Financial Reporting Choices, Governance, and Strategic Assets: A Transaction Cost Perspective

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Author Information : Ravi Dharwadkar (Whitman School of Management, Syracuse University) with Parthiban David (Kogod School of Business, American University) and Augustine Duru (Kogod School of Business, American University).

Year of Publication : Academy of Management Review (2021)

Summary of Findings : This paper provides a theoretical avenue for integrating the governance and performance measurement research approaches in Transaction Cost Economics (TCE) which have heretofore been considered independently and separately in most research.

Research Questions : 1) Why are ex-post performance measurement concerns important for governance mechanisms in order to assess ex-post contract fulfillment?
2) How do ex-post performance measurement concerns interact with governance mechanisms to influence transaction costs?

What we know : Based on the works of Ronald Coase (Nobel Prize Recipient, 1991) and Oliver Williamson (Nobel Prize Recipient, 2009), organization theorists have developed two divergent approaches to assessing transactions costs within contracting frameworks. The governance approach emphasizes the role of ex-post holdup problems resulting from asset specificity that necessitates hierarchical governance (making things internally) rather than market governance (buying them from the market). The measurement approach similarly highlights the role of performance measurement resulting from information impactedness that necessitates hierarchical governance rather than market governance. While even Williamson (1985) recognizes the need for an integrated treatment of governance and measurement approaches as they are inherently interdependent, the two approaches remain largely divergent to this day due to the emphasis on them as independent, ex-ante drivers of governance choices.

Novel Findings : 1) We extend TCE research by highlighting that performance measurement concerns are equally important once governance choices are made and subsequently interact with governance to influence transaction costs. Using the corporate governance setting, we posit that performance measurement differences in financial reporting choices, by influencing governance effectiveness, incrementally affect transaction costs over and beyond what is currently predicted by TCE. Accounting research on financial reporting suggests that managers have the discretion to shift earnings over time to either opportunistically report higher current earnings to make current performance appear better, to conservatively lower current earnings by incorporating losses more quickly than gains, or to lower variance of earnings over time to iron out short-term fluctuations and provide more information on long-term prospects. We add to Williamson’s “comparative” governance insight by theorizing that conservatism strengthens the market governance of debt, incrementally reducing transaction costs when used in conjunction with debt for generic assets, while smoothing bolsters the hierarchical governance of equity, incrementally mitigating transaction costs when used in combination with equity for specific assets.

2) We also contribute to the literature by explaining that financial reporting choices constitute credible commitments to performance measurement that complement governance choices. Integrating performance measurement using mandatory financial reporting choices from accounting with the governance branch of TCE research can help foster fruitful synergies across strategy and accounting research, as these disciplines have largely operated in different domains. Management scholars have recognized that accounting numbers can be manipulated to undermine value through opportunistic earnings management. However, they have paid little heed to how conservatism and informative smoothing can play a beneficial role with respect to a firm’s governance, strategy, and financial performance. Accounting scholars have shown that information revealed through financial reporting choices affects governance effectiveness and resource allocation to influence future cash flows and financial performance but have not fully considered linkages with strategy. Our paper connects these two scholarly streams to outline a broad research agenda that could provide fruitful integration.

Implications for Practice : Integrating governance research from TCE and performance measurement using financial reporting choices should avoid the pitfalls of considering the implications of choices from one discipline without recognizing interlinkages. There are often contradictory demands for increased use of specific performance measures. For example, accounting scholars push for increased emphasis on conservatism; practitioners favor income smoothing; and regulators such as FASB are more favorably disposed to fair-value or mark-to-market accounting rather than conservatism or smoothing. These choices represent a well-known trade-off in accounting between relevance and reliability. Conservatism scores high on reliability because it is relatively easy to verify, and reliability is a more useful attribute when incentives to overstate performance are more likely to be present. Conversely, smoothing and fair-value accounting score high on relevance, as they possess high information content, but low on reliability, as they are difficult to verify. Our research indicates that the efficacy of these performance measures is likely to be based on the needs of the governance mechanisms—thereby encouraging accounting research to consider strategy and TCE research.

Full Citations : David, P., Dharwadkar, R., & Duru, A. Financial Reporting Choices, Governance, and Strategic Assets: A Transaction Cost Perspective, Academy of Management Review, Published Online: 5 Mar 2021--https://doi.org/10.5465/amr.2019.0105

Abstract : We integrate the governance and measurement branches in transaction cost economics to highlight how differences in performance measurement choices influence the governance of strategic assets, thereby affecting transaction costs. We develop our theory in the context of corporate governance in firms. Financiers of debt and equity employ market and hierarchical governance to safeguard generic and specific assets, respectively. Financial reporting choices constitute credible commitments to generate performance reports that are used by financiers in exercising governance. We explain why conservatism (more timely information about potential losses) bolsters the market governance of debt to reduce transaction costs for generic assets, while smoothing (informative reports about future earnings) strengthens the hierarchical governance of equity to reduce transaction costs for specific assets. We outline a research agenda incorporating the implications of performance measurement from financial reporting choices for the governance of strategic investments.

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Ravi Dharwadkar
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