CORPORATE CHARACTERISTICS, GOVERNANCE RULES AND THE EXTENT OF VOLUNTARY DISCLOSURE IN SPAIN M. Rosario Babı ´ o Arcay and M. Flora Muin ˜ oVa ´ zquez ABSTRACT This study examines the relationships among corporate characteristics, the governance structure of the firm, and its disclosure policy. Empirical evidence supporting this investigation has been gathered from a sample of Spanish firms listed on the Madrid Stock Exchange. This setting is of interest because of its low level of investor protection, high ownership concentration, and poorly developed capital market. Our results show that a firm’s size, along with some mechanisms of corporate governance such as the proportion of independents on the board, the appointment of an audit committee, and directors’ shareholdi ngs and stock option plans, are positively related to voluntary disclosure. We have also observed that these governance practices are significantly influenced by cross-listings and by the ownership structure of the firm. Advances in Accounting Advances in Accounting, Volume 21, 299–331 Copyright r 2005 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 0882-6110/doi:10.1016/S0882-6110(05)21013-1 299 1. INTRODUCTION Corporate disclosure is of critical importance for the efficient functioning of capital markets. The Special Committee on Financial Reporting of the American Institute of Certified Public Accountants (AICPA) stated: Few areas are more central to the national economic interest than the role of business reporting in promoting an effective process of capital allocation (AICPA, 1994, p. 2). Although regulators have enforced legislation to ensure that companies provide at least a minimum set of infor mation to third parties, 1 legal re- quirements do not always satisfy stakeholder demands. 2 Not surprisingly, there is considerable variation among companie s in the disclosure of infor- mation that is not legally required. Research on the determinants of voluntary disclosure initially focused on corporate characteristics. 3 The basic assumption is that corporate disclosure policy is determined by a trade-off between the costs and benefits associated with disclosure, 4 for which corporate characteristics such as company size (Depoers, 2000), listing status (Meek, Roberts & Gray, 1995), and a firm’s performance (Singhvi & Desai, 1971) may serve as useful proxies. On the other hand, recent research suggests that factors other than cost-benefit analysis may determine a firm’s disclosure policy. In particular, corporate governance mechanisms may exert some control over a manager’s actions (Core, 2001, p. 444), and such mechanisms may help to fulfil the informa- tional demands of stakeholders. For example, Watts and Zimmerman (1990), drawing on the insights of the theory of the firm, suggest that man- agers make acco unting choices that can be considered to be efficient when they maximize the value of the firm, or opportunistic if they enhance the manager’s welfare at the expense of other contracting parties. Therefor e, the argument of efficiency assumes an alignment between organizational and managerial goals. The board of directors is regarded as a relevant mechanism in the over- sight of managerial actions 5 (Fama & Jensen, 1983). Researchers have ex- amined the role played by certain practices aimed at enhancing the monitoring role of the board on the provision of voluntary information (Chen & Jaggi, 2000; Ho & Wong, 2001; Nagar, Nanda & Wysocki, 2003). Comparisons among these studies provide some interesting insights. For example, Chen and Jaggi (2000) found that the appointment of non- executive directors was significantly related to disclosure, whereas Ho and Wong (2001) did not find it to be a significant variable in explaining cor- porate disclosure. Moreover, previous research focused on a particular M. ROSARIO BABI ´ O ARCAY AND M. FLORA MUIN ˜ OVA ´ ZQUEZ300 corporate governance mechanism (i.e. the board of directors), but as Bushman and Smith (2001, p. 286) stated, a complete understanding of the role played by corporate governance requires an explicit recognition of in- teractions across different mechanisms. In this paper, we seek to extend previous research in three different ways: (1) by exploring the role played by a number of good governance practices in enhancing corporate disclosure, (2) by examining the role of majority shareholders in the adoption of practices of good governance, and (3) by analysing the direct and indirect effects of various corporate characteristics on voluntary disclosure. First, we analyse the role played by the board of directors in enhancing corporate disclosure by examining a wide range of practices of good gov- ernance: the appointment of independent directors, the formation of an audit committee, the separation of the functions of CEO and chairman of the board, the participation of board members in the capital of the com- pany, the establishment of stock option plans as a means of directors’ re- muneration, and the size of the board. Nonetheless, the individual analysis of a particular practice of good governance does not allow for a full as- sessment of its role in promoting transparency, inasmuch as complement- arities and substitutability between them make the whole worthier than the mere aggregation of its individual constituents. 6 In this study, we have em- ployed confirmatory factor analysis to reduce governance practices to a single factor for the assessment of their global effect on corporate disclosure. Second, our analysis takes into account the role played by majority shareholders in corporate governance, as well as interactions between the adoption of good governance practices and the ownership structure of the company. Evidence is gathered from Spa in, a country especially suited to the development of this analysis. In contrast with common law countries, the Spanish institutional setting has in common with other European Con- tinental countries a relatively low number of listed companies, 7 an illiquid capital market, the existence of a large number of inter-corporate share- holdings and, above all, a high level of concentration in corporate share- holdings 8 (Leech & Manjo ´ n, 2002, p. 169). Research has shown that unlike civil-law nations, common-law countries enact rules and legislation to shield the informational rights of investors. As noted by La Porta, Lopez-de Silanes, Shleifer and Vishny (1998), civil-law countries enforce loose legis- lation because of the determinant role of ownership concentration 9 and ownership structure determines the governance practices followed by their companies. Wymeersch (2002) argues that compliance with the recommen- dations of codes of good governance in European countries is more difficult Corporate Characteristics, Governance Rules 301 than in the U.K. because of the greater presence of majority shareholders in Europe – investors who do not wish to see their influence reduced by the appointment of independent directors. Moreover, non-compliance with rec- ommendations such as the separation of the functions of the CEO and the chairman of the board may not be as negatively assessed in civil-law coun- tries as it is in common-law countries, which have been the focus of more studies. For example, the Spanish code of good governance recognizes that the combining of CEO and chairman positions is a common practice in Spain, because it is thought to sup port leadership both internally and ex- ternally (Olivencia Committee, 1998). Finally, our analysis of the determinants of voluntary disclosure focuses on such general company characteristics as size, cross-listing status, and the industry in which it operates. We employed structural equation modeling to analyse both the direct and indirect effects of these characteristics on cor- porate disclosure. In contrast with previous research, which focused on the direct effect attributed to the balance between benefits and costs linked to the provision of infor mation, we also recognize the effect that these char- acteristics exert on the firms’ practi ces of good governance (Denis & Sarin, 1999; Doige, 2004), which in turn would affect corporate disclosure policy. Corporate governance in Spain has relied heavily upon the role played by majority shareholders who were usually involved in the management of the company. Nevertheless, during the 1990s, free floating capital started to represent a significant proportion of equity in some listed companies, giving rise to greater concern about corporate governance and the protection of investors’ interests. Hence, Spain provides a suitable environment in which to test for the existence of interactions among corporate characteristics, good governance rules, and corporate disclosure. The remainder of the paper is structured as follows: Section 2 presents a review of the literature and the development of hypotheses to be tested; Section 3 provides a description of the data and methodology used in this study; Section 4 contains the empirical results of the study; and in Section 5 we discuss the results and conclusions. 2. CORPORATE DISCLOSURE AND FIRM CHARACTERISTICS Agency costs arising from the separation of ownership and control in mod- ern corporate forms may be reduced by strengthening the monitoring and M. ROSARIO BABI ´ O ARCAY AND M. FLORA MUIN ˜ OVA ´ ZQUEZ302 overseeing functions of the board of directors. 10 In large corporations, share- holders are not involved in the management and control of the corporation, but delegate such responsibilities to the board of directors to ensure goal congruence between shareholders’ interests and management actions. The corporate board’s role of overseeing is particularly relevant in protecting the interests of powerless minority shareholders. 11 In fact, commissions charged with the preparation of the so-called codes of good governance focused their attention on the composition and functioning of the board of directors. Practices such as the appointment of non-executive directors, the separation of the functions of chairman of the board and CEO, or the creation of specialized committees inside the board, such as the audit committee and the compensation committee, were considered as essential mechanisms to im- prove the monitoring of management. 12 They reduce the manager’s latitude to act opportunistically and contribute to the alignment of the internal and external interests of the organization (Denis, 2001, p. 195). Independent non-executive directors. Codes of good governance include a number of recommendations, one of them being the appointment of non- executive directors, an inclusion designed to reduce agency conflicts between managers and shareholders ( Gregory & Simmelkjaer, 2002, p. 53 ). Arguably, boards controlled by management may result in practices of collusion, among them the expropriation of shareholders’ wealth. Under such rationality, the inclusion of outsiders on the board should reduce the likelihood of collusive arrangements, inasmuch as non-executive directors are disciplined by the mar- ket, which a ssesses and r ewards performance (Fama, 1980, pp. 2993–2294). The extant literature provides empirical evidence supporting the role of non-executive directors in promoting higher transparency and better dis- closure policies. Chen and Jaggi (2000) found a positive association between the proporti on of independent directors on the board and the extent of a firm’s disclosure. The proportion of outside directors on corporate boards was also negatively associated with indicators that measured the (poor) quality of the information disclosed, such as the publication of fraudulent or defective financial statements (Beasley, 1996; Peasnell, Pope, & Young, 2001), as well as measures of earnings management (Peasnell, Pope, & Young, 2000). These results suggest that compan ies with a higher propor- tion of independents on the board show a greater concern for disclosure. Hence, we hypo thesize that: H1a. voluntary disclosure is positively related to the proportion of in- dependent directors on the board. Corporate Characteristics, Governance Rules 303 Audit committee. The audit committee operates as a monitoring mech- anism to improve the quality of information conveyed to external parties (Pincus, Rusbarsky, & Wong, 1989) and oversees the preparation and com- munication of financial information to third parties to ensure that such data fulfils the requisites of clarity and the completeness of disclosure (Smith Report, 2003, p. 12). Empirical evidence indicates that voluntary disclosure is positively related to the functioning of an audit committee (Ho & Wong, 2001). Furthermore, Dechow, Sloan and Sweeney (1996) and Peasnell, Pope, & Young (2001) observed that audit committees help to reduce the likelihood of accounting fraud. These factors lead us to hypothesize: H1b. voluntary disclosure is positively related to the existence of an audit committee. Chairman of the board and chief executive officer being the same person. Separating the positions of CEO and chairman of the board arguably helps to improve the monitoring function of the board. Jensen (1993) argues that conflicts of interests and difficulties in performing the monitoring function over management arise when the same individual holds both positions. This dual-role situation is quite common in some European countries (U.K., France, Spain, and Italy), but it may require a balance. The Olivencia Code of 1998 states, for example, that these dual roles may support leadership within the organization and towards external parties, but recommends the appointment of independent directors in order to balance the dominance of the CEO/chairman of the board. A number of studies have identified the combining of these two positions with poor disclosure practices. For ex- ample, Forker (1992) found a significant negative relationship between the combination of the two roles and the extent of disclosure. Furthermore, Ho and Wong (2001) observed a negative relationship, albei t a non-significant one, between corporate disclosure and the presence of a dominant person- ality on the firm’s board. Therefore, we are led to hypothesize: H1c. voluntary disclosure is positively related to the separation of the functions of CEO and chairman. Board participation in the capital of the company. Directors’ shareholdings constitute a relevant vehicle for monitoring the management, as it tends to restrain managerial incentives to divert resources that may ultimately jeop- ardize the attainment of shareholder value maximization (Jensen & Meckling, 1976). Furthermore, directors’ shareholdings help to align goals and financial incentives of board members with those of outside sharehold- ers (Bushman, Chen, Enge l, & Smith, 2004, p. 177). Shivdasani (1993) M. ROSARIO BABI ´ O ARCAY AND M. FLORA MUIN ˜ OVA ´ ZQUEZ304 observed that, relative to a control sample, outside directors in firms that are targets of hostile takeovers have lower ownership stakes. Bhagat, Carey and Elson (1999) found a positive correlation between the directors’ stock own- ership and firm’s performance, as well as a positive correlation between di- rector’s personal equity holdings and the likelihood of a disciplinary-type CEO succession in poorly performing companies. On the other hand, the examination of insider shareholdings has shown the existence of a non-linear relationship between ownership and a firm’s value – as ownership increases, firm value rises up to a point, and then decreases (McConnell & Servaes, 1990; Short & Keasey, 1999; Faccio & Lasfer, 1999). The authors of these studies considered the non-linearity between a firm’s value and ownership to be a consequence of the entrenchment effect associated with high levels of managerial ownership. In cases of low levels of director ownership, therefore, the monitoring role of the board is strengthened, which has a positive effect on voluntary corporate disclosure. Hence, we hypothesize that: H1d. voluntary disclosure is positively related to board participation in the capital of the company. Stock option plans as directors’ pay. Stock option plans serve the purpose of compensating board members by aligning their interests with the firm’s performance; increases in share prices lead to greater compensation for board members (Jensen & Murphy, 1990; Tosi & Gomez-Mejia, 1989). Gutie ´ rrez, Llore ´ ns and Arago ´ n (2000, p. 426) suggest that the linkage of management compensation to performance results in a transfer of risk to management and acts as a deterrent to opportunistic behaviour. In this respect, empirical evidence shows that stock option plans for outside direc- tors improves a firm’s value (Fich & Shivdasani, 2004) and increases the monitoring role played by the board (Perry, 2000). Moreover, a number of studies examines the relationship between stock options and disclosure practices. Nagar, Nanda and Wysocki (2003, p. 287) argue that general stock-priced-based incentives represent an effective means of encouraging both good and bad news disclosures; stock price appreciation promotes the release of good news, whereas withholding bad news may lead to litigation costs and a decrease in stock price, because investors may interpret non- disclosure as ‘‘worse’’ ne ws (Verrechia, 1983). In this respect, Miller and Piotroski (2000) and Nagar, Nanda and Wysocki (2003) report a positive association between corporate disclosure and the proportion of CEO com- pensation affected by stock price. Although these studies refer to the com- pensation of managers rather than the compensation of directors, we expect Corporate Characteristics, Governance Rules 305 to observe the same type of incentives to disclosure when directors benefit from stock option plans. This leads us to hypothesize: H1e. voluntary disclosure is positively related to the establishment of stock option plans as directors’ remuneration. Board size. In addition to the foregoing mechanisms for aligning man- agement and shareholder interests, codes of good governance usually rec- ommend limitations to the size of a board. 13 By restricting the number of directors, it is believed that the exchange of ideas between board members will be enhanced, as well as flexibility in the decision-making process. Jensen (1993, p. 865) argues that small boards are more effective in monitoring the CEO and are tougher for the CEO or the chairman to manipulate. In a similar vein, Yermack (1996) has shown that firms with smaller boards are valued more highly by the market than are their counterparts with larger boards; wher eas Vafeas (2000) has observed that investors place higher value on earnings information when provided by firms with smaller boards. Investigations have also examined the quality of disclosure and its relation- ship with board size. For example, Peasnell, Pope and Young (2001) found a tendency, albeit statistically non-significant, for mean board size to be higher for firms reporting defective financial statements than for those in- cluded in their control sample. The strength of these arguments, however, leads us to hypothesize: H1f. voluntary disclosure is negatively related to the size of the board. The adoption of any one of the above-mentioned practices of good gov- ernance does not exclude the assumption of others. In contrast, the effect of some practices may be strengthened when other rules are observed. As an example, Peasnell, Pope and Young (2000) observed that the role played by independent directors was enhanced by the functioning of a boa rd audit committee. Moreover, non-compliance with some rules of good governance may be partially offset by the adoption of others. Gul and Leung (2004) have shown that the presence of highly experienced non-executive directors on the board tends to moderate the negative effect of combining the po- sitions of CEO and chairman. As a consequence, we expect that the greater the degree of compliance with codes of good governance, the greater the improvement in corporate disclosure. Hence, we formulate the following general hypothesis: H1. voluntary disclosure is positively related to the adoption of rules of good governance. M. ROSARIO BABI ´ O ARCAY AND M. FLORA MUIN ˜ OVA ´ ZQUEZ306 The ownership structure of a firm may be a possible determinant of or- ganizational disclosure (Raffournier, 1995). At one extreme, high levels of concentration of capital may be accompanied by the owner’s considerable involvement in the firm’s management, which, in turn, may lead to unre- stricted access to information. Under these circumstances, the demand for information would be very low, or even absent, particularly if the manager owns all the firm’s shares. On the other hand, in cases of dispersion of ownership, investors lack first-hand access to information, and this may lead to increased demands for organizational information that can be used to monitor management (Gelb, 2000, p. 169). In this respect, McKinnon and Dalimunthe (1993, p. 37) suggest that voluntary disclosure may be helpful in reducing conflicts between managers and shareholders that arise when a firm’s shares are widely held. Furthermore, ownership dispersion may in- fluence the supply of information. For example, Craswell and Taylor (1992, p. 299) argue that increases in the separation of ownership and control are likely to be accompanied by additional disclosures of information to third parties. By ov ercoming owners’ perceived asymmetry of information, man- agement expects to reduce the discount implicit in its compensation pack- age. Additionally, the ownership structure may have a significant impact on the adoption of rules of good governance which, in turn, will affect cor- porate disclosure. As suggested by Wymeersch (2002), compliance with the recommendations of codes of good governance is more difficult when a significant proportion of a firm’s equity is held by a majority shareholder. Therefore, we are led to hypothesize: H2. voluntary disclosure is negatively related to the level of ownership concentration. Corporate size was commonly used as an explanatory factor for voluntary disclosure. Ball and Foster’s (1982) review shows that firm size has been regarded as an adequate proxy for the costs and benefits linked to the provision of information. The cost of gathering and preparing detailed in- formation an d the risk of creating a competitive disadvantage through dis- closure will be lower for larger companies that prepare the information for internal use and invest large amounts of resources in fixed assets and in- novation processes. This large company advantage, it is argued, acts not only as an entry barrier towards smaller companies (Depoers, 2000, p. 251), but it also enables larger firms to benefit from the salutary effects of better disclosure because the provision of information facilitates access to capital markets (Singhvi & Desai, 1971, p. 131). Additionally, corporate disclosure leads to the allaying of public criticism or government intervention (Watts & Corporate Characteristics, Governance Rules 307 Zimmerman, 1986). Therefore, the balance between benefits and costs linked to the provision of information is expected to be more favourable for large than for small companies. Furthermore, codes of good governance may also lead large companies to provide more voluntary information than their smaller counterparts do. Research has shown the existence of a positive association between a firm’s size and the adoption of some practices of good governance, such as the appointment of independent directors or the separation of the functions of CEO and chairman (Denis & Sarin, 1999 ; Dehaene, De Vuyst, & Ooghe, 2001). Thus, the size of the company may exert an indirect influence on disclosure. Therefore, we hypothesize: H3. voluntary disclosure is positively related to the size of the company. A number of studies regard listing status as a determinant of disclosure variability (Firth, 1979; Cooke, 1991; Meek, Roberts & Gra y, 1995). Listed companies must comply with stock market regulations that require far more information disclosure than applies to unlisted companies. Additionally, listed firms voluntarily disclose information in order to garner investors’ trust and to obtain better financing conditions (Raffournier, 1995, p. 263). Empirical stud- ies have shown that fi rms that more readily practice voluntary information disclosure enjoy such beneficial effects a s increased stock p rices (Healy, Hutto n, & Palepu, 19 99; Lang & Lundholm, 2000), higher a nalyst following (Lang & L undholm, 1996), improvements in stock liquidity (Welker, 1995), and a reduction in t he cost of cap ital (Botosan, 1997; Botosan & Plumlee, 2 002 ). Our study focuses on listed companies, but we attempt to examine dif- ferences in disclosure between firms that are only traded domestically and firms that are both traded domestically and cross-listed internationally. Meek, Roberts and Gray (1995) suggest that listed companies face addi- tional capital market pressures for the provision of information. Further- more, such pressures will arguably increase with the efficiency of the markets in which the firms are traded, as may be the c ase for firms trading in foreign stock markets as opposed to those trading solely on the Madrid Stock Exchange. 14 Therefore, once a firm discloses information volunta rily to foreign stock markets, it would incur only a marginal cost increase if it also reported such information in its domestic market. Empirical research has shown evidence of greater information disclosure for companies that are listed both domestically and in foreign stock exchanges (Cooke, 1991). In a similar vein, Khanna, Palepu, and Srinivasan (2004) found a positive as- sociation between disclosure and a U.S. listing for a sample of European and Asian-Pacific companies. M. ROSARIO BABI ´ O ARCAY AND M. FLORA MUIN ˜ OVA ´ ZQUEZ308 [...]... about the provision of voluntary information Lack of data prevented us from distinguishing between the participation of inside and outside directors in the capital of the company and from obtaining a measure of the amount of stock-price-based compensation received by directors Hence, we could not assess the impact of inside shareholdings and the amount of stock option incentives on the provision of voluntary. .. counterparts Therefore, the positive association between corporate ownership structure and disclosure is explained by the in uence exercised by the dispersion of ownership on the adoption of rules of good governance that, in the end, strengthens the disclosure policy of the company Cross-listing in foreign stock markets also exerts a significant in uence on the adoption of practices of good governance. .. BABI´O ARCAY AND M FLORA MUINO VAZQUEZ 5 DISCUSSION AND CONCLUSIONS The results of this study indicate that corporate decisions regarding the provision of voluntary information are complex processes affected by a number of interrelated factors: the governance rules followed by the firm, corporate size, cross-listing status, and the ownership structure of the firm Our results show that the adoption of a... from the model exerted some in uence on corporate disclosure As shown in Fig 2, however, not all governance factors were included in our model – for example, the size of the board and the combination of the functions of chairman and CEO were not included These results conform to those obtained from the univariate analysis and, hence, Hypotheses 1c and 1f must be rejected The other four practices of good... in the disclosure index ´mica (39.4%) Results are similar using the unadjusted Actualidad Econo Index, and indicate that the size of the company, along with its governance structure, are important factors in explaining not only the amount of voluntary information provided but also the disclosure strategy of the company regarding the design and presentation of reports Table 9 Variable INDEX GOVERNANCE. .. results of the univariate analysis, the industry variable was nonsignificant in explaining disclosure variability and was therefore eliminated from the model Therefore, Hypothesis 5 must be rejected Square multiple correlation coefficients (Table 9) show that, taken together, the size of the entity and the factor representing its governance rules account for a significant proportion of the variability in the. .. number of good governance practices such as the appointment of independent directors, the formation of audit committees, participation of the board in the capital of the company, and establishment of stock option plans as a means of director remuneration exert a significant in uence on corporate voluntary disclosure As expected, independent directors and audit committees strengthen the monitoring function... good governance remain in the model and have significant coefficients (Table 8), a result that could be inferred from the ANOVA and from examination of the correlation matrix We reduced these practices to a governance factor that was positively associated with disclosure, and suggest that the appointment of independent directors, the formation of an audit committee, the participation of the board in the. .. those obtained in previous studies (Cooke, 1991; Khanna, Palepu & Srinivasan, 2004), and suggest that it is not the cost-benefit trade-off that explains the positive association between cross-listing and disclosure, but the improvement in corporate governance that is realized after cross-listing occurs Additionally, our findings reveal that corporate size is a significant determinant of corporate disclosure. .. compliance with recommendations of the Olivencia Code for appointing an audit committee and for limiting the size of the board are common practices in firms included in our sample (i.e 75% have an audit committee, and the total number of directors in 76% of the firms is between 5 and 15) Finally, we observed high variability in the proportion of independent directors on the board The mean value for this variable . for the following regres- sions 24 : GOVERNANCE - CHAIRMAN GOVERNANCE - SIZEB INDUSTRY - GOVERNANCE INDUSTRY - INDEX LASSETS - GOVERNANCE LISTING - INDEX LOWNERSHIP - INDEX LOWNERSHIP 2 LISTING LOWNERSHIP. practices in enhancing corporate disclosure, (2) by examining the role of majority shareholders in the adoption of practices of good governance, and (3) by analysing the direct and indirect effects of. for the costs and benefits linked to the provision of information. The cost of gathering and preparing detailed in- formation an d the risk of creating a competitive disadvantage through dis- closure