebchuk and Cohen (2005), we
exclude REITs (SIC 6798), which have unique governance structures.
We start with 41 governance attributes for each firm beginning in 2002. These 41
attributes can be classified into four sub-categories: Board (24 attributes), Audit (3), Antitakeover (6), and Compensation (8). Prior studies that examine aspects of the relation between
corporate governance and firm value have used ISS data to create a firm-level corporate
governance index (e.g., CITATIONS). We identify ten governance attributes within the ISS data
that were affected by SOX-related governance mandates:1
1
There is not a complete one-to-one mapping between the ISS criteria and the SOX-related governance mandates.
For example, the ISS definition of independent director is more stringent than that mandated by regulation. Another
9
1.
2.
3.
4.
5.
The Board must consist of majority independent directors.
Non-management directors must have executive session without management.
Nominating Committee must have only independent directors.
Compensation Committee must have only independent directors.
Audit Committee must have only independent directors and a minimum of three
members.
6. Firms must adopt corporate governance guidelines.
7. Performance of the Board is reviewed regularly.
8. Board approved succession plan is in place for CEO.
9. Stock-incentive plans adopted with shareholder approval.
10. Consulting fee paid to auditors is less than audit fee paid to auditors.
We believe that these ten governance attributes represent a reasonable proxy for SOX-
related governance mandates. Some firms had already adopted a majority or all of these
provisions prior to 2002. Therefore, we are able to examine the relation between these
governance attributes and firm value in the period before regulation required them. Other control
mechanisms, for example, CEO/CFO certification of periodic reports (Sections 302 and 906),
were not adopted by firms prior to 2002 and hence we cannot study these SOX-related
provisions in the pre-regulation period. We follow prior studies (e.g., Gomper, Iishi, and Metric
2003; Bebchuk, Cohen, and Ferrell 2004; Bebchuk and Cohen 2005; Brown and Caylor 2005)
and construct a governance index by assigning a value of one to a governance attribute if the
firm meets minimally acceptable guidelines, and zero otherwise. Each of the ten governance
attributes is assigned equal weight and we sum the dummy variables and express the index as a
percentage. Thus, the maximum (minimum) governance index is 100 (zero) percent if a firm
adheres to all (none) of the mandated governance provisions in 2002.
example is that new regulations only require that firms adopt corporate governance guidelines but ISS in addition
requires that they be published. The ISS criterion not only requires the audit, compensation, and nominating
committee to be composed solely of independent directors but also requires that each committee be able to hire its
own advisors. These higher ISS standards could impact our inferences because firms at the minimum level of
compliance could lead to some cross-sectional differences even after compliance.
10
To identify firms that a priori are likely to be differentially affected by SOX-related
governance mandates, we split the sample firms into two categories based on the extent to which
they were voluntarily meeting the ten mandated regulations. Conceptually, we use the ten ISS
attributes to define “affected firms” (AFFECTED) as those firms that were forced to make more
changes to their governance structures post-SOX due to regulatory mandates compared with a
sample of “control firms.” These control firms (CONTROL) were already in compliance with a
majority or all of the regulatory mandates and hence required fewer or no changes to their
governance structures.2 Specifically, AFFECTED firms are those that complied with the median
or fewer of the ten regulations as of 2002 and therefore were required to make significant
changes to their governance structure.3 The median number of regulations met by our sample
firms is four out of ten; therefore AFFECTED firms met four or fewer of the SOX-related
governance attributes. CONTROL firms met at least seven of the ten regulations in 2001 or 2002
and hence were less likely to be required to make significant changes to their governance
structure. Few firms had adopted certain governance attributes in the pre-regulation period; for
example, only 2.9 percent of firms tracked by ISS held meetings of outside directors without the
CEO, while only 9.2 percent of firms had a board-approved CEO succession plans (untabulated).
2
Our classification strategy is broadly consistent with several recent studies. Duchin, Matsusaka, and Ozbas (2011)
use a sample of firms that were required to increase the number of independent directors to examine the relation
between board independence and firm performance. The paper shows that the cost of information acquisition
influences the effectiveness of outside directors. Kim and Lu (2011) find that mandating a majority of independent
directors has led to modifications in board composition that maintained top management’s influence over the board
while facilitating compliance with regulatory mandates. Dahya and McConnell (2007) classify U.K. firms that did
and did not voluntarily adopt Cadbury Commission governance recommendations.
3
Although SOX was passed on July 30, 2002, and NYSE and Nasdaq corporate governance listing standards were
approved by the SEC in November 2003, firms were given through 2004 to comply with many of the governance
mandates. However, several exceptions were granted. For example, firms with classified boards were allowed an
additional year to comply. Also, listed firms were given until their first annual meeting after June 30, 2005, to
replace directors in order to satisfy the revised definition of independence. Exemptions were also granted to certain
types of firms, for example, controlled firms in which more than 50 percent of the voting power is held by a single
individual, group, or another entity were not required to have independent boards and independent nominating and
compensation committees. Similarly, small firms were allowed extra time to comply. However, many firms adopted
these governance attributes before regulation addressed them while other firms implemented the rules during the
2003 through 2004 period in order to meet the compliance deadline.
11
In addition, less than one percent of firms had adopted all ten governance attributes and less than
7 percent had adopted at least seven attributes. (untabulated). Thus, defining CONTROL to be
firms that met at least seven attributes appears to be a reasonable threshold.
Table 1, Panel A reports the distribution of AFFECTED and CONTROL firms from 1996
through 2009. We use our 2002 identification process to classify firms pre- and post-regulation
into the AFFECTED and CONTROL samples. We remove firms that complied with five or six
governance attributes from our analysis and focus instead on comparisons between AFFECTED
and CONTROL firms. Affected firms comprise 82 percent to 86 percent of the total sample from
1996 to 2009. While we use 2002 to classify firms into AFFECTED and CONTROL, the
proportion of these subsamples remains relatively constant across time, indicating that
AFFECTED firms fall out of the sample at approximately the same rate as the CONTROL firms.
Our sample has 11,831 AFFECTED firm-year observations and 2,283 CONTROL observations
across the 1996-2009 period.
Table 1, Panel B reports the distribution of AFFECTED and CONTROL firms after we
trim the sample using propensity score method. This propensity score trimmed sample is used
throughout our empirical analysis. Crump et al. (2009) suggest an implementable way of
selecting a subsample to improve overlap in covariate distributions that is consistent with the
current practice of dropping observations with propensity score values close to zero or one. Their
method is generally applicable and in particular does not require that the control sample be larger
than the treated sample. This is especially useful in our research setting, as the number of firms
that meet at least seven governance mandates in 2002 is significantly smaller that the number of
firms that were less likely to be significantly affected by the governance mandates. This
imbalance in sample sizes prevents us from using matching with replacement methods.
12
We begin our trimming process by estimating propensity score values for the likelihood
of being classified as AFFECTED versus CONTROL in 2002. It is well-known that governance
indexes are correlated with measures of firm size, growth rates, and industry membership. To
address this issue, we use the natural logarithms of total assets, revenues, and market value of
equity, year-on-year sales growth, and two-digit NAICS industry membership to estimate firmlevel propensity score values. Because accounting for firm size is particularly important, we also
include a squared term for total assets in the estimation. After estimating propensity scores, we
follow Crump et al. (2009) and drop observations with values less than 0.1 and greater than 0.9,
which represent observations that would likely be difficult to match within the sample. This
trimming process removes approximately 20 percent of the entire sample and approximately 65
percent of the CONTROL firms. The significant reduction in CONTROL firms is consistent with
such firms having significantly different firm-level characteristics when compared with
AFFECTED firms and thereby are not suitable comparisons. Our trimmed sample has 10,465
AFFECTED firm-year observations and 790 CONTROL observations across the 1996-2009
period. Affected firms comprise approximately 93 percent of the trimmed sample.
Table 2 reports descriptive statistics for the untrimmed and trimmed samples split by
AFFECTED and CONTROL firms. Column 4 reports that AFFECTED firms are significantly
smaller based on all three size proxies: book value of total assets (SIZE), market value of equity
(MKTCAP), and revenue (REVENUE) in the untrimmed sample. This is consistent with
arguments advanced elsewhere that the costs of SOX-related governance provisions were borne
disproportionately by smaller firms and thus could partially explain the lack of compliance in the
pre-regulation period. AFFECTED firms have higher cash holdings, higher capital expenditure
relative to total assets, less leverage, higher sales growth, lower dividend yields, higher CEO
13
stock holdings, and higher stock returns despite lower valuation as measured by Tobin’s Q and
lower return on assets. Column 5 reports normalized differences between the affected and control
samples. The size proxies differ by more than 1.37 standard deviations, suggesting problematic
imbalances in the covariate distributions between subsamples. Taken together, AFFECTED firms
are significantly different from CONTROL firms, indicating that trimming to improve balance in
covariate distributions is critical to make informed comparisons.
Table 2, Column 8 reports descriptive statistics for the trimmed sample split by
AFFECTED and CONTROL firms. The difference in firm characteristics after using propensity
score values to trim the sample is reduced. In particular, the AFFECTED and CONTROL
samples do not display significant differences across measures of firm size and sales growth,
which formed the basis for our propensity score estimation. Column 9 highlights the significant
improvement in normalized differences between the subsamples. The size proxies differ by less
than 0.02 standard deviations, suggesting improved covariate balance when compared with the
untrimmed sample. In addition, the remaining normalized differences are generally less than 0.14
standard deviations. Overall, the trimming process has enhanced the comparability between our
treated and untreated samples. In the following sections, we will use the trimmed sample to
assess the consequences of corporate governance mandates for affected firms relative to control
firms.
3.2 Differences in Corporate Governance Across Firms
Table 3, Panel A reports mean corporate governance scores by year for the trimmed
subsamples of firms that were required to make significant changes to their governance structure
(AFFECTED) in response to SOX-related corporate governance mandates and our control firms
(CONTROL). Firm-level governance increased considerably between 2002 and 2009. The mean
14
governance score for the 41 ISS governance attributes consistently measured during the 20022009 period increased from 0.421 in 2002 to 0.688 in 2009. Thus, firms adhered to 42.1 percent
of the 41 governance attributes tracked by ISS in 2002 and 68.8 percent of these attributes in
2009. AFFECTED (CONTROL) firms adhered to 41.0 percent (61.6 percent) of the governance
attributes in 2002 and 68.4 percent (74.4 percent) in 2009. This pattern of evidence suggests that
AFFECTED firms experienced a significant change in governance structure between 2002 and
2009 relative to the more modest governance changes in CONTROL firms. The final column in
Panel A highlights how the difference in governance scores between AFFECTED and
CONTROL firms narrows across time, although the difference remains significant. This
difference suggests that well after the SOX-related governance mandates were required,
AFFECTED firms remain significantly different compared with CONTROL firms with respect to
the governance attributes tracked by ISS.
Table 3, Panel B reports differences in corporate governance across size quintiles. We
divide the sample firms into size quintiles based on market capitalization in 2002 to assess
potential differences in governance across firm size. We use 2002 as the benchmark year to
examine the relation between firm size and governance prior to governance mandates. Panel B
shows the mean governance score for the 41 ISS governance attributes for the full sample and
the AFFECTED and CONTROL subsamples. The average governance score is 0.392 for the full
sample of firms in the smallest quintile, implying that on average, these firms meet 39.2 percent
of the 41 governance attributes. There is a monotonic increase in the governance score across
size quintiles. A similar pattern is observed for the AFFECTED and CONTROL subsamples.
AFFECTED firms have a lower governance score compared with CONTROL firms in each size
quintile. This is consistent with Linck, Netter, and Yang (2009); the cost of compliance with
15
SOX-related governance mandates was likely higher for smaller firms, because of the need for
these firms to make significant changes to their governance structures.
Table 3, Panel C reports differences in corporate governance across industry
membership. We use two-digit NAICS to identify industries to assess potential differences in
governance across industry for the 2002-2009 period. There is wide variation in governance
score based on industry after the passage of SOX-related governance mandates. Column 1 shows
that Utilities has the highest governance score (0.627). AFFECTED firms have directionally
lower governance scores compared with CONTROL firms across each industry, suggesting that
the identification of affected and control firms is not influenced by industry membership.
IV. CORPORATE GOVERNANCE MANDATES AND FIRM VALUE
This section examines the difference between firm value, measured by Tobin’s Q, of
AFFECTED versus CONTROL firms. One view of the implementation of SOX-related
regulations is that it shifted firms away from an optimal governance structure. Consistent with
this view, if firms in the pre-regulation period had adopted governance structures that were the
most appropriate for them then there should not be any difference between the values of
AFFECTED and CONTROL firms after controlling for other relevant firm-level attributes. We
should also find that after AFFECTED firms are required to change governance structures, firm
value should decline relative to the control group. On the other hand, there is a steadily growing
body of research that suggests SOX-related provisions have increased the scrutiny of public
firms which, in turn, has had a positive influence on firm outcomes. Thus, AFFECTED firms
could experience an increase in firm value compared with CONTROL firms.
Table 4 investigates the relation between corporate governance mandates and firm value,
measured using Tobin’s Q (Q), for the period 1996-2009. The dependent variable in columns 1-4
16
is defined as [(total assets + market value of equity – total common equity – deferred taxes)/total
assets]. The dependent variable in columns 5-8 is industry-adjusted Q. We test the prediction of
no difference in firm value between AFFECTED and CONTROL firms. We create a dummy
variable equal to one for AFFECTED firms and zero for CONTROL firms. We also examine the
impact of being required to adopt the mandated regulations by studying the relation between firm
value and the AFFECTED dummy in the post-regulation period. To control for the correlation
between firm value and other observable firm characteristics, we include the following firm
characteristics: SIZE is the natural log of total assets; CASH is the ratio of total cash and cash
equivalents to lagged total assets; CAPEX is the ratio of capital expenditure to lagged total
assets; LEVERAGE is the ratio of long-term debt plus debt in current liabilities to the sum plus
stockholders' equity total debt; SGROWTH is growth in total revenues; YIELD is the ratio of total
dividends to market value of equity; PPE is the ratio of property, plant, and equipment to total
revenue; ROA is the ratio of income before extraordinary items to total assets; RETURNS is oneyear firm stock return; POSTREG is a dummy equal to one if the firm’s fiscal year end is
December 31, 2004 or later. Columns 1-4 include two-digit NAICS industry dummies (not
reported) and standard errors are clustered by firm. We winsorize extreme percentiles (1st and
99th) of all continuous variables.
Table 4, columns 1-4 reports that the coefficient estimate for SIZE is insignificant,
consistent with propensity score trimming reducing the firm size imbalance between the two
subsamples. Columns 1-4 also reports positive and significant coefficients for CASH, CAPEX,
and SGROWTH at the 1 percent level. ROA is positive and significant at the 10 percent level,
suggesting that variation in firm performance in the trimmed sample remains important in
explaining Q. Higher leverage (LEVERAGE) and dividend yield (YIELD) are negatively related
17
to Q. In column 2, we introduce the dummy variable AFFECTED in order to examine the
difference between the firm value of AFFECTED and CONTROL firms. Over our sample time
period AFFECTED firms have lower valuation than CONTROL firms as reflected in the negative
and statistically significant coefficient.
We further investigate this negative relation to examine whether it is concentrated in the
post-regulation period. Column 3 introduces a dummy variable POSTREG to capture the postregulatory years 2005-2009. We find a negative and statistically significant relation between
POSTREG and Q, suggesting that in the post-regulation period, all firms had lower valuations
relative to the pre-regulation period of 1996-2004. We are primarily interested in the difference
between firms that were affected by the regulations versus the control firms. Hence, in column 4
we add an interaction term POSTREG*AFFECTED. This interaction term is positive and
significant, indicating that despite the overall decline in firm value in the post-regulation period,
the valuation of AFFECTED firms increased after they adopted corporate governance mandates
(AFFECTED+POSTREG*AFFECTED=0 is rejected; Prob>F=0.141). This evidence suggests
SOX-related governance mandates had a positive influence on firm value for the subset of firms
that were likely most affected by these requirements. Table 4, columns 5-8 report similar
evidence
using
industry-adjusted
Tobin’s
Q
(Q-adj)
as
the
dependent
variable
(AFFECTED+POSTREG*AFFECTED=0 is rejected; Prob>F=0.219).
We supplement the analysis in Table 4 with a difference in differences estimation, shown
in Panel A of Table 5. The difference between Tobin’s Q of AFFECTED and CONTROL firms
during the pre-regulation period is -0.385 and is statistically significant at the 1 percent level
(consistent with the coefficient estimate for AFFECTED in Table 4, column 4). During the postregulation period, there is no significant difference between AFFECTED and CONTROL firms,
18
suggesting a convergence in Q for AFFECTED and CONTROL firms in the post-regulation
period. The resulting difference in differences is positive and significant (consistent with the
coefficient estimate for POSTREG*AFFECTED in Table 4, column 4). This analysis shows that
the affected firms increase in value relative to the control firms after the government mandates
and highlights that affected and control firm value were not significantly different in the postregulation period. We repeat the analysis using Q-adj and the results are similar: AFFECTED
firms had lower firm value compared with CONTROL firms in the pre-regulation period, firm
value between the two subsamples were similar in the post-regulation period, and the resulting
differences in differences is positive and significant. The results imply that corporate governance
mandates had a positive influence on firm value for the subset of firms that were likely most
affected by these requirements.
Table 6 reports regressions that include interactions interacts the AFFECTED dummy
with individual year fixed effects. This approach enables us to assess the time trend in the change
in firm value for firms that were relatively more affected by the governance mandates compared
with control firms. As shown in columns 1 Table 6, the AFFECTED*YEAR coefficient estimates
are not significant through 2003, suggesting that there were no year-specific firm value effects
for affected firms compared to control firms.4 The coefficient estimates on the interactions
become positive and significant from 2004 through 2007. These results suggest that firms that
were required to adopt governance mandates had an increase in firm value relatively earlier in
the post-regulation period compared with control firms. Column 2 reports similar results using
industry-adjusted Tobin’s Q as the dependent variable.
4
We exclude 2000 and 2001 to partially account for the dot.com bubble period.
19
V. CORPORATE GOVERNANCE MANDATES AND BOARD MONITORING
The results reported in the prior section indicate that AFFECTED firms had lower
valuations than CONTROL firms during the sample period. In the post-regulation period, all
firms on average have lower valuations compared with the pre-regulation period. However, the
value of AFFECTED firms is relatively higher during the post-regulation period compared with
control firms, suggesting that the value of affected firms increased after the implementation of
governance mandates. This provides evidence that corporate governance mandates had a positive
influence on firm value for the subset of firms that were likely most affected by these
requirements, raising the natural question as to where this enhanced value originates. In this
section, we examine how board monitoring and decision-making within affected firms changed
after adopting governance mandates.
Governance mandates could be associated with higher firm value in a variety of ways.
The mandates could have altered the outcome of bargaining between the board and top
management thereby transferring additional power and monitoring abilities to the board. This
increase in monitoring could influence the extent of management entrenchment via lower
observed executive compensation and higher likelihood of executive turnover. Increased
monitoring could also influence management decisions through changes in investment policies
(e.g., Bergeron, Lehn, and Zutter (2009) and financial reporting practices. Finally, modifications
in governance structures could have indirectly influenced firm performance and thus firm value.
We investigate these potential explanations in the following sub-sections.
5.1 Management Entrenchment
Table 7 examines the relation between corporate governance mandates and measures of
the extent of management entrenchment. In Panel A, we use Execucomp to obtain CEO
20
compensation data and thus our sample size is reduced from 11,255 (93 percent AFFECTED, 7
percent CONTROL) to 5,484 (94 percent AFFECTED, 6 percent CONTROL) observations. The
dependent variable in Panel A is the natural log of ex-ante total CEO compensation. We control
for the following proxies for economic determinants of CEO compensation (e.g., Core,
Holthausen, and Larcker, 1999; Murphy, 1999): REVENUE is the natural log of total revenue;
SP500 is a dummy variable equal to one if the firm is in the S&P 500, zero otherwise; BTM is
book-to-market; RETURNS is one-year firm stock return; ROA is the ratio of income before
extraordinary items to total assets; POSTREG is a dummy equal to one if the firm’s fiscal year
end is December 31, 2004 or later. All columns in Panel A include two-digit NAICS industry
dummies (not reported). Standard errors are clustered by firm.
Table 7, Panel A reports that firm size, S&P 500 membership, and higher current and
lagged stock returns are associated with higher total ex-ante compensation. Consistent with Core,
Guay, and Larcker (2008), higher current and lagged return on assets is associated with lower
total ex-ante compensation. Column 4 shows that AFFECTED is positive and modestly
significant, suggesting that such firms were providing somewhat higher levels of total ex-ante
compensation compared with control firms in the pre-regulation period.5 Column 4 also reports a
significant increase in total ex-ante compensation in the post-regulation period across all firms.
While not a direct test, this finding is directionally consistent with Hermalin and Weisbach’s
(2011) caution that increased regulation and disclosure may lead to higher CEO compensation.
Importantly, Column 4 reports a negative and significant coefficient on POSTREG*AFFECTED,
indicating that affected firms provided lower total CEO compensation compared with control
firms in the post-regulation period (AFFECTED+POSTREG*AFFECTED=0 is rejected;
Prob>F=0.5202).
5
The mean variance inflation factor for the regression presented in column 4 is 5.02 (untabulated).
21
Table 7, Panel B investigates whether the extent of management entrenchment was
manifest in the form of lower likelihood of CEO turnover. We use Execucomp to identify CEO
turnovers using the following procedure. We begin by identifying CEOs using the PCEO flag. If
a firm is missing a CEO in a given year, we then use the CEOANN flag. If a firm is still missing
a CEO in a given year, we then use text searches of the TITLE fields to identify CEOs and delete
executives who are not the firm’s CEO (e.g., division CEOs). For firms with multiple CEOs in a
firm-year, we select the executive with the highest ex-ante total compensation. We control for
the following determinants of CEO turnover: SIZE is the natural logarithm of total assets,
RETURNS is one-year firm stock return; ROA is the ratio of income before extraordinary items
to total assets; PCT_OWN is the percentage of shares outstanding held by the chief executive
officer, obtained from Execucomp; RETIREMENT_AGE is a dummy variable equal to one when
the CEO is at least 62 years of age. Requiring PCT_OWN and RETIREMENT_AGE reduces the
sample size to 5,007 observations (94 percent AFFECTED, 6 percent CONTROL). All columns
in Panel B include two-digit NAICS industry dummies (not reported). Standard errors are
clustered by firm.
Table 7, Panel B reports that the likelihood of CEO turnover is decreasing in stock
returns, return on assets, and CEO stock holdings and increases when the CEO reaches
retirement age. Column 4 shows that AFFECTED is negative and modestly significant,
suggesting that the likelihood of CEO turnover for such firms was somewhat lower compared
with control firms in the pre-regulation period.6 Column 4 reports a significant increase in the
likelihood of CEO turnover in the post-regulation period across all firms. Column 4 reports a
positive and modestly significant coefficient on POSTREG*AFFECTED, indicating that affected
firms had a somewhat higher likelihood of CEO turnover in the post-regulation period compared
6
The mean variance inflation factor for the regression presented in column 4 is 1.98 (untabulated).
22
with control firms (AFFECTED+POSTREG*AFFECTED=0 is rejected; Prob>F=0.3206). This is
indicative of boards of the affected firms becoming more active in monitoring the CEO.
We supplement the analysis in Panel B with a difference in differences estimation, shown
in Panel C of Table 7. This analysis uses linear regression (rather than logistic regression) to
investigate the likelihood of CEO turnover. The difference between the likelihood of turnover
among AFFECTED and CONTROL firms during the pre-regulation period is -0.042 and is
statistically significant at the 10 percent level. During the post-regulation period, there is no
significant difference between AFFECTED and CONTROL firms, suggesting a convergence in
the likelihood of CEO turnover for AFFECTED and CONTROL firms. The resulting difference
in differences is positive and significant at the 5 percent level.
Taken together, the evidence presented in Table 7 suggests that board monitoring has
increased among firms that were most affected by governance mandates compared with control
firms, translating into a lower extent of management entrenchment in the post-regulation period.
5.2 Management Decisions
5.2.1 Investment
Another potential explanation for the increase in valuation of AFFECTED firms
compared with control firms in the post-regulation period is a change in investment behavior.
Bargeron, Lehn, and Zutter (2007) make a similar argument and relate it to the risk-taking of
management that could impact firm value. Table 8, Panel A investigates the relation between
governance mandates and two measures of firm investment. Columns 1-3 define investment as
the ratio of capital expenditure to lagged total assets (CAPEX) and columns 4-6 define
investment as the ratio of research and development expenditures to lagged total assets (R&D).
Following Kaplan and Zingales (1997), columns 1-6 also include Q, the ratio of cash flow to
23
lagged total assets, and two-digit NAICS industry dummies (not reported) as control variables.
Standard errors are clustered by firm.
Table 8, Panel A reports a positive and significant coefficient estimate on AFFECTED
for both measures of firm investment, suggesting that across the 1996-2009 period affected firms
invested more compared with control firms. Further, column 4 shows an overall decline in
capital expenditure investment in the post-regulation period. Column 4 shows that there is no
difference in CAPEX between affected and control firms in the post-regulation period implying
that these firms did not change their investment behavior under the new governance structure.
Columns 4-6 report regression results using R&D as the measure of investment and show a
similar pattern of results. Thus, it appears that the increase in firm value for affected firms
compared with control firms is not related to differences in the level of investment in the postregulation period.
5.2.2 Earnings Quality
As shareholders’ representatives, directors are responsible for monitoring the quality of
financial information released to investors, and studies have examined the relation between
governance attributes and the quality of reported financial information. Klein (2002) presents
evidence that independent boards and audit committees are associated with better earnings
quality, measured by lower discretionary accruals, while Xie, Davidson, and DaDalt (2003)
report similar results for board and audit committee composition. Faleye, Hoitash, and Hoitash
(2011) and Larcker, Richardson, and Tuna (2007) also examine the relation between governance
attributes and earnings quality. Table 8, Panel B investigates the relation between governance
mandates and two measures of earnings quality.
24
We use the absolute value of abnormal accruals as a proxy for the quality of reported
financial information released to investors by management and tolerated by the board. Using the
unsigned value of abnormal accruals more completely identifies the discretion afforded
managers by their boards. We use two measures of the absolute value of abnormal accruals. The
first is developed by Dechow, Sloan, and Sweeney (1995) and is commonly termed the modified
Jones model (ABNORMAL ACCRUALS). The second is based on Kothari, Leone, and Wasley
(2005) who augment the modified Jones model with a control for firm performance (ROA
augmented ABNORMAL ACCRUALS. Following these studies, among others, we control for
SIZE, BTM, the absolute value of the change in net income scaled by total assets, a dummy
variable equal to one if the firm has negative net income in the year and LEVERAGE (not
reported). Standard errors are clustered by firm.
Columns 1-3 of Table 8, reports a negative but insignificant coefficient estimate on
AFFECTED, suggesting that across the 1996-2009 period affected firms’ earnings quality was
similar to that of control firms. Further, column 3 shows that there is no difference in abnormal
accruals between affected and control firms in the post-regulation period, implying that these
firms did not modify their earnings quality under the new governance structure. Columns 4-6
report regression results using ROA augmented ABNORMAL ACCRUALS as the measure of
earnings quality. Column 6 reports a negative and modestly significant coefficient estimate on
AFFECTED and a positive and modestly significant coefficient on POSTREG*AFFECTED,
suggesting that across the 1996-2009 period affected firms had lower accruals compared with
control
firms
and
that
accruals
increased
after
the
governance
mandates
(AFFECTED+POSTREG*AFFECTED=0 is rejected; Prob>F=0.141). This mixed evidence
25
suggests that the increase in firm value for affected firms compared with control firms is not
likely related to differences in earnings quality in the post-regulation period.
5.2.3 Operating Performance
The increase in firm value for the affected firms compared with the control firms after the
mandated governance changes could be driven simply by improvements in operating
performance, and studies have examined the relation between governance attributes and firm
operating performance. Modifications in governance structures that enhanced monitoring of
management could have motivated managers to use assets more efficiently and thereby improve
firm value. Larcker, Richardson, and Tuna (2007) present evidence that some governance factors
are associated with firm operating performance, measured using return on assets. We assess the
relation between governance mandates and future operating performance in columns 7-9 of
Table 8, Panel B. Specifically, columns 7-9 use ROA in year t+1 as the dependent variable and
measure the independent variables in year t. Columns 7-9 include SIZE, CAPEX, and two-digit
NAICS dummies as control variables (not reported). Standard errors are clustered by firm. The
results in columns 7-9 suggest that there is no difference in the operating performance of affected
firms compared with control firms in the post-regulation period. This indicates that the relative
increase in firm value for affected firms is not related to differences in operating performance in
the post-regulation period.
VI. ROBUSTNESS
To identify firms that a priori are likely to be differentially affected by SOX-related
governance mandates, we defined AFFECTED firms as those that complied with the median or
fewer of the ten regulations as of 2002. The median number of regulations met by our sample
firms is four out of ten; therefore AFFECTED firms met four or fewer of the SOX-related
26
governance attributes. We assess the robustness of our results to this definition by defining
AFFECTED as firms that met three or fewer of the SOX-related governance attributes.
CONTROL firms continue to meet at least seven of the ten regulations, as defined previously.
In untabulated analysis, we continue to find that AFFECTED firms had lower valuations
than CONTROL firms during the sample period. Specifically, in the post-regulation period, the
value of AFFECTED firms is relatively higher during the post-regulation period compared with
control firms. This provides evidence that corporate governance mandates had a positive
influence on firm value for the subset of firms that were likely most affected by these
requirements. The evidence also suggests that board monitoring has increased among firms that
were most affected by governance mandates compared with control firms, translating into a
lower extent of management entrenchment in the post-regulation period. Further, the untabulated
analysis continues to show no significant differences in managerial decisions regarding
investment, earnings quality, and operating performance among affected and control firms.
VII. CONCLUSION
Using a unique sample of firms that were most affected by the SOX governance
provisions compared to a control group of firms that was least affected by the provisions, we
examine the impact of changes in corporate governance mandated by legislation and regulation
on firm value and outcomes. The general belief is that if firms choose a governance structure
that maximizes firm value and any attempt by regulatory mandates to move firms from this
optimum will result in negative firm outcomes. Conversely, if firms are not at their optimum
governance structure then mandates that force firms closure to the optimum will result in higher
firm value and better outcomes. We attempt to address the two conflicting views empirically. To
27
help resolve this debate, our paper studies the impact of regulation on firm value, board
monitoring and managerial decision-making.
We find valuations for firms most affected by the new governance provisions to be lower
in general, however, after these firms were forced to adopt the mandated governance changes,
their valuation increased relative to the control group of firms that were less affected by the
mandates. We then examine the factors associated with the increased valuation. Consistent with
the entrenched management hypothesis, we find that the compensation paid by the affected
group versus the control group of firms is lower in the post-regulation period. Additionally, we
find that CEO turnover increases for affected firms in the post-regulatory period. This is
consistent with boards becoming more active in the monitoring of managers. We find that
investment by affected firms in the post-regulatory period is unchanged relative to the preregulatory period. Accruals of the two groups are not different and remain similar to the preregulation period. We also find that there is no change in the operating performance of the
affected firms in the post-regulation period.
Overall, our results suggest that firm value increases after firms are forced to adopt the
mandatory governance structure for firms that were the target of the reforms. We find that
operating performance did not suffer as a result of being forced to adopt the regulatory
governance requirements, which indicates that at least some firms were not at their optimum
governance structure. This implies that the new regulations did lead to boards of affected firms
becoming more empowered and diligent in their monitoring responsibilities which resulted in
higher firm value.
28
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31
TABLE 1
Sample Distribution by Year
Panel A: Distribution (Untrimmed Sample)
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Total obs.
(1)
Full Sample
(#)
(2)
AFFECTED
(#)
(3)
AFFECTED
(% of Row Total)
(4)
CONTROL (#)
(5)
CONTROL
(% of Row Total)
894
978
1,027
1,085
1,138
1,216
1,190
1,144
1,117
1,050
968
869
759
719
14,134
733
816
862
922
976
1,012
1,012
966
939
877
802
715
623
586
11,841
82
83
84
85
86
86
85
84
84
84
83
82
82
82
84
161
162
165
163
162
174
178
178
178
173
166
154
136
133
2,283
18
17
16
15
14
14
15
16
16
16
17
18
18
18
16
Panel B: Distribution (Trimmed Sample)
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Total obs.
(1)
Full Sample
(#)
(2)
AFFECTED
(#)
(3)
AFFECTED
(% of Row Total)
(4)
CONTROL (#)
(5)
CONTROL
(% of Row Total)
124
778
848
890
925
982
999
1,001
957
900
844
744
649
614
11,255
116
706
773
822
865
933
940
934
885
843
781
692
606
569
10,465
94
91
91
92
94
95
94
93
92
94
93
93
93
93
93
8
72
75
68
60
49
59
67
72
57
63
52
43
45
790
6
9
9
8
6
5
6
7
8
6
7
7
7
7
7
This table reports the number of sample observations by year for the full sample and sub-samples categorized by
AFFECTED and CONTROL firms. AFFECTED equals one for firms that complied with the median or fewer of
the ten regulations that were required to be implemented in the 2003-2004 period in 2002, zero otherwise.
CONTROL equals one for firms that complied with at least seven of the ten regulations that were required to be
implemented in the 2003-2004 period in 2002, zero otherwise.
32
TABLE 2
Descriptive Statistics for Untrimmed and Trimmed Samples
TOBIN’S Q
SIZE
MKTCAP
REVENUE
CASH
CAPEX
LEVERAGE
SGROWTH
YIELD
PPE
ROA
RETURNS
GOV41
(1)
Mean
(Full sample;
untrimmed)
1.98
6.48
6.47
6.35
0.12
0.07
0.32
0.13
0.01
0.50
-0.02
0.11
0.59
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
AFFECTED
(untrimmed)
CONTROL
(untrimmed)
t-statistic
(2) v. (3)
Norm.
Diff.
AFFECTED
(trimmed)
CONTROL
(trimmed)
t-statistic
(6) v. (7)
Norm.
Diff.
1.97
6.11
6.10
5.98
0.13
0.07
0.30
0.14
0.008
0.51
-0.03
0.12
0.57
2.05
8.38
8.37
8.30
0.08
0.06
0.41
0.08
0.018
0.49
0.01
0.06
0.69
-2.52**
-67.48***
-60.25***
-63.11***
13.81***
6.52***
-17.18***
8.28***
-28.44***
0.64
-13.60***
4.28***
-30.37***
-0.04
-1.55
-1.37
-1.53
0.36
0.14
-0.41
0.22
-0.02
0.01
-0.32
0.11
-1.11
1.93
6.19
6.16
6.07
0.13
0.07
0.30
0.14
0.008
0.49
-0.03
0.12
0.57
1.95
6.17
6.15
6.05
0.14
0.07
0.29
0.14
0.009
0.45
-0.03
0.11
0.59
-1.22
0.73
0.73
0.93
-3.26***
2.22**
1.44
-0.14
-5.67***
3.07***
1.96**
1.27
-9.91***
-0.07
0.02
0.01
0.01
-0.08
0.14
0.04
0.04
-0.06
0.05
0.09
0.02
-0.19
This table reports descriptive statistics for the full sample and sub-samples categorized by AFFECTED equals one for firms that complied with the median
or fewer of the ten regulations that were required to be implemented in the 2003-2004 period in 2002, zero otherwise. CONTROL equals one for firms that
complied with at least seven of the ten regulations that were required to be implemented in the 2003-2004 period in 2002, zero otherwise. Panel A reports
mean values for firm characteristics in the untrimmed sample. Panel B reports mean values for firm characteristics in the propensity score trimmed sample.
TOBIN’S Q is defined as [(total assets + market value of equity – total common equity – deferred taxes)/total assets]. SIZE is the natural log of total assets.
MKTCAP is market capitalization of equity. REVENUE is the natural log of total revenue. CASH is the ratio of total cash and cash equivalents to lagged
total assets. CAPEX is the ratio of capital expenditure to lagged total assets. LEVERAGE is the ratio of long-term debt plus debt in current liabilities to the
sum plus stockholders' equity total debt. SGROWTH is growth in total revenues. YIELD is the ratio of total dividends to market value of equity. PPE is the
ratio of property, plant, and equipment to total revenue. ROA is the ratio of income before extraordinary items to total assets. RETURNS is one-year firm
stock return. GOV41 is an index of corporate governance based on an equal-weight summation of 41 governance attributes considered to be minimallyacceptable by ISS and consistently measured from 2002 to 2009. The t-statistic measures the difference in each firm characteristic between AFFECTED
and CONTROL firms. *, **, *** reflect statistical significance at the 10 percent, 5 percent, and 1 percent levels. The final column reports the normalized
difference.
33
TABLE 3
Corporate Governance Scores by Year, Firm Size, and Industry
PANEL A: Mean Corporate Governance Scores by Year
Year
2002
2003
2004
2005
2006
2007
2008
2009
Full Sample
0.421
0.487
0.566
0.612
0.636
0.651
0.672
0.688
AFFECTED
0.410
0.477
0.558
0.607
0.630
0.647
0.667
0.684
CONTROL
0.616
0.637
0.665
0.687
0.710
0.714
0.732
0.744
Difference
-0.206
-0.160
-0.107
-0.080
-0.080
-0.067
-0.065
-0.060
t-statistic
-21.019***
-12.151***
-8.541***
-5.796***
-6.257***
-4.791***
-4.360***
-4.190***
PANEL B: Mean Corporate Governance Scores by Firm Size
Quintile
Smallest
Quintile 2
Quintile 3
Quintile 4
Largest
Full Sample
0.392
0.408
0.416
0.418
0.455
AFFECTED
0.390
0.406
0.407
0.420
0.430
CONTROL
0.585
0.586
0.612
0.608
0.626
34
Difference
-0.195
-0.180
-0.205
-0.188
-0.196
t-statistic
-4.236***
-3.8677***
-9.147***
-9.092***
-13.602***
TABLE 3, Cont’d
PANEL C: Mean Corporate Governance Scores by Industry
Industry
(Two-Digit NAICS)
Mining & Extraction (21)
Utilities (22)
Construction (23)
Manufacturing (31)
Manufacturing (32)
Manufacturing (33)
Wholesale Trade (42)
Retail Trade (44)
Retail Trade (45)
Transportation (48)
Information (51)
Real Estate (53)
Professional (54)
Admin. & Support (56)
Health Care (62)
Accommodation & Food (72)
Other (99)
(1)
Full Sample
(2)
AFFECTED
(3)
UNAFFECTED
0.586
0.627
0.605
0.573
0.593
0.585
0.570
0.592
0.568
0.569
0.559
0.588
0.564
0.563
0.582
0.555
0.535
0.585
0.619
0.601
0.562
0.582
0.577
0.556
0.589
0.556
0.568
0.556
0.582
0.562
0.553
0.577
0.551
0.477
0.604
0.679
0.650
0.690
0.684
0.688
0.687
0.702
0.729
0.582
0.714
0.679
0.673
0.697
0.756
0.646
0.697
(4)
Difference
(2) minus (3)
-0.019
-0.060
-0.049
-0.137
-0.102
-0.111
-0.131
-0.113
-0.173
-0.014
-0.158
-0.097
-0.111
-0.144
-0.179
-0.095
-0.220
(5)
t-statistic
(2) v. (3)
-0.416
-2.260**
-0.758
-5.710***
-7.112***
-10.106***
-5.487***
-2.312**
-4.177***
-0.280
-4.495***
-1.468
-2.008**
-4.441***
-2.649***
-1.859*
-6.560***
This table reports GOV41 scores for the full sample and sub-samples categorized by AFFECTED and
UNAFFECTED firms. AFFECTED firms complied with three or fewer of the ten regulations that were required to
be implemented in the 2003-2004 period. UNAFFECTED firms complied with at least seven of the ten
regulations that were required to be implemented in the 2003-2004 period. GOV41 is an index of corporate
governance based on an equal-weight summation of 41 governance attributes considered to be minimallyacceptable. Panel A, B and C report GOV41 scores by year, by size deciles, and by industry, respectively. The tstatistic measures the difference in each firm characteristic between AFFECTED and UNAFFECTED firms. *, **,
*** reflect statistical significance at the 10 percent, 5 percent , and 1 percent levels.
35
TABLE 4
Corporate Governance Mandates and Tobin’s Q
SIZE
CASH
CAPEX
LEVERAGE
SGROWTH
YIELD
PPE
ROA
(1)
Q
0.025
[0.02]
2.599***
[0.18]
1.300***
[0.32]
-0.264**
[0.13]
0.832***
[0.07]
-5.240***
[0.96]
-0.095***
[0.03]
0.460*
[0.27]
(2)
Q
0.012
[0.02]
2.603***
[0.19]
1.304***
[0.32]
-0.265**
[0.13]
0.840***
[0.07]
-5.599***
[0.97]
-0.089***
[0.03]
0.457*
[0.27]
-0.296***
[0.09]
(3)
Q
0.022
[0.02]
2.607***
[0.18]
1.211***
[0.31]
-0.288**
[0.13]
0.828***
[0.07]
-5.620***
[0.98]
-0.088***
[0.03]
0.436*
[0.27]
-0.279***
[0.09]
-0.132***
[0.03]
1.438***
[0.11]
11,255
17%
1.798***
[0.16]
11,255
18%
1.778***
[0.16]
11,255
18%
AFFECTED
POSTREG
POSTREG*AFFECTED
Intercept
N
R2
(4)
Q
0.022
[0.02]
2.611***
[0.19]
1.212***
[0.31]
-0.287**
[0.13]
0.829***
[0.07]
-5.614***
[0.98]
-0.087***
[0.03]
0.438*
[0.27]
-0.385***
[0.13]
-0.380***
[0.11]
0.268**
[0.12]
1.878***
[0.18]
11,255
19%
(5)
Q-adj
0.033*
[0.02]
2.287***
[0.18]
1.172***
[0.30]
-0.217*
[0.13]
0.698***
[0.07]
-3.629***
[0.92]
-0.055**
[0.03]
0.579**
[0.27]
(6)
Q-adj
0.021
[0.02]
2.286***
[0.18]
1.175***
[0.30]
-0.218*
[0.13]
0.705***
[0.07]
-3.947***
[0.93]
-0.051*
[0.03]
0.577**
[0.26]
-0.262***
[0.09]
(7)
Q-adj
0.030
[0.02]
2.289***
[0.18]
1.095***
[0.30]
-0.237*
[0.13]
0.695***
[0.07]
-3.965***
[0.93]
-0.049*
[0.03]
0.558**
[0.26]
-0.246***
[0.09]
-0.114***
[0.03]
-0.194*
[0.11]
11,255
14%
0.123
[0.16]
11,255
15%
0.107
[0.16]
11,255
15%
(8)
Q-adj
0.030
[0.02]
2.294***
[0.18]
1.095***
[0.30]
-0.236*
[0.13]
0.695***
[0.07]
-3.959***
[0.93]
-0.049*
[0.03]
0.559**
[0.26]
-0.344***
[0.12]
-0.342***
[0.11]
0.245**
[0.11]
0.199
[0.17]
11,255
15%
This table reports the relation between corporate governance mandates and firm value for 1996-2009 for the propensity
scored trimmed sample. The dependent variable in columns 1-4 is TOBIN’S Q defined as [(total assets + market value of
equity – total common equity – deferred taxes)/total assets]. The dependent variable in columns 5-8 is industry-adjusted
TOBIN’S Q. AFFECTED firms complied with three or fewer of the ten regulations that were required to be implemented
in the 2003-2004 period. CONTROL firms complied with at least seven of the ten regulations that were required to be
implemented in the 2003-2004 period. SIZE is the natural log of total assets. CASH is the ratio of total cash and cash
equivalents to lagged total assets. CAPEX is the ratio of capital expenditure to lagged total assets. LEVERAGE is the ratio
of long-term debt plus debt in current liabilities to the sum plus stockholders' equity total debt. SGROWTH is growth in
total revenues. YIELD is the ratio of total dividends to market value of equity. PPE is the ratio of property, plant, and
equipment to total revenue. ROA is the ratio of income before extraordinary items to total assets. RETURNS is one-year
firm stock return. POSTREG is a dummy equal to one if the firm’s fiscal year end is December 31, 2004 or later. Columns
1-4 include two-digit NAICS industry dummies (not reported). Standard errors are clustered by firm and reported in
parentheses. *, **, *** indicates two-tailed statistical significance at the 10 percent, 5 percent and 1 percent levels,
respectively.
36
TABLE 5
Differences-in-Differences Analysis of Corporate Governance Mandates and Tobin’s Q
Q
Std. Error
N
R2
Q-adj
Std. Error
N
R2
CONTROL
1.878
[0.18]
11,255
18%
CONTROL
0.199
[0.17]
11,255
15%
Base Line
AFFECTED
1.493
[0.11]
Base Line
AFFECTED
-0.146
[0.11]
Difference
-0.385***
[0.12]
Follow Up
CONTROL AFFECTED
1.498
1.380
[0.16]
[0.13]
Difference
-0.118
[0.08]
Diff-in-Diff
0.268**
[0.12]
Difference
-0.344***
[0.12]
Follow Up
CONTROL AFFECTED
-0.144
-0.243
[0.16]
[0.13]
Difference
-0.099
[0.08]
Diff-in-Diff
0.245***
This table reports the relation between corporate governance mandates and firm value for 1996-2009 for the
propensity scored trimmed sample. The base line period is 1996 through POSTREG, defined as a dummy variable
equal to one if the firm’s fiscal year end is December 31, 2004 or later. The follow up period is POSTREG
through 2009. Q is defined as [(total assets + market value of equity – total common equity – deferred taxes)/total
assets]. Q–adj is industry-adjusted Q. The treatment is AFFECTED, which complied with three or fewer of the
ten regulations that were required to be implemented in the 2003-2004 period. The control is CONTROL, which
complied with at least seven of the ten regulations that were required to be implemented in the 2003-2004 period.
The analyses include the following covariates: SIZE is the natural log of total assets. CASH is the ratio of total
cash and cash equivalents to lagged total assets. CAPEX is the ratio of capital expenditure to lagged total assets.
LEVERAGE is the ratio of long-term debt plus debt in current liabilities to the sum plus stockholders' equity total
debt. SGROWTH is growth in total revenues. YIELD is the ratio of total dividends to market value of equity. PPE
is the ratio of property, plant, and equipment to total revenue. ROA is the ratio of income before extraordinary
items to total assets. RETURNS is one-year firm stock return. The analyses include two-digit NAICS industry
dummies (not reported). Standard errors are clustered by firm and reported in parentheses. *, **, *** indicates
two-tailed statistical significance at the 10 percent, 5 percent and 1 percent levels, respectively.
37
TABLE 6
Time Trend in Relation between Corporate Governance Mandates and Tobin’s Q
SIZE
CASH
CAPEX
LEVERAGE
SGROWTH
YIELD
PPE
ROA
AFFECTED
AFFECTED*1996
AFFECTED*1997
AFFECTED*1998
AFFECTED*1999
AFFECTED*2002
AFFECTED*2003
AFFECTED*2004
AFFECTED*2005
AFFECTED*2006
AFFECTED*2007
AFFECTED*2008
AFFECTED*2009
Intercept
Year FE
N
AFFECTED
CONTROL
R2
(1)
Q
0.039*
[0.02]
2.686***
[0.18]
0.916***
[0.31]
-0.324**
[0.13]
0.746***
[0.07]
-5.582***
[1.016]
-0.077***
[0.03]
0.366
[0.27]
-0.397**
[0.19]
-0.772
[0.51]
0.145
[0.19]
-0.290
[0.23]
0.209
[0.24]
0.281
[0.20]
0.096
[0.18]
0.325*
[0.19]
0.463**
[0.21]
0.328*
[0.20]
0.390*
[0.22]
0.235
[0.21]
0.125
[0.20]
1.808***
[0.23]
Yes
11,255
93%
7%
21%
38
(2)
Q-adj
0.033
[0.02]
2.296***
[0.18]
0.989***
[0.30]
-0.260**
[0.13]
0.693***
[0.07]
-4.311***
[0.96]
-0.046*
[0.03]
0.538**
[0.26]
-0.405**
[0.19]
-0.594
[0.48]
0.123
[0.18]
-0.251
[0.23]
0.126
[0.23]
0.265
[0.19]
0.098
[0.18]
0.280*
[0.18]
0.442**
[0.20]
0.344*
[0.20]
0.407**
[0.21]
0.262
[0.21]
0.166
[0.20]
0.331
[0.22]
Yes
11,255
93%
7%
16%
This table reports the relation between corporate governance mandates and firm value for 1996-2009 for the
propensity scored trimmed sample. The dependent variable in column 1 is TOBIN’S Q defined as [(total assets +
market value of equity – total common equity – deferred taxes)/total assets]. The dependent variable in column 2
is industry-adjusted TOBIN’S Q. AFFECTED firms complied with three or fewer of the ten regulations that were
required to be implemented in the 2003-2004 period. CONTROL firms complied with at least seven of the ten
regulations that were required to be implemented in the 2003-2004 period. SIZE is the natural log of total assets.
CASH is the ratio of total cash and cash equivalents to lagged total assets. CAPEX is the ratio of capital
expenditure to lagged total assets. LEVERAGE is the ratio of long-term debt plus debt in current liabilities to the
sum plus stockholders' equity total debt. SGROWTH is growth in total revenues. YIELD is the ratio of total
dividends to market value of equity. PPE is the ratio of property, plant, and equipment to total revenue. ROA is
the ratio of income before extraordinary items to total assets. RETURNS is one-year firm stock return. Columns 1
and 2 include two-digit NAICS industry dummies and year dummies (not reported). Standard errors are clustered
by firm and reported in parentheses. *, **, *** indicates two-tailed statistical significance at the 10 percent, 5
percent and 1 percent levels, respectively.
39
TABLE 7
Relation between Corporate Governance Mandates and Chief Executive Officer Entrenchment
PANEL A: Ex-ante CEO Compensation
REVENUE (lagged)
SP500
BTM (lagged)
RETURNS
RETURNS (lagged)
ROA
ROA(lagged)
(1)
TOTAL COMP
0.396***
[0.02]
0.232***
[0.08]
-0.738***
[0.10]
0.214***
[0.03]
0.149***
[0.03]
-0.296*
[0.17]
-0.511***
[0.16]
(2)
TOTAL COMP
0.398***
[0.02]
0.236***
[0.08]
-0.738***
[0.10]
0.214***
[0.03]
0.149***
[0.03]
-0.296*
[0.17]
-0.511***
[0.16]
0.083
[0.07]
(3)
TOTAL COMP
0.381***
[0.02]
0.256***
[0.08]
-0.731***
[0.10]
0.221***
[0.03]
0.155***
[0.03]
-0.284*
[0.17]
-0.485***
[0.16]
0.062
[0.07]
0.215***
[0.03]
5.808***
[0.22]
5,484
94%
6%
34%
5.711***
[0.23]
5,484
94%
6%
34%
5.713***
[0.25]
5,484
94%
6%
35%
AFFECTED
POSTREG
POSTREG*AFFECTED
Intercept
N
AFFECTED
CONTROL
R2
40
(4)
TOTAL COMP
0.381***
[0.02]
0.255***
[0.08]
-0.729***
[0.10]
0.221***
[0.03]
0.154***
[0.03]
-0.283*
[0.17]
-0.484***
[0.16]
0.146*
[0.08]
0.402***
[0.08]
-0.198**
[0.09]
5.633***
[0.25]
5,484
94%
6%
36%
TABLE 7, Cont’d
PANEL B: Likelihood of CEO Turnover
SIZE
RETURNS
ROA
PCT_OWN
RETIREMENT_AGE
(1)
(2)
(3)
(4)
Turnover
Turnover
Turnover
Turnover
0.020
[0.02]
-0.213***
[0.07]
-0.972***
[0.25]
-0.002***
[0.00]
0.615***
[0.07]
0.018
[0.02]
-0.215***
[0.07]
-0.977***
[0.25]
-0.002***
[0.00]
0.614***
[0.07]
-0.126
[0.10]
0.022
[0.02]
-0.218***
[0.07]
-0.979***
[0.25]
-0.002***
[0.00]
0.591***
[0.07]
-0.114
[0.10]
-0.097*
[0.05]
-1.755***
[0.63]
5,007
94%
6%
6%
-1.673***
[0.63]
5,007
94%
6%
7%
-1.674***
[0.63]
5,007
94%
6%
7%
0.022
[0.02]
-0.218***
[0.07]
-0.982***
[0.25]
-0.002***
[0.00]
0.590***
[0.07]
-0.217*
[0.12]
-0.517**
[0.25]
0.440*
[0.24]
-1.619***
[0.62]
5,007
94%
6%
7%
AFFECTED
POSTREG
POSTREG*AFFECTED
Intercept
N
AFFECTED
CONTROL
R2
PANEL C: Likelihood of CEO Turnover (Differences-in-Differences)
Q
Std. Error
N
R2
Base Line
CONTROL AFFECTED
0.022
-0.020
[0.04]
[0.04]
5,007
4%
Difference
-0.042*
[0.02]
Follow Up
CONTROL AFFECTED
-0.054
-0.032
[0.04]
[0.03]
Difference
0.022
[0.02]
Diff-in-Diff
0.064**
[0.03]
This table reports the association between corporate governance mandates and CEO entrenchment for 1996-2009.
The dependent variable in Panel A is the natural log of (1+ex-ante CEO compensation) (i.e., TDC1). The
dependent variable in Panel B is CEO turnover, measured as the last year the CEO is in office. AFFECTED firms
complied with three or fewer of the ten regulations that were required to be implemented in the 2003-2004 period.
CONTROL firms complied with at least seven of the ten regulations that were required to be implemented in the
2003-2004 period. REVENUE is the natural log of total revenue. SP500 is a dummy variable equal to one if the
firm is in the S&P 500. BTM is book-to-market. RETURNS is one-year firm stock return. ROA is the ratio of
income before extraordinary items to total assets. POSTREG is a dummy equal to one if the firm’s fiscal year end
is December 31, 2004 or later. SIZE is the natural log of total assets. All columns in Panel A and B include twodigit NAICS industry dummies (not reported). Standard errors are clustered by firm and reported in parentheses.
*, **, *** indicates two-tailed statistical significance at the 10 percent, 5 percent and 1 percent levels,
respectively.
41
TABLE 8
Relation between Corporate Governance Mandates and Investment, Abnormal Accruals, and Return on Assets
PANEL A: Investment
AFFECTED
(1)
CAPEX
0.010***
[0.003]
(2)
CAPEX
0.009***
[0.003]
-0.015***
[0.002]
(3)
CAPEX
0.012***
[0.004]
-0.010***
[0.004]
-0.005
[0.004]
11,255
93%
7%
33%
11,255
93%
7%
34%
11,255
93%
7%
34%
POSTREG
POSTREG*AFFECTED
Intercept
N
AFFECTED
CONTROL
R2
(4)
R&D
0.005*
[0.003]
(5)
R&D
0.005*
[0.003]
-0.003***
[0.001]
(6)
R&D
0.006*
[0.004]
-0.001
[0.003]
-0.003
[0.004]
11,255
93%
7%
45%
11,255
93%
7%
47%
PANEL B: Abnormal Accruals, ROA Augmented Abnormal Accruals, and Return on Assets
AFFECTED
(1)
(2)
(3)
ABNORMAL
ACCRUALS
ABNORMAL
ACCRUALS
ABNORMAL
ACCRUALS
-0.001
[0.002]
-0.002
[0.002]
0.003***
[0.001]
-0.002
[0.002]
-0.001
[0.003]
POSTREG
POSTREG*AFFE
CTED
Intercept
N
AFFECTED
CONTROL
R2
(4)
ROA
Augmented
ABNORMAL
ACCRUALS
-0.002*
[0.001]
(5)
ROA
Augmented
ABNORMAL
ACCRUALS
-0.002*
[0.001]
-0.001
[0.001]
0.002
0.029***
[0.004]
11,255
93%
7%
34%
0.029***
[0.004]
11,255
93%
7%
34%
[0.003]
0.030***
[0.004]
11,255
93%
7%
34%
(6)
ROA
Augmented
ABNORMAL
ACCRUALS
-0.003*
[0.001]
-0.002
[0.001]
(7)
(8)
(9)
ROA
ROA
ROA
-0.010
[0.007]
-0.008
[0.007]
-0.011***
[0.004]
-0.010
[0.008]
-0.016*
[0.009]
0.002*
0.013***
[0.002]
11,255
93%
7%
21%
42
0.013***
[0.002]
11,255
93%
7%
21%
[0.001]
0.013***
[0.002]
11,255
93%
7%
21%
0.005
-0.172***
[0.011]
11,255
93%
7%
8%
-0.172***
[0.011]
11,255
93%
7%
9%
[0.010]
-0.174***
[0.012]
11,255
93%
7%
9%
This table reports the relation between corporate governance mandates and firm outcomes for 1996-2009 for the propensity scored trimmed sample. In
Panel A, CAPEX is the ratio of capital expenditure to lagged total assets and R&D is the ratio of research and development expenditures to lagged total
assets. All columns include TOBIN’s Q, the ratio of cash flow to lagged total assets and two-digit NAICS industry dummies (not reported). AFFECTED
firms complied with three or fewer of the ten regulations that were required to be implemented in the 2003-2004 period. CONTROL firms complied with at
least seven of the ten regulations that were required to be implemented in the 2003-2004 period. POSTREG is a dummy equal to one if the firm’s fiscal
year end is December 31, 2004 or later. All columns include two-digit NAICS industry dummies (not reported). In Panel B, the accrual model is estimated
using the Jones (1991) technique of decomposing total accruals into a normal (expected) and abnormal (unexpected) component. The method of
decomposition is as follows: TA = α + β1(ΔSales-ΔREC) + β2PPEG + β3BM + β4CFO + ε; TA is the difference between Compustat reported operating
cash flows (with extraordinary items and discontinued operations reclassified as part of operating cash flows) and income before extraordinary items.
ΔSales is the change in revenue for the year. ΔREC is the change in receivables reported on the statement of cash flows for the year. PPEG is the gross
amount of property, plant, and equipment. CFO is the operating cash flows. All variables used in the abnormal accrual model (except BM) are scaled by
average total assets using assets from the start and end of the fiscal year. The regression is run for every two-digit NAICS group in the sample with a
requirement of at least 10 observations in each group. Independent variables in the accrual model are all winsorized to be no greater than one in absolute
value, with the exception of BM that is winsorized at the extreme two percentiles. Abnormal accruals is the residual from the above equation and
ABNORMAL ACCRUALS is the absolute value of the residual. ROA Augmented ABNORMAL ACCRUALS follows the above procedure and includes return
on assets in the decomposition regression. Columns 1-6 include SIZE, BTM, the absolute value of the change in net income scaled by total assets, a dummy
variable equal to one if the firm has negative net income in the year and LEVERAGE (not reported). Columns 7-9 use ROA in year t+1 as the dependent
variable and measure the independent variables in year t. Columns 7-9 include SIZE, CAPEX, and two-digit NAICS dummies as control variables (not
reported). Standard errors are clustered by firm and reported in parentheses. *, **, *** indicates two-tailed statistical significance at the 10 percent, 5
percent and 1 percent levels, respectively.
43