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Review of Quantitative Finance and Accounting

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07-01-2021 | Original Research

The effectiveness of chief financial officer board membership in improving corporate investment efficiency

Authors: Yin Liu, Huiqi Gan, Khondkar Karim

Published in: Review of Quantitative Finance and Accounting | Issue 2/2021

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Abstract

The key roles of the Chief Financial Officer (CFO) in firm operating performance, corporate strategic choices, and corporate governance have been increasingly emphasized in recent decades. In this study, we empirically investigate the relation between CFO board membership and corporate investment efficiency to determine whether CFO presence on the board reduces firms’ propensity to over- or underinvest. We find that CFO board membership is significantly associated with a decreased level of corporate over- and underinvestment. Further, the positive effects of CFO board membership on corporate investment efficiency are greater for firms with greater information asymmetries. Last but not least, we find that the improved investment efficiency experienced by firms with CFOs on their boards has a positive effect on the firms’ future performance. Overall, we find that CFO board membership is associated with improved investment efficiency and firms’ future profitability. By documenting the real business impact of CFO board membership on investment efficiency and firms’ future performance, we add bricks to the literature on board composition and how it influences firms’ strategic choices and performance. Our findings suggest that having CFOs on boards could benefit firms’ investment practices, which directly relate to corporate strategic performance.

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For example, according to Sect. 302 of SOX, CEOs and CFOs are the only two top executives responsible for certifying that the financial statements fairly present, in all material respects, the operations and financial condition of the company.

Capital investment is the function of the ratio of stock-market-valued existing real capital assets divided by their replacement cost (Yoshikawa 1980; Hayashi 1982; Abel 1983).

In our additional analysis of future profitability, the dependent variable is Volatility Future ROA, which is the standard deviation of the future ROA measured over the periods t + 1 to t + 5 and adjusted by subtracting the Fama and French (1997) industry-year mean. To construct this variable, we need to have enough data for each firm observation for the future five years. Therefore, we end our sample period at 2010.

EXECUCOMP reports data for at least the five most highly paid executives in the firm. While it is possible that an executive may be on the board but not be among the top five most highly paid, this is unlikely given the greater responsibility and authority represented by a board seat. Furthermore, missing CFOs who are on the board but not listed in EXECUCOMP create a bias against finding significant results in the subsequent analyses.

In order to alleviate the concern about potential bias arising from EXECUCOMP’s backfilling practices, we follow Mobbs (2018) and use ISS to identify CFOs who are on the board but not reported on EXECUCOMP.

Following Coles et al. (2006), we set R&D expenditure to zero if it is missing from COMPUSTAT during the testing period for all our regression analyses. The full sample (before the observations with missing variables are deleted) of Mobbs (2018) is 27,014 firm-year observations from 1997 to 2014, and the mean of CFOs as inside directors is 11% for this full sample. Our full sample is 29,926 firm-year observations from 1996 to 2010, and the mean of CFOs as inside directors is 14% for our full sample. This is comparable with the sample of Mobbs (2018). After we delete observations with missing variables in our model, our sample size decreases to 5547 firm-year observations, and the mean of CFOs as inside directors becomes 16%. The large decrease in the sample size is due to observations that are missing variables required for our model.

See Hartford (1999), Richardson (2006), and D’Mello and Miranda (2010).

Firms with CFOs serving on the board have higher financial reporting quality (Bedard et al. 2014). There is a positive association between financial reporting quality and investment efficiency (Biddle et al. 2009). Therefore, we control for financial reporting quality (AQ) in our models to ensure that our result is not simply due to improved financial reporting quality for firms with a CFO on the board.

See the Appendix for variable definitions.

In an unreported analysis, the mean (median) CFO board membership on the initial firm-year observations from Execucomp and ISS (29,719 firm-year observations from 1996 to 2010) is 0.014 (0.000). The mean (median) CFO board membership on the initial firm-year observations of Mobbs (2018) (27,014 firm-year observations from 1997 to 2014) is 0.011 (0.000). Therefore, our sample on the CFO board membership is comparable with that of Mobbs (2018).

Following Bedard et al. (2014), we also use CFO tenure as the instrumental variable for our tests. Untabulated results are consistent with the main results in Table 4.

Following Biddle et al. (2009) and Cheng et al. (2013), our model includes industry fixed effects based on the Fama–French 48-industry classifications. We also re-test Model (1) controlling for firm fixed effects. Untabulated results are consistent with the results in Table 4.

Following Biddle et al. (2009), we require all industries with at least 20 observations in a given year.

To construct the aggregate-economy partition variable (OverAggregate), Biddle et al. (2009) extend the testing period from 1993–2005 to 1975–2005, as long testing period is important for the test at the economy level. However, EXECUCOMP and ISS for constructing the CFO on board variable do not have the data in the earlier years. Therefore, we cannot extend our testing period to the earlier years. It can be one of the limitations of this robustness test here, which leaves a room for future researchers.

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Title: The effectiveness of chief financial officer board membership in improving corporate investment efficiency
Authors: Yin Liu
Huiqi Gan
Khondkar Karim
Publication date: 07-01-2021
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 2/2021
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-020-00953-2

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