tan et al - does stronger corporate governance improve financial reporting quality

Does Stronger Corporate Governance Improve Financial Reporting Quality? Evidence from a Regression Discontinuity Analysis of Shareholder-Sponsored Governance Proposals Liang Tan George Washington University Ph: 202-994-7481 liangtan@gwu.edu Yanfeng Xue George Washington University Ph: 202-994-6747 yxue@gwu.edu Yong Yu University of Texas at Austin Ph: 512-471-6714 Yong.Yu@mccombs.utexas.edu Abstract This study examines whether stronger corporate governance leads to higher quality financial reporting We use a regression discontinuity method to analyze the effect on financial reporting quality of shareholder-sponsored governance proposals that pass or fail by a small margin of votes in annual meetings This empirical strategy allows us to overcome the endogeneity problem of governance mechanisms and provide evidence on the causal effect of corporate governance on financial reporting quality We find that passing proposals related to board of directors and executive compensation leads to an improvement in the quality of financial reporting We also find that this positive effect on financial reporting is more pronounced for firms with lower quality financial reporting prior to the voting We find no evidence that passing proposals related to antitakeover provisions affects financial reporting quality Preliminary draft - Please not cite or quote Comments welcome Introduction How corporate governance affects financial reporting is an important question in accounting research However, despite the large volume of research devoted to this topic, there is limited evidence on the causal effect of corporate governance on financial reporting, primarily because of the joint endogeneity of governance mechanisms and accounting system (Armstrong et al 2010; Brickley and Zimmerman 2010) As Brickley and Zimmerman (2010) conclude, "Upon more careful reflection, however, most of these results are also consistent with alternative explanations Moreover, causality often is impossible to infer." The difficulty of establishing a causal relation is further exacerbated by the lack of comprehensive theories that allow researchers to classify a specific governance feature as "good" or "bad." The objective of this study is to provide evidence on the causal effect of corporate governance on financial reporting by applying a regression discontinuity method to analyze a threshold event - shareholder proposals related to corporate governance Our empirical strategy focuses on examining the effect on financial reporting quality of shareholder-sponsored governance proposals that pass or fail by a small margin of votes in annual meetings (i.e., closecall proposals) For such close-call proposals, the treatment firms (e.g., those with a proposal that just passes with 50.1% of the votes) are, on average, the same as the control firms (e.g., those with a proposal that just fails to pass with 49.9% of the votes) on virtually every dimension (Lee, 2008) However, a proposal is significantly more likely to be implemented and thus lead to changes in corporate governance for the treatment firms than for the control firms (Ertimur et al 2010) Thus, for the close-call proposals, passing a proposal is a "locally" exogenous event The estimated effects of passing a proposal on financial reporting quality should not be affected by any observed or unobserved confounding factors, as long as their effects are continuous around the majority threshold (which we show is indeed the case for our setting) Therefore, our empirical strategy allows us to overcome the endogeneity problem of governance mechanisms and provide clear evidence of a causal effect of corporate governance on financial reporting Our research design also allows us to overcome the limitation of having to classify a governance feature as "good" or "bad" arbitrarily To the extent that shareholders have better information and abilities to detect the weakness of a firm' governance structures, they are likely to request changes that represent improvements in the firm's governance Consistent with the shareholder proposals improving governance, Cunat et al (2012) find that passing governancerelated shareholder proposal triggers significant positive market reactions We use the regression discontinuity method to analyze a large sample of 3,775 governance-related shareholder proposals from 1997 to 2010 We gauge financial reporting quality using both the accrual-based measure from the modified Dechow and Dechiv (2002) model and the measures based on accounting restatements and internal control deficiencies We find that the passing of governance-related shareholder proposals is related to an improvement in the accrual-based measure of reporting quality and a reduction in the likelihood of having internal control deficiencies, suggesting that stronger corporate governance results in higher quality financial reporting Next, we examine which types of governance mechanisms drive the positive effect on financial reporting quality We classify all shareholder-initiated governance proposals into three groups that are related to executive compensation, boards of directors, and antitakeover provisions (included in the G-index constructed by Gompers et al 2003), respectively.1 We find strong evidence that passing proposals related to board of directors improves the accrual-based We also attempt to identify proposals directly related to auditing However, there are too few proposals related to auditing issues, making it difficult to estimate the impact of these proposals precisely using our research design measure of reporting quality, and reduces the likelihood of having accounting restatements and internal control deficiencies We also find some evidence that passing proposals related to executive compensation improves the accrual-based measure of reporting quality However, we find no evidence that passing proposals related to antitakeover provisions affects financial reporting quality Further, we conduct cross-sectional analyses to examine whether the effects of passing governance proposals on financial reporting depend on the sponsorship of the proposals and the quality of financial reporting prior to the voting Prior research shows that shareholder governance proposals are more likely to be implemented when they are sponsored by institutions rather than individuals (Gillian and Starks 2007; Ertimur et al 2010) Further, improvements in governance mechanisms are likely to lead to a larger increase in financial reporting quality for firms with relatively poorer financial reporting prior to the voting We find some evidence that passing proposals related to executive compensation and boards of directors leads to a larger increase in financial reporting quality for firms with poorer reporting quality prior to the voting We find no evidence that the effects of passing shareholder proposals on reporting quality vary with institution sponsorship of the proposals Furthermore, we find no evidence in any subsample that passing proposals related to antitakeover provisions affects financial reporting quality Overall, our results suggest that stronger corporate governance leads to an improvement in financial reporting quality, and this positive effect is concentrated in governance mechanisms related to board of directors and, to a lesser extent, executive compensation Our paper makes two primary contributions First, it contributes to our understanding of the relation between corporate governance and financial reporting by providing clear evidence on the causal effect of corporate governance on financial reporting Using the regression discontinuity design and the threshold event of shareholder-sponsored governance proposals, we are able to overcome the problem of the joint endogeneity of governance and accounting system as well as the difficulty of lacking theories to classify a governance feature as good or bad Our results suggest that stronger governance mechanisms, particularly those related to board of directors and executive compensation, lead to improved financial reporting Second, our study also adds to our understanding of the economic consequences of shareholder-initiated governance proposals Cunat et al (2012) examine market reactions to governance proposals and find that passing governance proposals triggers significant positive market reactions, reduces acquisitions and capital expenditures, and improves long-term firm performance We extend Cunat et al (2012) by demonstrating that the governance-related shareholder proposals have an important, and previously unidentified, benefit of improving firms' financial reporting Our results are also relevant to the standing debate on shareholder-sponsored governance proposals While proponents argue that such proposals can improve governance and enhance firm value, critics raise the concern that shareholders who initiate the proposals can be selfserving and the shareholder voting could be uninformed and disruptive to firm operation (Bainbridge 2006) This debate is especially heated by the recent enactment of the Dodd-Frank Act, which requires firms to put their executive compensation policy under shareholder advisory vote at least once every three years Our study shed light on the economic consequence of shareholder-sponsored governance proposals by providing evidence on the role of those proposals in improving firms' financial reporting quality The rest of the paper proceeds as follows Section reviews prior literature and discusses institutional background Section describes the regression discontinuity research method, and Section describes our sample and empirical measures Section presents the empirical findings Second concludes Prior research and institutional background 2.1 Prior research Although a large body of research has examined whether financial reporting quality is influenced by various governance mechanisms, the empirical evidence is generally mixed (see Armstrong et al (2010) for a comprehensive review of this literature) For example, research examining how managerial compensation influences financial reporting fails to find consistent results On one hand, some studies find a negative relation between managerial equity incentives and the quality of financial reporting (e.g., Cheng and Warfield 2005; Bergstresser and Philippon 2006; Efendi et al 2007); on the other hand, other studies find no relation between the two (e.g., Erickson et al 2006; Baber et al 2007) or even a positive relation (e.g., Warfield et al 1995; Armstrong et al 2010) The results from the stream of research examining the effects of various features of boards of directors on financial reporting are also mixed For example, while some studies find that more independent boards are associated with higher quality reporting (e.g., Klein 2002; Efendi et al 2007), others find little evidence that board independence has a significant impact on financial reporting quality (e.g., Agarawal and Chadha 2005; Larcker et al 2007) The evidence from examining anti-takeover provisions (G-index) is also inconclusive For example, Larcker et al (2007) find no relation between G-index and measures of reporting quality, whereas Baber et al (2012) document a negative relation between G-index and restatement in part of their sample period and no relation in the rest of the sample period While many factors may contribute to the mixed findings in the extant literature, the joint endogeneity of corporate governance and financial reporting represents perhaps the biggest challenge (Armstrong et al 2010; Brickley and Zimmerman 2010) A firm’s choice of a particular governance mechanism is endogenously determined by many factors including firm fundamental characteristics, information environments, other governance mechanisms, and managerial attributes And many of those factors are also likely to be important determinants of the firm's financial reporting This endogeneity problem raises concerns that any association found between corporate governance and financial reporting can be driven by observable or unobservable confounding factors Recent reviews of the literature (Armstrong et al 2010; Brickley and Zimmerman 2010) conclude that the extant literature has provided very little evidence on the causal relation between corporate governance and financial reporting and call for more research that better addresses the endogneity problem and provides clearer causal evidence In addition to this endogeneity problem, the difficulty in providing causal evidence between corporate governance and financial reporting is further exacerbated by the lack of comprehensive theories that allow researchers to classify a feature of corporate governance as "good" or "bad." (Brickley and Zimmerman 2010) A particular governance feature (e.g., more outside directors or smaller board size) is unlikely to be optimal for all firms Rather, whether a specific governance feature is good or bad for a particular firm likely depends on the firm's fundamental characteristics, information environments, other governance mechanisms, shareholder structure, etc As such, the same governance feature may be good for some firms, but bad for others This difficulty forces researchers to rely on some ad hoc classification (e.g., having more outside directors on boards is assumed to be a good governance feature for all firms), which can lead to mixed findings, depending on the sample of firms examined, and also make it difficult to interpret the findings In this study we examine the causal effect of corporate governance on financial reporting by applying a regression discontinuity method to analyze a threshold event - shareholder proposals related to corporate governance One key advantage of our empirical strategy is to overcome the endogeneity problem of governance and provide clear evidence of a causal effect of corporate governance on financial reporting In addition, our research design also overcomes the limitation of having to classify a governance feature as "good" or "bad" arbitrarily 2.2 Institutional background According to Rule 14a-8 of the Securities Exchange Act of 1934, shareholders who continuously own more than $2,000 or 1% of a company for at least one year can initiate a proposal The shareholder proposal must be placed on the agenda of the next annual meeting and included in the proxy distributed to the shareholders.2 Shareholder proposals have been used to address all kinds of issues including removing anti-takeover provisions, monitoring management compensation, strengthening shareholder voting rights, promoting corporate social or environmental responsibilities, and advocating corporate charitable contributions Because we are interested in how corporate governance affects financial reporting, we focus on the shareholder proposals that are directly related to firms’ corporate governance mechanisms, which comprise the vast majority of all shareholder proposals Although shareholder proposals are advisory in nature (i.e, the voting results are not binding and the implementation of the proposals are subject to the boards’ and managers’ One exception is that if the proposal violates certain conditions, such state law, the company may ask the SEC to approve their exclusion of the proposal from the meeting agenda discretion), the voting results on the proposals have been demonstrated to have significant influences on firm policies, especially when the proposals receive majority support from shareholders Ertimur et al (2010) show that among S&P 1500 firms, 40% of proposals receiving majority votes were implemented in 2004, and the proposals receiving majority votes are significantly more likely to be implemented than the ones without majority support Ferri and Sandino (2009) find that firms that are targeted by shareholder proposals in support of expensing employee stock options are more likely to adopt the accounting practice and this likelihood increases with the voting support for the proposals Ertimur et al (2011) document that the likelihood of implementing executive compensation-related proposals increases substantially after receiving majority votes The shareholder proposals offer a threshold event that allows us to address the endogneity of governance mechanisms and provide causal evidence on the effect of corporate governance on financial reporting Specifically, we apply a regression discontinuity (RD) method to examine changes in firm’s financial reporting quality in response to proposals that pass or fail the shareholder votes by a small margin The main idea behind the design is that the governance rules adopted can be considered random in those closed-call firms whose proposals pass or fail by a very small margin (Lee 2008) In other words, firms whose proposal passes by a small margin are essentially the same as firms whose proposal fails by a small margin in all dimensions, except for the significant difference in the likelihood of implementing the governance changes requested by the proposal Thus, a positive association between the voting results and changes in financial reporting quality in the subsequent periods should not be affected by any observed or unobserved confounding factors, as long as their effects are continuous around the majority threshold (which we show is indeed the case) Therefore, this positive association can be interpreted as the causal evidence that improvements in corporate governance lead to higher financial reporting quality Examining shareholder proposals also allows us to overcome the difficulty in classifying a governance feature as good or bad Instead of classifying a change in a governance mechanism as an improvement or a deterioration arbitrarily, we assume that shareholders are in better position (than researchers) to access a firm's governance structure and they make valuemaximizing decisions in their initiation of and voting on governance proposals, and thus the changes required by the shareholder proposals represent improvements in governance on average This assumption is supported by recent evidence Cunat et al (2012) show that passing governance-related proposal leads to significant positive market reactions, suggesting that shareholder proposals represent governance improvements that enhance firm value We first examine all governance-related proposals to provide evidence on the average effect of corporate governance on financial reporting We then examine the effect of specific categories of governance mechanisms Because there are only limited numbers of shareholder proposals related to each specific governance mechanism, we follow Cunat (2011) to group all governance-related proposals into different categories: 1) proposals related to executive compensation (e g., putting a cap on executive bonus); (2) proposals related to board of directors (e.g., requiring majority vote for director elections); and (3) proposals related to anti-takeover provisions included in the G-index developed by Gompers, Ishii, and Metrick (2003) (e.g., proposals to eliminate classified board or golden parachute) Identification Strategy – A Regression Discontinuity Design 10 coefficient on Pass(Comp) in Column one) but has no significant impact on internal control weakness and restatements Overall, these results provide evidence that governance improvements related to boards of directors and, to a lesser extent, executive compensation, lead to higher quality financial reporting In the next set of analysis, we examine whether the impact of passing of shareholder proposal on firms’ reporting quality is affected by the sponsorship of the proposals and financial reporting quality in prior periods Table reports the empirical results of these cross-sectional analyses Panel A shows that institutional sponsorship of the proposals not have significant impact on the relation between passing of the shareholder proposals and subsequent financial reporting quality Panel B examines whether firms with worse prior period financial reporting quality witness a bigger improvement after passing of the governance-related proposals We find some support consistent with the notion that firms with worse financial reporting quality prior to the proposal year experience bigger improvement after the passing of proposals related to executive compensation and board of directors The coefficient on Pass(Comp) x ICWt-1 is significantly negative, indicating that firms with more incidences of Section 404 internal control weakness (ICW) prior to the voting of the proposal see larger reduction in ICW after passing of proposals targeting at executive compensation contracts For tests using restatements as the measure of financial reporting quality, the results suggest that the incidence of restatement is significantly reduced by shareholder proposals related to board efficiency and executive compensation when the firm already experienced more restatements in years prior to the voting of the proposal – the coefficients on Pass(Board) x Restatet-1 and Pass(Comp) x Restatet-1 in Column are significantly negative 20 Conclusions This study examines the causal effect of corporate governance on financial reporting quality To overcome the endogeneity problem related to corporate governance, we use a regression discontinuity design to analyze a threshold event - passing of governance-related shareholder proposals This research design explores a unique semi-experimental setting where the shareholder proposals pass or fail the majority vote by a small margin (closed-call proposals) Firms receiving those closed-call proposals should be the same in all aspects except for the likelihood of implementation of the governance proposal, which jumps discretely once the proposal receives majority vote Thus, passing a proposal represents a locally exogenous shock to firms’ governance structure, and the estimated effects on financial reporting can be interpreted as causal evidence of the effect of corporate governance on financial reporting quality Using three measures of financial reporting quality (i.e., accrual-based measure from the modified Dechow and Dechiv model, incidences of internal control weakness, and incidences of accounting restatements), we find that the passing of governance-related shareholder proposals leads to higher quality financial reporting Further, we find that this positive effect on financial reporting quality is primarily driven by proposals related to boards of directors and to a lesser extent, executive compensation However, we find no evidence of improved financial reporting quality for proposals in response to the passing of shareholder proposals related to anti-takeover provisions (G-index) Additionally, We find that passing proposals related to boards of directors and executive compensation leads to a greater improvement in financial reporting quality for firms with weaker financial reporting quality prior to the proposal voting Our study contributes to the literature by establishing a clearer causal relation between corporate governance and financial reporting Our study also adds to our understanding of the 21 economic consequences of shareholder-initiated governance proposals by demonstrating that the governance-related shareholder proposals have an important, and previously unidentified, benefit of improving firms' financial reporting Our results are relevant to the ongoing debate on the effectiveness of the advisory voting on shareholder-initiated proposals, which is intensified by the recent enactment of the Dodd-Frank Act that mandates shareholder advisory vote on firms’ executive compensation contracts at least once every three 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of ICW # of Restate % with Institution Sponsor High MDD t-1 ICWt-1 Restatet-1 N 1856 1687 2282 2082 2282 2282 2282 Mean 0.046 0.082 0.117 0.446 0.471 0.057 0.117 SD 0.084 0.336 0.373 0.497 0.499 0.233 0.321 25th 0.010 0.000 0.000 0.000 0.000 0.000 0.000 Median 0.022 0.000 0.000 0.000 0.000 0.000 0.000 75th 0.052 0.000 0.000 1.000 1.000 0.000 0.000 Note: This table presents summary statistics of the sample The sample consists of 3,775 governance related shareholder proposals from 1997 to 2010 for all nonfinancial S&P 1500 companies plus an additional 500 widely held firms Panel A reports summary statistics at the proposal level Panel B reports summary statistics at the firmyear level for key variables used in the study MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1 # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting # of Restate is the number of restatements within three years after the proposal meeting Ins Ownt-1 is the percentage ownership by institutional investors right before the proposal meeting Union Fund (G-index) is an indicator variable equal to if the G-index type of proposals is sponsored by union fund, otherwise Union Fund (Board) is an indicator variable equal to if the Board related type of proposals is sponsored by union fund, otherwise Union Fund (Comp) is an indicator variable equal to if the Compensation related type of proposals is sponsored by union fund, otherwise Negret t-1 is an indicator variable equal to if the buy-and-hold abnormal return is negative for the proposal firm one year before the proposal meeting High MDDt-1 is an indicator variable equal to if a firm’s MDD is above median the year before the proposal meeting, otherwise ICWt-1 is an indicator variable equal to if internal control weakness has been found for a firm one year before the proposal meeting, otherwise Restatet-1 is an indicator variable equal to if a firm has made restatement one year before the proposal meeting, otherwise 27 Table Density Discontinuity Test Discontinuity estimate (log difference in height): Log discontinuity estimate t-stat 0.139 1.168 Note: This table presents results testing the density discontinuity of the vote shares distribution The test statistic is based on McCrary (2008) 28 Table Pre Proposal Covariates (1) MDD t-1 -0.006 (-0.67) (2) ICWt-1 -0.097 (-0.51) (3) Restatet-1 -0.120 (-0.52) (4) Ins Own t-1 0.136 (1.58) (5) Negret t-1 -0.345 (-1.08) Vote Sharew 0.823 (1.11) 11.459 (0.57) -25.473*** (-3.66) -0.770 (-0.24) 2.394 (0.24) Vote Sharew2 -3.422 (-1.10) -50.771 (-0.62) 108.450*** (3.98) 1.480 (0.12) -3.727 (-0.10) Vote Sharew3 4.666 (1.10) 71.656 (0.65) -148.593*** (-4.24) -0.692 (-0.04) 0.199 (0.00) Vote Sharew4 -2.060 (-1.09) -32.004 (-0.66) 66.354*** (4.50) -0.194 (-0.03) 1.768 (0.08) Vote Sharel 0.254 (1.16) -6.924*** (-2.89) -0.313 (-0.12) -1.088** (-2.03) -0.389 (-0.21) Vote Sharel2 -1.593 (-0.89) 74.001*** (3.98) 8.666 (0.33) 8.307 (1.43) 5.500 (0.29) Vote Sharel3 3.181 (0.53) -249.214*** (-5.10) -46.794 (-0.54) -23.147 (-1.17) -11.516 (-0.19) Vote Sharel4 -1.777 (-0.26) 261.999*** (5.80) 62.478 (0.70) 22.435 (1.07) 0.299 (0.00) Constant 0.033*** (3.71) 2151 0.0124 -1.470*** (-7.60) 2282 0.0197 -1.194*** (-12.47) 2282 0.0094 0.570*** (17.88) 2282 0.0181 0.063 (0.59) 2236 0.0035 Pass Observations Adjusted/Pseudo R2 Note: This table presents results examining whether observed baseline covariates are locally balanced on either side of the cutoff before proposal meeting in year t-1 MDDt-1 is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t-1 ICWt-1 is an indicator variable equal to if internal control weakness has been found for a firm one year before the proposal meeting, otherwise Restatet-1 is an indicator variable equal to if a firm has made restatement one year before the proposal meeting, otherwise Ins Own t-1 is the percentage ownership by institutional investors right before the proposal meeting Negret t-1 is an indicator variable equal to if the buy-and-hold abnormal return is negative for the proposal firm one year before the proposal meeting Pass is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for all proposals voted for a firm on a particular meeting date Vote Share is the aggregate vote shares supporting all the proposals for a firm on a particular meeting date t statistics are in parentheses and are adjusted for within cluster correlation by firm and by year *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and 1%, respectively 29 Table All Proposals (1) MDD (2) # of ICW (3) # of Restate Pass -0.013*** (-3.12) -0.050* (-1.70) 0.057 (0.69) MDDt-1 0.258*** (4.14) Constant 0.028*** (4.19) 0.085*** (3.53) 0.130*** (4.82) Yes Yes Yes 1841 0.0796 1686 -0.0005 2281 0.0009 Polynomial Controls Observations Adjusted R2 Note: This table presents results examining the effect of passing a governance related shareholder proposal on firms’ financial reporting quality MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1 # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting # of Restate is the number of restatements within three years after the proposal meeting Pass is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for all proposals voted for a firm on a particular meeting date Vote Share is the aggregate vote shares supporting all the proposals for a firm on a particular meeting date MDDt-1 is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t-1 t statistics are in parentheses and are adjusted for within cluster correlation by firm and by year *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and 1%, respectively 30 Table Three Types of Proposals (1) MDD 0.009 (0.86) (2) # of ICW 0.113 (1.35) (3) # of Restate 0.282 (1.53) Pass (Board) -0.035* (-1.92) -0.107*** (-4.01) -0.136** (-2.16) Pass (Comp) -0.044** (-2.34) -0.109 (-0.65) -0.068 (-0.95) MDDt-1 0.259*** (4.29) Constant 0.028*** (4.37) 0.084*** (3.54) 0.122*** (5.11) Yes Yes Yes Yes Yes Yes Yes Yes Yes 1841 0.0775 1686 0.0026 2281 0.0164 Pass (G-index) Polynomial Controls (G-index) Polynomial Controls (Board) Polynomial Controls (Comp) Observations Adjusted R2 Note: This table presents results examining the effects of passing three major types of governance related shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting quality MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1 # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting # of Restate is the number of restatements within three years after the proposal meeting Pass (G-index) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for G-index proposals voted for a firm on a particular meeting date Pass (Board) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Board related proposals voted for a firm on a particular meeting date Pass (Comp) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Compensation related proposals voted for a firm on a particular meeting date MDDt-1 is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t-1 t statistics are in parentheses and are adjusted for within cluster correlation by firm and by year *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and 1%, respectively 31 Table Cross-Sectional Tests Panel A: Interaction-Institution Sponsor (1) MDD 0.011 (0.95) (2) # of ICW 0.106 (1.36) (3) # of Restate 0.274 (1.41) Pass (Board) -0.046 (-1.56) -0.073* (-1.66) -0.160* (-1.83) Pass (Comp) -0.061* (-1.84) -0.189 (-0.84) -0.050 (-0.78) Pass (G-index) × Ins Sponsor 0.003 (0.23) 0.012 (0.21) 0.050 (1.08) Pass (Board) × Ins Sponsor 0.028 (1.00) 0.050 (0.88) 0.004 (0.05) Pass (Comp) × Ins Sponsor 0.008 (1.31) 0.060 (1.01) 0.012 (0.57) Yes Yes Yes Yes Yes Yes Yes Yes Yes 1841 0.0801 1686 0.0049 2281 0.0150 Pass (G-index) MDDt-1 Polynomial Controls (G-index) Polynomial Controls (Board) Polynomial Controls (Comp) Observations Adjusted R2 0.405*** (3.19) Note: This table presents results examining the cross-sectional variations of the effects of passing three major types of governance related shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting quality MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1 # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting # of Restate is the number of restatements within three years after the proposal meeting Pass (G-index) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Gindex proposals voted for a firm on a particular meeting date Pass (Board) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Board related proposals voted for a firm on a particular meeting date Pass (Comp) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Compensation related proposals voted for a firm on a particular meeting date Ins Sponsor is an indicator variable of whether the sponsor of the proposal is an institutional investor t statistics are in parentheses and are adjusted for within cluster correlation by firm and by year *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and 1%, respectively 32 Panel B: Interaction-Past Accounting Quality (1) MDD 0.013 (0.93) (2) # of ICW 0.105 (1.22) (3) # of Restate 0.274 (1.44) Pass (Board) -0.043 (-1.36) -0.104*** (-3.57) -0.134** (-2.06) Pass (Comp) -0.065*** (-2.62) -0.096 (-0.56) -0.055 (-0.82) Pass (G-index) Pass (G-index) × High MDDt-1 -0.004 (-0.73) Pass (Board) × High MDDt-1 0.014 (1.08) Pass (Comp) × High MDDt-1 0.009 (0.81) Pass (G-index) × ICWt-1 -0.105 (-1.51) Pass (Board) × ICWt-1 0.196 (1.42) Pass (Comp) × ICWt-1 -0.102** (-2.31) Pass (G-index) × Restatet-1 0.043 (1.11) Pass (Board) × Restatet-1 -0.142*** (-2.84) Pass (Comp) × Restatet-1 -0.093* (-1.75) Constant Polynomial Controls (G-index) Polynomial Controls (Board) Polynomial Controls (Comp) Observations Adjusted R2 0.022*** (2.67) 0.076*** (3.14) 0.115*** (4.89) Yes Yes Yes Yes Yes Yes Yes Yes Yes 1841 0.0810 1686 0.0078 2281 0.0219 33 Note: This table presents results examining the cross-sectional variations of the effects of passing three major types of governance related shareholder proposals: G-index, Board related and Compensation on firms’ financial reporting quality MDD is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t+1 # of ICW is the number of internal control weaknesses found under SOX 404 within three years after the proposal meeting # of Restate is the number of restatements within three years after the proposal meeting Pass (G-index) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Gindex proposals voted for a firm on a particular meeting date Pass (Board) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Board related proposals voted for a firm on a particular meeting date Pass (Comp) is the summation of an indicator variable equal to if the proposal passes the majority threshold, otherwise for Compensation related proposals voted for a firm on a particular meeting date High MDDt-1 is an indicator variable equal to if a firm’s MDD is above median the year before the proposal meeting, otherwise ICWt-1 is an indicator variable equal to if internal control weakness has been found for a firm one year before the proposal meeting, otherwise Restatet-1 is an indicator variable equal to if a firm has made restatement one year before the proposal meeting, otherwise MDDt-1 is the accrual-based Dechow and Dichev (2002) model modified by McNichols (2002) in year t-1 t statistics are in parentheses and are adjusted for within cluster correlation by firm and by year *, ** and *** indicate significance at two-tailed probability levels of 10%, 5%, and 1%, respectively 34 ... MDD t-1 -0 .006 (-0 .67) (2) ICWt-1 -0 .097 (-0 .51) (3) Restatet-1 -0 .120 (-0 .52) (4) Ins Own t-1 0.136 (1.58) (5) Negret t-1 -0 .345 (-1 .08) Vote Sharew 0.823 (1.11) 11.459 (0.57) -2 5.473*** (-3 .66)... (1.44) Pass (Board) -0 .043 (-1 .36) -0 .104*** (-3 .57) -0 .134** (-2 .06) Pass (Comp) -0 .065*** (-2 .62) -0 .096 (-0 .56) -0 .055 (-0 .82) Pass (G-index) Pass (G-index) × High MDDt-1 -0 .004 (-0 .73) Pass (Board)... Sharew4 -2 .060 (-1 .09) -3 2.004 (-0 .66) 66.354*** (4.50) -0 .194 (-0 .03) 1.768 (0.08) Vote Sharel 0.254 (1.16) -6 .924*** (-2 .89) -0 .313 (-0 .12) -1 .088** (-2 .03) -0 .389 (-0 .21) Vote Sharel2 -1 .593 (-0 .89)