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A study on geographical empire building,
forward-looking disclosures and board quality.
Name: Mitchell Achthoven Student number: 10873554 Date: 25-05-2016
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam Word count: 12,101
2 Statement of originality
This document is written by Mitchell Achthoven who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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Abstract
Prior research discuss that some managers of firms are subjected to empire building and related this to the financial disclosures. A possible cause of empire building is that the quality of the board is low. When there is a relative low quality of the board it is harder to monitor mechanisms. This research will have as purpose providing empirical evidence of empire building in the United States and the effect of the quality of the board on the relation between forward-looking disclosures and empire building. To test this, I will use a sample of 522 observations. The results show signs of empire building when firms disclose forward-looking disclosures. Also there is a significant positive relation between firms who disclose forward-looking sentences with an independent board and foreign profit margin. Also there is a negative relation between firms who disclose forward-looking sentences with an independent board and foreign sales growth, which are signs that independency of the board leads to less empire building.
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Table of contents
1. Introduction____________________________________________________________________ 5 2. Theory and hypotheses___________________________________________________________ 7 2.1. Empire building______________________________________________________________ 7 2.1.1. Agency theory___________________________________________________________ 7 2.1.2. Geographical empire building_______________________________________________ 8 2.1.3. Motives for empire building_________________________________________________ 9 2.2. Disclosures_________________________________________________________________ 10 2.2.1. Firm disclosures_________________________________________________________ 10 2.2.2. Forward-looking disclosures_______________________________________________ 11 2.2.3. Credibility of forward-looking disclosures_____________________________________ 11 2.2.4. Regulations according to geographical disclosures______________________________ 12 2.3. Board quality_______________________________________________________________ 13 2.3.1. Corporate Governance and Internal Board Governance__________________________ 13 2.3.2. Board structure_________________________________________________________ 14 2.3.3. Board size______________________________________________________________ 16 2.4. Hypothesis development_____________________________________________________ 18 3. Research methodology___________________________________________________________ 21 3.1 Sample Selection____________________________________________________________ 21 3.2 Research design_____________________________________________________________ 23 4. Results_______________________________________________________________________ 26 4.1 Descriptive Statistics Table 2: Overview of the descriptive statistics of the variables_______ 26 4.2 The relation between FLS and geographical empire building__________________________ 29 4.3 The relation between board quality and geographical empire building__________________ 30 4.4 The relationship of forward-looking disclosures and board quality on empire building_____ 32 5. Conclusion____________________________________________________________________ 35 5. References____________________________________________________________________ 38
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1. Introduction
Over the last decades, agency theory has emerged as the dominant in the financial economics literature (Miller and Sardais, 2010). As developed in that literature has been primarily concerned with the relationship between managers and shareholders.
Jensen and Meckling (1976) discuss the conflict between shareholders and the agent where individuals choose actions to maximize their own utility. According to the researchers it’s suggests that managers do not always act in the best interest of the shareholders.
Mirlees (1999) emphasizes that the most problems of moral hazard are derived by agency. This because managers can monitor their own actions and behaviour, where it is hard for the shareholder to observe this. This leads to moral hazard problems.
In the past there has been research on geographical empire building and the managerial behaviour (Hope and Thomas, 2008). This may imply that managers may start up projects or investments abroad, while this may be unprofitable in the end.
Prior literature finds that several aspects of executive compensation induce more risky management actions that might in the end destroy shareholder value (Coles et al. 2006). So the difference in interest is mainly in the short versus long-term vision. Where managers want to create more firm value on short term to expand in foreign areas, it is for shareholders far more important if the continuity of the firm is guaranteed. Hope and Thomas (2008) discuss that some managers of firms are subjected to empire building. A possible cause of this occurrence is that the quality of the board is low. When there is a relative low quality of the board it is harder to monitor mechanisms, for example when financial disclosures are
reduced, it is harder for investors to relate managerial decisions to firm performance. Thereby it is interesting to do further research on this topic. In addition to this, it is possible that the quality of corporate boards is related to the quality of the disclosures (Hermalin and Weisbach, 2007). So I will do research if the board quality has an effect on the relation between forward-looking disclosures and geographical empire building.
In order study this topic I will answer the following research question:
To what extent is there a relation between forward-looking disclosures and empire building and what is the role of the quality of the board of directors in this relation?
6 In order to give a well-structured answer to this research question, I used a dataset of
forward-looking sentences from US firms on non-US investments. These sentences have been extracted from MD&A sections of 10-K filings. This left me with a sample of 522
observations taken from 174 different firms. The sample consist of US firms and covers the period from 1998 to 2000. The results shows that there is a positive relation between firms which engage in investments outside of the United States and the sales of the firm.
Furthermore, there is a negative relation between the sales and the profit of firms which engage in investments outside the United States.
This research will have as purpose providing empirical evidence of empire building in the United States and the relation of the quality of the board of directors. Much has been written about the quality of the board and corporate governance, but there has not been done any research on the quality of the board of directors and empire building. Also there is not much research has been done to empire building as itself. The research of Hope and Thomas (2008) provide empirical evidence on the relation between financial disclosure and managers’ propensity to overinvest. Furthermore they states that when shareholders are not capable to monitor the decisions of managers in related to foreign operations , managers will excessively grow the foreign operations of the firm, leading to reduced foreign profitability and a overall reduction in firm value. As monitoring is reduced, managers are more willing to expand international operations even though it leads to lower profitability.
This research will contribute to what is already been written about board quality by looking at board structure and board size over a certain time period. Furthermore, it will give insights in the relation between the quality of the board and the behaviour of managers and whether there is evidence of empire building behaviour.
The remainder of this thesis is organized as follows. In the second chapter, I will start with a literature review in which I will further explain empire building and board quality. I will then move forward to my hypothesis development in which I will present the hypotheses which will be examined in this thesis. In the third chapter, I will give a description of the used methodology, an explanation of how I obtained the data and are the regression models which will be used discussed. In the fourth chapter, I will present and discuss the empirical results of my analysis. In the fifth chapter, the conclusion will be presented as well as suggestions for further research.
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2. Theory and hypotheses
The focus of this thesis is to investigate if there is empire building in the United States and if this is related to the quality of the board of directors. In this section I will discuss the relevant theory related to this research. I will start with a brief explanation of the agency theory as an introduction to empire building and firm disclosures. Also corporate governance will be discussed in addition to the board quality. To discuss and review the board quality are the main determinants for the quality board described. In the second part I will, based on the theoretical framework, develop the hypotheses.
2.1. Empire building
2.1.1. Agency theory
The relationship of agency is one of the oldest and commonest codified modes of social interaction (S.A. Ross, 1973). The principal–agent problem occurs when one person or entity is able to make decisions on behalf of, or that impact, another person or entity. The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal. The agent-principal relationship is a useful analytic tool in political science and economics, but may also apply to other areas.
Agency theory describes the natural conflict between shareholders and managers. The conflict arises because individuals choose actions to maximize their own utility, suggesting that managers do not always act in the best interest of shareholders (Jensen and Meckling, 1976). Agency theory predicts that managers have empire-building incentives that motivate them to opportunistically increase or retain discretionary expenditures such as selling, general and administrative costs. Prior research has argued that managers with short term objectives leads to underinvestment in long term projects, due to imperfect information and the fear of losing control, the market has less information than the firm’s managers about the firm’s long term projects. Research have indicated that in some situations, short-term objective and imperfect information may lead to underinvestment or overinvestment in long term projects (Bebchuk and Stole, 1993). The agency problem in this case will be mainly focused on the long versus short term motivations. Managers want to expand their ‘’empire’’ and give less about the profitability of the expansion of the organization.
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2.1.2. Geographical empire building
According to Hope and Thomas (2009) is empire building the act of attempting to increase the size and scope of an individual or organization's power and influence. An example of empire building is when managers or executives are more concerned with expanding their business units than they are with developing and implementing ways to benefit shareholders (Jensen, 1986).
Theoretical and empirical evidence suggest that managers of corporations may seek to expand their firms beyond the optimal, profit maximizing scale that is, to empire building. Empire building is typically seen as unhealthy for a corporation, as managers will often become more concerned with acquiring greater resource control than with optimally
allocating resources. Explanations for corporate empire building are based on the individual self-interest of managers. Corporate growth may benefit managers by raising their salaries, enhancing their job security by reducing the risk of a takeover, or perhaps providing them with non-material benefits in the currency of prestige (Levinson, 2005). Then again, managers may prefer to pass up expansionist opportunities in order to minimize their workloads or to avoid being blamed for high-profile failures (Rajesh and Samwick, 1999). Aggarwal and Samwick (2006) state that managers still continue to invest in projects even after all net present value investments have been taken.
Managers are the agents of shareholder principals who have a unified, common interest in maximizing firm profits. Monitoring and control by shareholders, combined with the takeover market and product market competition, leave limited room for managers to deviate from profit-maximizing behaviour. (Levinson, 2005)
Empire building can be distinguished between two types, namely excessive investment and excessive growth. There are different motivations for managers to engage into empire building. They can have the incentive to serve private interest in various ways by increasing the firm size and its activities.
Stulz (1990) conclude that by engaging in empire building, managers gain by
increasing the resources under their control and their prestige. Murphy (1985) states that it is possible for managers to increase their compensation when engaging in empire building since compensation is often tied to firm size, sales growth and diversification. Amihud and Lev (1981) explain the theory of managerialism, which address to the managerial behaviour and promotions. This can be related to empire building, because by growing the firm beyond its optimal size its decreases the unemployment risk of managers, which creates additional
9 manager promotions and makes the manager more indispensable to the firm which are
incentives for managers to engage in empire building.
2.1.3. Motives for empire building
As mentioned in the previous section, the incentive why managers may engage in empire building is to serve their own private interests in different ways. Examples for managers to engage in empire building can be: hunger for status, prestige, power and bonuses (Hope & Thomas, 2008; Jensen, 1986). In the study of Jensen (1986), he discuss a ‘free cash flow’ theory. Here, firms with low investment opportunities and with relative high free cash flows, might have incentives to grow beyond their optimal size.
According to Stulz (1990), when managers engage in empire building, they increase their resources under their control and their prestige. Furthermore it is also possible for managers to increase their bonuses when engaging in empire building since bonuses are often determined on factors like firm size, sales growth and diversification (Jensen & Murphy, 1990). When an organization is growing beyond its optimal size, the unemployment risk of managers decrease, which creates additional middle manager promotions. This creates a situation where the manager is more indispensable to the firm which are incentives for managers for engaging in empire building (Amihud & Lev, 1981).
In the study of Narayanan (1985), there is been looked at managerial incentives for making decisions which are at cost of the shareholders. This research is done because there is a serious concern about managers in the United States, which make decisions, which yield short-term results at expense of the long-term interests of the shareholders. According to Narayanan (1985) this behaviour exist because of the influence of institutional investors. In order to retain and attract clients, these institutional investors are put under pressure to show short-term profits. However, this pressure on institutional investors puts pressure on
corporate managers to show short-term profits and influence the share price of the firm. Furthermore, Narayanan (1985) argues that wage schemes also influence the short-term bias because they base executive bonuses on annual profits.
Narayanan (1985) mentions these explanations for the short-term bias of managers, they can fall into two categories. The first category is that the short-term view of stockholders who want quick profits is reflected in the decisions of managers. The second category is that managers tend to be quick profit-orientated because of profit sharing.
10 decisions at the cost of the long-term interests of the firm which yield only short-term profits. This only occurs if the manager possesses private information that is not available to the investors. The incentive behind these decisions arise because the manager hopes to increase his reputation faster which will lead to higher wages.
Narayanan (1985) also states that the experience of the manager is a determinant where is stated that when a manager is more experienced that there are less incentives for short-term profits. Another determinant, which is discussed by Narayanan (1985) is the length of the contract of the manager, when the duration of the contract of the manager is longer the likeness that the manager will choose quicker-return projects will be lower. The manager will be less incentivized to sacrifice long-term benefits from future cash flows in the case of longer contract duration.
2.2. Disclosures
2.2.1. Firm disclosures
Agency theory predicts that investors’ information requirements increase with the agency cost of the firm. Managerial ownership mitigates agency costs and therefore should reduce investors’ information needs. The principal-agent theory suggests a negative relationship between managerial ownership and accounting disclosures. As the agency costs associated with the separation of ownership and control increase, investors perceive a greater need to monitor the firm’s managers and will therefor demand more information from these firms. (Jensen and Meckling, 1976). Bushman and Smith (2001) gives an overview of the large literature that documents how financial accounting information is an important source of information used by shareholders and others to monitor managers.
Jiraporn et al. (2006) suggest when managers are less accountable to the firm’s
investors, managers are more likely to make decisions for private gain, leading to poorer firm performance and ultimately loss of shareholder value. Financial disclosures are one important means of monitoring managers to make them more accountable. Investors seek high-quality disclosures that reduce information asymmetries between investors and managers and among informed and uninformed market participants (Diamond and Verrecchia, 1991). Better disclosures improve the ability of the shareholders to relate managerial decisions to firm performance. The relation between disclosure quality and monitoring ability may also apply to the quality of corporate boards (Hermalin and Weisbach, 2007).
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2.2.2. Forward-looking disclosures
A crucial part of the annual report is the Management Discussion and Analysis (MD&A) section. This section treats managerial commentary about a firm’s current state and future prospects (Muslu et al., 2015). As an integral part of their 10-K filings, organizations are required to file MD&A sections, however most of the content of the MD&A is not mandatory to disclose (Muslu et al., 2015). So overall the disclosure setting of the MD&A section is neither mandatory nor voluntary, since it has to be disclosed, but the contents are multi interpretable and the specific firm can choose to their own liking, how to implement the MD&A section in their annual report (Muslu et al., 2015).
The SEC has periodically provided guidance with relation to the content of MD&A disclosures with the intention that MD&A disclosures provide investors with the opportunity to see the organization through the eyes of the management (Garmong, 2007). The SEC has guided to present any known factors which are likely to materially affect the company’s liquidity, future operations or capital resources. However, the SEC is of opinion that MD&A disclosures are deficient in general (Garmong, 2007).
In prior studies, MD&A disclosures are investigated by using small samples (Muslu et al., 2015). Pava and Epstein (1993) did research on MD&A disclosures and find evidence that MD&A sections mostly describe past performance after they selected 25 random organizations. In other studies, researchers make use of computer intensive techniques in order to examine MD&A disclosures (Muslu et al., 2015). An example of such a study is that of Hussainey and Walker (2009). They provide evidence that investors are able to form better expectations about the changes in cumulative earnings during the following next three years. Another example is the study of Li (2010), where the tone of forward-looking MD&A disclosures between 1994 and 2007 is assessed by using a machine learning a certain algorithm. Li (2010) finds that optimistic tone is positively related to future earnings and pessimistic tone is negatively related to future earnings.
2.2.3. Credibility of forward-looking disclosures
Prior literature show that the quality of voluntary disclosures is associated with information of the stock prices (Muslu et al., 2015). There is also the possibility that MD&A disclosures are not informative. There are several reasons why MD&A disclosures are not informative.
12 Muslu et al. (2015) use the timeliness, lack of evidence with regard to the usefulness of MD&A disclosures as reasons why MD&A disclosures might not be informative to the capital markets.
With regard to voluntary disclosures, theories seem to be ambivalent about whether managers disclose useful information. According to the ‘in formativeness perspective’, managers will disclose value relevant information (Muslu et al., 2015). In order to mitigate adverse selection problems, early signalling models argue that all value-relevant information is disclosed (Muslu et al., 2015). By using subsequent models which impose costs and derive selective disclosure strategies, managers disclose good news in general (Muslu et al., 2015). However, in accordance with the litigation risk hypothesis, firms voluntarily disclose bad news. According to an independent strand of literature, managers meet investors’ information demands or align investors’ expectations with their own by disclosing either good or bad news.
Also, the opportunism perspective argues that managers’ motives largely shape the company disclosures. In order to ‘hype’ the stock, especially prior to raising capital or extracting rents, managers disclose good news to the market (Lang and Lundholm, 2000). Additionally, when there is good news, managers seem to leak this on a timely fashion, but when there is bad news, managers are more likely to withhold the news. This because they might be concerned of their career with that specific firm. (Kothari et al., 2009).
Overall, voluntary disclosures will be informative regardless if these are selective according to the in formativeness perspective. In contrast, the opportunism perspective states that the market can be misled in the short-term by voluntary disclosures. Therefore the question if MD&A disclosures contains useful information to the capital markets remains unanswered.
2.2.4. Regulations according to geographical disclosures
In June 1997, the Financial Accounting Standards Board introduced the ‘’Statement of Financial Accounting Standards No. 131 (SFAS 131). SFAS 131 introduced two important changes to the disclosure of geographic information (Hope et al., 2009).
First, in an attempt to provide more disaggregated disclosure, it encourages firms to disclose country-level geographic information for ‘’material’’ countries. SFAS allows immaterial countries to be aggregated into a single ‘’Other Foreign’’ segment (Hope et al., 2009). Prior to SFAS 131, most firms disaggregated their foreign operations into a couple of broad regions or continents. Thus implementation of SFAS 131 may result in more
13 disaggregation for firms that claim to have material countries or less disaggregation for firms that claim to individual countries are not material (Hope et al., 2009).
Second, SFAS 131 allows firms to no longer disclose earnings for secondary segments. Firms that define their primary operating segments on any basis other than geographic area are required to disclose only sales and assets for geographic operations (Hope et al., 2009). Prior to SFAS 131 firms were required to disclose sales, assets and earnings by geographic area (Hope et al., 2009). According to the analysis of Herrmann and Thomas (2000) only 16% of the observed companies continue to report geographic earnings after implementation of SFAS 131.
Since firms in the United States are no longer required to disclose detailed geographic information regarding sales and earnings, the behaviour of the management might change. Because of the implementation of SFAS 131, firms are not required to disclose detailed geographic information, which may lead that managers might do riskier investments outside the United States.
2.3. Board quality
2.3.1. Corporate Governance and Internal Board Governance
Corporate governance can be described as a system of rules, practices and processes by which an organization is directed and controlled. The purpose of corporate governance is to ensure the interest of shareholders and prevention of divergence between operators and owners. The main characteristics of the corporate governance structure consist of the shareholders meetings, the board of directors, the board of supervisors and managers
(Baysinger and Butler, 1985). Boards are primarily charged with monitoring management to protect shareholders’ interest (Xie et al., 2002).
Fama and Jensen (1983) argue that the board is an effective organ for monitoring decisions by the management. Furthermore they states that outside directors need incentives to carry out their task. Xie et al. (2002) states that independent outside directors are better capable to monitor the management than inside directors, because inside directors might be biased compared to independent outside directors. However, inside directors are better informed regarding firm projects than outside directors (Bushman et al., 2004). This means that the ability of outside directors to monitor the decisions of the management can be restricted by the limited knowledge related to firm projects (Baber et al., 2012).
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2.3.2. Board structure
Hope and Thomas (2009) discuss that some managers of firms are subjected to empire building. A possible cause of this occurrence is that the quality of the board is low. When there is a relative low quality of the board of directors it is harder to monitor mechanisms. For example when financial disclosures are reduced, it is harder for investors to relate managerial decisions to firm performance. A low quality of the board of directors is often derived by poor corporate governance. The disclosure quality is appreciated through the quantity and also through the nature (type) of information disclosed. Corporate governance attributes consists of ownership structure, board of directors and audit committees (Khiari and Karaa, 2013).
Prior literature mentioned the task of the board in different ways. The major role of the board of directors is to supervise and provide advices to the management (Coles et al, 2008). The board is supposed to act as an agent for shareholders by representing the interest of the shareholders (Barkema and Gomez-Meija, 1998). Jensen (1993) state that the board has the final responsibility for the functioning of the organization.
There are two main models which are used to organize the board of directors, these are the one-tier and the two-tier board. The one-tier board is an Anglo-Saxon model, which is often used in the United Kingdom, Canada and the United States. The two-tier board is first adopted by Germany and is mostly used in European countries like the Netherlands, but also Asian countries like China. The board of directors in a one-tier supervise and provide advice to the management. In a two-tier structure the management and monitoring of the
management is separated between the management board and the supervisory board. The management does the daily operations of the organization, while the supervisory board monitors and give advice to the members of the management board. The main difference between these two structures is that the function of CEO and the chairman are always separated and that there are formal board functions for the executives and non-executives board members (Maassen, 2002).
An advantage of the one-tier board is that it decreases information asymmetry between executives and non-executives. One of the reasons that there is less information asymmetry, is because of the more frequent meetings of the one-tier board compared to the two-tier board (Cheffins, 1997). A disadvantage of a one-tier board is that decisions and monitoring of these decisions are done by the same board members, so the monitoring of these decisions might not be objective (Cheffins, 1997). The two-tier is introduced to ensure
15 the protection of the shareholders and the public’s interest by making a distinction between the decision making and monitoring activities by implementing a management board and a supervisory board. A disadvantage of the two-tier structure is that non-executive board members are not present at the meetings of the executive board members. This has the result that information asymmetry may arise between the two boards and this will have a negative consequences in relation to the quality of the monitoring.
In the United States, the one-tier structure is most used. A Chief executive officer (CEO) is the position of the most senior corporate executive responsible for initiating and implementing the plans and policies of an organization. A chairman is responsible for ensuring that the board provides good quality advises and monitoring of the CEO. The chairman has a significant control function and that is why it is ideal that the CEO and the chairman functions are separated (Fayale, 2007). Fama and Jensen (1983) states that when the CEO also fulfil the role as a chairman, the principle of separating decision making and control will be violated and this will affect the board’s function to perform its monitoring function. According to Jensen (1993) is a separation between the roles of CEO and chairman is crucial for the effectiveness of the board. The research of Rechner and Dalton (1991) shows that organizations where the position of CEO and chairman are separated, performed better on a number of accounting measures. Their research concludes that when there is distinction between these two functions there is a better performance than when these functions are combined. Furthermore they conclude that a board structure where the CEO serves as the chairman of the board has a negative impact on the performance of the organization.
Daily and Dalton (2007), did research on the relation between corporate governance and the board composition. According to their research there is a relation between a stronger corporate governance when there is more independency on the board of directors. When there is more independence the likeliness that directors will approve decisions of managers, which may at cost of the shareholders, will decrease (Daily and Dalton, 2007). This is because directors which have a direct relation with the firm can become too familiar with the management, which makes them more biased. This can lead that directors may approve decisions in the interest of the management at the cost of the shareholders.
According to Vafeas (2003) the length of board tenure of directors is also a
determinant for the board quality. Prior research show that there are conflicting views of the length of board tenure on the quality and independence of the board. Vafaes (2003) suggests that long-term directors are associated with greater experience, competence and commitment.
16 This is because when directors have more service years, it gives them more knowledge of the firm, the environment and industry of the firm. According to Vance (1983) that forcing directors to retire leads to waste of experience of the board. Also Buchanan (1974) states that a longer tenure enhance willingness and commitment of the board toward the goals of the firm. However, Katz (1982) states that extended tenure reduces group communication and isolates groups from key information sources. Katz (1982) also states that the performance of groups is not linearly related to tenure. He finds evidence increasing learning effect in the beginning and declining learning effect thereafter. According to Katz (1983), the business environment has concerns about directors who are too long active on the boards to the detriment of shareholders.
2.3.3. Board size
According to the research of Faleye (2007) the quality of the board is not only dependent on the structure of the board, but also on other factors like the size of the board.
The board size can be seen as one of the mechanism for the quality and effectiveness of the board of directors. The negative relation between board size and firm performance is substantiated that many boards are inefficient due to that more noise occurs when there are more board members. According to the research of Jensen (1993) is the board size is one of the most important characteristics to determine the quality of the corporate governance. Jensen (1993) also states that large boards can results in miscommunications and worse decision making. In the research of Guest (2009) it is stated that problems of poor communication and decision making undermine the effectiveness of large boards. Prior literature suggest that smaller boards will enhance the board quality. Lipton et al. (1992) states that that boards which consist of eight or nine board members are the most effective. According to their research a small board will create more productivity, more cohesion and is effective in controlling and supervising the organization. This is supported by the research of Jensen (1993), which state that small boards are less subject to noise and
miscommunications, which increase the quality and productivity of the organization. Board which are too large will have disadvantages in the form of free rider problems and
coordination costs (Guest, 2009).
Recent advances in economic theory suggest that the board of directors is an important part of the governance structure of large business corporations
17 The board of directors, which has the power to hire, fire, and compensate senior management teams, serves to resolve conflicts of interest among decision makers and residual risk bearers. This economizes the transaction (agency) costs associated with the separation (specialization) of ownership and control and facilitates the survival of the open corporation as an organizational form (Baysinger and Butler, 1985). So the relation between low level corporate governance and the low quality of the board might be associated with empire building. According to Ball (2006), an increased transparency will lead to behaviour by managers which is more in the interest of the shareholders.
Figure 1 presents the relationship between the board of directors and the stakeholders. The figure below show that the management is in charge of decisions in regard to
investments and expenditures. The right side represents the external part of the firm, where capital is created.
Fig. 1. Corporate Governance and Balance sheet of an organization (Gillan, 2006)
According to prior research there are different opinions about the optimal board size for firms to function efficient and effectively. It is clear that the board size has an important role on the quality of the board, but it is still unclear whether the quality of the board increases when the number of directors in the board increase or decrease.
According to the research of Fields et al. (2012), the main drivers to determine the quality of the board of directors are:
- Size of the board
- Distinguish between the inside (executive) and outside (supervisory) board members; - Independent chairman
- Experience in the role of director of the board - Diversity of the board
18 - The amount of ownership in the firm by the directors
2.4. Hypothesis development
As has been mentioned in the previous section it is clear that managers have incentives to engage in empire building. Managers serve their own private interests at the cost of the shareholders interest. Furthermore, because it is no longer required for firms to disclose geographic earnings under SFAS 131 (Hope and Thomas, 2007). I expect that this will give managers the opportunity to mislead the market in the short-term even more using forward-looking sentences on foreign operations and investments. In this study I will do a research on the association between forward-looking sentences and geographical empire building. I will look to firms in the United States who disclose an abnormal amount of forward-looking disclosures on foreign operation and investments whereas the foreign profit/ income from these operations seem to be significantly low in the end, provide evidence for geographical empire building.
As has been discussed in the previous section, literature on the relation between forward-looking disclosures and empire building quite comprehensive. However, there are numerous proxies to measure empire building, the proxies that will be used are sales growth and profit margin growth. If managers disclose forward-looking disclosures which address expanding in foreign areas, whereas the foreign income from these particular investments appears to be low in the end, this might be evidence for geographical empire building Since it is no longer required to disclose geographic earnings and opportunism perspective to mislead the market in the short-term, I expect that firms in the United States that disclose forward-looking disclosures on foreign operations and investments are more likely to engage in geographical empire building than US firms which do not disclose forward-looking sentences on foreign operations and investments. The measurement is based on prior research done by Hope and Thomas (2007).
H1: Firms in the United States which have forward-looking disclosures about foreign investments are more likely to be subject to empire building than firms in the United States which do not have forward-looking disclosures about foreign investments.
In the table below are the proxies summarized related to the hypothesis. The below mentioned proxies will be used in order to analyse whether firms in the United States are
19 subject to empire building.
Figure 2: Sales growth and Profit Margin growth are the proxies of the hypothesis
For my second hypothesis I am interested in the relationship between the quality of the board and the likeliness of a firm engaging in geographical empire building. Board quality is determined based on the following criteria:
- Board size;
- Independent directors %;
- Directors with tenure >10 years %; - Directors who serve at least 3 boards.
If organizations don’t meet at least two of the four requirements, it will assume that there is a poor quality of the board.
Building on the theory and prior research on empire building and corporate governance quality, the following hypotheses is stated.
H2: Firms in the United States with a low quality board are more likely to engage in empire building.
The figure below shows a graphical representation of the relations I am going to examine in the following sections. As is shown in the figure I expect a positive correlation with positive forward-looking disclosures and empire building and a negative correlation between board quality and empire building.
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Figure 3: Interaction of board quality on the relationship between forward-looking disclosures and empire building
In addition to the two stated hypothesis I am going to research if the board quality has an effect on the relation between forward-looking disclosures and empire building. Therefore is the following hypothesis is stated.
H3: The relationship between forward-looking disclosures and empire building is more positive for low board quality.
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3. Research methodology
This section will explain how the research is conducted. It will start with an explanation of the sample selection. In the second paragraph are the used variables described. And in the last paragraph the empirical models and the control variables are presented.
3.1 Sample Selection
In order to do my research I will use a dataset of forward-looking sentences (FLS) on foreign operations. This dataset is provided by the University of Amsterdam. These forward-looking sentences contain disaggregated foreign operations like: foreign sales, profits, costs and investments. These sentences are often qualitative in nature. These sentences have been extracted from MD&A sections of 10-K filings, using automated language processing techniques. This dataset needs manual recoding. For instance, some sentences might be misclassified and should be excluded from the database, while other sentences need to be classified under some other criteria.
This dataset contains forward-looking disclosures from US firms on non-US investments the company is engaging in. If managers disclose an abnormally high number of these
disclosures, but foreign income appears to be low in the end, this might be evidence of geographical empire building.
The initial dataset contains 2,090 observations from US firms from the years 1996 to 2000. These observations will be classified under the following criteria:
- If the selected sentence is a forward-looking disclosure;
- If the forward-looking disclosure contains information about investments;
- The country/ region it concerns, this will be classified under: outside North America, inside North America (US and Canada), inside US and inside Canada.
A forward-looking sentence contains information about changes in firm value. An example of a forward-looking disclosure can be as follow:
‘’In addition, the Company intends to continue to invest substantial resources to increase sales of its systems to Japanese semiconductor manufacturers, who represent a substantial portion of the worldwide semiconductor market and whose market is difficult for non-Japanese equipment companies to penetrate.’’
22 The initial dataset contains 418 firms, for these 418 firms is examined if there are forward-looking sentences disclosed in their annual report form the years 1996 to 2000. So the initial dataset contains 418 (firms) * 5 (years) = 2,090 observations. In this dataset were 10
observations which did not have sufficient data or contradictions in the data, which made them unusable for data research. In order to determine the foreign profit margin, is the following formula used: foreign profit margin = foreign pretax income / foreign sales. However there was no information available about the foreign pretax income and foreign sales about for all the firms. So for the remaining 2,080 observations in the dataset, 333 observation were dropped cause of missing data. Therefore there were 1,747 observations, which remained in the dataset. Since I am interested in the forward-looking sentences since the adoption of SFAS 131, the data of the years 1996 and 1997 are eliminated from the dataset. After deleting the data of 1996 and 1997 (n=701), 1,046 observation remained. Since this research looks to data of multiple years (1998 to 2000), a time series analysis is
necessary. To run a time series analysis, it is required to have panel data. Panel data represents a multidimensional dataset, with multiple observations of several variables at different times. This means that of all years from 1998 and 2000 the data must be available. If there is data missing of one year, all observations of that particular firm has to be dropped from the dataset. There were 44 observation which are dropped to form the panel data. My data regarding the board quality is taken from ISS (formerly RiskMetrics) that provide a set of characteristics related to the structure of the board of directors and ownership structure. The variables which are used are as following: board size, independent directors and experience of the directors. To extract the data from ISS, I use the tickers of the 334
remaining firms in the MD&A database (which represents 1,002 observations). However, not all the data is available from ISS for the remaining 334 firms. From the dataset from ISS are only 174 of the 334 firms found with information about the board for the years 1998 to 2000. This leads to a final dataset of 522 observations.
There are two main limitations in this research due to the dataset. The first limitation is that the raw dataset, which is provided by the University of Amsterdam contains numeral contradictions, which makes the dataset less useful and these observations had to be
eliminated from the dataset. Furthermore, of the 334 firms of the initial dataset, only 174 firms had information about board quality. This led to a huge drop in the sample. The second limitation is that the provided dataset is contains sentences for a limited amount of years. Because the SFAS 131 is introduced in June 1997, it is only possible to use data from 1998
23 and beyond. Since there is only data available from 1996 to 2000, it is only possible to look the three years after the adoption of SFAS 131. These limitations of the dataset can make it more difficult to find evidence for significant results.
Table 1 shows the break down from the raw dataset provided by the University of Amsterdam to the final dataset, which will be used to test my stated hypotheses.
n
observations drop Initially data provided by the University of Amsterdam 2.090 Excluding misclassifications 2.080 -10 Excluding observations without information about foreign pretax
income or foreign sales
1.747 -333 Excluding data regarding years 1996 & 1997 1.046 -701 Excluding data of firms with data missing of years 1998-2000 1.002 -44 Excluding data merging ISS database with board quality
information 522 -480
Table 1: Overview of the process in the generation of the final sample.
3.2 Research design
In order to give a structured answer to the research question and to test the stated hypotheses, the analysis will be as follows.
Primary to the research the manually codified dataset will be used to determine if firms in the US engage in empire building. This will be examined by analysing the relation between the sales growth and the profit growth. There will be made a selection of forward-looking sentences that have the intention to expand their activities outside the US and have an increase in sales but no realistic related profit. If this is the case there is evidence of empire building and have information about which companies engage in empire building.
To determine if the firms are subject to empire building, I will use a similar regression as used in the research of Hope and Thomas (2008). Hope and Thomas (2008) find evidence for empire building when there is a growth in foreign sales, a decline in foreign profit margin and a decline in the value of the firm for firms who do not disclose. In this research, I will look to the forward-looking disclosures and will use the forward-looking sentences as my independent variable. The dataset of the 522 observation is strongly balanced.
To test empire building I will use the following formulas, based on the research of Hope and Thomas (2008).
24 + β5 ForeignPerc + β6 ForSeg + e
ForeignProfitMargin = α + β¹ FLS + β² DomProfitMargin + β³ Size + β4 Follow + + β5 ForeignPerc + β6 ForSeg + e
In order to test if there is a relation between the board quality of the firms and empire
building, I will use the same firms which are in the selection. The following step is to test the quality of the corporate governance related to the level of empire building.
ForeignSalesGrowth = α + β¹ Board Quality + β² DomSalesGrowth + β³ Size + β4 Follow + β5 ForeignPerc + β6 ForSeg + e
ForeignProfitMargin = α + β¹ Board Quality + β² DomProfitMargin + β³ Size + β4 Follow + β5 ForeignPerc + β6 ForSeg + e
In addition to the two stated hypothesis I will test if there is an effect on the relation between forward-looking disclosures and empire building. Therefore the following regression will be used.
ForeignSalesGrowth = β¹ FLS + β² Board Quality + β³ (Board Quality*FLS)
+ β4 DomSalesGrowth + β5 Size + β6 Follow + β7 ForeignPerc
+ β8 ForSeg + e
ForeignProfitMargin = β¹ FLS + β² Board Quality + β³ (Board Quality*FLS)
+ β4 DomProfitMargin + β5 Size + β6 Follow + β7 ForeignPerc
+ β8 ForSeg + e
Dependent variables:
- ForeignProfitMargin is based on: Foreign pretax income Foreign sales
- ForeignSalesGrowth is based on the natural log of growth in foreign sales since base year (1996). In order to filter out the outliers, the data of this the foreign sales growth is winsorized at the 1st and 99th percentiles of their distributions.
Control variables:
-DomSalesGrowth: Natural log of growth in domestic sales since base year. In order to filter out the outliers, the data of this the domestic sales growth is winsorized at the 1st and 99th
percentiles of their distributions.
- DomProfitMargin: Domestic pretax income
Domestic sales
- Size: log of total assets
- Follow: The number of analysts following the firm. - ForeignPerc: Foreign sales
25 - ForeignSegment: Reported number of foreign segments
Independent variables:
- FLS: Number of forward-looking sentences - BoardQuality
- BSize: The natural logarithm of the number of directors
- IndDir (%): The percentage of independent directors in the board. - DirTen (%): The percentage of directors with a minimum of 10 service years within the board.
26
4. Results
This section will discuss the results of this study. This empirical research is based on prior research of Hope and Thomas (2008). The first paragraph will show the descriptive statistics of all variables used in this study. The following paragraphs will discuss the outcomes of the research.
4.1 Descriptive Statistics
Table 2: Overview of the descriptive statistics of the variables
(1) (2) (3) (4) (5)
VARIABLES N mean sd min max
BSizelog 522 0.951 0.143 0.602 1.204 DirTen 522 0.396 0.226 0 1 IndDir 522 0.627 0.189 0.143 0.917 DusDir 522 0.137 0.144 0 0.600 FLS 522 0.370 0.766 0 4 following 522 9.400 11.03 0 45 ForSeg 522 3.034 1.315 2 8 DomSG 522 0.0104 1.036 -4.584 3.635 ForSG 522 0.00239 1.148 -4.843 3.887 ForPM 522 0.0685 0.0797 -0.0716 0.367 DomPM 522 0.0829 0.138 -0.314 0.727 Size 522 7.487 1.824 3.243 12.48 ForeignPerc 522 0.408 0.157 0.104 0.798 FLSxBSlog 522 0.347 0.726 0 3.528 FLSxDirTen 522 0.139 0.315 0 1.600 FLSxIndDir 522 0.228 0.503 0 2.625 FLSxBusDir 522 0.0501 0.152 0 0.938 Number of firms 174 174 174 174 174
Descriptive results on the distribution of observations based are presented in Table 2. In this overview are the dependent and the independent variables shown. These descriptive statistics give preliminary insights to explore the hypothesis of this study. In the sample of the 552 observations, 39,6% of the directors has a minimum of ten service years. The mean of the independent directors in this study comes close to the study of Fields et al. (2012), where they reported a mean of 0.7 independent directors. Also the director which serves a minimum of three boards are comparable of the study of Fields et al. (2012), where they reported a mean of 0.11 of directors who serves more than 3 boards. The mean of the number of forward-looking sentences is 0.37 with a standard error of 0.77. The maximum number of sentences is four forward-looking sentences per firm per year. The mean of number of analyst following
27 the firm is 9.4, this is similar as the study of Hope and Thomas (2008). In their research they report a mean of 8.7 analyst following the firm.
The correlation table (Table 3), shows the correlation between the different variables. This table shows that there are no significant strong linear relationships, other than variables which have information on forward-looking sentences (FLS). This is expected because these variables partly contain the same information. The only moderate uphill positive relationship is between the number of analysts following the firm and the size of the firm (which is determined by the total assets of the firm) on a significance level of <0.01. This means that when a firm increase in size that the number of analyst who is following the firm also increase moderately.
Table 3: Overview of the process in the generation of the final sample.
FLS BSlog DirTen IndDir BusDir FLSxBS FLSxDT FLSxID FLSxBD DomSG DomPM Size following Foreignperc For Seg
FLS 1 BSlog -0,01 1 0,78 DT perc -0,01 -0,07 1 0,79 0,09 ID prec -0,01 0,17 -0,28 1 0,79 0,00 0,00 D3B 0,04 0,42 -0,07 0,17 1 0,42 0,00 0,11 0,00 FLSxBS 0,98 0,06 -0,03 0,01 0,07 1 0,00 0,18 0,55 0,80 0,13 FLSxDirTen 0,86 0,04 0,20 -0,10 0,00 0,83 1 0,00 0,40 0,00 0,02 0,92 0,00 FLSxIndDir 0,95 -0,04 -0,07 0,13 0,06 0,95 0,74 1 0,00 0,39 0,10 0,00 0,16 0,00 0,00 FLSxBusDir 0,71 0,13 -0,06 0,03 0,34 0,75 0,55 0,71 1 0,00 0,00 0,16 0,43 0,00 0,00 0,00 0,00 DomSG -0,05 -0,01 -0,08 0,01 0,01 -0,05 -0,08 -0,04 -0,05 1 0,23 0,86 0,16 0,79 0,78 0,28 0,08 0,41 0,28 DomPM -0,01 -0,01 -0,02 -0,03 0,01 -0,03 -0,04 -0,02 -0,04 -0,04 1 0,73 0,88 0,62 0,46 0,75 0,54 0,34 0,59 0,03 0,42 Size 0,03 0,07 -0,04 0,05 -0,03 0,04 0,01 0,04 0,06 0,30 0,15 1 0,44 0,12 0,35 0,28 0,46 0,38 0,75 0,38 0,20 0,00 0,00 following 0,02 0,06 -0,14 0,05 0,01 -0,03 0,02 0,03 0,06 0,18 0,29 0,53 1 0,57 0,16 0,00 0,71 0,80 0,53 0,69 0,57 0,15 0,00 0,00 0,00 Foreignperc -0,03 -0,09 0,04 0,01 0,09 -0,04 -0,03 0,00 0,00 -0,01 0,16 0,03 0,11 1 0,53 0,04 0,37 0,75 0,05 0,41 0,53 0,95 0,95 0,80 0,00 0,53 0,01 For Seg -0,03 0,00 0,04 -0,05 0,04 -0,04 -0,05 -0,03 -0,03 0,06 0,07 0,12 0,03 0,30 1 0,52 0,98 0,32 0,24 0,32 0,40 0,22 0,57 0,55 0,18 0,09 0,01 0,47 0,00
4.2 The relation between FLS and geographical empire building
The first hypothesis of this study is as following: ‘’Firms in the United States which have forward-looking disclosures about foreign investments are more likely to be subject to empire building than firms in the United States which do not have forward-looking disclosures about foreign investments.’’
This hypothesis would be accepted if there is significant positive relation between forward-looking sentences (FLS) and foreign sales growth (ForSG) and a significant negative relation between FLS and foreign profit margin (ForPM). Table 4 contains the results of the regression analysis of several variables on the foreign sales growth and foreign profit margin. According to the research of Hope and Thomas (2008) there is only evidence of geographical empire building when there is a positive relation with the foreign sales growth and a negative relation with the foreign profit margin. FLS is positive correlated with foreign sales growth and negative correlated with foreign profit margin, however these results are not significant. Furthermore it is shown that Size has a positive relation with ForSG, this is consistent with the results of Hope and Thomas (2008), who report a significant positive relation with foreign
sales growth of 0.005. Also the relation between Size and ForPM show a similar result as the
research of Hope and Thomas (2008), they report a significant positive relation between Size and ForPM of 0.002. The number of analyst who follow the firm (following) has a negative correlation of -0.004 with foreign sales growth and a positive relation with ForPM, this results is also consistent with the research of Thomas and Hope (2008) which report a
significant negative relation of -0.003 with the foreign sales growth and a significant positive relation of 0.001 with the foreign profit margin. This means that when there are more
analysts are following a firm, that the foreign sales growth slightly decrease and the foreign
profit margin slightly increase. The domestic sales growth show a significant positive relation
with the FORSG growth, this means that when a firm has more domestic sales the foreign
sales also grows. The same can be concluded about the foreign percentage, when the foreign percentage increase the foreign sales growth also increase, this makes sense cause the foreign percentage is determined by the foreign sales to total assets ratio. In the research of Hope and
Thomas (2008) is also the foreign percentage used as a control variable, and they also report a significant positive relation with the foreign sales growth (of 1.101). Overall can be
concluded that there when there are FLS that there is a growth in foreign sales and a decrease in the profit margin. However, these results are not significant and therefore there is no
30 evidence for a significant correlation between FLS and ForPM and FLS and ForPM. A possible explanation of the absence of significance results, is that the sample is too small. Since the results are as expected, but are not significant, this hypothesis is rejected.
__________________________________________________________________________________
Table 4: Empirical results of hypothesis 1
(1) (2) VARIABLES Expectation FLS = ForSG + ForPM - FLS 0.023 -0.001 (0.384) (0.805) DomSG 0.950*** (0.000) Size 0.025 0.003 (0.140) (0.199) following -0.004 0.001** (0.146) (0.024) ForeignPerc 1.598*** -0.036 (0.000) (0.198) ForSeg 0.002 -0.005** (0.900) (0.021) DomPM 0.138*** (0.000) Constant -0.827*** 0.050** (0.000) (0.022) Observations 522 522 Number of firms 174 174 Wald Chi2 1129.21 53.46
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
4.3 The relation between board quality and geographical empire building
The second hypothesis of this study is as following: ‘’Firms in the United States with a low quality board are more likely to engage in empire building.’’
This hypothesis would be accepted if there is significant negative relation between the board quality and ForSG and a significant positive relation between the board quality and ForPM. However, board quality is based on four different variables, which have different interpretations. For two of these variables there is an expectation, when there is more
31 and a positive relation with the ForPM. When directors are active on more boards (>=3), they are considered more busy and it is expected that there is a positive relation between busy directors and ForSG and a negative relation with ForPM. Table 5 shows a positive relation between the IndDir and ForPM with a significance of 0.015. This means that when there are more independent the foreign profit marge increase, which is in line with the expectations. However, there is no negative relation found between IndDir and ForSG. For BusDir are no significant relations found on ForSG and ForPM. The results show a significant positive relation between board size and ForSG. This can be interpreted that when there is a larger board that the foreign sales growth increase. There is no significant relation on board size and ForPM.
Overall Table 5 show a significant positive correlation between foreign profit margin and independent directors, there is no significant relation shown for independent directors and foreign sales growth. Also there are no significant results for directors who serve a minimum of three boards and directors with a minimum of ten service years. The results show a significant positive relation between board size and ForSG. This can be interpreted that when there is a larger board that the foreign sales growth increase. Since there is no variable which has evidence which correspondent with both expectations (ForSG and ForPM), this hypothesis is rejected.
__________________________________________________________________________________
Table 5: Empirical results of hypothesis 2
(1) (2) VARIABLES Expectations if: Boardsize DirTenure IndDir BusDir ForSG ? ? - + ForPM ? ? + - BSlog 0.457** 0.018 (0.021) (0.560) DirTen 0.044 0.003 (0.696) (0.812) IndDir 0.037 0.061** (0.747) (0.015) BusDir -0.304 -0.029 (0.122) (0.424) DomSG 0.952*** (0.000) Size 0.022 0.003
32 (0.213) (0.235) following -0.004 0.001** (0.152) (0.023) ForeignPerc 1.679*** -0.035 (0.000) (0.193) ForSeg 0.001 -0.005** (0.970) (0.022) DomPM 0.138*** (0.000) Constant -1.260*** -0.002 (0.000) (0.954) Observations 522 522 Number of firms 174 174 Wald Chi2 1109.05 53.73
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
4.4 The relationship of forward-looking disclosures and board quality on empire building
The third hypothesis of this study is as following: ‘’The relationship between forward-looking disclosures and empire building is more positive for low board quality.’’
This hypothesis would be accepted if there is significant negative relation between the board quality*FLS and ForSG and a significant positive relation between the board
quality*FLS and ForPM. Board quality is determined by different variables, with different expectations. For FLSxBoardSize and FLSxDirTen are due to the literature no expectations. For FLSxIndDir is expected that there is a negative relation with ForSG and a positive relation with ForPM. For FLSxBusDir it is expected that there is a positive relation with ForSG and a negative relation with ForPM. Table 6 show a significant positive relation between FLSxIndDir and ForPM, which is corresponding with the expectation. Also there is a negative relation with FLSxIndDir and ForSG, however this relation is not significant. There are no significant results shown for FLSxBusDir and ForSG or ForPM. In Table 6 is shown that FLSxBoardSize is positively related to ForSG and negatively related to ForPM. This means that when a firm disclose forward-looking sentences (FLS) and the board size of the firm increase that the foreign sales growth also increase and the foreign profit margin decrease. For firms who disclose forward-looking sentences and have directors who has a minimum of 10 service years there is no significant results on the relation with ForSG and ForPM. Table 6 show that there is a direct effect of FLS and IndDir on ForPM, because the positive relation between FLSxIndDir is significant compared to the IndDir relation to
33 ForPM.
The overall conclusion of Table 6 are that there is no significant results on the relation between firms who disclose forward-looking sentences with directors who serve a minimum
of three boards and empire building. However, there is a significant positive relation between
firms who disclose forward-looking sentences with an independent board and foreign profit
margin. Also there is a negative relation between firms who disclose forward-looking sentences with an independent board and foreign sales growth. However, this relation is not
significant. A possible explanation of this insignificant negative relation is that the used sample is too small. This can lead to an insufficient number of observations to provide evidence for the stated hypothesis.
__________________________________________________________________________________
Table 6: Empirical results of hypothesis 3
(1) (2) VARIABLES Expectations: FLSxBoardsize FLSxDirTenure FLSxDirInd FLSxBusDir ForSG ? ? - + ForPM ? ? + - FLS 0.010 -0.022 (0.971) (0.288) BSlog 0.423* 0.022 (0.067) (0.503) DirTen 0.068 -0.006 (0.576) (0.702) IndDir 0.061 0.043 (0.632) (0.109) BusDir -0.264 -0.014 (0.269) (0.693) FLSxBSlog 0.138 -0.024 (0.508) (0.234) FLSxDirTen -0.091 0.034 (0.522) (0.109) FLSxIndDirc -0.092 0.060** (0.643) (0.014) FLSxBusDir -0.159 -0.038 (0.570) (0.493) DomSG 0.952*** (0.000) Size 0.022 0.003 (0.229) (0.216) following -0.004 0.001** (0.167) (0.027) ForeignPerc 1.693*** -0.032
34 (0.000) (0.242) ForSeg 0.001 -0.005** (0.961) (0.013) DomPM 0.137*** (0.000) Constant -1.273*** 0.005 (0.000) (0.886) Observations 522 522 Number of firms 174 174 Wald Chi2 1132.27 69.72
Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1
35
5. Conclusion
Over the last decades, agency theory has emerged as the dominant in the financial economics literature (Miller and Sardais, 2010). Jensen and Meckling (1976) discuss the agency theory as the conflict between shareholders and the agent where individuals choose actions to maximize their own utility. Mirlees (1999) emphasizes that moral hazard problems arise when managers monitor their own actions and behaviour, where it is hard for the
shareholders to observe this. In the past Hope and Thomas (2008) did research on
geographical empire building and the managerial behaviour. They observe the behaviour that managers may start up projects or investments abroad, while this may be unprofitable in the end. The focus of this study is mainly focussed on the difference in interest in short-term versus long-term vision, where managers want to create more firm value on short-term to expand in foreign areas, while for shareholders it is far more important if the continuity of the firm is guaranteed. Hope and Thomas (2008) discuss that some managers of firms are
subjected to empire building. A possible cause of this occurrence is that the quality of the board is low. When there is a low quality of the board it is harder to monitor mechanisms, for example when financial disclosures are reduced, it is harder for investors to relate managerial decisions to firm performance. According to Hermalin and Weisbach (2007) it is possible that the quality of corporate boards is related to the quality of the financial disclosures.
The relation between forward-looking disclosures and board quality on geographical empire building is analysed by using a dataset of 174 U.S. firms. These 174 firms have observations of the years 1998 to 2000, which leads to a final dataset of 522 observations. In this research are three hypotheses tested, all of these hypotheses will be tested to two variables: foreign sales growth and foreign profit margin. There is evidence for geographical empire building when the foreign sales are positive and the foreign profit margin is negative. The first hypothesis looks at the relation between forward-looking sentences and
geographical empire building. The results are in line with the research of Hope and Thomas (2008). Not only the direction of the results are similar to their research but also the values are similar. The findings show that FLS is positive correlated with foreign sales growth and negative correlated with foreign profit margin, this would be evidence for geographical empire building. However these results are not significant, therefore this hypothesis is rejected.
36 and empire building. It is expected that when there is a low board quality there is more
empire building. Overall can be concluded that there is a significant positive correlation between foreign profit margin and independent directors, there is no significant relation shown for independent directors and foreign sales growth. Also there are no significant results for directors who serve a minimum of three boards and directors with a minimum of ten service years. The results show a significant positive relation between board size and foreign sales growth. This can be interpreted that when there is a larger board that the foreign sales growth increase. Since there is no variable which has evidence which correspondent with both expectations, this hypothesis is rejected.
In the third hypothesis is tested, if the board quality of a firm has an effect on the relation between forward-looking disclosures and geographical empire building. The results shows that there is no significant results on the relation between firms who disclose forward-looking sentences with directors who serve a minimum of three boards and empire building. However, there is a significant positive relation between firms who disclose forward-looking sentences with an independent board and foreign profit margin. Also there is a negative relation between firms who disclose forward-looking sentences with an independent board and foreign sales growth. These are signs that independency of the board increase the board quality and reduce empire building. However, this relation is not significant. Most results in this study are in line with the expectations, however these results are not significant. A possible explanation of the lack of significant results can be due to the small sample which is used in this study. This can lead to an insufficient number of observations to provide
evidence for the stated hypotheses.
There are a few limitations in this study which have to be taken into account. The first limitation is regarding the dataset. The raw dataset, which is provided by the University of Amsterdam contains numeral errors and contradictions, which made the dataset less useful and these observations had to be eliminated from the dataset. Furthermore, of the 334 firms of the initial dataset, only 174 firms had information about board quality. This led to a huge drop in the sample. The second limitation is that the provided dataset is contains sentences for a limited amount of years. Because the SFAS 131 is introduced in June 1997, it is only
possible to use data from 1998 and beyond. Since there is only data available from 1996 to 2000, it is only possible to look the three years after the adoption of SFAS 131. These limitations made it more difficult to find evidence for significant results.
37 For further research it is interesting to research if there is a difference between
forward-looking disclosures and empire building prior to the SFAS 131 period compared to the period after the adoption of SFAS 131. It is interesting to investigate if there is a
difference of the behaviour of the managers with the adoption of SFAS 131. It would add a contribution to this study to do research if firms which disclose forward-looking sentences are more subject to geographical empire building after the adoption of SFAS 131.
Furthermore it would be interesting to look further into the type of forward-looking
disclosures and the relation with the board quality on geographical empire building. It would add a dimension to this study, since in this study there is no distinction made in positive, negative and neutral forward-looking disclosures. Therefore it is interesting to investigate if positive forward-looking sentences and the board quality are related to geographical empire building.
