Economic consequences of implementing and communicating value based management systems

• Author: Tami Dinh,Wolfgang Schultze,Thomas List,Bettina Schabert
• DOI: http://doi.org/10.1111/jbfa.12297
• Date: 01 May 2018
• Published date: 01 May 2018

DOI: 10.1111/jbfa.12297

Economic consequences of implementing and

communicating value based management systems

Wolfgang Schultze1Thomas List1Bettina Schabert1Tami Dinh2

1Universityof Augsburg, Universitaetsstr. 16,

86159Augsburg, Germany

2Universityof St. Gallen, Tigerbergstr. 9, 9000 St.

Gallen,Switzerland

Correspondence

WolfgangSchultze, University of Augsburg,

Universitaetsstr.16, 86159 Augsburg, Germany.

Email:wolfgang.schultze@wiwi.uni-augsburg.de

Fundinginformation

PCAWissenschaftliche Gesellschaft fuer Prue-

fungund Controlling, Augsburg.

Abstract

We study the consequences of implementing and communicating

Value Based Management (VBM) systems on information asymme-

tries and the cost of capital. We analyse the firms’ reporting on inter-

nal control systems as the source of information for market partic-

ipants. In addition, literature posits that improving communications

with shareholders by providing additional information on value gen-

eration (Value Based Reporting, VBR) is an integral part of imple-

menting VBM. We find that the implementation of VBM and the

extent of VBR are, both individually and jointly,significantly related

to lower information asymmetries and lower cost of capital. We

find a slight moderation of the effect of VBM by VBR. For increas-

ing VBR, we find that information asymmetries and cost of capital

decrease more strongly for firms without implemented VBM sys-

tems. This indicates that VBR can to some extent substitute VBM.

Overall, however,firms using a combination of VBM and VBR attain

lower levels of information asymmetry and cost of capital. We pro-

vide evidence for the real effects of disclosure, suggesting that dis-

closures on internal control systems serve as a governance mecha-

nism, reducing information asymmetries and the cost of capital by

aligning shareholders’ and managers’ interests.

KEYWORDS

cost of capital, disclosure, information asymmetry, shareholder

value, value based management

1INTRODUCTION

We analyse the economic consequences of the implementation of and the reporting on Value Based Management

(VBM) systems for information asymmetries and the cost of equity capital. VBM systems are considered one of the

main new developments in management accounting in the past decades, incorporating a wide variety of other innova-

tions(Ittner & Larcker, 2001). VBM was introduced as a response to reduce agency conflicts arising from the separation

of ownership and control (Jensen, 1986). These agency conflicts lead to adverse selection problems (Akerlof, 1970)

for shareholders. The implementation of VBM can be considered a signal of management'scommitmenttoactinthe

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512 SCHULTZEET AL.

shareholders’ best interest. The signal can reduce uncertainty on the part of investors, potentially leading to reduced

information asymmetries and lower cost of capital.

For the implementation of VBM to have capital marketconsequences, the market needs to have knowledge about

the former.We analyse the firms’ disclosures on internal control systems as the source of information for market par-

ticipants. Lambert, Leuz, and Verrecchia (2007) find that disclosure affects the cost of capital through two channels:

an ‘information effect’ and a ‘stewardship effect’ (Core, Hail, & Verdi, 2015). Firstly,disclosure may reduce investors’

uncertainty about expected cash flows (information effect). Secondly,disclosure can have indirect effects on the cost

of capital by affecting real decisions (stewardship effect). Disclosure improves monitoring and affects real decisions,

improving the alignment between managers’ and shareholders’ interests. Higher quality information reduces manage-

rial misappropriation of the firm's cash flows and consequently reduces the firm's cost of capital. Johnstone (2015,

2016) challenges the information effect and finds that improved disclosure may both increase and decrease the cost

of capital. In this paper, we concentrate on the stewardship effect and seek to provideevidence for the role of VBM

systems as a management control mechanism to reduce the cost of capital.

VBM systems are specifically designed as mechanisms to align managers’ interests with those of shareholders to

reduce agency conflicts (Ryan & Trahan,2007; Young & O'Byrne, 2000). While prior research has mainly been inter-

ested in the link between VBM and firm performance (e.g., Biddle, Bowen, & Wallace, 1997; Ryan & Trahan, 2007),

no evidence exists for its capital marketconsequences. Literature posits that the implementation and communication

of VBM reduce information asymmetries and the cost of capital (Copeland, Koller,& Murrin, 2000; Rappaport, 1986,

2006). Our paper seeks to provide empirical evidence for this claim.

The rise of VBM was largely associated with the idea of ‘value gaps’ (Copeland et al., 2000; Fruhan, 1988), that is,

the difference between a firm's current value and its potential value if it were managed efficiently.1VBM is intended

to close these gaps by: (1) improving operations, asset ownership and financial structure; (2) improving communica-

tion with shareholders (Copeland et al., 2000). Investors in firms with hidden characteristics are faced with a typical

adverse selection problem. According to Jensen's (1986) free cash flow hypothesis, firms investing in organizational

inefficiencies are traded at below their potential values. Such value gaps present risks for firms of being taken over

or being subject to shareholder activism, and risks for current managers of losing their jobs (Fruhan, 1988). These

risks create incentives for managers to manage the firm's resources more efficiently.As a consequence, capital market

pressures are effective means of directing resources to more efficient usage (Jensen, 1989). The advent of the market

for corporate control has contributed greatly to establishing VBM as a means to manage shareholder value. Likewise,

agency-theoretical research suggests that VBM systems, especially incentive systems based on residual income, are

mechanisms to reduce agency conflicts (Reichelstein, 1997; Rogerson, 1997). Consequently, information about the

implementation of VBM systems can work as a signal of management's commitment to act in the shareholders’ best

interest, reducing the investors’ adverseselection problem.

We use the firms’ disclosures about their internal control processes as the source of shareholders’ information. To

the extent that published information on the implementation of VBM works as a credible signal, information asym-

metries should decrease. If these disclosures improve monitoring and help alignmanagers’ and shareholders’ interests

(stewardship effect), then disclosures on implemented VBM systems can reduce information asymmetries as well as

the cost of capital.

In addition, improvements in the communication with shareholders are considered to be an integral part of imple-

menting VBM.2Literature on VBM suggests that firms can improve market valuation by providing additional infor-

mation on the fundamental value of the firm and its drivers (Copeland et al., 2000). We refer to such disclosures as

Value Based Reporting (VBR). Such additional information on the value creation process and the drivers of value of a

1‘Thevalue gap is the difference between the market price of a share of a company's common stock and the value of that share if the company were managed

as though the current owners were the only constituency that mattered – that is, managed for the maximum share price possible at this time’ (Fruhan,1988,

p.63).

2Copeland et al. (2000) suggest in their ‘restructuring pentagon’ that firms should improve communications with shareholders to close gaps in perceptions

aboutthe future prospects of the firm.

SCHULTZEET AL.513

particular firm is provided in order to meet the needs of market participants in the process of valuing shares.3The

underlying assumption is that by providing additional information on the ‘true’ value of the firm, fundamental values

and market values can be aligned, eliminating opportunities for takeover premiums to be reaped (e.g. Eccles, Herz,

Keegan, & Phillips, 2001; Eccles, Serafeim, & Krzus, 2011; Koller, Goedhart, & Wessels,2010). Consistent with this

notion, Serafeim (2011) finds that uncoveringhidden information about firm value is an effective deterrent from being

targeted by a hostile takeover.VBR potentially reveals characteristics of the firm that help investors assess the true

value of the firm, reducing their adverse selection problem. To the extentthat VBR meets the information needs of

market participants, we can expect that a higher level of VBR is associated with lower information asymmetries and

cost of capital. This expectationis in line with findings that improvements in investor relations are associated with pos-

itive abnormal returns and significantreductions in information asymmetries (Vlittis & Charitou, 2012). Disclosures on

the fundamental value of the firm and its drivers do not necessarily require the firm to have implemented a VBM sys-

tem; such disclosures can individually be used as means to reduce information asymmetries and as signals of a share-

holder orientation. Hence, we investigate two related research questions: 1) Does the implementation of VBM systems

(as reported in the annual report) reduceinformation asymmetries and the cost of capital? 2) Does the voluntary disclosure of

information on the fundamental value of the firm and its drivers (VBR) havea moderating effect in this process?

We analyse a sample of the 118 largest publicly listed German firms for 2000–04. The German governancesystem

has long been considered insider-controlled and stakeholder-oriented (e.g. Chirinko & Elston, 2006; Franks, 1997).

While the system is slowly and partly moving toward a more capital market based system, the main characteristics of

the German system – strong concentration of ownership, relationship-lending, internal labour markets and an inter-

nalization of information – are still in place (Hackethal, Schmidt, & Tyrell, 2005). Within this system, capital market

pressures like hostile takeover bids are less pronounced than in capital market based Anglo-Saxon countries. Mar-

ket imperfections are more likely to be present, providing us with an ideal setting to study the link between disclo-

sure, information asymmetries, and the cost of capital (Armstrong, Core, Taylor, & Verrecchia, 2011; Lambert, Leuz, &

Verrecchia,2012).

The German setting is also particularly interesting in this context because VBR has received much public atten-

tion and firms provide a wealth of related voluntary disclosures (e.g. Baetge & Solmecke, 2006; Haller & Dietrich,

2001; Koethner,2005; Ruhwedel & Schultze, 2002). We use a framework of VBR developed by the German Schmalen-

bach Society of Business Administration to measure VBR quality (SG, 2002). The framework has been widely used in

research and has stimulated public debate on the capital market's need for such disclosures that has led to the intro-

duction of the German Accounting Standard (GAS) 15 on Management Reporting in 2005, making many of these dis-

closures mandatory.We therefore limit our analysis to the period before 2005 in order to analyse VBR within the the-

oretical framework of voluntary disclosures. The SG framework includes disclosures on internal control mechanisms,

fundamental drivers of business success, sources of value generation within the firm such as intellectual capital. The

score is particularly useful for our study as it systematically comprises the additional non-financial information rele-

vant for analysing a firm's value gap. It contains both information on market valuation and internal value generation.

The score measures the degree of transparency about internal control processes and the sources of internal value

generation. The score also captures information about implemented internal control processes relevant for assessing

management's commitment to act in the shareholders’ interests.

We find evidence consistent with our expectations. Both the implementation of VBM systems and higher levels

of VBR are significantly related to lower information asymmetries and lower cost of capital. For firms that have not

implemented a VBM system, VBR has a stronger effect on information asymmetries and the cost of capital than for

VBM firms. However,when used in conjunction, firms with implemented VBM attain lower levels of information asym-

metries and cost of capital than firms not employing VBM systems.

Our results contribute to the discussion on the effectiveness of implementing VBM systems (e.g. Biddle et al.,

1997; Ryan & Trahan,2007). We provide evidence for a link between VBM systems and the information processing in

3Consultingfirms have developed value based reporting systems to meet the needs of investors. For example, ValueReportingTM isa consulting conceptand

protectedtrademark of PricewaterhouseCoopers (PwC).