Does Stronger Corporate Governance Improve Financial Reporting Quality?

Evidence from a Regression Discontinuity Analysis of Shareholder-Sponsored

Governance Proposals

Liang Tan
George Washington University
Ph: 202-994-7481
liangtan@gwu.edu

Yanfeng Xue
George Washington University
Ph: 202-994-6747
yxue@gwu.edu

Yong Yu
University of Texas at Austin
Ph: 512-471-6714
Yong.Yu@mccombs.utexas.edu

Abstract

This study examines whether stronger corporate governance leads to higher quality financial
reporting. We use a regression discontinuity method to analyze the effect on financial reporting
quality of shareholder-sponsored governance proposals that pass or fail by a small margin of
votes in annual meetings. This empirical strategy allows us to overcome the endogeneity
problem of governance mechanisms and provide evidence on the causal effect of corporate
governance on financial reporting quality. We find that passing proposals related to board of
directors and executive compensation leads to an improvement in the quality of financial
reporting. We also find that this positive effect on financial reporting is more pronounced for
firms with lower quality financial reporting prior to the voting. We find no evidence that passing
proposals related to antitakeover provisions affects financial reporting quality.

Preliminary draft - Please do not cite or quote. Comments welcome.

1. Introduction

How corporate governance affects financial reporting is an important question in

accounting research. However, despite the large volume of research devoted to this topic, there

is limited evidence on the causal effect of corporate governance on financial reporting, primarily

because of the joint endogeneity of governance mechanisms and accounting system (Armstrong

et al. 2010; Brickley and Zimmerman 2010). As Brickley and Zimmerman (2010) conclude,

"Upon more careful reflection, however, most of these results are also consistent with alternative

explanations. Moreover, causality often is impossible to infer." The difficulty of establishing a

causal relation is further exacerbated by the lack of comprehensive theories that allow

researchers to classify a specific governance feature as "good" or "bad."

The objective of this study is to provide evidence on the causal effect of corporate

governance on financial reporting by applying a regression discontinuity method to analyze a

threshold event - shareholder proposals related to corporate governance. Our empirical strategy

focuses on examining the effect on financial reporting quality of shareholder-sponsored

governance proposals that pass or fail by a small margin of votes in annual meetings (i.e., close-

call proposals). For such close-call proposals, the treatment firms (e.g., those with a proposal that

just passes with 50.1% of the votes) are, on average, the same as the control firms (e.g., those

with a proposal that just fails to pass with 49.9% of the votes) on virtually every dimension (Lee,

2008). However, a proposal is significantly more likely to be implemented and thus lead to

changes in corporate governance for the treatment firms than for the control firms (Ertimur et al.

2010). Thus, for the close-call proposals, passing a proposal is a "locally" exogenous event. The

estimated effects of passing a proposal on financial reporting quality should not be affected by

any observed or unobserved confounding factors, as long as their effects are continuous around

2
the majority threshold (which we show is indeed the case for our setting). Therefore, our

empirical strategy allows us to overcome the endogeneity problem of governance mechanisms

and provide clear evidence of a causal effect of corporate governance on financial reporting.

Our research design also allows us to overcome the limitation of having to classify a

governance feature as "good" or "bad" arbitrarily. To the extent that shareholders have better

information and abilities to detect the weakness of a firm' governance structures, they are likely

to request changes that represent improvements in the firm's governance. Consistent with the

shareholder proposals improving governance, Cunat et al. (2012) find that passing governance-

related shareholder proposal triggers significant positive market reactions.

We use the regression discontinuity method to analyze a large sample of 3,775

governance-related shareholder proposals from 1997 to 2010. We gauge financial reporting

quality using both the accrual-based measure from the modified Dechow and Dechiv (2002)

model and the measures based on accounting restatements and internal control deficiencies. We

find that the passing of governance-related shareholder proposals is related to an improvement in

the accrual-based measure of reporting quality and a reduction in the likelihood of having

internal control deficiencies, suggesting that stronger corporate governance results in higher

quality financial reporting.

Next, we examine which types of governance mechanisms drive the positive effect on

financial reporting quality. We classify all shareholder-initiated governance proposals into three

groups that are related to executive compensation, boards of directors, and antitakeover

provisions (included in the G-index constructed by Gompers et al. 2003), respectively.1 We find

strong evidence that passing proposals related to board of directors improves the accrual-based

1
We also attempt to identify proposals directly related to auditing. However, there are too few proposals related to
auditing issues, making it difficult to estimate the impact of these proposals precisely using our research design.

3
measure of reporting quality, and reduces the likelihood of having accounting restatements and

internal control deficiencies. We also find some evidence that passing proposals related to

executive compensation improves the accrual-based measure of reporting quality. However, we

find no evidence that passing proposals related to antitakeover provisions affects financial

reporting quality.

Further, we conduct cross-sectional analyses to examine whether the effects of passing

governance proposals on financial reporting depend on the sponsorship of the proposals and the

quality of financial reporting prior to the voting. Prior research shows that shareholder

governance proposals are more likely to be implemented when they are sponsored by institutions

rather than individuals (Gillian and Starks 2007; Ertimur et al. 2010). Further, improvements in

governance mechanisms are likely to lead to a larger increase in financial reporting quality for

firms with relatively poorer financial reporting prior to the voting. We find some evidence that

passing proposals related to executive compensation and boards of directors leads to a larger

increase in financial reporting quality for firms with poorer reporting quality prior to the voting.

We find no evidence that the effects of passing shareholder proposals on reporting quality vary

with institution sponsorship of the proposals. Furthermore, we find no evidence in any

subsample that passing proposals related to antitakeover provisions affects financial reporting

quality. Overall, our results suggest that stronger corporate governance leads to an improvement

in financial reporting quality, and this positive effect is concentrated in governance mechanisms

related to board of directors and, to a lesser extent, executive compensation.

Our paper makes two primary contributions. First, it contributes to our understanding of

the relation between corporate governance and financial reporting by providing clear evidence on

the causal effect of corporate governance on financial reporting. Using the regression

4
discontinuity design and the threshold event of shareholder-sponsored governance proposals, we

are able to overcome the problem of the joint endogeneity of governance and accounting system

as well as the difficulty of lacking theories to classify a governance feature as good or bad. Our

results suggest that stronger governance mechanisms, particularly those related to board of

directors and executive compensation, lead to improved financial reporting. Second, our study

also adds to our understanding of the economic consequences of shareholder-initiated

governance proposals. Cunat et al. (2012) examine market reactions to governance proposals and

find that passing governance proposals triggers significant positive market reactions, reduces

acquisitions and capital expenditures, and improves long-term firm performance. We extend

Cunat et al. (2012) by demonstrating that the governance-related shareholder proposals have an

important, and previously unidentified, benefit of improving firms' financial reporting.

Our results are also relevant to the standing debate on shareholder-sponsored governance

proposals. While proponents argue that such proposals can improve governance and enhance

firm value, critics raise the concern that shareholders who initiate the proposals can be self-

serving and the shareholder voting could be uninformed and disruptive to firm operation

(Bainbridge 2006). This debate is especially heated by the recent enactment of the Dodd-Frank

Act, which requires firms to put their executive compensation policy under shareholder advisory

vote at least once every three years. Our study shed light on the economic consequence of

shareholder-sponsored governance proposals by providing evidence on the role of those

proposals in improving firms' financial reporting quality.

The rest of the paper proceeds as follows. Section 2 reviews prior literature and discusses

institutional background. Section 3 describes the regression discontinuity research method, and

5
Section 4 describes our sample and empirical measures. Section 5 presents the empirical

findings. Second 6 concludes.

2. Prior research and institutional background

2.1 Prior research

Although a large body of research has examined whether financial reporting quality is

influenced by various governance mechanisms, the empirical evidence is generally mixed (see

Armstrong et al. (2010) for a comprehensive review of this literature). For example, research

examining how managerial compensation influences financial reporting fails to find consistent

results. On one hand, some studies find a negative relation between managerial equity incentives

and the quality of financial reporting (e.g., Cheng and Warfield 2005; Bergstresser and Philippon

2006; Efendi et al. 2007); on the other hand, other studies find no relation between the two (e.g.,

Erickson et al. 2006; Baber et al. 2007) or even a positive relation (e.g., Warfield et al. 1995;

Armstrong et al. 2010). The results from the stream of research examining the effects of various

features of boards of directors on financial reporting are also mixed. For example, while some

studies find that more independent boards are associated with higher quality reporting (e.g.,

Klein 2002; Efendi et al. 2007), others find little evidence that board independence has a

significant impact on financial reporting quality (e.g., Agarawal and Chadha 2005; Larcker et al.

2007). The evidence from examining anti-takeover provisions (G-index) is also inconclusive.

For example, Larcker et al. (2007) find no relation between G-index and measures of reporting

quality, whereas Baber et al. (2012) document a negative relation between G-index and

restatement in part of their sample period and no relation in the rest of the sample period.

6
 While many factors may contribute to the mixed findings in the extant literature, the joint

endogeneity of corporate governance and financial reporting represents perhaps the biggest

challenge (Armstrong et al. 2010; Brickley and Zimmerman 2010). A firm’s choice of a

particular governance mechanism is endogenously determined by many factors including firm

fundamental characteristics, information environments, other governance mechanisms, and

managerial attributes. And many of those factors are also likely to be important determinants of

the firm's financial reporting. This endogeneity problem raises concerns that any association

found between corporate governance and financial reporting can be driven by observable or

unobservable confounding factors. Recent reviews of the literature (Armstrong et al. 2010;

Brickley and Zimmerman 2010) conclude that the extant literature has provided very little

evidence on the causal relation between corporate governance and financial reporting and call for

more research that better addresses the endogneity problem and provides clearer causal evidence.

In addition to this endogeneity problem, the difficulty in providing causal evidence

between corporate governance and financial reporting is further exacerbated by the lack of

comprehensive theories that allow researchers to classify a feature of corporate governance as

"good" or "bad." (Brickley and Zimmerman 2010). A particular governance feature (e.g., more

outside directors or smaller board size) is unlikely to be optimal for all firms. Rather, whether a

specific governance feature is good or bad for a particular firm likely depends on the firm's

fundamental characteristics, information environments, other governance mechanisms,

shareholder structure, etc. As such, the same governance feature may be good for some firms,

but bad for others. This difficulty forces researchers to rely on some ad hoc classification (e.g.,

having more outside directors on boards is assumed to be a good governance feature for all

7
firms), which can lead to mixed findings, depending on the sample of firms examined, and also

make it difficult to interpret the findings.

In this study we examine the causal effect of corporate governance on financial reporting

by applying a regression discontinuity method to analyze a threshold event - shareholder

proposals related to corporate governance. One key advantage of our empirical strategy is to

overcome the endogeneity problem of governance and provide clear evidence of a causal effect

of corporate governance on financial reporting. In addition, our research design also overcomes

the limitation of having to classify a governance feature as "good" or "bad" arbitrarily.

2.2 Institutional background

According to Rule 14a-8 of the Securities Exchange Act of 1934, shareholders who

continuously own more than $2,000 or 1% of a company for at least one year can initiate a

proposal. The shareholder proposal must be placed on the agenda of the next annual meeting and

included in the proxy distributed to the shareholders.2 Shareholder proposals have been used to

address all kinds of issues including removing anti-takeover provisions, monitoring management

compensation, strengthening shareholder voting rights, promoting corporate social or

environmental responsibilities, and advocating corporate charitable contributions. Because we

are interested in how corporate governance affects financial reporting, we focus on the

shareholder proposals that are directly related to firms’ corporate governance mechanisms, which

comprise the vast majority of all shareholder proposals.

Although shareholder proposals are advisory in nature (i.e, the voting results are not

binding and the implementation of the proposals are subject to the boards’ and managers’

2
One exception is that if the proposal violates certain conditions, such state law, the company may ask the SEC to
approve their exclusion of the proposal from the meeting agenda.

8
discretion), the voting results on the proposals have been demonstrated to have significant

influences on firm policies, especially when the proposals receive majority support from

shareholders. Ertimur et al. (2010) show that among S&P 1500 firms, 40% of proposals

receiving majority votes were implemented in 2004, and the proposals receiving majority votes

are significantly more likely to be implemented than the ones without majority support. Ferri and

Sandino (2009) find that firms that are targeted by shareholder proposals in support of expensing

employee stock options are more likely to adopt the accounting practice and this likelihood

increases with the voting support for the proposals. Ertimur et al. (2011) document that the

likelihood of implementing executive compensation-related proposals increases substantially

after receiving majority votes.

The shareholder proposals offer a threshold event that allows us to address the

endogneity of governance mechanisms and provide causal evidence on the effect of corporate

governance on financial reporting. Specifically, we apply a regression discontinuity (RD)

method to examine changes in firm’s financial reporting quality in response to proposals that

pass or fail the shareholder votes by a small margin. The main idea behind the design is that the

governance rules adopted can be considered random in those closed-call firms whose proposals

pass or fail by a very small margin (Lee 2008). In other words, firms whose proposal passes by a

small margin are essentially the same as firms whose proposal fails by a small margin in all

dimensions, except for the significant difference in the likelihood of implementing the

governance changes requested by the proposal. Thus, a positive association between the voting

results and changes in financial reporting quality in the subsequent periods should not be affected

by any observed or unobserved confounding factors, as long as their effects are continuous

around the majority threshold (which we show is indeed the case). Therefore, this positive

9
association can be interpreted as the causal evidence that improvements in corporate governance

lead to higher financial reporting quality.

Examining shareholder proposals also allows us to overcome the difficulty in classifying

a governance feature as good or bad. Instead of classifying a change in a governance mechanism

as an improvement or a deterioration arbitrarily, we assume that shareholders are in better

position (than researchers) to access a firm's governance structure and they make value-

maximizing decisions in their initiation of and voting on governance proposals, and thus the

changes required by the shareholder proposals represent improvements in governance on

average. This assumption is supported by recent evidence. Cunat et al. (2012) show that passing

governance-related proposal leads to significant positive market reactions, suggesting that

shareholder proposals represent governance improvements that enhance firm value.

We first examine all governance-related proposals to provide evidence on the average

effect of corporate governance on financial reporting. We then examine the effect of specific

categories of governance mechanisms. Because there are only limited numbers of shareholder

proposals related to each specific governance mechanism, we follow Cunat (2011) to group all

governance-related proposals into different categories: 1) proposals related to executive

compensation (e..g., putting a cap on executive bonus); (2) proposals related to board of directors

(e.g., requiring majority vote for director elections); and (3) proposals related to anti-takeover

provisions included in the G-index developed by Gompers, Ishii, and Metrick (2003) (e.g.,

proposals to eliminate classified board or golden parachute).

3. Identification Strategy – A Regression Discontinuity Design

10
 We use a regression discontinuity (RD) design to examine changes in firms’ financial

reporting quality in response to governance-related shareholder proposals that pass or fail by a

small margin (i.e., closed-call proposals). 3 A RD design is a quasi-experimental data design

where treatment assignment depends upon an observed assignment variable around certain

thresholds (Hahn, Todd, and van der Klaauw, 2001; Lee and Lemieux 2010). Lee (2008)

demonstrates that as long as the treatment assignment process cannot be precisely manipulated,

all outcome related factors other than the treatment will evolve continuously with respect to the

assignment and variations in the treatment will be locally randomized around the cutoff. The

treatment effect can, therefore, be causally identified by controlling for a smooth function of the

assignment variable and focusing on discontinuous changes in outcomes around the cutoff. In

other words, from a regression perspective, even if there exist omitted correlated variables, as

long as they do not exhibit precisely the same discontinuity as the treatment does, the treatment

effect can be consistently estimated. Such a mild identification condition makes the RD analysis

more credible than typical “natural experiment” strategies, such as difference-in-differences or

instrumental variables (Lee and Lemieux, 2010).

In the context of governance-related shareholder proposals, the treatment is the impact of

the proposed change in a firm’s governance structure and the assignment variable is the vote

shares for the proposals. Two important features in a shareholder proposal are critical to our

identification. First, passing a proposal results in a discrete jump in the probability that this

3
The RD design was first invented in the psychology literature by Thistlethwaite and Campbell (1960) to estimate
the impact of merit awards on future academic outcomes. It has gained great popularity in economics and finance
research since late 1990s to address endogeneity because its relative mild assumption for causal inference compared
to other non-experimental approaches. Lee and Lemieux (2010) provide an excellent introduction and user guide to
this design. Related to our study, in financial reporting literature, Tan (2013) adopts the RD design in the covenant
violation setting and studies creditors’ demand for conservatism reporting. In shareholder proposal literature, two
papers have adopted the RD design. Cunat et al. (2012) use the RD design to examine market reaction on
shareholder proposals that pass or fail by a small margin. Ertimur et al. (2013) focus on a specific type of
shareholder proposals – adopting majority voting for directors and analyze market reactions to such change in the
director election system.

11
proposal will be implemented. Ertimur et al. (2010) document that 31.1% of passed proposals

were implemented, while only 3.2% of failed proposals were implemented and most of the jump

occurs around the passing cutoff (20.7%). Ertimur et al. (2011) show that the likelihood of

implementing executive compensation-related proposals increases substantially after the

proposals receive majority votes. This discrete jump in the probability of implementation

ensures that our quasi-experiment gets a legitimate treatment at the majority threshold.4

Second, no discontinuity should be observed on vote share distribution around the

majority threshold. Recall that the critical identification assumption for a RD design is that the

treatment assignment process is not precisely manipulated. A precise manipulation will result in

a discontinuous distribution of the assignment variable around the cutoff. First of all, in practice,

the vote outcome of a shareholder proposal is not revealed until the meeting date. This mitigates

the possibility that someone has superior information about the likely voting outcome and

influences the vote to change the result of a close-call proposal. Second, using a shareholder

proposal sample similar to ours, Cunat at al. (2012) do not find any discontinuity in distribution

around the threshold5.

The standard RD regression model applying to our shareholder proposals setting is the

following:

Financial Reporting Qualityi,t+1 = α0 + α1Passi,t + Pl(Xit, βl) + Pr(Xit, βr) + εit (1)

4 In the RD design literature, this means that we have a “fuzzy” regression discontinuity setting (Lee and Lemieux
2010). Therefore, a proposal is not required to be binding for identification.
5
The reason that we focus on shareholder proposals instead of management-sponsored proposals is that
management-sponsored proposals’ voting results are likely being influenced by management. Listokin (2008)
documents widespread irregularities in the distribution of votes in management-sponsored proposals. He finds that
management is overwhelmingly more likely to win votes by a small margin than lose by a small margin.

12
where Financial Reporting Qualityit+1 is one of our three proxies of financial reporting quality

for a firm i in year t+1 after the proposal meeting year t. Passit is an indicator variable equal to 1

if the shareholder proposal is passed in year t, 0 otherwise. Xit is the vote share for the proposal.

P(Xit ,β) is a polynomial in vote shares and represents the smooth function of the assignment

variables. We allow the coefficients to differ on either side of the voting cutoff, indicated by

superscript/subscript l and r for the polynomial functions. Similar to Cunat et al. (2012), we

present our results using a polynomial of order four, though our findings are robust to higher-

order polynomials. We correct the standard errors using two-way clustering by firm and by year

(Petersen, 2009; Gow, Ormazabal and Taylor, 2010).

One complication in the application of the standard RD regression model (i.e. model (1))

to analyze shareholder proposals is that shareholders of a firm may vote on more than one

proposal on a particular meeting date. That is, we could have one outcome but multiple

treatments. Theoretically, we can create and estimate a Pass dummy and a set of polynomials in

vote shares for each individual proposal. However, there are 72 distinct types of governance-

related shareholder proposals according to Risk Metrics’ classification. The limited number of

observations for each type prevents us precisely estimating the governance effect for every

proposal, and requires the aggregation of shareholder votes.

Let’s assume there are J types of proposals voted in a shareholder meeting. Following

Cunat et al. (2012) and assuming for all J, αJ =α, PJl = Pl and PJr = Pr, then we can rewrite

model (1) as

Financial Reporting Qualityi,t+1 = α∑Nj=1Passji,t + Pl(∑Nj=1Xjit, βj,l) + Pr(∑Nj=1Xjit, βj,r) + εit (2)

13
α thus captures the average causal effect of passing a proposal on financial reporting quality. We

first estimate the average causal effect among all proposals using model (2). Then, we relax the

restriction and let α vary by three major types of proposals (i.e., proposals related to boards of

directors, executive Compensation, and anti-takeover provisions (G-index), respectively) and

estimate their individual effects jointly using the following regression model:

Financial Reporting Qualityi,t+1 = α0 + α1PassGi,t + α2PassBi,t + α3PassCi,t + PGl(XGit, βG,l) +

PrG(XGi,t, βG,r) + PBl(XBit, βB,l) + PrB(XBi,t, βB,r) + PGl(XCit, βC,l) + PrG(XCi,t, βC,r) + εit (3)

The key coefficients in model (3) are α1, α2 and α3. Because our three measures of financial

reporting quality (to be discussed in section 4.2) are all negatively correlated with reporting

quality, we expected the three coefficients α1, α2 and α3 to be negative, consistent with the notion

that passing of governance-related shareholder proposals leads to higher reporting quality.

4. Data and Variable Measurement

4.1. Data

We obtain shareholder proposals data from Risk Metrics’ shareholder proposals database,

which contains shareholder proposals from all S&P 1500 companies plus an additional 500

widely held firms. It provides information such as company names, meeting dates, a description

of the resolution and categorization of the proposal type, the voting percentage in favor of the

proposal, an indicator variable showing whether the proposal has received a majority vote and

the name of shareholder proponents. We keep only proposals classified as governance-related by

the database for nonfinancial firms with available meeting dates and vote share data. Our sample

14
contains 3,775 governance-related shareholder proposals from 1997 to 2010. Further, we obtain

accounting data from Compustat and stock price data from CRSP. We obtain SOX 404 internal

control weakness data from the Audit Analytics database, and the accounting restatement data

from the Audit Analytics database and the U.S. government accountability office (GAO)

database.6

Figure 1 draws the distribution of vote shares. The figure plots both histograms and

kernel density estimation of the distribution. Close-call proposals are not uncommon. In fact,

they are more frequent than proposals that are supported overwhelmingly. For example, the

number of proposals with supporting vote shares between 40% and 60% (26.68%) are 7.5 times

greater than that with supporting vote shares between 80% and 100% (3.58%). We also notice

that vote shares are generally distributed smoothly. There is no noticeable kink around the 50%

threshold (see formal statistical tests in Section 5.1).

Table 1 reports summary statistics of the sample. Panel A shows summary statistics at the

proposal level. On average, proposals receive around 37% of the supporting votes and are passed

29% of the time. G-index, Board and Executive Compensation related proposals are the three

major types of proposals in the sample. 38.7% of the sample is G-index proposals and they

receive the highest shareholder approval (56.36%) than any other types of proposals. These

observations are consistent with Cunat et al. (2010). There are only 57 proposals that are related

to Audit and 343 other types of proposals. Audit and Other categories are approved in only 5%

of the cases. Given the low approval rate for these two types, there are very few observations

6
Unlike Audit Analytics, the GAO data only provide the date when the restatements were issued but not the
restatement periods. We examine restatement data from Audit Analytics and find that the median number of days
between the start and end dates of the restatement periods are 455 days and the median number of days between the
end dates of restatement period and the restatement dates are 167 days. We apply these statistics to estimate the
restatement periods for restatements in the GAO database. That is, we assume that the restatement period is from
622 days (455+167) to 167 days prior to the restatement date.

15
around the majority threshold, which prevents us from estimating their individual effects

precisely. As a result, we exclude Audit and Other categories from our analyses.

Panel B of Table 1 presents summary statistics at the firm-year level for key variables

used in this study. The number of observations varies according to the availability of the data. On

average, 44.6% of the sample firms have proposals sponsored by institutional investors. The

average number of restatements happening in the three year window after the proposal voting

year is 0.117 and average incidences of internal control weakness in the same window is 0.082,

consistent with statistics documented in prior studies.

4.2. Financial Reporting Metrics

We use three measures to proxy for financial reporting quality. Our first measure of

financial reporting quality is the accrual-based Dechow and Dichev (2002) model modified by

McNichols (2002) (MDD). Following Kothari et al. (2005), we also control for performance in

the model.

ΔWCi,t = α +β1CFOi,t-1 + β2CFOi,t + β3CFOi,t+1 + β4ΔREVi,t + β5PPEi,t + β6ROAi,t-1 +ε (4)

where ΔWCi,t is the change in working capital from year t-1 to year t and calculated as ΔAR +

ΔInventory - ΔAP - ΔTP +ΔOther Assets (net), where AR is accounts receivable, AP is accounts

payable, and TP is taxes payable. CFO’s are operating cash flows from fiscal year t-1, t, and t+1.

ΔREVi,t is the change of sales from year t-1 to t. All variables are scaled by average total assets of

year t-1 and t. ROAi,t-1 is the net income before extraordinary items in year t divided by average

total assets of year t-1 and t.

16
 Dechow and Dichev (2002) estimate firm-specific time-series regressions and use

standard deviation of the residuals over eight years as measures of accrual quality. Our research

design makes it hard to estimate accrual quality over a time window as long as eight years. We

therefore estimate model (1) cross-sectionally for each industry (two-digit SIC code) and year,

and use the absolute value of the residuals as our measure of reporting quality. Jones et al. (2008)

shows that the residuals from the cross-sectional regressions based on the Dechow and Dichev

(2002) model modified by McNichols (2002) is the best at predicting accounting fraud compared

to other measures of accrual quality.

Our second measure of financial reporting quality is number of internal control

weaknesses (# of ICW) reported under SOX 404 within three years after the proposal meeting

year. Sarbanes-Oxley Act Section 404 requires management and auditors to disclose any

material internal control weaknesses over financial reporting if detected. Finally, we use number

of restatement (# of Restate) within three years after the proposal meeting year as our third

measure of financial reporting quality.

5. Empirical results

5.1. Density Discontinuity and Pre Proposal Covariates

Before formally testing our hypotheses, we first examine the validity of our RD setting.

As discussed before, the local randomization assumption is valid as long as the economic agents

cannot precisely manipulate the assignment variable, i.e., vote shares for the proposals. A direct

test of it is to examine the density of vote shares. If voting results are not manipulated, then the

aggregate distribution of vote shares should be continuous. We use the two-step procedure

described in McCrary (2008) to formally test this assumption. In the first step, we partitioned the

17
vote shares into equally spaced histogram bins and calculate frequencies within each bin. Then,

we run local linear regressions using the frequency counts as dependent variable and midpoints

of the histogram bins as independent variable on either side of the 50% cutoff. We test whether

the log difference in dependent variable at the cutoff is statistically significant. Figure 2 presents

a graphical analysis of the vote share density. The solid line represents the non-parametric local

polynomial smoothing on either side of the cutoff. The dashed lines represent the 95%

confidence intervals of the estimation. At the cutoff, we do not observe significant shifts in

distribution. Table 2 reports the test statistic. The estimated log discontinuity is 0.139 and is not

statistically significant (t-stat = 1.168), which confirms our graphical result.

Another key implication of local randomization is that the baseline covariates should be

locally balanced on either side of the cutoff before proposal voting. Cunat et al (2012) have

examined a variety of baseline variables. We complement their findings by examining our

financial reporting quality proxies in year t-1 (i.e., MDDt-1, ICWt-1 and Restatet-1). We also

examine prior institutional ownership and whether return is negative in t-1. We use these

variables in our cross-sectional variation tests. We employ the RD analysis model, but replace

the dependent variable with each of the observed baseline covariates in year t-1. Table 3 presents

the test results. We do not find any discontinuities for baseline covariates. The Pass variables are

not statistically significant across all regressions. Overall, these results provide assurance that

the local randomization assumption is valid to our setting.

5.2 Empirical results from regression analysis

The regression results of Model (2) are presented in Table 4, where we aggregate all

types of governance-related proposals and examine the impact of the passing (>50% approval

18
vote) of the proposals on three measures of financial reporting quality. The coefficient on the

variable Pass is significantly negative in the first column, indicating that passing of governance-

related proposals leads to an improvement in the accrual-based measure of financial reporting

quality. In the second column, we use the incidences of internal control weakness to gauge the

quality of a firm’s financial reporting system, and the significantly negative coefficient on Pass

suggests that passing governance-related shareholder proposals results in fewer incidences of

internal control weakness. In column three, we use the incidences of restatement in the

subsequent three years as a measure of financial reporting quality and the coefficient on Pass is

statistically insignificant. The insignificant result for the restatement test could be driven by the

small number of restatements. Specifically, only 11% of our sample has at least one restatement

during the three-year window following the year of the proposal. Another possible explanation is

that different forms of governance mechanisms may have different impact on firms’ reporting

quality and grouping all governance related proposals together reduces the power of our tests.

We next classify shareholder proposals into three types: G-index, board, and executive

compensation, examining the impact of each specific category of governance mechanisms on

firms’ financial reporting quality. Table 5 presents the empirical results of Model (3) for the

three proposal types. Passing of G-index related proposals do not seem to have any significant

impact on our measures of financial reporting quality. However, the proposals aiming to

improve board efficiency are found to significantly improve accrual quality (negative coefficient

on Pass(Board) in Column (1)), reduce incidences of internal control weakness (negative

coefficient on Pass(Board) in Column (2)), and reduce incidences of restatement (negative

coefficient on Pass(Board) in Column (3)). For proposals related to executive compensation

contracts, we find the passing of this type of proposals improves accrual quality (negative

19
coefficient on Pass(Comp) in Column one) but has no significant impact on internal control

weakness and restatements. Overall, these results provide evidence that governance

improvements related to boards of directors and, to a lesser extent, executive compensation, lead

to higher quality financial reporting.

In the next set of analysis, we examine whether the impact of passing of shareholder

proposal on firms’ reporting quality is affected by the sponsorship of the proposals and financial

reporting quality in prior periods. Table 6 reports the empirical results of these cross-sectional

analyses. Panel A shows that institutional sponsorship of the proposals do not have significant

impact on the relation between passing of the shareholder proposals and subsequent financial

reporting quality. Panel B examines whether firms with worse prior period financial reporting

quality witness a bigger improvement after passing of the governance-related proposals. We find

some support consistent with the notion that firms with worse financial reporting quality prior to

the proposal year experience bigger improvement after the passing of proposals related to

executive compensation and board of directors. The coefficient on Pass(Comp) x ICWt-1 is

significantly negative, indicating that firms with more incidences of Section 404 internal control

weakness (ICW) prior to the voting of the proposal see larger reduction in ICW after passing of

proposals targeting at executive compensation contracts. For tests using restatements as the

measure of financial reporting quality, the results suggest that the incidence of restatement is

significantly reduced by shareholder proposals related to board efficiency and executive

compensation when the firm already experienced more restatements in years prior to the voting

of the proposal – the coefficients on Pass(Board) x Restatet-1 and Pass(Comp) x Restatet-1 in

Column 3 are significantly negative.

20
6. Conclusions

This study examines the causal effect of corporate governance on financial reporting

quality. To overcome the endogeneity problem related to corporate governance, we use a

regression discontinuity design to analyze a threshold event - passing of governance-related

shareholder proposals. This research design explores a unique semi-experimental setting where

the shareholder proposals pass or fail the majority vote by a small margin (closed-call proposals).

Firms receiving those closed-call proposals should be the same in all aspects except for the

likelihood of implementation of the governance proposal, which jumps discretely once the

proposal receives majority vote. Thus, passing a proposal represents a locally exogenous shock

to firms’ governance structure, and the estimated effects on financial reporting can be interpreted

as causal evidence of the effect of corporate governance on financial reporting quality.

Using three measures of financial reporting quality (i.e., accrual-based measure from the

modified Dechow and Dechiv model, incidences of internal control weakness, and incidences of

accounting restatements), we find that the passing of governance-related shareholder proposals

leads to higher quality financial reporting. Further, we find that this positive effect on financial

reporting quality is primarily driven by proposals related to boards of directors and to a lesser

extent, executive compensation. However, we find no evidence of improved financial reporting

quality for proposals in response to the passing of shareholder proposals related to anti-takeover

provisions (G-index). Additionally, We find that passing proposals related to boards of directors

and executive compensation leads to a greater improvement in financial reporting quality for

firms with weaker financial reporting quality prior to the proposal voting

Our study contributes to the literature by establishing a clearer causal relation between

corporate governance and financial reporting. Our study also adds to our understanding of the

21
economic consequences of shareholder-initiated governance proposals by demonstrating that the

governance-related shareholder proposals have an important, and previously unidentified, benefit

of improving firms' financial reporting. Our results are relevant to the ongoing debate on the

effectiveness of the advisory voting on shareholder-initiated proposals, which is intensified by

the recent enactment of the Dodd-Frank Act that mandates shareholder advisory vote on firms’

executive compensation contracts at least once every three years. Our study highlights the

important role of those governance-related shareholder proposals in improving firms' financial

reporting quality.

22
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24
Figure 1 Vote Shares Distribution

2
1.5
Density

1
.5
0

0 .2 .4 .6 .8 1
Vote Shares

Note: This figure presents vote share distribution of shareholder proposals. The horizontal line is Vote Shares for the
proposals.

25
Figure 2 Graphical Analysis of Density Discontinuity
3
2
1
0

-1 -.5 0 .5 1

Note: This figure presents a graphical analysis of the density discontinuity of the vote shares distribution. The
horizontal line is the margin of victory for passing a proposal. It is defined as the difference between vote shares
supporting a proposal and the 50 percent threshold.

26
Table 1 Summary Statistics

Panel A: Summary Statistics – Proposal Level

Proposals N % of Proposals Passed Average % of Supporting Vote
All Proposals 3775 29.03% 37.00%
Board 859 15.02% 29.99%
Comp 1054 11.39% 26.99%
G-index 1462 56.36% 53.34%
Audit 57 5.26% 22.44%
Other 343 5.83% 18.05%

Panel B: Summary Statistics – Firm-Year Level

N Mean SD 25th Median 75th
MDD 1856 0.046 0.084 0.010 0.022 0.052
# of ICW 1687 0.082 0.336 0.000 0.000 0.000
# of Restate 2282 0.117 0.373 0.000 0.000 0.000
% with Institution Sponsor 2082 0.446 0.497 0.000 0.000 1.000
High MDD t-1 2282 0.471 0.499 0.000 0.000 1.000
ICWt-1 2282 0.057 0.233 0.000 0.000 0.000
Restatet-1 2282 0.117 0.321 0.000 0.000 0.000

Note: This table presents summary statistics of the sample. The sample consists of 3,775 governance related
shareholder proposals from 1997 to 2010 for all nonfinancial S&P 1500 companies plus an additional 500 widely
held firms. Panel A reports summary statistics at the proposal level. Panel B reports summary statistics at the firm-
year level for key variables used in the study. MDD is the accrual-based Dechow and Dichev (2002) model modified
by McNichols (2002) in year t+1. # of ICW is the number of internal control weaknesses found under SOX 404
within three years after the proposal meeting. # of Restate is the number of restatements within three years after the
proposal meeting. Ins Ownt-1 is the percentage ownership by institutional investors right before the proposal
meeting. Union Fund (G-index) is an indicator variable equal to 1 if the G-index type of proposals is sponsored by
union fund, 0 otherwise. Union Fund (Board) is an indicator variable equal to 1 if the Board related type of
proposals is sponsored by union fund, 0 otherwise. Union Fund (Comp) is an indicator variable equal to 1 if the
Compensation related type of proposals is sponsored by union fund, 0 otherwise. Negret t-1 is an indicator variable
equal to 1 if the buy-and-hold abnormal return is negative for the proposal firm one year before the proposal
meeting. High MDDt-1 is an indicator variable equal to 1 if a firm’s MDD is above median the year before the
proposal meeting, 0 otherwise. ICWt-1 is an indicator variable equal to 1 if internal control weakness has been found
for a firm one year before the proposal meeting, 0 otherwise. Restatet-1 is an indicator variable equal to 1 if a firm
has made restatement one year before the proposal meeting, 0 otherwise.

27
Table 2 Density Discontinuity Test
Discontinuity estimate (log difference in height):

Log discontinuity t-stat

estimate

0.139 1.168

Note: This table presents results testing the density discontinuity of the vote shares distribution. The test statistic is
based on McCrary (2008).

28
Table 3 Pre Proposal Covariates
(1) (2) (3) (4) (5)
MDD t-1 ICWt-1 Restatet-1 Ins Own t-1 Negret t-1
Pass -0.006 -0.097 -0.120 0.136 -0.345
(-0.67) (-0.51) (-0.52) (1.58) (-1.08)

Vote Sharew 0.823 11.459 -25.473*** -0.770 2.394

(1.11) (0.57) (-3.66) (-0.24) (0.24)

Vote Sharew2 -3.422 -50.771 108.450*** 1.480 -3.727

(-1.10) (-0.62) (3.98) (0.12) (-0.10)

Vote Sharew3 4.666 71.656 -148.593*** -0.692 0.199

(1.10) (0.65) (-4.24) (-0.04) (0.00)

Vote Sharew4 -2.060 -32.004 66.354*** -0.194 1.768

(-1.09) (-0.66) (4.50) (-0.03) (0.08)

Vote Sharel 0.254 -6.924*** -0.313 -1.088** -0.389

(1.16) (-2.89) (-0.12) (-2.03) (-0.21)

Vote Sharel2 -1.593 74.001*** 8.666 8.307 5.500

(-0.89) (3.98) (0.33) (1.43) (0.29)

Vote Sharel3 3.181 -249.214*** -46.794 -23.147 -11.516

(0.53) (-5.10) (-0.54) (-1.17) (-0.19)

Vote Sharel4 -1.777 261.999*** 62.478 22.435 0.299

(-0.26) (5.80) (0.70) (1.07) (0.00)

Constant 0.033*** -1.470*** -1.194*** 0.570*** 0.063

(3.71) (-7.60) (-12.47) (17.88) (0.59)
Observations 2151 2282 2282 2282 2236
Adjusted/Pseudo R2 0.0124 0.0197 0.0094 0.0181 0.0035

Note: This table presents results examining whether observed baseline covariates are locally balanced on either side
of the cutoff before proposal meeting in year t-1. MDDt-1 is the accrual-based Dechow and Dichev (2002) model
modified by McNichols (2002) in year t-1. ICWt-1 is an indicator variable equal to 1 if internal control weakness has
been found for a firm one year before the proposal meeting, 0 otherwise. Restatet-1 is an indicator variable equal to 1
if a firm has made restatement one year before the proposal meeting, 0 otherwise. Ins Own t-1 is the percentage
ownership by institutional investors right before the proposal meeting. Negret t-1 is an indicator variable equal to 1 if
the buy-and-hold abnormal return is negative for the proposal firm one year before the proposal meeting. Pass is the
summation of an indicator variable equal to 1 if the proposal passes the majority threshold, 0 otherwise for all
proposals voted for a firm on a particular meeting date. Vote Share is the aggregate vote shares supporting all the
proposals for a firm on a particular meeting date. t statistics are in parentheses and are adjusted for within cluster
correlation by firm and by year. *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and
1%, respectively.

29
Table 4 All Proposals
(1) (2) (3)
MDD # of ICW # of Restate

Pass -0.013*** -0.050* 0.057

(-3.12) (-1.70) (0.69)

MDDt-1 0.258***
(4.14)

Constant 0.028*** 0.085*** 0.130***

(4.19) (3.53) (4.82)

Polynomial Controls Yes Yes Yes

Observations 1841 1686 2281

Adjusted R2 0.0796 -0.0005 0.0009

Note: This table presents results examining the effect of passing a governance related shareholder proposal on firms’
financial reporting quality. MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols
(2002) in year t+1. # of ICW is the number of internal control weaknesses found under SOX 404 within three years
after the proposal meeting. # of Restate is the number of restatements within three years after the proposal meeting.
Pass is the summation of an indicator variable equal to 1 if the proposal passes the majority threshold, 0 otherwise
for all proposals voted for a firm on a particular meeting date. Vote Share is the aggregate vote shares supporting all
the proposals for a firm on a particular meeting date. MDDt-1 is the accrual-based Dechow and Dichev (2002) model
modified by McNichols (2002) in year t-1. t statistics are in parentheses and are adjusted for within cluster
correlation by firm and by year. *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and
1%, respectively.

30
Table 5 Three Types of Proposals
(1) (2) (3)
MDD # of ICW # of Restate
Pass (G-index) 0.009 0.113 0.282
(0.86) (1.35) (1.53)

Pass (Board) -0.035* -0.107*** -0.136**

(-1.92) (-4.01) (-2.16)

Pass (Comp) -0.044** -0.109 -0.068

(-2.34) (-0.65) (-0.95)

MDDt-1 0.259***
(4.29)

Constant 0.028*** 0.084*** 0.122***

(4.37) (3.54) (5.11)

Polynomial Controls (G-index) Yes Yes Yes

Polynomial Controls (Board) Yes Yes Yes
Polynomial Controls (Comp) Yes Yes Yes

Observations 1841 1686 2281

Adjusted R2 0.0775 0.0026 0.0164

Note: This table presents results examining the effects of passing three major types of governance related
shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting quality. MDD is the
accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1. # of ICW is the number
of internal control weaknesses found under SOX 404 within three years after the proposal meeting. # of Restate is
the number of restatements within three years after the proposal meeting. Pass (G-index) is the summation of an
indicator variable equal to 1 if the proposal passes the majority threshold, 0 otherwise for G-index proposals voted
for a firm on a particular meeting date. Pass (Board) is the summation of an indicator variable equal to 1 if the
proposal passes the majority threshold, 0 otherwise for Board related proposals voted for a firm on a particular
meeting date. Pass (Comp) is the summation of an indicator variable equal to 1 if the proposal passes the majority
threshold, 0 otherwise for Compensation related proposals voted for a firm on a particular meeting date. MDDt-1 is
the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t-1. t statistics are in
parentheses and are adjusted for within cluster correlation by firm and by year. *, ** and *** indicate significance at
two-tailed probability levels of 10%, 5%, and 1%, respectively.

31
Table 6 Cross-Sectional Tests
Panel A: Interaction-Institution Sponsor
(1) (2) (3)
MDD # of ICW # of Restate
Pass (G-index) 0.011 0.106 0.274
(0.95) (1.36) (1.41)

Pass (Board) -0.046 -0.073* -0.160*

(-1.56) (-1.66) (-1.83)

Pass (Comp) -0.061* -0.189 -0.050

(-1.84) (-0.84) (-0.78)

Pass (G-index) × Ins Sponsor 0.003 0.012 0.050

(0.23) (0.21) (1.08)

Pass (Board) × Ins Sponsor 0.028 0.050 0.004

(1.00) (0.88) (0.05)

Pass (Comp) × Ins Sponsor 0.008 0.060 0.012

(1.31) (1.01) (0.57)

MDDt-1 0.405***
(3.19)

Polynomial Controls (G-index) Yes Yes Yes

Polynomial Controls (Board) Yes Yes Yes
Polynomial Controls (Comp) Yes Yes Yes

Observations 1841 1686 2281

Adjusted R2 0.0801 0.0049 0.0150
Note: This table presents results examining the cross-sectional variations of the effects of passing three major types
of governance related shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting
quality. MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1. #
of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal
meeting. # of Restate is the number of restatements within three years after the proposal meeting. Pass (G-index) is
the summation of an indicator variable equal to 1 if the proposal passes the majority threshold, 0 otherwise for G-
index proposals voted for a firm on a particular meeting date. Pass (Board) is the summation of an indicator variable
equal to 1 if the proposal passes the majority threshold, 0 otherwise for Board related proposals voted for a firm on a
particular meeting date. Pass (Comp) is the summation of an indicator variable equal to 1 if the proposal passes the
majority threshold, 0 otherwise for Compensation related proposals voted for a firm on a particular meeting date. Ins
Sponsor is an indicator variable of whether the sponsor of the proposal is an institutional investor. t statistics are in
parentheses and are adjusted for within cluster correlation by firm and by year. *, ** and *** indicate significance at
two-tailed probability levels of 10%, 5%, and 1%, respectively.

32
Panel B: Interaction-Past Accounting Quality
(1) (2) (3)
MDD # of ICW # of Restate
Pass (G-index) 0.013 0.105 0.274
(0.93) (1.22) (1.44)

Pass (Board) -0.043 -0.104*** -0.134**

(-1.36) (-3.57) (-2.06)

Pass (Comp) -0.065*** -0.096 -0.055

(-2.62) (-0.56) (-0.82)

Pass (G-index) × High MDDt-1 -0.004

(-0.73)

Pass (Board) × High MDDt-1 0.014

(1.08)

Pass (Comp) × High MDDt-1 0.009

(0.81)

Pass (G-index) × ICWt-1 -0.105

(-1.51)

Pass (Board) × ICWt-1 0.196

(1.42)

Pass (Comp) × ICWt-1 -0.102**

(-2.31)

Pass (G-index) × Restatet-1 0.043

(1.11)

Pass (Board) × Restatet-1 -0.142***

(-2.84)

Pass (Comp) × Restatet-1 -0.093*

(-1.75)

Constant 0.022*** 0.076*** 0.115***

(2.67) (3.14) (4.89)

Polynomial Controls (G-index) Yes Yes Yes

Polynomial Controls (Board) Yes Yes Yes
Polynomial Controls (Comp) Yes Yes Yes

Observations 1841 1686 2281

Adjusted R2 0.0810 0.0078 0.0219

33
Note: This table presents results examining the cross-sectional variations of the effects of passing three major types
of governance related shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting
quality. MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1. #
of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal
meeting. # of Restate is the number of restatements within three years after the proposal meeting. Pass (G-index) is
the summation of an indicator variable equal to 1 if the proposal passes the majority threshold, 0 otherwise for G-
index proposals voted for a firm on a particular meeting date. Pass (Board) is the summation of an indicator variable
equal to 1 if the proposal passes the majority threshold, 0 otherwise for Board related proposals voted for a firm on a
particular meeting date. Pass (Comp) is the summation of an indicator variable equal to 1 if the proposal passes the
majority threshold, 0 otherwise for Compensation related proposals voted for a firm on a particular meeting date.
High MDDt-1 is an indicator variable equal to 1 if a firm’s MDD is above median the year before the proposal
meeting, 0 otherwise. ICWt-1 is an indicator variable equal to 1 if internal control weakness has been found for a firm
one year before the proposal meeting, 0 otherwise. Restatet-1 is an indicator variable equal to 1 if a firm has made
restatement one year before the proposal meeting, 0 otherwise. MDDt-1 is the accrual-based Dechow and Dichev
(2002) model modified by McNichols (2002) in year t-1. t statistics are in parentheses and are adjusted for within
cluster correlation by firm and by year. *, ** and *** indicate significance at two-tailed probability levels of 10%,
5%, and 1%, respectively.

34