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BEHAVIORAL RESEARCH IN ACCOUNTING

Vol. 22, No. 1


2010
pp. 120

American Accounting Association


DOI: 10.2308/bria.2010.22.1.1

The Effect of Governance on Credit Decisions


and Perceptions of Reporting Reliability
Lori Holder-Webb
Western New England College
Divesh S. Sharma
Florida International University
ABSTRACT: We conduct an experiment to examine how lending decisions are affected
by lender perceptions of reporting and governance quality. We perform a set of experiments to determine whether lenders are sensitive to the quality of governance as measured by board composition along multiple dimensions, whether their perceptions of
reporting reliability are a function of the strength of the board, and whether their lending
decisions are then affected by their perceptions of reporting reliability. Study participants are a group of 62 professional lenders from Singapore, with at least three years
of professional credit analysis and lending experience. We find that lenders are primarily sensitive to financial condition and the perceived reliability of financial reporting.
While we also find that lenders are sensitive to board strength, further tests suggest
lenders appear particularly sensitive to board strength only for relatively highperforming firms. We also find that the perceived reliability of the financial reports does
not appear to be affected by board strength or by the applicants financial condition. The
paper discusses implications for policy making, practice, and research.
Keywords: corporate governance; board independence; agency theory; resource dependence theory.

INTRODUCTION
he spate of accounting scandals of the early 2000s began with financial reporting failures
and ended with bankruptcies Catanach and Rhoades 2003; Cutler 2004. The attention of
regulators and the investing public was drawn to the guardians that had been entrusted with
preserving the integrity of the capital markets and ensuring the reliability of reported
informationprimarily the institutions of transparency in disclosure, and corporate governance
mechanisms Cutler 2004. Sweeping regulationthe Sarbanes-Oxley Act of 2002 SOX
dramatically emphasized both disclosure and governance. Among the most significant assumptions
of the Act is that independence with respect to the board of directors should be a primary focus
when establishing and revising governance structures, and that the board of directors, specifically,

We thank Lay Huay Yeap for her research assistance, and the bankers for their participation in this study. We also thank Jeff
Cohen for his comments.

Published Online: January 2010


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Holder-Webb and Sharma

is charged with maintaining the integrity of the financial reporting process Cutler 2004. The
SOX-led reforms in the U.S. transcended cross-national boundaries and affected regulatory reforms across the globe as regulators worldwide attempted to regain and enhance investors confidence in their capital markets.1
Significant developments in information technology combined with a societal objective of
wealth accumulation fueled the exponential growth in cross-national capital flows Rezaee 2007.
Leading corporations traditionally domiciled in the U.S. and U.K. shifted their operationsand in
some cases, headquartersto Asia, with many companies cross-listing on foreign exchanges
Monks and Minow 2008. Despite the prevalence and intensity of these cross-national economic
exchanges, there is no accepted global corporate governance regulation.
By the late 1990s, the lack of adequate governance regulation manifested in the Asian financial crisis, deterioration in the financial markets, numerous high-profile corporate failures, and
several scandals perpetrated by management Monks and Minow 2008. The World Bank, International Monetary Fund IMF, and Organization for Economic Cooperation and Development
OECD pressured Asian nations to significantly reform their corporate disclosure regulations
toward greater transparency and introduce corporate governance regulations to better protect providers of capital Sharma et al. 2008.2 In an effort to maintain its position as the financial hub of
Asia, Singapore responded by introducing corporate governance reforms e.g., Code of Corporate
Governance 2001 and required the Singapore Stock Exchange to amend listing rules relating to
disclosure practices and corporate governance.3
One of the most important governance reforms in Singapore requires listed companies to
strengthen the independence and skill set of their boards of directors. The Singapore Code of
Corporate Governance 2001 hereafter, Singapore Code 2001 emphasizes that a boards role is
not limited to providing oversight of management but also to manage risk and create value for
stakeholders. The implication of this emphasis is clear: it is assumed that governance, including
board composition, affects both reporting reliability and the risk of fraud, opportunistic behavior,
and corporate performance. However, while the Singapore governance reforms generally mimic
the U.S. SOX-driven governance regulations, they are guidelines and not legally binding, which
provides listed companies in Singapore considerable discretion in the formation, composition, and
disclosure of their governance practices.
While the primary focus of the public attention and subsequent regulation revolved around
equity holders, the damage sustained by creditors in the financial reporting failures was significant
Lambert 2002; Schiesel and Romero 2002. The prominent role of the World Bank and IMF
pushing for corporate governance reforms illustrates the importance of losses suffered by lenders.
For example, the World Banks financial assistance to Asian nations and corporations was contingent on progress toward more stringent and transparent corporate governance and financial reporting practices Monks and Minow 2008.
1

For example, Australia, U.K., and countries in Asia such as Malaysia and Singapore reformed their corporate governance standards in a manner consistent with the provisions of SOX Rezaee 2007; Monks and Minow 2008; Sharma et
al. 2008.
Singapore faced particular pressure to reform its corporate regulations because of the scandal-led collapse of Barings
Bank in 1995. Nick Leeson, a rogue trader in the Singapore office of Barings Bank, made unapproved risky investments
and covered up losses that eventually led to the collapse of one of the largest financial institutions in the world.
Most financial institutions operating in Singapore have global operations and elect to domicile themselves in Singapore
instead of other Asian nations due to Singapores rigorous institutional framework and lending practices. Many U.S.
financial institutions, including American Express, CitiBank, Bank of America, JPMorgan Chase, The Northern Trust
Company, and State Street Bank and Trust Company, as well as numerous major U.S. industrial corporations, also
conduct major Asia-Pacific operations through Singapore offices Koh 2005. The 2004 Free Trade Agreement between
the U.S. and Singapore bolsters the presence and operations of U.S. financial institutions, industrial companies, and
recognition of U.S. qualifications in Singapore.

Behavioral Research In Accounting


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The Effect of Governance on Credit Decisions and Perceptions

However, it is not clear from the extant literature if and how the improvements in corporate
governance will affect lending judgments. The nonbinding nature of the Singapore governance
regulation provides an attractive laboratory to explore lender incorporation of governance factors
in that Singapore lenders are customarily exposed to a broader range of governance quality than
U.S. lenders, who are now accustomed to evaluating firms in compliance with SOX. While it is
understood that creditors make use of a wide array of information when making lending decisions,
the degree to which they consider governance has not been systematically examined Anderson et
al. 2004; Standard & Poors 2006.
Our paper contributes to this literature by examining how credit decisions are affected by
lender perceptions of reporting and governance quality. We perform a set of experiments to
determine whether lenders are sensitive to the quality of governance as measured by board composition along multiple dimensions, whether their perceptions of reporting reliability are a function of the strength of the board, and whether their lending decisions are then affected by their
perceptions of reporting reliability.4 Study participants are a group of 62 professional lenders from
Singapore, with at least three years of professional credit analysis and lending experience. We find
with these study participants that lenders are primarily concerned with the financial performance
of the firm and their perceptions of the reliability of corporate reporting. In general, corporate
governance as proxied by the strength of the board of directors influences lending decisions only
for high-performing firms.
In the following section, we address the topics of board strength, reporting reliability, financial condition, and the literature pertaining to these items with respect to credit decisions. We then
outline our experimental design, discuss the results, and conclude with a discussion of the limitations of the study and directions for further research.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT


Governance Strength
Academic research demonstrates linkages between board strength and firm performance
Boyd 1990; Dalton et al. 1998; Hillman and Dalziel 2003; Monks and Minow 1995; Pfeffer 1972;
Pfeffer and Salancik 1978. Zahra and Pearce 1989 define four perspectives on board strength
with respect to the relationship between governance and performance. The two perspectives with
the greatest degree of empirical support are resource dependency where the board is instrumental
in garnering resources critical to the firms performance and the agency view where the board
serves primarily to monitor actions of the managers and protect owner interests. Resource dependence posits a direct relationship between board composition and performance and indicates that
the board should be comprised of directors who provide an interface between the company and
suppliers of necessary resources Baysinger and Butler 1985; Boyd 1990; Johnson et al. 1996;
Hillman et al. 2000; Hillman and Dalziel 2003. The agency view also suggests a direct link
between performance and board composition, in that independent directors are better able to limit
opportunistic behavior on the part of managers Watts and Zimmerman 1978, 1986.
Larcker et al. 2007 provide an extensive review of the agency-based governanceperformance literature and perform numerous statistical tests that yield mixed or unstable results.
4

We acknowledge the need for caution when generalizing these results to the U.S. due to potential cultural and governance differences. However, the U.S. and Singapore possess very similar investor protection regulation see La Porta et
al. 1998, 2006; furthermore, economic globalization suggests that cross-national capital allocation decisions are increasingly common, while rationality indicates that capital providers should be attuned to institutional differences
between the two economies. Therefore, we believe that even though we employ a sample of Pacific Rim lenders, the
results possess the potential to inform the understanding of decisions made with respect to U.S. firms.

Behavioral Research In Accounting

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Holder-Webb and Sharma

The resource-dependence literature yields more consistent results Boyd 1990; Coles et al. 2008;
Dalton et al. 1998; Pfeffer 1972. Nicholson and Kiel 2007 find case-specific support for performance effects of both agency and/or resource dependence theories of board formation, and
conclude that no single theory explains the general pattern of behavior, as do Hillman and Dalziel
2003 and Cohen et al. 2004, 2007.
Professional and investing bodies such as the Business Roundtable BRT 2002 and the
Association for Investment Management and Research AIMR 1999 agree that independence is
important, but also argue that focusing on independence without regard to the strategic valuecreation ability of directors is myopic and may yield unintended consequences. These industry
players argue that a boards roles go beyond a basic watchdog role to generating long-term
shareholder value which requires suitably qualified and experienced board members. They argue
that independent directors lacking relevant industry knowledge and experience are less effective
for strategic purposes. The Singapore Code 2001 explicitly states boards should comprise members capable of exercising judgments independently of management and possessing appropriate
industry experience and qualifications to create value for stakeholders. The literature, then, does
not support a dominant perspective on what constitutes a strong board of directors. Therefore, in
this study, we define a strong board as one that is jointly strong on independence and on
resource dependence.5
The linkages between governance strength and firm performance suggest linkages between
governance strength and credit assessments, to the extent that firm performance is a significant
determinant of the ability to repay debt. Standard & Poors 2006 explicitly identifies governance
matters as being of great relevance to credit assessments, but notes the lack of a universally
appropriate board structure. Hermalin and Weisbach 1988 and Dalton and Daily 1999 suggest
that firms that rely more heavily on debt financing require more advising. Dalton et al. 1998 and
Dalton et al. 2003 suggest a linkage between firm performance and board function that carries
implications for the firms ability to repay debt. Anderson et al. 2004 find a relationship between
the cost of publicly traded debt and board composition, but were unable to determine whether this
effect is due to effects on reporting reliability or through effects on firm performance. In light of
the established connection between board composition and firm performance, we posit the following research hypothesis:
H1: Governance board strength positively affects lenders decisions to extend credit.
Regulators consider the board of directors to be one of the sentries or gatekeepers of the
markets Cutler 2004. The SOX and the Singapore Code 2001 significantly increased the responsibilities of the board of directors in overseeing the reporting function, suggesting a link
between board strength and reliability of reporting. Empirical evidence supports this proposition
Anderson et al. 2004; Cutler 2004; Standard & Poors 2006.6 Klein 2002 demonstrates the
boards role in monitoring and improving the reporting process. Carcello et al. 2007 find a link
between restatements and board structure. Dechow et al. 1996 and Abbott et al. 2000 find that
firms with demonstrably low-quality reporting practices exhibit weak governance structures, while
Beasley 1996 and Beasley et al. 2000 find linkages between weak governance and fraudulent
5

Sharma 2006 finds that investors rate investment risk as low and are willing to make larger investments when the
board is comprised of a majority of independent directors with relevant industry experience i.e., manifesting both the
agency-driven independence and resource-dependence characteristics.
See Cohen et al. 2004 for a comprehensive review of the literature pertaining to corporate governance and reporting
reliability.

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The Effect of Governance on Credit Decisions and Perceptions

financial reporting. As a consequence of the empirical work demonstrating linkages between


governance and reporting reliability, we advance the following research hypothesis:
H2: Governance board strength positively affects the perceived reliability of reported financial information.
Additional evidence suggests a linkage between reporting reliability and credit decisions
through the need for lenders to assess borrowers ability to repay on an ongoing basis Danos et al.
1989; Leftwich 1983; Smith 1993; Beaulieu 1994; Standard & Poors 2006. Accounting numbers
provide a critical input into the initial credit analysis Standard & Poors 2006, while many
private lending agreements contain restrictive covenants based upon reported account balances
Dharan and Lev 1993; DeFond and Jiambalvo 1994; Sweeney 1994; Dichev and Skinner 2002.
Smith and Warner 1979 find evidence that debt pricing is sensitive to the availability of or
difficulty obtaining the information required to enforce binding constraints; Anderson et al.
2004 interpret this as indicating that if boards provide oversight to the reporting process, lending
agreements should also be sensitive to board characteristics. Anderson et al. 2004 premise their
study on the agency theory of optimal board composition and find that independent boards are
associated with a lower cost of debt, but do not directly test the implied relationship between
reporting reliability and the cost of debt. Based on the hypothesized relationships between governance and reporting reliability, and governance and the lending decision, as well as the empirical
work cited above, we advance the following hypothesis:
H3: Perceived reporting reliability positively affects the lenders decision to extend credit.
Prior research suggests that financial condition is often an indicator of potential financial
misstatements. Kinney and McDaniel 1989, 74 note that managements of firms in weak financial condition are more likely to window-dress in an attempt to disguise what may be temporary
difficulties. Kreutzfeldt and Wallace 1986 show that companies experiencing financial problems
have significantly more financial statement errors. Such findings are consistent with more recent
evidence on management incentives to overstate income in order to avoid losses and meet market
expectations e.g., Beasley 1996; Dechow et al. 1996. In order to reduce doubts about the loan
applicants financial information, lenders are likely to assess the source credibility of the financial
information, which in this case is the boards ability to monitor the financial reporting process.
However, it is not clear how lenders would factor in the boards attributes in the context of
financial condition. Lenders may be more sensitive to board attributes when a borrower is underperforming. They may rate the financial information as less reliable when board attributes are
weaker or they may be more willing to extend credit to a marginal client with stronger board
attributes even if the firms financial performance is not strong. On the other hand, lenders may not
care much about board attributes if the borrowers financial condition is strong or they may
evaluate board attributes for such borrowers to corroborate the reliability of their financial information. In light of the lack of clear expectations about the relationship between governance
strength and financial condition on lending decisions, we propose a null hypothesis:
H4: There is no interaction between governance strength and financial condition on lending
decisions.
Our hypothesized associations are summarized in Figure 1, indicating the direction of hypothesized effects and the predicted sign for each hypothesis is in parenthesis.

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FIGURE 1
Summary of Hypothesized Associations

RESEARCH DESIGN
Participants
The sample of experimental participants consists of 62 experienced corporate lending managers from two international commercial banks operating in Singapore.7 Discussions with the head
of corporate lending at each bank suggested that suitable participants are those with at least three
years of experience at the corporate lending level. These individuals have considerable experience
analyzing corporate borrowers and have undergone many years of formal and on-the-job training.
The two banks providing sample participants from their corporate lending offices derive a significant amount of business from U.S. multinationals operating in the Asia-Pacific region; therefore,
professional training for the participants has included significant emphasis on the U.S. business
context including governance reforms. The study was carried out in the second quarter of 2003 to
permit assimilation of the scope of U.S. and U.S.-influenced governance reforms and introduction
of Singapore Code 2001 that is modeled on the Anglo-Saxon governance regulations. All participants held university degrees. Their mean age was 38 years, with an average of more than ten
years of experience in the banking industry and eight years of experience in commercial lending.
Table 1 provides descriptive statistics about the participants.
The use of highly skilled participants imposes a limitation on the number of participants
available; therefore, this study employs a type of repeated measures design. Each participant was
presented with a single case incorporating information about the client, information about the
governance structure designed to be strong or weak, and financial data and ratios reflecting either
a high-normal or low-normal financial position. The participant was asked to evaluate the board of
directors along several dimensions independence, qualifications, financial expertise, and industry
experience, and to evaluate the firms financial position, profitability, and the un-audited financial
7

Both banks are rated in the Business Insights Global Top 10 Retail Bank listing.

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The Effect of Governance on Credit Decisions and Perceptions

TABLE 1
Participant Demographics
(n 62)
n
a

Gender
Male
Female
Age
2035 years
3650 years
5165 years
Education
Bachelors Degree
Masters Degree
Experienceb
1 year
12 years
35 years
610 years
10 years
a
b

22
39
50
11
1
51
11
1
4
11
29
15

Gender includes one missing observation.


Experience includes two missing observations.

forecast. The participant was then asked to evaluate the reliability of the financial information and
to make a yes/no lending decision for a specific loan.8 After completing this task, the participants
provided demographic information as a distraction task, then relinquished the experimental
instruments to the investigators. They were then provided with a fresh set of experimental materials reflecting an identical governance structure but a different financial position.9 The experiment
therefore manipulates governance strength between subjects and financial performance within
subjects as the repeated task. The total number of participants is 62, and the total number of
lending decisions and other assessments is 124.
This experiment was designed to maximize the information provided by the participant pool,
but in that process may yield demand effects.
Manipulation checks were performed on participant perceptions of board strength. As discussed above, the literature does not yield conclusive results as to whether independence or
resource dependence should be more highly valued by lenders. Therefore, the experimental instruments were designed to depict strong boards those strong both on independence and on
resource dependence dimensions and weak boards those weak on both dimensions. Participants
8

While Pany and Reckers 1987 note distinct demand effects in the within-subjects design here, reflected in the effects
of financial performance, they also note that the issue of demand effects is greater when participants are not accustomed
to making repeated decisions pertaining to the experimental manipulation see also Bamber 1983. The participants in
this study are loan officers, whose primary professional responsibility is repeatedly making credit decisions along the
within-subjects manipulation of financial performance. Governance, however, is the primary variable of interest in this
study and is thus manipulated between subjects, reducing the potential for demand effects on the main study findings.
The order of the cases was randomized to avoid potential order effects. Our post-experimental tests did not show
significant order effects p 0.234.

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were asked to rate their perceptions of four attributes of the board: independence, qualifications,
financial expertise, and industry expertise. Participant perceptions of these four attributes were
compared to the experimental conditions. Any participant receiving a weak governance case that
rated it a 7 very strong on any one of the four dimensions, and any participant receiving a
strong governance case but rating it a 1 very weak was considered to have failed the
manipulation check. No participant misclassified the board strength in this manner. Likewise, any
participant rating the low-normal condition as very strong or rating the high-normal condition as very weak was also considered to have failed the manipulation check. No participant
misclassified the financial position of the company under this criterion. As with the governance
manipulation check, participants provided average ratings of the financial position of lownormal firms that were significantly lower than ratings provided for high-normal firms.10
An additional manipulation check was performed to test participant sensitivity to the manipulations beyond the gross error check discussed above. In this check, the mean participant perceptions pertaining to each of the four dimensions identified above and rated on seven-point Likert
scales were compared across experimental groups partitioned by strong versus weak
boards. For all four attributes the average rating for strong boards was higher than the average
rating for weak boards, and all differences between these means were significant at p 0.001.
Description of the Experimental Task
The fictitious case involved a listed food and beverage manufacturer seeking a loan to finance
working capital. The case was constructed with substantial corroboration from the managers of the
lending function at the two banks and pilot tested on corporate lending managers who did not
participate in the study. The nature and content of the information, including the background of the
borrower, industry and management information, summary financial statements, and financial
ratios were presented in a format normally used by the managers.11 A table defining each financial
ratio was also presented to ensure consistency.
As discussed above, the experiment consisted of four case scenarios featuring betweensubjects board strength manipulations and within-subjects financial position manipulations. Participants were randomly assigned a strong board or weak board experimental packet.12 Each
packet contained two cases packaged separately that differed only with respect to the financial
condition of the fictitious loan applicant.
The between-subjects governance manipulation featured two scenarios, strong governance
and weak governance. The board strength attributes that were varied between the two governance classifications were independence, finance and accounting knowledge, appropriate business
qualifications, and industry experience. Board size was held constant at seven directors. In
the strong weak board case there are five two independent directors. Three out of five zero out
of two independent directors have finance and accounting knowledge, five out of five zero
out of two independent directors have relevant business qualifications, and two out of five
zero out of two independent directors have related industry experience. These attributes were
selected as a result both of the findings in the literature and regulatory reforms discussed in the
context of the hypothesis development, as well as discussions with the bank managers and their
credit training personnel at each participating bank. These discussions indicated that industry

10
11
12

The average rating for the financial performance of the low-normal firms was 3.60, while the average rating for
high-normal firms was 5.00; the difference in means is statistically significant at p 0.001.
Prior research shows that format influences human judgment Ashton and Ashton 1995. Post-experimental discussions
did not show any concerns related to the format of the loan application documentation.
Results of a one-way ANOVA indicate no significant demographic differences p 0.10 between groups, suggesting
that random assignment is successful.

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The Effect of Governance on Credit Decisions and Perceptions

qualifications and experience are important considerations when lenders assess the likelihood of
the borrower succeeding in its investment strategies and servicing its debts. Consequently, the
strong governance scenario features a slate of directors that are predominantly independent, with
relevant industry experience and/or financial expertise. The weak governance scenario features
a slate of directors, many of whom are current or former officers of the company; nonemployees
offer little industry experience and/or less notable financial expertise. BOARD_STRENGTH is a
dichotomous variable assuming a value of 0 for the weak scenario and a value of 1 for the
strong scenario.
As explained earlier, we manipulated financial performance within-subjects because lenders
are accustomed to making repeated decisions based primarily on financial performance of a borrower. The within-subjects financial performance manipulation included a high-normal scenario
and a low-normal scenario. In the high-normal scenario, the loan applicants three prior years
of operating performance and solvency based on audited financial statements increased steadily
and exceeded the industry average performance; unaudited forecasts indicated further improvements. In the low-normal scenario, the audited and forecast performance and solvency of the
company are stable and just below the industry average. FINANCIAL_COND is a dichotomous
variable assuming a value of 1 for the low-normal scenario and a value of 0 for the highnormal scenario.13
Participants were asked to rate the financial position, financial performance, and the forecasted financial data on a seven-point Likert scale anchored by very weak 1 and very strong
7. Our pilot tests and debriefing revealed that the loan and information contained therein are
realistic and the low-normal case created some degree of uncertainty.14 All other information e.g.,
management, auditor, industry, loan amount, collateral, purpose of the loan, etc. is held constant
for each case.
The experiment was conducted at each bank during a training session. Lenders typically
assess an applicants integrity, risk management processes, and financial information prior to
making a lending decision Ruth 1987. Our discussions with the corporate managers at the two
banks confirmed this sequence and suggested the tasks for rating the applicants financial status
and board should precede the lending judgment tasks. Based on the information provided about
the loan applicant, lenders were required to rate the board and financial condition of the loan
applicant. They were then asked to assess the credibility reliability of the loan applicants
financial information and to indicate their approval or nonapproval of the loan. RELIABLE is the
participants response to the request Please rate the reliability of the financial information provided by the applicant on a seven-point Likert scale anchored by Not reliable at all 1 and
Very reliable 7. MAKELOAN is the participants response to the question Do you recommend
approval or rejection of the $5 million revolving loan application? and is a binary variable
assuming the value of 0 if the participant would reject the loan application and 1 if the participant
would approve the loan application.
Univariate Analysis
Table 2 provides descriptive statistics pertaining to the two dependent variables MAKELOAN
and RELIABLE, partitioned by the experimental manipulations BOARD_STRENGTH and
13
14

This permits direct examination of the marginal effects of governance for underperforming firms.
A t-test of the difference between lenders rating of financial condition for the moderate case and the midpoint 4 in the
17 point rating scale indicates no significant difference p 0.10.

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TABLE 2
Descriptive Statistics of Participant Variables
Panel A: MAKELOAN by Experimental Cell [n, (%)]
Board Strength
Weak

All Participants
Financial Performance
Low-Normal
High-Normal

Strong

Reject

Approve

Reject

Approve

46
71.9

18
28.1

35
58.3

25
41.7

29
90.6
17
53.1

3
9.4
15
46.9

26
86.7
9
30.0

4
13.3
21
70.0

Panel B: RELIABLE by Experimental Cell [n, (mean) {median}]


Board Strength

All Participants

Partitioned by Financial Performance


Low-Normal

Strong

64
5.281
5.000

60
5.433
5.000

32
5.250
5.000
32
5.312
5.500

30
5.500
6.000
30
5.367
5.000
(continued on next page)

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High-Normal

Weak

Accept (n 43)

Mean

Median

Mean

Median

5.235

5.000

5.581

6.000

MAKELOAN is the participants binary response to the question Do you recommend approval or rejection of the $5 million revolving loan application?; RELIABLE is the
participants rating of the reliability of the financial information, based on a 7-point Likert scale anchored on Not at all reliable 1 and Very reliable 7; INDEP, QUAL, FINEXP,
and INDEXP are participant ratings of the strength of the governance structure based on perceived member independence, perceived member qualifications, perceived board financial
expertise, and perceived board industry expertise respectively, all based on 7-point Likert scales anchored on Very weak 1 and Very strong 7.

The Effect of Governance on Credit Decisions and Perceptions

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Panel C: RELIABLE by MAKELOAN


Reject (n 81)

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FINANCIAL_COND.15 Panel A displays frequencies and percentages for rejecting or approving


the loan application. When all cases are pooled, it is clear that participants are more inclined to
grant loans to applicants with higher quality boards. A Chi-square test rejects the null of no
association between the lending decision and board strength at p 0.081. The second portion of
Panel A partitions the sample by financial condition. At this level, it appears that the marginal
effect of board strength is only relevant for firms that are performing above the industry norm. A
Chi-square test fails to reject the null of no association at p 0.10 for the low-normal group;
a Chi-square test rejects the null at p 0.056 for the high-normal group. The results in Panel A
provide conditional support for H1, that governance is a factor in the lending decision.
Panel B displays mean and median values of RELIABLE. Mean and median assessments of
reliability are fairly high across the board; t-tests nonparametric tests for differences in means
medians do not reveal any statistically significant differences at p 0.10 between any of the
cells in this table. The results of Panel B, therefore, do not provide univariate support for H2, that
perceived reliability is a function of governance strength.
Panel C displays mean and median values for RELIABLE partitioned by MAKELOAN. Mean
median RELIABLE values for cases where the participant indicated approval of the loan are
significantly higher than those for cases where the loan would be denied; these differences are
significant at p 0.048 difference in means and p 0.042 difference in medians. The results
in this table, therefore, provide support for H3, that the perceived reliability of financial information is a factor in the lending decision.
Multivariate Analysis
To test H1 and H3, we provide Equation 1. Equation 1 models the lending decision as a
function of the strength of the board, the perceived reliability of the financial data provided by the
applicant, and the financial condition of the applicant:16
MAKELOAN = 0 + 1BOARD_STRENGTH + 2RELIABLE + 3FINANCIAL_COND
+ BOARD_STRENGTH FINANCIAL_COND + .

If H1 that board strength positively affects the lending decision is true, 1 will have a
positive coefficient. If H3 that perceived reliability positively affects the lending decision is true,
2 will also have a positive coefficient. To the extent that borrower financial condition affects
lending decisions, 3 will have a negative coefficient. If board strength makes a difference on the
margin for underperforming firms that is, if they can increase their probability of receiving a loan
through offering a strong board, then 4 will also be positive. The negative expectation on 3 is
due to the coding of financial condition, where weaker firms receive higher values; this coding is
necessary in order to draw conclusions about the value of governance for underperforming firms
in the interaction term.
Table 3 presents the results of a logistic regression estimation of Equation 1.17 As would be
expected, the financial condition of the loan applicant is a strong determinant of the lenders
15

16

17

A Chi-square test rejects the null of no association between financial condition and the lending decision at p 0.001;
as it is hardly surprising that lenders are more likely to grant loans to more financially solid clients than those that are
underperforming industry averages, this finding is not reported as a main result.
Equation 1 was also run with a vector of demographic variables to control for participant-specific effects; however,
none of these variables attained statistical significance and have consequently been omitted from the main analysis.
Also, results of the model estimations do not change in significance when participants with fewer than three years of
experience are removed from the analysis.
Results are qualitatively and quantitatively similar for simple ANOVA and logit estimations of this model. GLM results
are presented for simplicity of assessment of the goodness-of-fit.

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TABLE 3
Logistic Regression of MAKELOAN on BOARD_STRENGTH, RELIABLE,
FINANCIAL_COND, and BOARD_STRENGTH FINANCIAL_CONDb
Variable (prediction)
Intercept ?
BOARD_STRENGTH
RELIABLE
FINANCIAL_COND
BOARD_STRENGTH
FINANCIAL_COND ?
Model Chi-square: 41.530 p .000
a
b

Parameter
Estimate

Std. Error

Wald

p-valuea

3.381
0.992
0.610
2.268
0.627

1.467
0.552
0.264
.731
.989

5.312
3.236
5.328
9.641
0.402

.034
.036
.011
.001
.526

The reported p-values are based on the direction of the test as indicated in the first column.
MAKELOAN is the participants binary response to the question Do you recommend approval or rejection of the $5
million revolving loan application?; BOARD_STRENGTH is a dichotomous variable coded 0 for the weak governance
manipulation and 1 for the strong governance manipulation; RELIABLE is the participants rating of the reliability of the
financial information, based on a 7-point Likert scale anchored on Not at all reliable 1 and Very reliable 7;
FINANCIAL_COND is a dichotomous variable coded 1 for the low-normal performance manipulation and 0 for the
high-normal performance manipulation; and BOARD_STRENGTH is an interaction term assuming the value of 1 for the
low-normal performance firms with strong governance, and 0 for all other conditions.

decision to approve or reject the loan, with lenders significantly less likely to extend a loan to an
underperforming firm. The p-values displayed in Table 3 are directional as indicated and guided by
our hypotheses. The main effect of BOARD_STRENGTH is significant p 0.036, which lends
support to H1. However, the interaction term between board strength and financial condition is not
significant, which suggests that if a firm is underperforming, possession of a strong board will not
increase the probability of the firm receiving a loan.18 That is, for this class of firms, lenders
appear to be relatively insensitive to the presence of a strong board; likewise, high-performing
firms do not appear to have lower chances of receiving a loan if they possess a weak board. In
Table 3, RELIABLE is also positive and significant at p 0.010, indicating support for H3.
To test H2, we provide Equation 2. Equation 2 models the perceived reliability of the
financial information as a function of board strength and financial condition as discussed in the
literature review, underperforming firms may possess less credibility than better firms.
RELIABLE = 0 + 1BOARD_STRENGTH + 2FINANCIAL_COND + .

If H2 that board strength positively affects the perception of the reliability of reporting is
true, then 1 will have a positive coefficient. To the extent, as suggested by the literature, that
underperforming firms may have less reliable reporting, 2 will also be positive underperforming
firms are coded a 1, as discussed above.
Table 4 provides the results from a general linear model estimation of Equation 2. Consistent with the univariate analysis shown in Panel B of Table 2, there does not appear to be a
significant relationship between board strength and perceived reliability of the financial reports.
Thus, the results shown in Table 4 do not provide support for H2, that perceived reliability is a
18

The cross-tabulation presented in Table 2 suggests, therefore, that the effects of financial condition are dominant, with
weak firms unlikely to receive a loan at all, and that board strength effects are reserved for the high-performing firms.
That is, high-performing firms may increase their probability of receiving a loan if they also possess a strong board.

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TABLE 4
OLS Regression of RELIABLE on BOARD_STRENGTH and FINANCIAL_CONDb
Variable (prediction)
Intercept ?
BOARD_STRENGTH
FINANCIAL_COND ?
R2: .084
Adj. R2: .009
F 0.429, p .652
a
b

Parameter
Estimate

Std. Error

t-statistic

p-valuea

5.265
0.152
0.032

.144
.168
.168

36.611
0.906
0.192

.000
.184
.848

The reported p-values are based on the direction of the test as indicated in the first column.
RELIABLE is the participants rating of the reliability of the financial information, based on a 7-point Likert scale
anchored on Not at all reliable 1 and Very reliable 7; BOARD_STRENGTH is a dichotomous variable coded 0 for
the weak governance manipulation and 1 for the strong governance manipulation; and FINANCIAL_COND is a dichotomous variable coded 1 for the low-normal performance manipulation and 0 for the high-normal performance
manipulation.

function of governance. They are also somewhat inconsistent with the maintained hypothesis in
the literature that underperforming firms suffer from a credibility problem. Effects of the main
variables are not remotely significant, and the model as a whole possesses very poor explanatory
power.
Further Analysis
The main analyses follow the experimental manipulation, which is a simple binary definition
of strong versus weak governance. Given that the results of the multivariate tests above suggest
that lenders are sensitive to governance factors, it is possible that they evaluate these factors on a
more nuanced basis than provided by the researchers. Therefore, participants were asked to rate
their perceptions of the independence of the board members INDEP_RATING, the qualifications
of the board members QUAL_RATING, the financial expertise of the board FINEXP_RATING,
and the industry expertise INDEXP_RATING of the board on four seven-point Likert scales
anchored by very weak 1 and very strong 7. Equations 1 and 2 were re-estimated,
substituting the four attributes of perceived board strength for the binary BOARD_STRENGTH
experimental manipulation. Results are displayed in Table 5. As with the results in Tables 3 and 4,
all p-values shown are directional as indicated; the board strength, financial condition, and reliability variables have directional expectations and should be evaluated with one-tailed significance
levels.
Panel A of Table 5 shows results of the estimation of the effects of the perceived governance
attributes on the lending decision. As before, RELIABLE and FINANCIAL_COND are positive and
significant. Of the four governance perceptions, the only one that is significant is the lender
perception of board qualifications p 0.051. Panel B shows results of the estimation of governance perceptions on RELIABLE. While the binary manipulation of strong and weak governance is not significantly related to perceptions of reliability as shown in Table 4, there do appear
to be some significant relationships between the perception of governance strength and the perception of reliability. In particular, it appears that perceived independence p 0.012 and perceived financial expertise p 0.017 affects the perception of the reliability of the financial
information. This finding is consistent with the prior literature e.g., Dechow et al. 1996; Beasley

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Panel A: General Linear Model of MAKELOAN on Participant Perceptions of the Strength of Board Attributesb
Parameter
Variable (prediction)
Estimate
Std. Error
Intercept ?
INDEP_RATING
QUAL_RATING
FINEXP_RATING
INDEXP_RATING
RELIABLE
FINANCIAL_COND
Model Chi-square: 51.881 p .000

5.903
0.079
0.521
0.060
0.175
0.474
2.850

1.844
0.208
0.319
0.223
0.264
0.288
0.554

Panel B: General Linear Model of RELIABLE on Participant Perceptions of the Strength of Board Attributesb
Parameter
Variable (prediction)
Estimate
Std. Error
4.593
0.182
0.124
0.176
0.043
0.045

0.387
0.080
0.120
0.083
0.097
0.180

.000
.351
.051
.394
.254
.045
.000

p-valuea
.000
.012
.150
.017
.328
.801

(continued on next page)

15

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Intercept ?
INDEP_RATING
QUAL_RATING
FINEXP_RATING
INDEXP_RATING
FINANCIAL_COND ?
Model Chi-square: 14.345 p .014

p-valuea

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TABLE 5
Further Analysis

16

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a
b

The reported p-values are based on the direction of the test as indicated in the first column.
MAKELOAN is the participants binary response to the question Do you recommend approval or rejection of the $5 million revolving loan application?; INDEP_RATING is the
participants rating of the independence of the board from the Management; QUAL_RATING is the participants rating of the qualifications of the Board; FINEXP_RATING is the
participants rating of the Boards financial/accounting knowledge; and INDEXP_RATING is the participants rating of the Boards industry-related experience; the preceding four
items are all based on a 7-point Likert scale anchored on very weak 1 and very strong 7. RELIABLE is the participants rating of the reliability of the financial information,
based on a 7-point Likert scale anchored on not at all reliable 1 and very reliable 7; and FINANCIAL_COND is a dichotomous variable coded 1 for the low-normal
performance manipulation and 0 for the high-normal performance manipulation.

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17

1996; Klein 2002 that demonstrates an association between board oversight and financial reporting choices.
CONCLUSIONS AND DIRECTIONS FOR FURTHER RESEARCH
The study is motivated by the debates between regulators and the business community regarding the composition of the board and the growing worldwide corporate governance reforms at
the board level, and the lack of research on how information about corporate governance is
incorporated in investment decisions. In contrast to the legally enacted governance regulations in
the U.S. e.g., SOX, governance reforms elsewhere e.g., U. K., Australia, Singapore are not
mandatory or enforceable by law. Emerging research on equity investors consideration of governance factors provides mixed results and suggests we do not know if the recent worldwide
governance reforms will enhance users confidence in the financial reporting process and the
resultant financial information.
In this study, we explore the degree to which lending decisions are affected by governance
strength and financial reporting credibility. We also explore the degree to which governance
strength affects credibility and how the lending decision and credibility are affected by the financial condition of the firm. We find that lenders appear to incorporate governance factors into the
lending decision, and that this effect is more pronounced for firms that are outperforming the
industry when compared to those that are underperforming the industry. One possibility for this
effect is that lenders may possess asymmetric loss functions whereby the risk of a loss is weighted
more heavily than the possibility of a gain similar to that observed by Smith and Kida 1991.
Because of the uniformly high rejection of low-performing loans 89 percent of applications from
these firms would have been denied, the governance effect is observed only in the population of
firms that are evidently considered suitable candidates for a loan. We also find, consistent with
expectations from the literature, that the perceived reliability of a financial report is a factor in the
lending decision.
While we are unable to identify a direct effect between the manipulation of board strength and
the perception of reliabilitythat is, there are no differences in the mean perceptions of reliability
based on this experimental conditionwe do find that perceptions of some components of board
strength are relevant to the assessment of reporting reliability. In particular, the perceived independence and perceived financial expertise of the board are significant determinants of perceived
reliability. This finding is consistent with the literature that suggests that independence and financial expertise provide a degree of oversight that may lead to better financial reporting.
This exploratory study has several policy, practice, and research implications. Our results
provide marginal support to regulators e.g., AIMR, BRT, IMF, World Bank pushing for reforms
to the boards of directors. Our results suggest that regulatory reforms to board independence and
competence enhance financial statements users perceptions of the integrity of the financial reporting process, and hence, their confidence in the resultant information. From a practice perspective,
our results provide evidence that board attributes are important at the individual level in the
private debt market. Further, the contextual sensitivity to governance factors evinced by professional lenders suggests that there may be a need for explicit training with respect to their understanding of the role of the board of directors. The primary implication for future governance
research is that board effectiveness as a construct embodies various attributes. Future research may
consider these attributes instead of employing a single proxy for board effectiveness such as the
proportion of outside or independent directors on the board.
Our study offers several directions for further research. This paper provides preliminary
evidence that lenders value different aspects of board strength; future research should evaluate
whether lenders prize independence or strategic resource dependence more highly. Second, this

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study makes use of a participant pool of professional lenders from Singapore, and is a limitation
of the study. While these participants are familiar with the U.S. perspectives on governance due to
the need to service their major U.S. clients, it is possible that cultural factors and institutional
differences may affect the perceptions of reliability and the lending decision. We caution against
generalizing our results across cross-national boundaries because of such differences. Future research could consider evaluating these effects among a broader population. Third, the study makes
use of an instrument built around a single industry; while this is a common industry, if lenders
specialize in particular industries there may be specialization effects.

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