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Researchers Investigate Earnings Quality Deterioration and Director Departures

With the separation of ownership and control in publicly traded companies, shareholders depend on boards of directors to serve as their representatives, maximize the value of their investments and monitor the firm’s management. In this way, boards of directors can prevent fraud, provide guidance and mitigate against the problem of self-interest in managers. In principle, it’s an effective way to counterbalance the power of a firm’s management – and it gives shareholders the peace of mind that when the firm needs help, experts are there to step in. But what if board members, too, are motivated to act in their own self-interest? What if instead of steering the ship in times of trouble, directors jump off it?

These are questions that led a team of researchers, including Poole College’s associate professor of finance Srini Krishnamurthy, to do some digging.

Off Kilter

“All the regulators – including the U.S. Securities and Exchange Commission, the New York Stock Exchange and Nasdaq – require board committees to follow strict guidelines. If everyone follows these guidelines and if the system is working, we shouldn’t see any fraud or corporate wrongdoing. But we do. This tells us that something is broken in the system,” Krishnamurthy says.

In order for the counterbalance to work, Krishnamurthy explains, board members need to stay on the board – especially when the firm isn’t performing well. When everything is running smoothly, shareholders are content and there’s no real need for board members to monitor or assist. When things go awry, however, board members must step up to the plate.

Perhaps the reason the system isn’t working, we thought, is that directors are leaving when their help is most needed.

“Perhaps the reason the system isn’t working, we thought, is that directors are leaving when their help is most needed. Like managers, board members are human beings who can choose to act in their self-interest. So perhaps they’re getting some advance information that tells them the firm is headed for trouble – and rather than using this information to benefit shareholders, they’re choosing to act in their self-interest by leaving,” Krishnamurthy says.

“It’s like when your medical insurer refuses to pay your claim. You pay a premium for 20 years and then the one year you have a medical issue and need help paying for it, they say, ‘Sorry, no deal.’ This is a very similar scenario. The shareholders depend on directors to defend against managerial wrongdoing when it surfaces – but when it comes time for them to do their duty, they quit,” he continues.

Tackling Big Data

How, though, do directors learn about the firm’s poor performance before it becomes public? And what, exactly, incentivizes them to leave?

Suspecting that directors were accessing private information through their audit committee memberships, Krishnamurthy’s team decided to take a closer look into director departures and financial statement data. Accessing several large databases, they evaluated financial statement data from every publicly-filed financial report over a  15-year period, plus information on 150,000+ directorships.

“Our thinking was that directors serving on audit committees may be using financial statement information to reverse-engineer earnings quality. If the earnings quality is low, that would alert directors that there may be trouble down the road – and with that knowledge, they may be persuaded to leave before the problems surfaced,” Krishnamurthy says.

If the earnings quality is low, that would alert directors that there may be trouble down the road – and with that knowledge, they may be persuaded to leave before the problems surfaced.

To determine this, they tested whether directors on audit committees leave in advance of a firm’s deterioration in earnings quality – which would demonstrate that they used private information from audit committee memberships to their own advantage. 

“That’s exactly what we found. Audit committee directors tend to leave after becoming aware of declines in earnings quality – while directors who do not serve on audit committees are not leaving at the same rate. This serves as a good falsification test, confirming that the mechanism we’re proposing here seems to be what’s actually going on,” Krishnamurthy explains.

Additionally, the team found that among directors not serving on audit committees, the ones more likely to leave are those connected to departing audit committee directors via their service together on other committees. 

“The director market is characterized by close networks between directors – especially between directors who serve on committees together. To preserve the value of such networks, it seems that departing committee directors are sharing this earnings quality information with the directors they share connections with. Unconnected directors, however, are not leaving at the same rate, because audit committee directors have no incentive to share this information with them. This serves as another falsification test for us,” he continues.

Assessing Motivation

Additionally, Krishnamurthy’s team examined why directors are incentivized to leave – determining whether directors left the board to preserve their reputation in the marketplace, avoid getting entangled in lawsuits or make a break from a heavier workload.

“Our research shows that most directors aren’t leaving for reasons related to their reputation. We do see some evidence of directors wanting to steer clear of firms with increasing litigation risk. For most directors, though, the evidence shows that directors are leaving because they prefer a quieter life. They don’t want to do a lot of work – and so they avoid sitting on boards where the workload is expected to increase,” Krishnamurthy says.

“Often, these board members are retired employees who don’t want to do much additional work. They may decide to join another company’s board and make the same kind of money without having to put in as much effort,” he continues.

Research Implications

The research suggests that while regulators can put a number of policies and regulations in place to structure and govern boards of directors, these only go so far in preventing instances of managerial opportunism or fraud – because they can’t force board members to stay on when wrongdoing occurs.

“You can bring a horse to water but you cannot make it drink – especially when the water doesn’t taste very good. And if that’s the case, then a lot of these rules and regulations are just window dressing. Unless the people who have been selected to serve as directors stay on, all the benefits you expect to get from them aren’t going to come through – and all the problems they are intended to prevent will continue,” Krishnamurthy explains.

Unless the people who have been selected to serve as directors stay on, all the benefits you expect to get from them aren’t going to come through – and all the problems they are intended to prevent will continue.

One potential way to combat this problem, Krishnamurthy says, is to motivate directors to think like long-term shareholders by offering long-term compensation linked to the firm’s performance.

“By structuring the compensation appropriately, you can help your directors think and act like shareholders – motivating them to work hard, do the right things on behalf of the firm’s investors and make decisions for the long-term success of the firm. In this way, they’re less likely to bow out when they spot trouble on the horizon. It’s not a perfect solution, but it is a path forward,” he says.

Continuing the Conversation

The study serves as a continuation of Krishnamurthy’s research into financial reporting and earnings restatements.

“In my earlier research, I found that short sellers specifically targeted firms with poor earnings quality. By using measures of earnings quality from financial statements, they were able to foresee trouble up to 18 months prior to a firm’s financial restatement. Recognizing that stock prices would tank, they decided to short sell the stock. If short sellers access this information and act on it to their own advantage, I realized then perhaps board members are likely to do so, too,” Krishnamurthy says.

The paper, “Board committees and director departures” is published as the lead article in Financial Review. The paper was co-authored with Murali Jagannathan of Binghamton University and Joshua Spizman of Loyola Marymount University.

The study abstract follows.

“Board committees and director departures”
Authors: Murali Jagannathan, Binghamton University; Srinivasan Krishnamurthy, NC State University; Joshua Spizman, Loyola Marymount University
Published: April 2021, Financial Review
DOI: 10.1111/fire.12267

Abstract: We examine whether directors utilize private information obtained through their committee memberships to depart from firms prior to the revelation of their poor performance. Such departures raise the concern that directors leave the firm when they are most needed. Utilizing private information to make decisions in their personal interest may also violate the directors’ fiduciary duties. We focus on departures of audit committee members since information regarding earnings quality should be available to them prior to public release. The departure of audit committee members who serve on multiple boards is coincident with a deterioration in earnings quality. Other directors do not appear to time their departure based on declines in earnings quality. Results from examining the reasons behind this finding are consistent with the director’s preference to lead a “quiet life” and a desire to lower their exposure to litigation risk rather than to protect their reputation in the director market.

This post was originally published in Poole Thought Leadership.