Accounting for Value and Governance

107 Pages·2014·1.683 MB·English

by  Julia Mundy,Musa Mangena,Jia Liu

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Accounting for value and governance Research
Guest Editors: Professor Musa Mangena and Dr Jia Liu
249 Editorial advisory board
250 Guest editorial
255 Room for improvement: the impact of bad losses on board quality
Mark B. Mulcahy Accounting for value
273 Board structure and supplementary commentary on the primary financial statements
Venancio Tauringana and Musa Mangena and governance
291 The life cycle of initial public offering companies in China
Jia Liu and Dairui Li Guest Editors: Professor Musa Mangena
308 Reinforcing users’ confidence in statutory audit during a post-crisis period: an empirical study and Dr Jia Liu
Umar-Farook Aziz and Kamil Omoteso
323 Company specific determinants of greenhouse gases disclosures
Lyton Chithambo and Venancio Tauringana
339 Capital market pressures and the format of intellectual capital disclosure in intellectual capital V
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Jing Li and Musa Mangena
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ISBN 978-1-78441-617-1 www.emeraldinsight.com m
EDITORIALADVISORY BOARD Editorial
advisory board
AssociateProfessorIsmailAdelopo DrKumbaJallow
UniversityoftheWestofEngland,UK LeicesterBusinessSchool,UK
DrIsabelleAllemand DrJackKrogstad
GroupeESCDijonBourgogne,France CreightonUniversity,USA
DrPanagiotisAndrikopoulos ProfessorYvesLevant
249
DeMontfortUniversity,UK LilleGraduateSchoolofManagement,France
DrDavidBence ProfessorWoodyM.Liao
UniversityofBath,UK UniversityofCaliforniaRiverside,USA
DrSarahBlackburn DrJoanneLocke
TheWaysideNetwork,UK BirminghamUniversity,UK
DrRhodaBrown DrAshokPatel
LoughboroughUniversity,UK DeMontfortUniversity,UK
ProfessorDavidCampbell DrAlySalama
NewcastleUniversityBusinessSchool,UK DurhamUniversity,UK
ProfessorGinChong ProfessorDrGerritSarens
PrairieViewA&MUniversity,USA Universite´CatholiquedeLouvain,Belgium
DrAndreaCoulson DrPhilipJ.Shrives
UniversityofStrathclyde,UK NewcastleBusinessSchool,UK
DrColinDey DrAntoniosSiganos
UniversityofStirling,UK UniversityofGlasgow,UK
ProfessorSamirM.El-Gazzar BrianSingleton-Green
PaceUniversity,USA ICAEW,UK
DrJaneGibbon ProfessorRichardSlack
NewcastleUniversityBusinessSchool,UK DurhamUniversityBusinessSchool,UK
AssociateProfessorJenniferGrafton ProfessorLauraF.Spira
TheUniversityofMelbourne,Australia OxfordBrookesUniversity,UK
ProfessorChristineHelliar ProfessorIanThomson
UniversityofSouthAustralia,Australia UniversityofStrathclyde,UK
DrDanielHerbert ProfessorAlfredWagenhofer
OxfordBrookesUniversity,UK Karl-Franzens-Universitaet,Austria
DrKhaledHussainey ProfessorMargaretWoods
UniversityofPlymouth,UK AstonBusinessSchool,UK
ProfessorLisaJack ProfessorJasonXiao
PortsmouthBusinessSchool,UK CardiffUniversity,UK
JournalofAppliedAccounting
Research
Vol.15No.3,2014
p.249
rEmeraldGroupPublishingLimited
0967-5426
JAAR Guest editorial
15,3
250 Accounting for value and governance
Introduction
The waves of financial scandals and corporate failures in most of the developed
countries in the 1980s and early 2000s, and indeed the 2008 global financial crisis,
placed the corporate governance of the modern firm under greater and closer
scrutiny.FilatotchevandNakajima(2010)pointtothedistortedsystemofincentives
and lapses in the personal and professional integrity of managers as having
contributed significantly to the global financial crisis, undermining confidence in
capital markets and leading to the erosion of stakeholder trust. Against this
backdrop, and beginning in the early 1990s, developed and developing countries
have published best practice corporate governance recommendations as well as
regulatory laws to improve the quality of corporate governance. The governance
recommendations and regulations are motivated by the rationale that strong
governance supports sustainable value creation in firms via improvement in
responsibility and accountability (OECD, 2004; King Report, 2009). Consequently,
aconsiderableamountofresearchhasexaminedtheroleofcorporategovernancein
organisations,particularlyinthepublicfirm.Inthiscontext,studieshaveexamined
the impact of corporate governance on organisational value creation outcomes
such as firm value (e.g. Yermack, 1996; Coles et al., 2008; Mangena et al., 2012; Liu
et al., 2013), disclosure (e.g. Karamanou and Vafeas, 2005; Ajinkya et al., 2005;
Mangena and Pike, 2005), and earnings management (e.g. Peasnell et al., 2005).
Collectively, these studies show that effective corporate governance arrangements
areimportantfororganisationaloutcomes.Nevertheless,LarckerandTayan(2011)
point to the fact that the impact of corporate governance on value creation is
complex and there are gaps in knowledge that further research should continue to
address. They argue that careful research is important in providing a framework
that enables policy makers to formulate sound corporate governance policy and
practitioners to make sound decisions in designing governance systems that
enhance value creation.
This Special Issue of the Journal of Applied Accounting Research (JAAR)
comprises a collection of six peer-reviewed papers that contribute to the debate
relatingtocorporategovernanceandvaluecreationoutcomes.Thesecontributions
are part of a large number of papers that were presented at the 2013 Joint Annual
ConferenceoftheBritishAccountingandFinanceAssociationNorthernAreaGroup
and Interdisciplinary Perspectives Special Interest Group held at Nottingham
Business School, Nottingham Trent University, UK. In line with the conference
theme, “Accounting for value and governance”, the JAAR special issue call for
papers invited submissions on a wide range of accounting and finance-related
topics.Thecontributionsinthisspecialissuehaveattemptedtoaddresssomeofthe
JournalofAppliedAccounting
Research issues raised in the call for papers, with particular focus on the role of corporate
Vol.15No.3,2014 ownershipandcorporategovernancequality,theexternalauditfunction,voluntary
pp.250-254
rEmeraldGroupPublishingLimited disclosure of information about greenhouse gases, and investments in intellectual
0967-5426
capital assets.
DOI10.1108/JAAR-09-2014-0095
Overviewof thecontributions Guest editorial
ThefirstpaperbyMulcahyfocusesonwhetherreportingalossprecipitatesachange
in corporate governance arrangements to improve quality. The paper argues that to
the extent that adverse accounting outcomes are associated with lower quality
corporategovernancearrangements,firmsreportingpersistentlossesaremorelikely
to improve corporate governance in an attempt to mitigate the consequences of
underperformance. Such consequences include potential takeovers or liquidation. 251
Drawing from agency theory and on earlier research examining board changes
followingamajoreconomicevent,thepaperspecificallyexamineswhetherfirmsmake
changes in non-executive and independent directors in response to the reporting of
a loss and whether these changes are conditioned by the severity of the loss. Using
an industry and size matched control sample, and a difference-in-difference analysis,
the results indicate that more severe initial loss events as well as subsequent losses
precipitate improvements in board quality. The studyconcludes that the relationship
between corporate governance and performance is therefore endogenous as the
majority of any improvement in board quality actually anticipates the reporting of
theloss.
The second paper by Tauringana and Mangena examines the role of corporate
boardsinthefirm’snarrativereportingpractices.FollowingtheASB(2006)andIASB
(2010), the authors make a distinction between complementary and supplementary
narrative information, and focus their study on examining supplementary narrative
commentary on amounts reported in the primary financial statements. They argue
that to the extent that supplementary narrative disclosures are important for
understandingthefinancialperformanceandpositionofthefirm,theboardswilltake
actionsthatimprovethequalityofthesedisclosures.Theirstudyexaminestwoaspects
ofnarrativereporting:thelevelofsupplementarycommentaryonamountsreportedin
the primary financial statements and the propensity to bias commentary towards
aspecificprimaryfinancialstatement(whichtheycallsupplementarynarrativefocus).
Their findings demonstrate that board structure quality improves the level of
commentaryandreducessupplementarynarrativefocus.Theauthors,therefore,infer
that policy makers and firms might improve the quality of information provided
to users by improving thequalityof corporate governance.
The next paper by Liu and Li explores the factors that determine the company’s
post-IPOtransitionintooneofthethreestates:acquisitionsduetoweakperformance,
acquisitions due to strong performance, or delisting outright. Motivated by prior
literature’s failure to capture these post-IPO states and using data of Chinese firms,
they find that delisting is predominantly influenced byoffering-specific information,
by the issuer’s financial status leading up to the eventual outcome, by agency costs,
andbycorporateownership andgovernancestructure.Acquisitionsduetostrongor
weak performance differ most significantly according to industry features, state
ultimateownership,andtheextentofboardsize.Moreimportantly,theyfindthatthe
trajectory in the IPO aftermarket is shaped by corporate ownership and control
considerations. The authors concluded that corporate evolution in China is jointly
shaped by marketforcesandstate control.
ThepaperbyAzizandOmotesofocusesonanimportantgovernancemechanism,
the external auditor, whose reputation came under scrutiny following the global
financial crisis. The external audit function was heavily criticised for their role in
the financial crisis, particularly given the fact that most of large banks that failed
during the crisis were all given a clean audit only some months before failing.
JAAR The authors argue that this leads to loss in confidencein the external audit function
15,3 and hence the financial statements. Accordingly, the paper investigates factors that
are perceived as important for restoring confidence in the external auditor and the
financialstatements.Theyusedatadrawnfrompractisingaccountants,auditors,and
accounting academicswithin the UK to provide an understanding of the factors that
mayimproveconfidenceintheexternalauditor.Usingfactoranalysis,theygroupthe
252 factors into four including competition, independence, regulatory response and
education,anddemonstratethatthemostimportantfactorsareimprovementinauditor
independence, regulatory response, and enhanced auditor training (education). They
concludethatpolicymakersneededtorefocustheirattentiontoaddressingtheissueof
auditorindependencewhilstprofessionalaccountancybodies,accountingeducators,and
accountingfirmsneededtorevampthecurriculumandtrainingschemes.
In their paper, Chithambo and Tauringana do not examine corporate governance
per se, but address issues relating to sustainability – a topic that has attracted
extensive attention from stakeholders around the world and has become an integral
part of corporate governance. They investigate the voluntary greenhouse gas
disclosures by UK-listed firms and examine whether differences in greenhouse
gasdisclosuresarerelatedtofirm-specificcharacteristics.Theirfindingsdemonstrate
that voluntary disclosure of greenhouse gases in the UK is low, and focuses on
providing more qualitative than quantitative information. They also show that
greenhouse gasdisclosures differ withfirm-specific characteristics and industry.
Thelastofthepapersinthespecialissue,byLiandMangenafocusesonintellectual
capitaldisclosure,animportantdimensionoftheinformationsetconsideredcriticalfor
thecapitalmarketinitsvaluationofthefirm’sshares.Drawingfromearlierresearch,
theyarguethatbecausetheexistingfinancialreportingmodelarbitrarilyamortisesor
immediately expenses investments in intellectual capital assets such as advertising
expenses, research, and development, these assets are not effectively captured in the
financial statements. This creates significant information asymmetry problems
and therefore enhanced voluntary disclosure is important. In this respect, unlike
previousstudies,thepaperexaminesthepresentationformat(i.e.text,numerical,and
graph/pictures) of intellectual capital disclosures and the impact of capital market
pressures.Aswewouldbeexpected,theydemonstratethatdisclosureisgreaterintext
format than in numerical and graph/picture formats, and that the impact of capital
marketpressures differswith presentation format.
Conclusions
The contributions in this special issue have addressed a number of issues, with
particularfocusontheroleofcorporateownershipandcorporategovernancequality,
the external audit function, voluntary disclosure of information about greenhouse
gases,andinvestmentsinintellectualcapitalassetsindifferenteconomicandmarket
settings.Onthewhole,thefindingsofthepapersinthisspecialissuepointtothefact
thatcorporategovernancemattersforvaluecreationandthereforeprovideimportant
insightsto theliterature.Thefindingsreportedinthese papershavebothpolicyand
practical implications in line with theobjectivesof theJAAR.
Professor Musa Mangena
Nottingham BusinessSchool,Nottingham Trent University, Nottingham, UK
Dr Jia Liu
Salford Business School,University of Salford, Salford, UK
References Guest editorial
Ajinkya, B., Bhojraj, S. and Sengupta, P. (2005), “The association between outside directors,
institutionalinvestorsandthepropertiesofmanagementearningsforecasts”,Journalof
AccountingResearch,Vol.43No.3,pp.343-376.
ASB (2006), Reporting Statement (RS) 1 – Operating and Financial Review, Accounting
StandardsBoard,London.
253
Coles,J.L.,Daniel,N.D.andNaveen,L.(2008),“Boards:doesonesizefitall?”,JournalofFinancial
Economics,Vol.87No.3,pp.329-356.
Filatotchev,I.andNakajima,C.(2010),“Internalandexternalcorporategovernance:aninterface
between an organization and its environment”, British Journal of Management, Vol. 21
No.3,pp.591-606.
IASB (2010), IFRS Practice Statement-Management Commentary, A Framework for
Presentation,InternationalAccountingStandardsBoard,London.
Karamanou, I. and Vafeas, N. (2005), “The association between corporate boards, audit
committees, and management earnings forecasts: an empirical analysis”, Journal of
AccountingResearch,Vol.43No.3,pp.453-486.
KingReport(2009),ReportonCorporateGovernanceforSouthAfrica,InstituteofDirectorsof
SouthAfrica,Parklands.
Larcker, D.F. and Tayan, B. (2011), Corporate Governance Matters: A Closer Look at
OrganiszationalChoicesandTheirConsequences,FTPress,UpperSaddleRiver,NJ.
Liu,J.,Lister,R.andPang,D. (2013),“Corporate evolutionfollowing initialpublic offeringsin
China:alife-courseapproach”,InternationalReviewofFinancialAnalysis,Vol.27,April,
pp.1-20.
Mangena,M.andPike,R.(2005),“Theeffectofauditcommitteeshareholding,financialexpertise
andsizeoninterimfinancialdisclosures”,AccountingandBusinessResearch,Vol.35No.4,
pp.327-349.
Mangena, M., Tauringana, V. and Chamisa, E. (2012), “Corporate boards, ownership structure
andfirmperformanceinanenvironmentofseverepoliticalandeconomiccrisis”,British
JournalofManagement,Vol.23No.S1,pp.23-41.
OECD(2004),“Principlesofcorporategovernance,organisationforeconomicco-operationand
development”, available at: www.oecd.org/corporate/ca/corporategovernanceprinciples/
31557724.pdf(accessed15September2014).
Peasnell,K.V.,Pope,P.F.andYoung,S.(2005),“Boardmonitoringandearningsmanagement:do
outside directors influence abnormal accruals?”, Journal of Business Finance and
Accounting,Vol.32Nos7/8,pp.1311-1346.
Yermack,D.(1996),“Highermarketvaluationoffirmswithasmallboardofdirectors”,Journalof
FinancialEconomics,Vol.40No.2,pp.185-211.
AbouttheGuestEditors
MusaMangena isa ProfessorofAccountingattheNottingham BusinessSchool,Nottingham
Trent University, UK. His main research interests are concentrated in the areas of corporate
governance, corporate disclosure and consequences, and the behavioural and organisational
effects of performance measurement systems. He has published his work in top journals
such as the British Journal of Management; Journal of Accounting, Auditing and Finance;
International Journal of Accounting; Accountingand Business Research; European Accounting
Review; British Accounting Review and Journal of International Financial Management
and Accounting. He is on the Editorial Board of the Journal of Accounting in Emerging
Economies. Professor Musa Mangena is the corresponding author and can be contacted at:
[email protected]
JAAR DrJiaLiuisaReaderinFinanceattheBusinessSchool,theUniversityofSalford,UK.Her
15,3 researchinterestsareintheareasofcorporatefinanceandgovernance,riskmanagement,capital
markets, market-based accounting research, and their related public policy implications. Her
work has appeared in top journals such as International Review of Financial Analysis,
InternationalJournalofEconomicsofBusiness,BulletinofEconomicResearch,Managerialand
Decisions Economic,Applied Economics and ChinaEconomicReview. Shesits on theEditorial
254 BoardofJournalofRiskManagement.SheistheChairoftheNorthernAreaGroupoftheBritish
AccountingandFinanceAssociation.
Thecurrentissueandfulltextarchiveofthisjournalisavailableat
www.emeraldinsight.com/0967-5426.htm
Room for improvement: the The impact of
bad losses on
impact of bad losses on
board quality
board quality
255
Mark B. Mulcahy
Accounting, Finance & Information Systems,
University College Cork, Cork, Ireland
Abstract
Purpose – The purpose of this paper is to study the relationship between reporting a loss and
changesinboardquality.Lowqualitycorporategovernanceisassociatedwithadverseaccounting
outcomesandischaracterisedbythelackofnon-executiveandindependentdirectorsontheboard.
Changesintheseboardqualityindicatorsinresponsetothereportingofalossandconditionedbythe
severityofthelossareexamined.
Design/methodology/approach–Thisstudyusesfouryearsofboardinformationspanningthe
reportofaninitiallossforcompanieslistedontheUKstockexchange.Anindustryandsizematched
control sample is used in a difference-in-difference analysis to isolate the impact of the loss from
underlyingchangesinboardquality.
Findings–Overalltheresultsindicatethatmoresevereinitiallosseventsprecipitateimprovements
inboardqualityoverandabovethecontrolsampleaswellaslessseverelossevents.
Researchlimitations/implications–Althoughunambiguous,thereportingofalossisonlyone
measure of underperformance. Also the board quality indicators used in this study are two from
severalindividualcorporategovernancevariablesandamalgamationsusedintheextentliterature.
Practical implications – The findings demonstrate that the relationship between corporate
governanceandperformanceisendogenousandthatthemajorityofanyimprovementinboardquality
actuallyanticipatesthereportingoftheloss.Anycelebrationofimprovementsingovernanceneedtobe
temperedbyanunderstandingoftheprecariousnessofthefirmsatwhichtheseimprovementsaremade.
Originality/value – This study contributes to a research stream that examines negative shocks,
andlossesinparticular,asaneventlikelytoprecipitatefirm-levelchangesinboardquality,i.e.firms
tendnottomakeimprovementstoboardqualitywithouttheimpetustodoso.
Keywords Difference-in-difference,Losses,Corporategovernance,Boardquality
Papertype Researchpaper
1. Introduction
Thereisampleevidenceofmajoreconomiceventsprecipitatingcorporategovernance
changes at national level: for example the Sarbanes Oxley Act (2002) and the Enron
and other scandals of 2001 and 2002. While some research has been done relating
to changes in management, particularly CEOs, following poor performance there is
a paucityof evidence pertaining to what instigates corporate governance changes at
firmlevel.Thelittleresearchthathasbeendonepertainsmainlytoresponsesinfirms’
governance to negative shocks including accounting misstatements, the discoveryof
fraudortherevelationofaninternalcontrolmaterialweakness(ICMW).Forexample,
Farber(2005)pointsoutthatfirmsidentifiedbytheSECoffraudulentlymanipulating
their financial statements take steps to improve their governance. ICMWs are often
JournalofAppliedAccounting
associatedwith underperformance or the reportingof aloss (Johnstone etal.,2011). Research
Basedonpredictionsfromagencytheorythisstudypredictsthatfirmswhichexperience Vol.15No.3,2014
pp.255-272
a loss will attempt to mitigate the adverse consequences of the underperformance by rEmeraldGroupPublishingLimited
0967-5426
improvingthequalityoftheirboardinresponse.Iflossesareallowedtoperpetuate DOI10.1108/JAAR-10-2013-0081
JAAR theshareholdersofthecompanywillexercisetheirputoptiontoliquidatethefirm
15,3 (Hayn, 1995). Incurring a loss is not as extreme an event as the discoveryoffraud
studied by Farber (2005), but it is indicative of a situation that requires remedial
action insofar as it could evolve into a crisis. Even if losses are not expected to
perpetuatetheyareindicativeofarateofreturnthatisclearlybelowthatrequired
byinvestors.Thesignalofunambiguousunderperformanceprovidedbyalosswill
256 not be tolerated by investors over a prolonged period and needs to be seen to be
addressed.
Asample(test)offirmsexperiencingtheirfirstlossinatleastthreeyearsbetween
2004 and 2006 is collected. A control sample matched by industry and size is also
collectedandtherelativechangesinboardqualityintheperiodsurroundingtheloss
are examined. Board quality is measured as both the percentage of non-executive
directors and the percentage of independent directors (excluding the Chair in both
cases) on the board. Although this study finds that loss firms improve the qualityof
their board and that there is a tendency for these observed changes to precede the
announcement of the loss, the extent of these changes are not significantly different
fromthecontrolsample.Thispaperarguesthatnotalllossesare equalsuchthatthe
relativeseverityofthelosseventwilllikelyplayasignificantroleonthebehaviourof
boardqualityinresponsetotheloss(Hennesetal.,2008;Desaietal.,2006;Srinivasan,
2005).Whentherelativeseverityoftheshock(determinedbothdirectlybytherelative
magnitude of the loss as well as indirectly by the relative market return around the
loss) is used to condition the analysis, the results indicate that the more severe (or
“worse”)theloss,themoreboardqualityimprovesvsboththecontrolsampleandthe
less severeloss sample.
2. Theoretical development
Agency theory analyses the managerial incentive problems that are induced by the
separationofcorporateownershipandcorporatedecisionmaking.AttributedtoJensen
andMeckling(1976)andFamaandJensen(1983),agencytheoryfocusesonidentifying
the optimal structure and the relative effectiveness of monitoring mechanisms (the
corporate board in this case) that discipline management’s potential opportunistic
behaviour.Giventhattheboard’sgoverningroleisoversight,itfollowsthataslongas
management’sdecisionsareconsistentwiththoseoftheshareholders,allboards(even
a non-optimal one) will appear effective as a corporate governance mechanism
(Mizruchi,1983).ItisforthisreasonthatKosnik(1987)arguesthattheeffectivenessof
the board is better gauged when a firm is facing a crisis such that, notwithstanding
governancestickiness,afirm’snon-adherencetobestorcommoncorporategovernance
practiceislikely tocomeintosharper focuswhenthefirmisintrouble.Thelogicis
that the crisis event destabilises the corporate governance equilibrium thereby
providinganimpetustochange(improve)corporategovernancemechanismsasthese
firms move dynamically towards their optimal governance structure (Larcker et al.,
2007). It is also worth noting that even though firm-level corporate governance
changesarediscretionary,theytypicallyaretakenagainstabackdropofbestpractice
recommendedbygovernancecodes–Ciceroetal.(2010)presentevidencethatUSfirms
pursuetargetboardstructures.Therefore,forestablishedfirms,theboard’sstructure
andmembership(i.e.quality)canbestickyarounduniformlevels(Beasleyetal.,2010).
Notwithstanding the potential of this stickiness to dampen the changes under
investigationhere,thisstudytheorisesthatthegovernanceequilibriumatshocked(i.e.
loss) firms is morelikely to destabilise.
Prior research has explored the relationship between shock events and The impact of
management- and board-level changes. For instance Agrawal and Cooper (2009) bad losses on
detailapositiverelationbetweenrestatementsandtopmanagementturnover;onthe
board quality
other hand, Beneish (1999) reports no association between restatements and
management turnover. A study that specifically examines changes in corporate
governanceinresponsetoashockeventisFarber(2005).Farberexamineswhetheran
investigation by the SEC precipitates a change in arange of governance metrics and 257
documentswhetheranyofthesechangesprovideeconomicbenefits.Hislogicisthatif
firmsaretoexpendscarceresourcesongovernanceimprovementprecipitatedbythe
shock, then evidence that such changes provide economic benefits would strengthen
the case being made by regulators in this regard. Farber finds that prior to the
announcementoftheSECinvestigationfraudfirmsexhibitedweakness, interalia,in
theproportionofoutsidedirectorsontheboard.However,attheendofthethreeyears
following the fraud detection, fraud firms were indistinguishable from a matched
controlsampleinthisvariable.Thisindicatesthatinresponsetoashockeventfraud
firms wish to report their financial information more credibly and improve their
governancemechanismsinanattempttodoso.Johnstoneetal.(2011)examinechanges
in corporate governance that stem from the revelation of ICMW. It is one of the
provisionsoftheSarbanes-OxleyActof2002thatfirmsandtheirauditorsmustreport
onthepresenceofICMWs.Theauthorsfindthatsuchrevelationsareassociatedwith
turnover in the board of directors, audit committee and top management and
specifically with subsequent improvements in corporate governance. Their empirical
analysis provides evidence that supports their predictions. Of particular relevance to
thecurrentstudyisthatoneofthecontrolvariablesusedbyJohnstoneetal.(2011),i.e.
the reporting of a loss, is positively associated with the incidence of an ICMW. This
notwithstanding, there is a paucity of studies that specifically address changes in
corporate governance in response to aloss event.
Incurring a loss can be a significant negative event in the life of a firm. Perry
and de Fontnouvelle (2005) and Plunus et al. (2012) have shown that a firm’s
reputation is damaged by the announcement of losses. This study predicts that
firms which experience a loss will attempt to mitigate these adverse reputational
consequencesbyimprovingtheircorporategovernanceinresponseto/anticipation
of their underperformance. As pointed out by Hayn (1995), shareholders will
not tolerate indefinite losses and will exercise their put option to liquidate the
firm. In terms of put call parity this can also be seen in terms of the lenders of
the company exercising their call option to seize and sell the assets of the firm.
Incurring a loss is not as extreme an event as the discovery of fraud studied by
Farber(2005)andPerryanddeFontnouvelle(2005)butitisindicativeofasituation
that requires remedial action and potentially may evolve to become a crisis
(Mulcahy and Linehan, 2014).
Whileitispossible evenforfirmsreportingaprofittofailtoachievetherequired
rate of return demanded by its shareholders, there is little doubt that loss firms are
aspecialcaseofunderperformance(Collinsetal.,1999).Thelatterauthorsshowthat
losseshavelimitedpredictiveabilityrelativetoprofitsforfuture earningsandsothe
company’sbookvaluebecomesmuchmoreimportantforthevaluationofloss-making
companiesbothasaproxyforfuturenormalearningsandanindicatorofliquidation
value.Aninitiallossmaybetransitorybutitmayalsosignalthebeginningoftheend
ofacompany.Whenthelossisfirstreportedinvestorswillattempttoassesswhether
the loss is a transitory blip or a symptom of the terminal decline of the company.