Independent Directors, Business Risk, and the Informativeness of Accounting Earnings for Debt Contracting

• DOI: http://doi.org/10.1002/cjas.1521
• Author: Robert Mathieu,Ling Chu,Chima Mbagwu
• Published date: 01 December 2019
• Date: 01 December 2019

Independent Directors, Business Risk, and the

Informativeness of Accounting Earnings for

Debt Contracting

Ling Chu

Wilfrid Laurier University

Robert Mathieu

Wilfrid Laurier University

Chima Mbagwu*

Wilfrid Laurier University

Abstract

Using a sample of new bank loans, we investigate the impact

of business risk on the usefulness of operating income after

controlling for the proportion of independent directors.

Consistent with the literature, our initial analyses reveal that

the presence of independent directors on a board reduces the

interest rate directly and indirectly through an increase in

the usefulness of operating income. However, we further

provide evidence that the indirect benef‌it of a high propor-

tion of independent directors is reduced when we account

for the presence of business risk. This suggests that studies

examining the usefulness of operating income should

take into account the effect of business risk. © 2018 ASAC.

Published by John Wiley & Sons, Ltd.

Keywords: debt-contracting value, accounting information,

independent directors, bank loans, risk

Résumé

À partir d’un échantillon de nouveaux prêts bancaires,

nous examinons l’incidence du risque d’entreprise sur

l’utilité du résultat d’exploitation après avoir tenu compte

de la proportion d’administrateurs indépendants. Les

résultats de nos premières analyses qui se situent dans le

prolongement des travaux antérieurs révèlent que la

présence d’administrateurs indépendants au sein du conseil

d’administration réduit directement et indirectement le

taux d’intérêt par une augmentation de l’utilité du

résultat d’exploitation. Toutefois, l’avantage indirect d’une

forte proportion d’administrateurs indépendants est réduit

lorsqu’on tient compte de la présence d’un risque commer-

cial. Cette découverte nous amène à proposer que dans

les études portant sur l’utilité du résultat d’exploitation,

on tienne compte de l’effet du risque commercial. © 2018

ASAC. Published by John Wiley & Sons, Ltd.

Mots-clés: valeur de l’endettement, données comptables,

administrateurs indépendants, prêts bancaires, risque

Introduction

An independent board is an important corporate gover-

nance mechanism for mitigating the agency problem and the

information asymmetry that occurs between management

and external stakeholders. It is not surprising therefore that

a requirement of the Sarbanes-Oxley (SOX) Act of 2002

is that f‌irms should improve the independence of the board

of directors. This is expected given that prior research

shows that a higher proportion of independent directors is

associated with, for example, higher accounting quality

(Davidson, Goodwin, & Kent, 2005; Dechow, Sloan, &

Sweeney, 1995; Jones, Krishnan, & Melendrez, 2008; Kent,

Routledge, & Stewart, 2010; Osma, 2008; Zhegal & Anis,

2011), a reduction in earnings management and f‌inancial

fraud through better oversight of the f‌inancial accounting

process (Beasley, 1996; Klein, 2002), and a lower likelihood

of the f‌irm becoming bankrupt or f‌inancially distressed

(Daily & Dalton, 1994; Elloumi & Gueyie, 2001).

Several studies provide evidence that the presence of

independent directors decreases f‌irm risk. As a result,

banks should take into account the impact of independent

directors when setting interest rates on new loans. In

line with this, Francis, Hasan, Koetter, and Wu (2012),

Klock, Mansi, and Maxwell (2005), Cremers, Nair, and

Wei (2007), and Chava, Livdan, and Purnanandam (2009)

document a strong negative impact of corporate governance

*Please address correspondence to: Chima Mbagwu, Wilfrid Laurier

University. Email: cmbagwu@wlu.ca

Canadian Journal of Administrative Sciences

Revue canadienne des sciences de l’administration

Published online 27 December 2018 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/CJAS.1521

36: 559–575 (2019)

Can J Adm Sci

© 2018 ASAC. Published by John Wiley & Sons, Ltd. 36(4), 559–575 (2019)559

on the cost of debt. This negative relationship is precipitated

perhaps by a lower likelihood of bankruptcy as documented

by Elloumi and Gueyie (2001), and by a reduction in earn-

ings management as documented by Klein (2002).

In addition to the reduction of the riskiness of the oper-

ations of a f‌irm, board independence can inf‌luence the valid-

ity of the measure of f‌irm prof‌itability. Firm prof‌itability,

which is ref‌lected in accounting earnings, is important to

banks because the measure is used in assessing f‌irms’

creditworthiness and the ability to service the debt. Accord-

ing to Francis, Olsson, and Schipper (2008), the quality of

earnings depends on both business factors (the operating

environment) and f‌irms’f‌inancial reporting decisions. These

business factors (the operating environment) constitute the

business risks to which the organization is exposed. Doff

(2008) def‌ines business risk as “the risk of f‌inancial loss

due to changes in the competitive environment or the extent

to which the organization could timely adapt to these

changes”([sic]; p. 320). Therefore, business risk is related

to uncertainty about the f‌irms’market position and the de-

mand for its products. A f‌irm facing a volatile market with

changing conditions faces higher business risks than other-

wise. Factors such as changes in technology and consumer

preferences, level of competition, and the ability of other

f‌irms to enter the market all impact business risk.

1

While the usefulness of accounting information for debt

contracting has been documented in the literature, our study

asks a different question. Does business risk reduce the use-

fulness of accounting information even when corporate gov-

ernance is strong? If business risk is high, the volatility of

the f‌irms’future performance is also high and it becomes

diff‌icult for banks to assess the ability of f‌irms to generate

enough cash f‌low to service the debt. In such a case, the use-

fulness of operating income may be signif‌icantly reduced

even when there is a high proportion of independent

directors.

To test our hypotheses, we use a sample of bank loans

issued between the years 2000 to 2011. Consistent with the

existing literature, we provide evidence that banks take into

account the independence of the board when setting the in-

terest rate on new loans. The independence of the board of

directors also increases the usefulness of operating income.

However, when we control for the level of business risk,

our analysis reveals that the effect of a higher proportion

of independent directors on the informativeness of earnings

decreases as business risk increases. In other words, when

business risk is high, a high proportion of independent direc-

tors has less impact on the reduction of the interest rate than

when business risk is low. Our results hold for various ro-

bustness checks.

In this study, we examine both the impact of business

risk and the impact of the proportion of independent direc-

tors on the interest rates of new loans. While Francis et al.

(2012), Klock et al. (2005), Cremers et al. (2007), and Chava

et al. (2009) document a strong negative impact of corporate

governance on the cost of debt, we view our study as making

the following contributions to the literature. First, we pro-

vide evidence that while the presence of independent direc-

tors directly affects the interest rate, it also has an indirect

effect, since banks’reliance on f‌inancial statements is an in-

creasing function of the presence of independent directors.

Second, we document that this relationship is affected by

the level of business risk. These f‌indings are important

because they suggest that it is not suff‌icient to control for

the presence of independent directors when examining the

usefulness of operating income since this relationship is also

affected by the level of business risk.

These f‌indings are important since SOX specif‌ically

recommends that, to improve the quality of accounting in-

formation, the board of directors should be composed

mainly of independent directors. While our study provides

evidence that, in the context of new bank loans, the useful-

ness of operating income increases as the proportion of inde-

pendent directors increases, we document that this

relationship depends on the level of business risk. In other

words, in evaluating the impact of the proportion of indepen-

dent directors, it is important that f‌inancial statement users

also evaluate the business risk of the f‌irm.

The rest of the paper is structured as follows: In the next

section, we provide a review of the related literature and

establish our hypotheses. In section three, we introduce the

empirical design and discuss our sample selection. In section

four, we present the results of our analyses, and in section

f‌ive introduce additional tests. We conclude in section six.

Literature Review and Hypothesis Development

The board of directors is an important corporate gover-

nance mechanism for controlling the agency problem within

an organization (Fama & Jensen, 1983). Highly independent

boards have been found to be associated with the likelihood

of replacing the CEO in response to poor performance

(Weisbach, 1988), reduced earnings management (Klein,

2002), control of CEO compensation (Core, Holthausen, &

Larcker, 1999), and with a reduced likelihood of f‌inancial

distress and bankruptcy (Elloumi & Gueyie, 2001). It is

therefore not surprising that Levesque, Libby, Mathieu,

and Robb (2010) f‌ind that the market values the monitoring

role played by independent directors, due to the reduced in-

formation risk associated with the f‌irm. For example, it is

possible that through their monitoring role, independent di-

rectors can reduce the overall risk-taking behaviour of f‌irms.

This implies that the presence of independent directors can

reduce the interest rate on new loans. This is consistent with

Francis et al. (2012), who document a strong negative im-

pact of higher corporate governance on the cost of debt.

In line with this argument, Bhojraj and Sengupta (2003)

f‌ind that f‌irms with stronger external monitoring have lower

bond yields. They argue that the reduction in agency risk

INDEPENDENT DIRECTORS, BUSINESS RISK, AND THE INFORMATIVENESS OF ACCOUNTING EARNINGS CHU ET AL.

Can J Adm Sci

© 2018 ASAC. Published by John Wiley & Sons, Ltd. 560 36(4), 559–575 (2019)