The Design of Management Control Systems in Small and Medium Sized Enterprises

Do Boards with Different Compositions Face Different Organizational Information Contexts?

Responding to recent calls in the literature to examine the organizational context of boards of directors, this study investigates whether different board compositions are associated with different organizational information contexts. The results of this study may shed light on the findings of the extant empirical governance literature, revealing that boards with outsiders are more effective in monitoring, despite outside directors’ information asymmetry compared to inside directors. In this study the organizational information context is measured in terms of the availability of management control information in the firm. Our results provide evidence that outsider presence on the board is significantly associated with a more formal and objective information context characterized by a higher availability of formal planning, budgeting and variance analysis information within the firm. Given this available information, which allows comparisons between planned and actual company performance, outside directors’ information seeking behaviour is likely to be productive and to result in a reduction of outside directors’ information asymmetry.

Keywords: Corporate Governance, Board Composition, Organizational Context, Management Control Systems

JEL codes: M41, G34

1 AUTHORS

Anne-Mie Reheul is assistant professor of accounting at the Hogeschool-Universiteit Brussel. Her research interests cover a wide range of issues related to management control systems in small organizations. These issues include contingency research, corporate governance, leadership and family business research. Email: [email protected] Address: Hogeschool-Universiteit Brussel, Stormstraat 2, 1000 Brussels, Belgium Phone: + 32 2 609 82 78

Ann Jorissen is full professor of accounting at the University of Antwerp. Her research and publications cover the areas of management accounting and control, corporate governance and earnings management. Email: [email protected] Address: Universiteit Antwerpen, Faculteit TEW, Stadscampus, Prinsstraat 13, 2000 Antwerp, Belgium Phone + 32 3 220 40 92 Fax + 32 3 220 40 64

(Funding: University of Antwerp - Faculty of Applied Economics)

2 I. INTRODUCTION

Responding to recent calls in the literature to examine the organizational context of boards of directors (Pye and Pettigrew 2005, Roberts et al. 2005) in order to gain more insight into variations in conduct and effectiveness among boards, we examine in this article whether differences in a board’s organizational context are associated with differences in a board’s composition (presence or absence of outsiders). As many studies provide evidence that information plays an essential role in many aspects of board functioning (Pye 2004, Rutherford and Buchholtz 2007), we single out one aspect of a board’s organizational context, being the information context captured by the availability of management control information within the firm. Based on the extant empirical literature, revealing that outside directors demonstrate higher monitoring effectiveness than inside directors (e.g. Peasnell et al. 2005, Dunn 2004, Benkel et al. 2006, Dehaene et al. 2001, Cowling 2001), we assume that boards comprising one or more outsiders are better monitors. In line with Pye and Pettigrew (2005) and Roberts et al. (2005), we try to shed light on differences in a board’s organizational context, which might point to conditions that clarify outside directors’ monitoring superiority despite their information asymmetry compared to inside directors (Finkelstein and Hambrick 1996, Finkelstein and D’Aveni 1994). By studying the association between the availability of management control information in the firm and outsider presence on the board, we investigate whether a board’s organizational context does differ in line with the composition of the board. Observed differences could point at elements of a board’s organizational context that enable outside directors to reduce their information asymmetry and to perform sound monitoring.

This study is carried out in the Flanders region of Belgium. Although prior research carried out in Flanders on board activities is limited (Van den Heuvel et al. 2006, Van den Berghe and Carchon 2002), the scarce studies available indicate that boards of small and medium- sized enterprises (SMEs) in this region do engage in monitoring. The Flanders SME setting offers three advantages. First, the research setting of an SME is advantageous because, due to inherent resource constraints, MCS sophistication in SMEs is not higher than needed or demanded. The SME setting thus provides a less noisy setting to study and explain the fundamental factors that influence MCS information characteristics (Mitchell and Reid 2000). Second, the Belgian research setting allows controlling for variations in information

3 resulting from the financial accounting system. The Belgian accounting law for bookkeeping and the presentation of the financial statements requires all Belgian firms (with the exception of small unincorporated firms) to comply with a uniform and standardized chart of accounts. Consequently, the availability of financial ratios for monitoring purposes, calculated on the basis of the annual accounts, is more or less constant over all companies involved. The Belgian research setting thus provides a unique opportunity to control for the availability of financial accounting information and to filter out the association between board composition and MCS characteristics. Third, there is more variability in the availability of MCS information among SMEs than among large listed firms that prior board studies focus on. Unlike SMEs, large firms are very likely to all have formal and broad scope MCS (Bhide 1999).

The results of our study reveal a significant and positive association between outsider presence on the board and the availability of formal (written) budgeting and variance analysis information within the firm. So, the information context of firms having boards with outsider presence is characterized by the availability of more formal and objective information regarding the firm’s planned and actual performance compared to firms with only insiders present on the board. This implies that outside directors’ well known information seeking behaviour (Rutherford and Buchholtz 2007) is likely to be productive, which reduces their information asymmetry and enables them to better exploit their independence and consequently increase their monitoring effectiveness.

This article is structured as follows. In the next section, we present a review of the literature and the development of hypotheses. In section three, we discuss the research method including the choice of the research population, the sample selection, the data collection, the variable measurement and the method of analysis. In section four we present the results and in section five we discuss the results and formulate a conclusion.

II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

4 The majority of the extant governance research aims at explaining board performance. Board performance is measured by how effective a board is in performing its key tasks: the monitoring task, the service and strategic task and the networking task (Zahra and Pearce 1989, Johnson et al. 1996, Styles and Taylor 2001). Traditionally, authors studied board composition to explain board performance (Daily et al. 2003). This research focus, however, has been criticized in the literature for not revealing insights into the underlying processes that enhance board performance. Consequently, several pleas have been made to focus on board processes instead of board composition (Pettigrew 1992, Forbes and Milliken 1999, Huse 2000, Hermalin and Weisbach 2003, Pye and Pettigrew 2005), but this approach suffers from data collection obstacles. Direct access to boards is limited (Daily et al. 2003, Leblanc and Schwartz 2007, Rutherford and Buchholtz 2007) and questioning board members about board processes and information use poses validity problems due to a social desirability bias (Zona and Zattoni 2007). Therefore, a number of authors have suggested studying a board’s organizational context (Pye and Pettigrew 2005, Roberts et al. 2005) as it might shed some light on board processes and subsequently might help explaining differences in board effectiveness. With this article we respond to this latter plea in the governance literature and aim to study a board’s organizational information context in relation to the monitoring task of the board. First, we review the literature on the monitoring task of the board. Subsequently, we focus on the empirical governance literature relating to board composition and monitoring effectiveness and next, we review the literature on information seeking behavior. Finally, based on the literature review we develop research hypotheses.

A. The Monitoring Task of the Board The monitoring task of the board consists of assessing an organization’s financial performance, monitoring the firm’s activities as well as assessing a CEO’s performance. Director responsibilities also include hiring and firing the CEO and other executives, determining executive pay, appraising executive performance and monitoring managers to ensure that they do not expropriate stockholder interest (Fama and Jensen 1983). Based on agency theory, this role suggests that boards are in place to ensure that the CEO or top management act in the best interests of a firm’s owners (Hillman and Dalziel 2003). When outside directors perform their monitoring task they are confronted with an independence

5 paradox. On the one hand, strong outsider representation strengthens the board’s independence (Daily and Dalton 1994, Mallette and Fowler 1992). Outside board members do not work for, nor have professional or familial relationships with the corporation they govern (Mallette and Fowler 1992). For this reason they are less inclined to be loyal to the CEO and treat him/her less harshly out of fear for retaliation. Therefore, compared to inside directors, outside directors demonstrate a higher ability to provide objective and fair evaluation (Baysinger and Hoskisson 1990). On the other hand, the presence of outsiders on the board can be associated with considerable information asymmetry. Due to their lack of firm-specific and very often industry-specific knowledge and due to their lack of day-to- day exposure to the CEO, outside directors have a significant information gap1 (Fama and Jensen 1983, Baysinger and Hoskisson 1990). This information asymmetry can jeopardize their ability to develop an objective assessment of the quality and performance of the firm’s management. Among large (listed) firms the information asymmetry of outside directors is widely recognized. The literature, however, also acknowledges the information asymmetry of outside directors in SMEs. A study of Gabrielsson and Huse (2005) points out that in mature family firms where second or later generations have taken over ownership and control, the higher involvement of external share- and stakeholders (banks) create demands for distant non-involved board members, protecting the formers’ interests. This study also reveals that in small non-family firms outsiders most often are non-executive shareholders or businesspersons not employed by the firm on whom shareholders trust. The outside board members in small mature family firms and in non-family firms are therefore likely to face amounts of information asymmetry approximating the situation in larger firms. However, the study found that in first generation family firms an outside director is often a person that has close connections to the business, such as the family attorney, a banker or a friend of the CEO (Corbetta and Tomselli 1996). In this subset of SMEs the information asymmetry faced by the outside director might be quite low. We can thus conclude that information asymmetry is a problem faced by outside directors in the majority of small firm boards as well. Even if outside directors’ information asymmetry would be somewhat lower in SMEs than in large firms, the higher MCS variability in SMEs compared to large firms compensates for this with regard to unvealing the relationships under study. B. Outside Directors and Monitoring Effectiveness According to agency theory outside directors’ independence favours monitoring effectiveness, however, their information asymmetry is a counteracting force. Nevertheless, the empirical governance literature revealed quite unanimously that as the percentage of outside

6 independent directors on the board increases board monitoring becomes more effective. Board monitoring effectiveness in these mainly US/UK studies focusing on large companies has been measured by variables representing the level of earnings management (Peasnell et al. 2005, Benkel et al. 2006)), voluntary disclosure (Cheng and Courtenay 2006) and the occurrence of fraudulent reporting (Dunn 2004). In Belgium Dehaene et al. (2001) found that among large Belgian firms the number of external directors on the board was found to be positively related to return on equity. In the SME literature empirical studies arrive at similar findings. Van den Berghe and Carchon (2002) found that in medium-sized Flemish family and non-family firms independent directors are taken on board as a means to safeguard sound decisions and control over management. In a sample of small UK firms the addition of a non- executive director on the board was found to increase productivity (Cowling 2001). Gabrielsson and Winlund (2000) found for Swedish SMEs that outsider proportion on the board is positively related to the performance of various control roles. According to an SME study in the US, the adoption of outside directors is an important condition for boards being able to take action and assert power in small (mature) firms (Fiegener et al. 2000). So, the extant research found that the presence of outside directors on the board contributes to the board’s monitoring effectiveness. This finding is quite surprising given outside directors’ information asymmetry (Finkelstein and D’Aveni 1994) and the finding of survey research among board members that outsiders are hampered by this information asymmetry (Conger et al. 2001, Van den Berghe and Levrau 2004). In this respect Van den Berghe and Levrau (2004) found that the quality and quantity of information at the board’s disposal is of great value to perform sound monitoring.

C. Management Control System (MCS) as an Element of the Organizational Context

In this section we review the scarce literature that explicitly focused on this information availability and information seeking behavior of board members. We refer to Raheja (2005) who found that outside directors probably employ other information mechanisms to close their information gap. Also Rutherford and Buchholtz (2007) observed an increase in information seeking behaviour when more outsiders are present on the board. Stiles and Taylor (2001) found, using a qualitative study, that boards perform their monitoring role and

7 the assessment of top management behaviour through management control systems (MCS). We build on these findings of Stiles and Taylor (2001) and capture the information context by investigating differences in available management control system information. MCS are defined as a means of gathering and using information to aid and coordinate the process of making planning and control decisions throughout the organization and to guide employee behaviour in the direction of the organization’s goals (Horngren et al. 1999). Management control information is in the first place used by the CEO and his management team to judge the performance of the firm and to evaluate whether or not subordinates act according to plan. According to Stiles and Taylor (2001), however, MCS information can also serve as a source of broad, quantitative and formal company information to (outside) board members. For the purpose of this study, we focus only on those aspects of the MCS that can provide directors with valuable information for monitoring purposes. Therefore, we analyze planning and budgeting information as well as the set of performance indicators used in the firm. Planning systems are involved in setting objectives, identifying strategies and selecting a course of action in the short run (budgets) as well as in the long run. When budget information is available actual company performance can be compared with budgeted figures (Drury 2008). Budgeted information also allows the application of a more sophisticated technique called variance analysis, whereby differences between budgeted and actual outcome are split into usage, efficiency and price variances. We analyze the formality of the planning and budgeting systems as well as the scope of the MCS information available. The degree of formality refers to the number of operational areas that is covered by the plans/budgets and to the degree to which plans/budgets are written out rather than to take place intuitively in the manager’s mind, which is not uncommon among SMEs. The scope of information refers to broad and narrow scope information. Narrow scope information refers to the consideration of a restricted amount of information for decision-making, often implying a restrictive financial focus (only financial key performance indicators). Broad scope information refers to the consideration of a large amount of information during decision-making, often implying both a financial and a non-financial focus. D. Hypothesis Development In this section we develop hypotheses concerning the association between board composition (outsider presence or absence) and the board’s information context in terms of availability of management control information. If the association is positive, boards with outside directors face an information context where more formal and objective information on a firm’s performance is available, compared to boards with only inside directors. Consequently,

8 outside directors’ information seeking activities are likely to result in a reduction of their information asymmetry. This mitigates outside directors’ information disadvantage and strengthens their independence advantage compared to inside directors, which can contribute to the explanation why outside directors are found in the extant literature to demonstrate higher monitoring effectiveness than inside directors. Therefore, we hypothesize that:

H1: The presence of outside directors on the board is related to more formal planning and budgeting systems included in the management control system H2: The presence of outside directors on the board is related to a more formal/extensive application of variance analysis H3: The presence of outside directors on the board is related to a broader scope of planning information included in the management control system H4: The presence of outside directors is related to a broader scope of performance indicators included in the management control system

To test the hypotheses we adopt the contingency research methodology used in the management control literature. Traditional contingency research tries to gain more insight into the design of MCS by investigating which contextual variables have a significant influence on MCS design in a company. In this study we control for those contextual variables that according to contingency research have a significant impact on the design of MCS: the firm’s strategy, perceived environmental uncertainty (PEU), size, age and ownership (family versus non-family ownership) (Chenhall 2003, Westhead 1997, Risseeuw and Masurel 1994). The applied research design consists of including in this traditional contingency model an independent variable representing outsider presence on the board. If the latter variable is found to be positively significant in explaining MCS design formality and scope, simultaneously controlling for the traditional contextual variables, we can conclude that the information context of boards comprising one or more outside directors is characterized by a more sophisticated MCS design than the information context of boards without outside directors.

9 III. RESEARCH METHOD

In this section we describe the research population, the sample selection, the data collection, the profile of respondents, the variable measurement and the method of analysis applied to test the hypotheses.

A. Sample Selection The research population from which the research sample is drawn, consists of Belgian (Flemish) SMEs. We only withheld the Flemish SMEs counting between 15 and 250 FTE employees, belonging to four industry-codes and existing for at least five years. We included the sector codes 361 (manufacturing of furniture), 292 (manufacturing of machinery for general use), 281 (manufacturing of metal constructions) and 252 (manufacturing of synthetic products). We selected these codes as of all three-digit Nace- Bel codes these sectors contain the largest number of SMEs within one three-digit code in Flanders. By restricting the industry codes we control for the industry’s influence on the research variables. We excluded firms that are less than 5 years in business because such firms are very likely to have very informal and intuitive MCS with minor variations. Further, because we limit the research population to companies of one region we exclude the influence of differences in governance quality between countries (see indicators Worldbank on governance quality) and differences in board systems between countries (one tier versus two tier board structure). The size, industry and age selection criteria result in a survey population of 948 firms.

B. Data Collection The data used in this research are gathered from different sources. First, the MCS data and firm-specific information like strategy, PEU and firm ownership are collected through a survey on the design and use of MCS. The 948 selected firms were sent a questionnaire in the spring of 2006. The questionnaire was addressed to the firms’ CEO. The survey implementation followed three steps: (i) initial mailing, (ii) first follow-up and (iii) second follow-up. The initial mailing consisted of a mail out package including a cover letter, questionnaire and return envelope and was sent to every contact name. The first follow up

10 was a mail-out package including cover letter and questionnaire sent to those who had not answered. The second follow-up consisted of an email with the questionnaire in attachment, sent to those who still had not answered. A total of 138 usable responses were received immediately. The two follow-ups resulted in an additional 82 usable responses. In total 220 usable responses were obtained, representing a response rate of 23.21 percent. This response rate is representative for SME studies (Dennis 2003). In order to analyze a potential presence of non-response bias, a two-step analysis was conducted. First, respondents were compared with non-respondents in terms of the sample characteristics firm size and sector. Chi-square tests did not reveal significant differences between respondents and non-respondents in terms of size and sector. Then, the main construct measures (the MCS variables, strategy, PEU, firm age and ownership) were checked for dissimilarity between the immediate respondents and the respondents to the follow-up surveys. Independent samples t-tests and chi square tests did not reveal differences. Consequently, non-response bias is not a major concern. Of the 220 respondents, 76 percent identified themselves as CEOs. We are aware of the potential variance among managers’ perceptions of organizational characteristics within the same firm (Snow and Hambrick 1980). However, a study by Crampton and Wagner (1994) suggests that the common method bias problem may be overstated, at least for the types of variables considered in this study. Crampton and Wagner (1994) did not specifically address the concept of management control, but they revealed that concepts that are external referents to the focal individual (for example organizational structure, job scope, organizational culture, goal setting processes, pay and benefits) are not seriously affected by common method bias. This is in contrast to variables whose referents are internal states or attributes (for example job satisfaction, personality, ability). Consequently, the problem of common method bias is negligible. Besides the survey data, we also used data from Graydon, a commercial company providing business information, enabling us to classify board members as ‘insider’ or ‘outsider’, taking into account family and professional relationships1. By combining survey data on the firms’ MCS with archival data on the firms’ board composition, we avoid a potential social desirability bias, which can be present if board members themselves are questioned on board processes and board information seeking behaviour (Rutherford and Buchholtz 2007). Third, data on firm age and firm size are taken from the published financial accounts of the companies.

11 Due to 39 limited liability companies not having a board of directors and due to some missing answers to the survey questions (24 firms) the final data set used for hypotheses testing consists of 157 SMEs. In Table 1 we provide the profile of these SMEs. Table 1 reveals that the large majority of the respondents consist of small, but mature, family-owned SMEs, which are quite proportionally distributed over the different types of industries, but slightly more present in the manufacturing of metal constructions. As the study of Gabrielsson and Huse (2005) revealed that outside directors of first-generation family firms often have close connections to the firm or its management, we stress here that our dataset contains only 30 firms of that type (19%).

Insert table 1

C. Variable Measurement In this section we describe the measurement of the dependent and the independent variables. The dependent variables in this study are variables relating to the formality and scope of MCS design. MCS formality is captured by the variables ‘planning and budgeting formality’ and ‘extent of variance analysis’. The scope of MCS information is measured by the variables ‘scope of planning information’ and ‘scope of performance indicators’. Planning and budgeting formality is measured by presenting four descriptions, based on the typology of Bracker and Pearson (1986) in the survey and asking the respondents to select the description that most resembles their firm’s practice. The four descriptions in decreasing order of formality are: we use written plans with regard to many (4 or more) operational areas (sales, production, purchases, personnel, R&D, investments, financing) (coded 4), we use written plans with regard to a restricted number of operational areas (coded 3), we do not use written plans, but planning happens intuitively on the basis of the manager’s experience (coded 2), we do not use written, nor intuitive plans (coded 1). Extent of Variance Analyses captures to what degree they apply the technique of variance analyses. This technique allows a further analysis of the differences between budgeted and actual performance, by splitting the differences into volume variances, price variances and efficiency variances. The respondents had to tick off one of the following four descriptions: ‘we calculate no variances between actual and budgeted performance’ (coded 1), ‘we calculate no variances, but compare actual and budgeted performance and try to achieve the budgeted goals’ (coded 2), ‘we occasionally calculate variances for specific

12 items in order to undertake corrective action’ (coded 3), ‘we regularly compare variances for various operational aspects, revenues and costs and take corrective action’ (coded 4). Scope of Planning Information is measured by asking the respondents to indicate the depth with which several analyses take place in the planning process, using a figure between 1 ‘not analyzed’ and 5 ‘analyzed in great depth’. These seven types of analyses, taken from Bracker and Pearson (1986) and Rue and Ibrahim (1998) are: strategic choices and alternative solutions, information regarding possible future events (e.g. new legislation), threats (e.g. emergence of substitute products) and opportunities (e.g. arrival of new technologies) in the environment of your organization, external/environmental factors outside the immediate environment of your organization (e.g. labor-management attitudes, national economic trends), strengths (e.g. strong brand name) and weaknesses (e.g. high cost structure) of your organization, alternative growth scenarios and business risk. The measure ‘scope of planning information’ is computed by averaging the seven scores. Scope of Performance Indicators is captured by four questions. Respondents had to indicate whether information is available with regard to four types of performance indicators. The four types of indicators were financial indicators, indicators regarding the customer, indicators regarding internal business processes and indicators regarding innovation and learning. The presence of these performance indicators is measured on a scale ranging from 1 (not included) to 5 (included in great detail). The scores for the four types of objectives is averaged to obtain the measure ‘scope of performance indicators’.

The independent variables consist of the main research variable, outsider presence on the board, and of several control variables, revealed by the extant MCS contingency literature as being significant variables in explaining MCS design. Outsider Presence on the Board. To operationalize the concept we made use of the data provided by Graydon. For each survey respondent Graydon provided us with two lists: a list containing the names and addresses of the board members, and a list containing the names of the CEO and the department managers. First, we classified board members as inside directors if they belong to the firm’s management or have family relationships with the firm’s management (on the basis of surname or address). Second, we used information available on the company and other websites (organigrams, contact details mentioned on vacancy messages and product information fiches, …), enabling us to classify some additional board members as inside directors. The board members not classified as inside directors according to the previous steps were classified as outside directors. In our study

13 outside directors do not belong to the firm’s management or its family, thus they face more information asymmetry than inside directors who are managers of the firm or their family. Outsider presence on the board is a dummy variable taking the value 0 if no outsiders are present on the board, and taking the value 1 if one or more outsiders are present. Perceived Environmental Uncertainty. To capture PEU we used an eight-item scale based upon Gordon and Narayanan (1984). Respondents were asked to tick off the degree of unpredictability of eight environmental elements, using a figure between 1 ‘completely unpredictable’ and 5 ‘completely predictable’. These eight environmental elements are market activities of competitors, needs and tastes of customers, actions of suppliers, production technologies, government regulation and policy, economic environment, industrial relations and deregulation/globalisation. Factor analysis revealed that only six of the eight items loaded sufficiently (> 0.5) on a single factor. Therefore, the respondents’ ratings on these six items (excluding the unpredictability of customers and suppliers) were averaged to arrive at an overall PEU index. To control for the influence of sector we calculated a sector adjusted PEU index (PEUs). First, the average PEU index is computed for each of the four sectors comprised in our dataset. Then, from each firm’s PEU index the corresponding sector mean is subtracted, and subsequently this difference is divided by the same sector mean. A higher sector adjusted PEU index indicates how much more (if positive) or less (if negative) uncertain a firm perceives its environment compared to its sector’s average. Strategy. Respondents were asked to identify their firm’s strategy by means of a six- item scale derived from Covin and Slevin (1989). The six statements at the one side of the five-point scale refer to launching known and proven products, producing at lowest cost, not having launched new product lines during the last five years, having applied minimal adjustments to product lines during the last five years, reacting to competitors’ actions and being rarely the first to introduce new products or technologies. At the other side of the scale there are six opposite statements, respectively referring to R&D, innovation and technological superiority, producing innovative products, having launched many new product lines during the last five years, having applied many adjustments to product lines during the last five years, initiating actions to which competitors react and being often the first to introduce new products or technologies. Because the items of the scale focus on different aspects of strategic posture (innovation and proactivity), they were factor analyzed. All of the items loaded above 0.5 on a single factor, thus all items were averaged to obtain an overall strategy index. To control for the influence of sector a sector adjusted strategy index (strategys) is calculated, following the same method to calculate PEUs. A higher sector adjusted strategy

14 index indicates how much more (if positive) or less (if negative) innovative and proactive a firm is compared to the sector mean. Firm Size. Firm size is captured by the natural logarithm of the total number of FTE (full time equivalent) employees. Most governance studies measure firm size using the variables total assets or net sales. MCS research reveals, however, that firm size measured in terms of the number of employees is a driver of MCS emergence (Bhide 1999, Davilla 2005). In the early stages of a company, control and coordination happens through frequent and informal interactions. As the number of employees grows, attention shifts to developing systems that anchor informal interactions around a set of formalized systems (Bhide 1999). Firm Age. Firm age is measured as the natural logarithm of the number of years that the firm exists. Family Ownership. We asked in the survey whether one family has a stake of more than 50% in the firm’s capital. If the respondent answered yes, family ownership is the case and the dummy variable is scored ‘1’. If the answer was no, the firm is not owned by a single family and the dummy variable family ownership is scored ‘0’.

In Table 2 below we present the descriptive statistics for all variables. Insert Table 2

D. Method of Analysis To test the hypotheses we run OLS and ordinal regression analyses. In the four regression analyses, each explaining a certain MCS aspect, the presence of outside directors is included as main independent research variable and the firm’s strategy, PEU, size, age and ownership (family versus non-family ownership) are included as control variables.

As the dependent variables planning formality and extent of variance analysis are ordered categories, we apply an ordinal regression model to explain them. In order to meet the assumption of parallel lines (e.g. equal regression coefficients) across all levels of the categorical outcome (Bender and Benner 2000), we had to take together the two lower-end, less represented categories of the planning formality and extent of variance analysis scales. As such, the original four categories are reduced to three categories. To estimate planning formality the logit link function is applied, given three quite equally distributed categories. To estimate the extent of variance analysis the complementary log-log function is used as

15 this measure contains most cases in the highest category (SPSS Inc 2002). We consider the -2log likelihood ratio (-2 LL) and the Nagelkerke pseudo-R2 measure to assess the validity of the ordinal regression models. A better fit is indicated by a lower -2 LL and a higher Nagelkerke pseudo-R².

As the variables scope of performance targets and scope of planning information are interval variables, we apply OLS regression analysis to test the hypotheses H3 and H4 (Berk 2003). All the assumptions of the regression model (Berry 1993) are fulfilled.

Insert table 3

First, Table 3 reveals that there is no high degree of correlation between the independent variables, implying that the issue of multicollinearity does not arise. The same conclusion is drawn through the inspection of the variance inflation factors (all VIFs below 1.4) and the condition indices (no independent variables that have large proportions of variance (.50 or more) that correspond to large condition indices (30 or more)). . Second, to check the assumption of homoscedastic residuals we examined a plot of the standardized residuals by the regression standardized predicted value for each regression analysis. In each of the regressions these plots reveal that the residuals’ variance is the same across all levels of the independent variable. Consequently, the homoscedasticity assumption is fulfilled. Third, to judge the normality of the distribution of a group of residuals we relied on histograms and normal probability plots. These graphs reveal that for all the regression analyses the residuals follow an approximately normal distribution. The quality of the estimated models is assessed by inspecting the adjusted R-square statistic and the F statistic.

IV. RESULTS

In this section we present the results of the statistical analyses.

16 A. Formality of Information available through the Management Control System The results in table 4 reveal that the presence of outsiders on the board is significantly and positively related to more formal planning and budgeting practices present in the firm. These results allow us to confirm hypothesis H1.

Insert table 4

We observe that outsider presence is associated with more formal planning systems in the company. This implies that a higher number of budgets is prepared in a written way. Consequently, more objective budgeting information on the companies’ future plans with regard to sales, production, purchases, personnel, … is available, which afterwards can be compared with the actual figures. Chi squared tests (not shown) reveal that introducing the variable outsider presence as an independent variable in a contingency model in addition to the traditional contingent variables explaining planning/budgeting formality, significantly enhances the model’s explanatory power (2= 3.84, df=1). With respect to variance analysis, the data reveal that the sophisticated technique of variance analysis is used significantly more in firms with outsiders on their board. So hypothesis H2 is supported (p < 0.1). This implies that companies with outside board members are more engaged in a regular calculation of different volume, price and efficiency variances, enabling an assessment of whether the company met the budgeted targets. .

B. Scope of Information Considered in the Management Control System Table 5 shows the regression results explaining the scope of planning information and the scope of performance targets considered in the MCS.

Insert table 5

Concerning the scope of planning information and the scope of performance indicators, the results reveal that there is no significant association with outsider presence on the board. So we are not able to confirm the hypotheses H3 and H4.

Overall the regression results reveal that outsider presence is significantly related to MCS formality, but not the scope of MCS. It is important to note that formality and scope are

17 analyzed as two separate independent features in this study. Broad scope MCS information can be of a formal nature, but it can also be of an informal or an intuitive nature. In this respect, it must be noted that in order to reach (outside) directors, not the scope of MCS information, but its formal or written nature is primordial.

C. Sensitivity Checks and Additional Analyses

We performed several sensitivity checks. First, the four regression analyses are performed with outsider proportion (number of outside directors / total number of directors) as independent variable instead of the dummy variable outsider presence. As outsider proportion could not be measured reliably for all the firms in the dataset, we performed the analyses in the main part of the article using outsider presence. The regressions using outsider proportion yield entirely similar conclusions. Outsider proportion is found to be positively and significantly related to planning/budgeting formality (coeff.= 1.96, s.e.= 0.61, p < 0.001) and extent of variance analysis (coeff.= 0.59, s.e.= 0.42, p < 0.1). Second, historical performance (average gross return on assets over the years 2003-2004) is included as an additional independent variable in the four original regression analyses. As in traditional contingency research performance is not considered as an explanatory variable of MCS design, it was excluded from the main analyses. In the governance literature, however, historical performance is found to explain board composition. After including historical performance the variable outsider presence remains significant. Third, the interactive effect of outsider presence and firm size is included in the four original regression analyses. This interaction effect is not significant in any of the regressions, and the results relating outsider presence to formality and scope of MCS information do not alter. Fourth, because outside board members in first-generation family firms are more likely to be closely connected to the firm (Gabrielsson and Huse 2005) we also ran the regression analyses without these firms. Outsider presence remains significantly and positively related to planning formality (coeff. 0.53, s.e. 0.42, p < 0.1 one tailed) and variance analysis (coeff. 0.74, s.e. 0.44, p< 0.05 one tailed) in the reduced dataset. Chi squared tests reveal that including outsider presence on the board as independent variable to explain extent of variance analysis, significantly enhances the fit between the model and the data (chi square = 2.79, df=1, p < 0.10).

18 V. DISCUSSION AND CONCLUSION

In this article we respond to a call in the literature to study a board’s organizational context (Roberts et al. 2005, Pye and Pettigrew 2005) in order to unveil variables that might affect board performance. In response to this plea we investigate whether the presence or absence of outside directors on the board is associated with a different organizational context in terms of management control information availability within the firm. We consider as outside directors those directors who do not belong to the firm’s management or the latter’s family. With this research question we try to gain more insight into the conditions and mechanisms which make that according to the empirical governance literature outside directors are superior to inside directors in performing the monitoring task (e.g. Gabrielsson and Winlund 2000), in spite of being hampered by information asymmetry (Conger et al. 2001).

The analyses reveal that outsider presence on the board is associated with the availability of more formal budgeting and variance analysis information within the firm, enabling the comparison between budgeted and actual figures with regard to sales, production, purchases, personnel, etc.. So, compared to boards without outside members, boards with one or more outside members are indeed characterized by a more formal and objective information context. This finding implies that the information context meets the requisites for outside directors’ information seeking behaviour (Rutherford and Buchholtz 2007) to be productive. Outside directors can retrieve and use this formal MCS information and make an objective assessment concerning how well top management acted according to plan. Thus, this information context enables outside directors to fully act upon their independence and to perform their monitoring task well. For inside directors the information benefits of formal MCS are much less important than for outside directors. Inside directors are exposed to the SME’s activities on a daily basis as by definition they belong to the SME’s (top) management or its family. Formalizing MCS information, which is known on an informal or intuitive level already, will not have a great impact on inside directors’ monitoring performance.

19 We can conclude that the presence of outside directors on Flemish SME boards goes together with a richer information context. The association between outsider presence on the board and a rich information context might explain why prior studies quite consistently found that outside directors are better monitors than inside directors despite the former’s information asymmetry. A different board information context could be a contributing variable. A first limitation of this study is that the research design does not allow us to make a judgment about the causality between the variables. So, either outside directors are only willing to serve on boards of companies that have more information available, or outside directors are the driving force behind the installation of formal MCS. We can only conclude that there is a positive association between outside presence and MCS formality. A second limitation is the fact that the inside/outside director classification is not perfect. Due to data limitations, ex-managers and people with family ties not detectable on the basis of surnames or addresses are classified as outside directors too, whereas they face lower levels of information asymmetry.

Finally, for the parties involved in the development of governance codes we recommend that attention also needs to be paid to elements of a board’s organizational context as differences in context can have an impact on a board’s ability to effectively carry out its mandatory duties.

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24 Table 1: Profile of Usable Respondents

Size 15- 25 FTEsa >25-50 FTEs >50-100 FTEs >100-250 FTEs Total

31.8% 33.2% 22.3% 12.7% 100% 50 52 35 20 157 Age 5–10 years >10–25 years >25-50 years >50-135 years

4.5% 31.2% 43.9% 20.4% 100% 7 49 69 32 157 Sector 281b 361b 292 b 252 b

31.8% 22.3% 22.3% 23.6% 100% 50 35 35 37 157 ownership Nonfamily Family firm firm 21.7% 78.3% 100% 34 123 157

First Second Third or later generation generation generation

19.1% 38.9% 20.3% 30 61 32 a FTEs : full time equivalent employees b Sector (Nace Bel) codes: 281= manufacturing of metal constructions, 361= manufacturing of furniture, 292= manufacturing of machinery for general use, and 252= manufacturing of synthetic products

25 Table 2: Research Variables - Descriptives

mean std. theor. actual cronb range range α Planning/budgeting formality 2.83 0.94 1 – 4 1 – 4 Extent of variance analysis 3.11 0.97 1 – 4 1 – 4 Scope of performance targets 3.33 0.93 1 – 5 1 – 5 0.82 Scope of planning information 3.27 0.63 1 – 5 1.43 – 5 0.78 Presence of outside directors (1=y, 0=n) 0.55 0.50 0/1 0/1 PEU 3.09 0.49 1 – 5 1.17 – 4.5 0.66 Strategy 3.35 0.82 1 – 5 1 – 5 0.78 PEUs (sector adjusted) 0.00 0.16 -0.62 – 0.47 Strategys (sector adjusted) 0.00 0.24 -0.70 – 0.55 Ln Firm size 3.63 0.76 2.7 - 5.5 2.71 - 5.5 Ln Firm age 3.38 0.66 1.6 - … 1.61 – 4.91 Family ownership (1=y, 0=n) 0.77 0.42 0 / 1 0 / 1

26 Table 3: Pearson Correlation Coefficients

Outsider PEU_s Strategy_s Ln Ln Family Presence Firm Size Firm Age Ownership

Outsider 1 presence

PEU_s -0.090 1

Strategy_s -0.079 0.009 1

Ln firm size 0.286** -0.129 -0.010 1

Ln firm age -0.137 -0.046 -0.018 0.372** 1

Family -0.434** -0.075 0.023 -0.140† 0.016 1 ownership N= 157 **/† correlation is significant at the 0.01/0.1 level (two-tailed)

27 Table 4 Ordinal Regression Analyses explaining MCS design

Planning/budgeting Extent of Variance Analysis Formality

Estimate S.E. Estimate S.E. Threshold Dependent variable = 1 b 3.58† 1.09 1.86*** 0.74 Dependent variable = 2 b 5.11* 1.12 2.64*** 0.75 Dependent variable = 3 a Location Presence of outside directors = 1 .75* .38 .36† .26 Presence of outside directors = 0 0.00a 0.00a * PEUs (sector adjusted) -2.11 1.12 .32 .74 * ** Strategys (sector adjusted) 2.49 .71 1.48 .47 Ln Firm size .64** .26 .37* .18 Ln Firm age .55* .29 .46* .21 Family ownership = 1 -1.61** .47 -.66* .35 Family ownership = 0 0.00a 0.00a

-2 LL full model 287.27 297.58 -2 LL intercept model 342.83 331.64 -2 LL model ignoring ‘presence of 291.11 299.40 outside directors’ Pseudo R² (Nagelkerke) .336 .222 N 157 157 a This parameter is set to zero because it is redundant b For the dependent variables, the following odds are modeled: θj = prob (score ≤ j) / (1 – prob (score ≤ j)) where j goes from 1 to the number of categories minus 1. The last category does not have an odds associated with it since the probability of scoring up to and including the last score is 1. The event of interest is observing a particular score or less. The ordinal logistic model for a single independent variable is then ln (θj )= αj – βX. † p < 0.1, * p < 0.05, ** p < 0.01 (one-tailed significance levels)

Table 5 OLS Regression analyses explaining MCS design

Scope of planning Scope of performance Information indicators

Unstand. Stand. Unstand. Stand. Coeff. Coeff. Coeff. Coeff.

28 B S.E. B B S.E. B

Constant 1.90*** .44 1.87*** 0.50

Outsider Presence (1/0) -.09 .15 -.05 -.081 0.17 -0.04

* * PEUs -.31 .44 -.05 -1.04 .50 -.16

** ** *** *** Strategys 1.09 .27 .31 1.05 .30 .26

Ln Firm size .15† .10 .14† .23* .11 .18*

Ln Firm age .22* .11 .17* .25* .13 .16*

Family Ownership (1/0) -.12 .17 -.06 -.24 .19 -.10

Adj R² .133 .157

F (Full model) 4.98*** 5.84***

N 157 157

† p < 0.1, * p < 0.05, ** p < 0.01, *** p < 0.001 (one-tailed significance levels)