02 Nov 2017
Corporate Governance is "a set of relationships between a company’s management, its board, its shareholders, and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently." (OECD Principles of Corporate Governance, 1999).
Though issues in corporate governance gained importance recently, its origins however, go back many years to the time when ownership and management of businesses first became separated. At that time, it was necessary for owners to implement mechanisms to monitor the performance of managers.
According to Heenetigala (2011 cited Chowdary 2003) it is also true that corporate governance in developed market economies has been built gradually over several centuries as a consequence of the economic development of industrial capitalism. As a result, there are different corporate governance structures that have evolved in different corporate forms to pursue new opportunities or resolve new economic problems.
Today corporate governance is said to be complex and a mixture of laws, regulations, politics, public institutions, professional associations and a code of ethics. In particular, even in the emerging markets of the developing countries many details of these structures are still missing.
As per Heenetigala (2011 cited Roche 2005) corporate governance is not easy to define as a result of the continuing expanding boundaries of the subject. Therefore definitions vary according to the context, the cultural situations (Armstrong and Sweeney 2002) and the perspectives of different researchers. For example, according to Tricker (2000), corporate governance is an umbrella term that includes specific issues from interactions among senior management, shareholders, board of directors, and other corporate stakeholders. On the other hand, Blair (1995) argues that corporate governance implicates, "the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated."
On the other hand, according to Organization for Economic Co-operation Development (OECD) principles, corporate governance is a system by which business corporations are directed and controlled.
However, corporate governance is considered to have wider implications, which are critical to economic and social well-being and stability and equity of a society. This is captured in the broader definition stated by Adrian Cadbury. He defines corporate governance in line with the stakeholder approach:
Corporate governance is concerned with holding the balance between economic and social goals, and between individual and communal goals. The governance framework is there to encourage efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align nearly as possible the interest of individuals, corporations and society (Cadbury 2000).
Corporate governance is important as it promotes the efficient use of resources within the firm and even the larger economy. It also helps firms to attract low cost investment capital through improved investor and creditor confidence, both nationally and internationally. It also increases the firms’ responsiveness to the need of the society and thereby resulting in improving long-term performance.
Good governance tries to achieve firm-wide efficiency and a fair return for investors. Furthermore, good governance can also benefit a company through better flow of funds, strong internal controls and discipline.
According to Keong (2002) good corporate governance brings better management; prudent allocation of the company’s resources, and enhances corporate performance which would significantly contribute to the company’s share price, increasing the value of a shareholder’s holdings.
There is still no commonly accepted model or theoretical base of corporate governance as yet (Larcker, Richardson and Tuna, 2007; Harris and Raviv, 2008) cited in Bhuiyan and Biswas ca.2009.As such corporate governance research lacks coherence of any form, either empirically, methodologically or theoretically, implying that gradual attempts have been made to understand and explain how the complex modern organization is run. As a result, a number of different theoretical frameworks, originating from a broad range of disciplines including economics, finance, management and sociology, have been used by researchers in explaining and analyzing corporate governance. Using various terminologies, these frameworks view corporate governance from different perspectives (Bhuiyan and Biswas ca.2009). Therefore, the theoretical perspectives that are relevant to this study are based on the governance structures and reporting practices that affect the value of the firm.
Since the early work of Berle and Means (1932), corporate governance has focused upon the separation of ownership and control which results in principal-agent problems arising from the dispersed ownership in the modern corporation. Even the most fundamental corporate governance problem deals with how is the principal (shareholder) able to prevent the agent (generally management) from maximizing his own self-interest (Jensen and Meckling, 1976; Fama and Jensen, 1983).Therefore, a monitoring mechanism is designed to protect the shareholder interest because when the agent tries to maximize his interest; this might conflict with the objectives that are used to achieve better firm performance.
In contrast to agency theory, stewardship theory presents a different model of management, where managers are considered good stewards who will act in the best interest of the owners (Donaldson and Davis 1991). The fundamentals of stewardship theory are based on social psychology, which focuses on the behavior of executives. In this model managers are more likely to serve organizational rather than personal goals where their needs are based on growth, achievement and self-actualization; they identify themselves with their organization and remain highly committed to the organizational values (Davis et al. 1997).
According to Smallman (2004) where shareholders wealth is maximized, the steward’s utilities are also maximized, as organizational success will serve most requirements (including better performance) and the stewards will have a clear mission. He also states that, stewards balance tensions between different beneficiaries and other interest groups. Therefore stewardship theory is an argument put forward for firm performance that satisfies the requirements of the interested parties resulting in dynamic performance equilibrium for balanced governance.
With a view to discuss the firm’s responsibility in relation to the wider community the Stakeholder theory is used. A stakeholder is any group of individuals who can affect or is affected by the activities of the firm, while trying to achieve its objectives. As such, a firm’s objective could be achieved through balancing the conflicting interests of these various stakeholders. The stakeholder theory is in fact an extension of the agency perspective, where responsibility of the board of directors is increased from shareholders to other stakeholders’ interests (Smallman 2004).
In fact the stakeholder theory provides a vehicle for connecting ethics and strategy (Phillips, 2003), and that firms that thoroughly seek to serve the interests of a broad group of stakeholders will create more value over time and in fact perform better. This is also because a firm’s decisions, and hence its performance, can be affected by the stakeholder activities.
Many Corporate governance reforms were made with a view to increase investor confidence in their capital markets which in turn increases firm performance. Among these were reports produced on corporate governance like the Cadbury, Hampel , Greenbury and Higgs reports in the UK, the Bosch report in Australia, the Business Roundtable report in the US and OECD Principles of Corporate Governance (Haniffa and Hudaib 2006).
Moreover, Khan et al. (2011) investigated the effect of corporate governance on firm’s performance of the Tobacco Industry of Pakistan by making use of data as from the year 2004 to 2008. The results showed that there is a strong and positive impact of corporate governance on firm’s performance.
Azam et al. (2011) examined the impact of corporate governance on the performance of firms from the oil and gas sector of Pakistan. A sample of 14 oil and gas related firms was taken for the period of 2005 to 2010.The findings show that corporate governance has significant and positive impact on firm’s performance and it is concluded that the performance of a firm can be increased by improving the corporate governance structure.
Brown and Caylor (2004) conducted a study entitled: "Corporate Governance and Firm Performance". The study examined whether firms with weaker corporate governance perform more poorly than firms with stronger corporate governance. It was found that firms with weaker corporate governance performed more poorly.
In addition, there are also some documentary evidence that suggests that the relationship between corporate governance structure and firm performance can either be positive (Morck et al. 1989), negative (Lehman and Weigand, 2000), or none (Bolton and Von Thadden, 1998).
Heenetigala (2011 cited Berle and Means 1932; Mace 1971) found that there are different ways in which boards can be structured to meet the needs of the organization. The variation in governance structures reflects the following competing view ; where it is believed that boards are formed to maximize the managerial control of the firm’s board, resulting in superior performance due to the inside information and better understanding of the needs of the firm than is possible with outside independent directors. As such external investors consider corporate governance as a significant factor which affects their investment decisions, because appropriate governance structures reduce risks and promote performance (Davis 2002). The governance structures that are considered in this study are: board leadership, board composition, board committees and board size.
A review of the existing research which addressed board structure in relation to the board composition and leadership structure, argued that board structure can influence a variety of organizational outcomes (Laing and Weir 1999).
The results of a study conducted in the UK by Weir and Laing (2001) on companies that complied with the governance structures, recommended by the Cadbury Committee did not find a relationship between the recommended structures and performance based on accounting-based measure of ROA. They found that the best performing firms have the lowest incidence of Cadbury preferred governance structures comprising of the separation of the CEO and the chairman, and boards comprising of majority of non-executive director representation and board committees. However the poorest performing firms tend to adopt the preferred governance structures. They state that a structure appropriate for one firm may not be suitable to another one.
An important mechanism of board structure is its leadership, which is reflected in the positions of the chairman and CEO (Heenetigala, 2011). Normally, combined leadership structure occurs when the CEO is both the CEO and the chairman and Cadbury (2002) refers to this as combined leadership. Alternatively, separate leadership is when two different people occupy the positions of the chairman and CEO (Rechner and Dalton 1991). Separation of the role of CEO and chairman is moreover largely grounded in the agency theory (Dalton et al. 1998). This theory argues for a clear separation of the responsibilities of the CEO and the chairman of the board and seems to prefer to have separate leadership structure (Jensen and Meckling, 1976; Fama and Jensen, 1983; Jensen, 1993). The reason is that since the day-to-day management of the company is led by the CEO, the chairman of the board, as a leader of a board, needs to monitor the decisions made by the CEO which will be implemented by the management and to oversee the process of hiring, firing, evaluating and compensating the CEO (Brickley et al. 1997). If the CEO and the chairman of the board is the same person, there would be no other individual to monitor his or her actions and CEO will be very powerful and may maximize his or her own interests at the expense of the shareholders. The combined leadership structure promotes CEO entrenchment by reducing board monitoring effectiveness (Florackis and Ozkan, 2004). Thus, a separate leadership structure is recommended in order to monitor the CEO objectively and effectively.
Conversely, advocates of stewardship theory argue that managers are inherently trustworthy and are good stewards of firm resources and work to attain a higher level of corporate profits (Donaldson and Davis 1991, 1994). On the other hand an advantage of combining the two roles is that it strengthens the leadership (Suryanarayana 2005).
Therefore, it can be said that agency theorists argue that the same person holding the CEO and chairman roles simultaneously will reduce effectiveness of board monitoring, whereas the argument put forward by stewardship theorists is that one person holding both roles may improve performance.
The agency theory and the corporate governance guidelines have even emphasized the importance of board independence from management through a separate leadership structure. The findings of Rahman and Haniffa (2005), Chen et al. (2005), Kula (2005) and Rebeiz and Salameh (2006) are in line with theoretical expectation, i.e. a positive relationship between separate leadership structure and performance.
Baliga et al. (1996) found weak evidence that duality of board chairman and CEO affect long term performance of US companies. Moreover, by analyzing 347 Kuala Lumpur Stock Exchange (KLSE) listed companies, Haniffa and Hudaib (2006) provides evidence that companies with role duality seem not to perform as well as their counterparts with separate board leadership. Brown and Caylor (2004) also support the notion that firms are more valuable when the CEO and board chair positions are separate.
A study conducted by Daily and Dalton (1992) reported no relationship between combined leadership structure and performance indicators, and Rechner and Dalton (1991) also reported that a firm which had a separate leadership structure indicated higher performance than firms with combined leadership structures.
Cyril (2008) examined the effect of corporate governance on company’s performance of the Malaysian Public Listed Companies using data for the years 1999 and 2005. Performance of the companies was compared with duality and board’s independence with those without duality and board’s independence. The results show that there is no significant relationship between corporate governance (leadership) structures and company’s performance.
Another important mechanism of board structure is the composition of the board, which refers to executive and non-executive director representation on the board. Both agency theory and stewardship theory apply to board composition. Boards dominated by non-executive directors are largely grounded in agency theory. According to agency theory, an effective board should be comprised of a majority of non-executive directors (their key responsibility being monitoring), who are believed to provide superior performance due to their independence from firm management (Dalton et al. 1998). In contrast to this the stewardship theory stipulates that the board of directors should comprise of a majority of executive directors (whose responsibility is the day-to-day operation of the business such as finance and marketing), this theory argues that managers are good stewards of the organization and work to attain higher profits and shareholder returns (Donaldson and Davis 1994).
If the representation on the board of non-executive directors increased the effectiveness of monitoring, then the performance of the company should improve. Studies by Fama (1980) and Fama and Jensen (1983) indicate that non-executive directors have more incentive to protect the interest of the shareholders, because of the importance of maintaining their reputation in the market for outside directorships.
Empirical evidence reports mixed results in relation to the proportion of non-executive directors and firm performance. However appointment of non-executive directors is widely accepted. Studies conducted by Rosentein and Wyatt (1990), concluded that appointment of outside directors results in significant and positive share price reactions. Companies which are dominated by non-executive directors are more likely to remove the CEO if their entity’s performance is poor (Boeker 1992. Studies by Hillman and Dalziel (2003), and Yoshikawa and McGuire (2008) report that the expertise and knowledge non-executive directors bring to the firm help it to perform better.
Hence, as per Kiel and Nicholson, 2003; Florackis and Ozkan, 2004; Le et al. 2006; Williams et al. 2006 the agency theory recommends the involvement of independent non-executive directors to monitor any self-interested actions by managers and to minimize agency costs (Muhammad et al. 2009).
The board is the central point of the corporate governance system and is ultimately accountable and responsible for the performance and affairs of the company however, board committees are also an important mechanism of the board structure providing independent professional oversight of corporate activities to protect shareholders interests. Board committees assist the board and its directors in discharging their duties through a more comprehensive evaluation of specific issues, followed by well-considered recommendations to the board.
As stated by the agency theory principle, the separation of the monitoring and execution function is established to monitor the execution functions of audit, remuneration and nomination (Roche 2005). Corporate failures in the past focused criticism on the inadequacy of governance structures to take corrective actions by the boards of failed firms. Importance of these committees was espoused by the business world (Petra 2007).
It is in the Cadbury Committee report in 1992, where recommendations were provided that boards should nominate sub-committees. Therefore, three well-accepted oversight board committees are audit, remuneration, and nomination committees.
audit committee
Its use is beneficial as it monitors the integrity of the financial statements of the company, review of the company’s internal control and risk management systems and others. The existence of audit committees could reduce errors, irregularities and illegal acts, financial restatements (Abbott et al. 2004) which, may in turn contribute to better financial performance.
remuneration committee
It must set the remuneration of executive directors. Hence the purpose of a remuneration committee is to determine the remuneration policy regarding executive directors and also to appraise their performance.
nominating committee
The use of a nomination committee enables the board to independently assess the value of a potential new board member. The use of the nomination committee is to allow for a true assessment of a potential board member based on their experience, merit and industry or other skills that they can offer to the board.
Research on the relationship between board committees and corporate performance is scarce (Dalton et al. 1998). However, an investigation of board sub-committees and firm performance by Klein (1998) revealed evidence that the presence of remuneration committees was positively related to firm performance, but the relationship was not strong. Laing and Weir (1999) found audit and remuneration committees had a positive impact on firm performance. All these imply that the number of sub-committees a firm nominate may affect firm performance.
Board size is mostly used as an indication of both monitoring and advisory role (Klein 1998). Empirical results on optimal board size are unsettled. Large board size has been criticized for increasing cost and quarrel about insignificant matters during board meetings, while it is also argued that small board size might not effectively monitor powerful managers.
Limiting board size is believed to improve firm performance because the benefits of larger boards (increased monitoring) are outweighed by the poorer communication and decision making of larger groups (Lipton and Lorsch 1992; Jensen 1993).
Even Brown and Caylor (2004) showed that firms with board sizes of between 6 and 15 have higher returns on equity and higher net profit margins than do firms with other board sizes.
Also, Zahra and Pearce (1989) and Kiel and Nicholson (2003) reveal board size is positively related to corporate performance.
As per agency theory, Jensen (1983) and Florackis and Ozkan (2004) mention that boards with more than seven or eight members are unlikely to be effective. They further elaborate that large boards result in less effective coordination, communication, and decision making, and are more likely controlled by the CEO. Yoshikawa and Phan (2003) also highlight that larger boards tend to be less cohesive and more difficult to coordinate because there might be a large number of potential interactions and conflicts among the group members. In addition, they further state that large boards are often created by CEOs because the large board makes the board members disperse the power in the boardroom and reduce the potential for coordinated action by directors, leaving the CEO as the predominant figure.
Several researchers have also proposed an optimal board size that might reduce the influence of the management on board’s decisions. For instance, Mak and Li (2001 cited Jensen 1983) proposes a board size of about seven to eight in order to have effective monitoring. In addition, Yoshikawa and Phan (2003) highlight that a CEO will purposely create a larger board size to make sure that he or she alone is the most powerful person and the board will be difficult to coordinate effectively due to the larger size. Thus, smaller board size seems to be better. The findings of Yermack (1996), Eisenberg et al. (1998), Mak and Kusnadi (2004), and Andres et al. (2005) support that there is a negative relationship between board size and firm’s performance.
Firm size may be related to corporate governance characteristics and may be correlated with firm performance. The book values of total assets of the firm can be used as a proxy for firm size.
As stated previously, firm size can also be measured by the book value of firms’ total assets. Previous research has made use of total assets to represent firm size. Firm size can be related to other governance variables. Pathan et al. (2007) states that a statistically significant correlation was reported for board size and total assets. Keil and Nicholson (2003) found total assets of a company were positively correlated to board size and board composition. Therefore the total assets are considered to have an impact on the variables used in this study. According to Tornyeva and Wereko 2012 the control variable of firm size has a positive relationship with performance though not statistically significant.
Firms may not be able to operate or exist if they are unable to access primary capital, in which case corporate governance would not be relevant as there would be no suppliers of capital (Banks ;2004).
To evaluate performance, it is necessary to determine the constituents of good performance using performance indicators. To be useful, a performance indicator must be meaningful, measurable, relevant and important to the performance of the organization.
There are many measures of firm performance. Financial measures of firm performance used in empirical research on corporate governance fit into both accounting-based measures and market-based measures (Kiel and Nicholson 2003). Most commonly used accounting based-measures are return on assets (ROA) (Kiel and Nicholson 2003), return on equity (ROE) (Baysinger and Butler 1985), net profit margin (NPM) and earnings per share (EPS) (Marn and Romuald 2012). One of the market-based measure is debt-to-equity.
Return On Assets (ROA) is also a measure of performance widely used in the governance literature for accounting-based measures (Kiel and Nicholson 2003; Weir and Laing 2001). It is a measure which assesses the efficiency of assets employed (Bonn, Yoshikawa and Phan 2004) and shows investors the earnings the firm has generated from its investment in capital assets (Epps and Cereola 2008). Efficient use of a firm’s assets is best reflected by its rate of return on its assets. Since managers are responsible for the operation of the business and utilization of the firm’s assets, ROA is a measure that allows users to assess how well a firm’s corporate governance system is working in securing and motivating efficiency of the firm’s management (Epps and Cereola 2008); (Heenetigala, 2011).
A study conducted by Al-Haddad et al. (2011) found that there is a direct and positive relationship between performance measured by ROA and corporate governance.
Heenetigala (2011) found that another important measure of firm performance used in corporate governance research is Return On Equity (ROE), which is also an accounting-based measure (Baysinger and Butler 1985; Dehaene et al. 2001). The primary aim of an organization’s operation is to generate profits for the benefit of the investors. Therefore, return on equity is a measure that shows investors the profit generated from the money invested by the shareholders (Epps and Cereola 2008).
The study considered by Heenetigala (2011) further provides evidence in support of a positive relationship for separate leadership, board composition, board committees and firm performance based on ROE.
Even the earnings per share (EPS) can be used as a measure of firm performance. Being an accounting-based measure it tries to indicate whether or not the firm’s earnings power on per share basis has changed over a certain period of time.
Aggarwal et al. (2008) examined the relationship between firm performance and governance scores. They found that the relationship generally was not significant between the scores and accounting- based measure of performance, whereby EPS being one of the proxy used.
Marn and Romuald 2012 investigated the relationship between corporate governance and company performance of 20 public listed companies in Malaysia. They discovered that Board Size being one of the CG variables has a significant effect on firm performance.
The net profit margin (NPM) is used as a performance indicator as it indicates a firm’s capacity to withstand adverse economic conditions and how effective it is at cost control. Normally, shareholders look at net profit margin closely because it also shows how good a firm is at converting revenue into profits available for shareholders.Â
The higher the net profit margin is, the more effective is the company at converting revenue into actual profit.
As mentioned earlier, the study conducted by Azam et al. whereby NPM was used as a proxy for measuring firm performance led to the conclusion that a firm’s performance can be increased by improving corporate governance structure.
Leverage (LR) is used as a measure of firm performance since it tries to judge the long-term financial position of a firm. It identifies the extent to which a firm uses debt in financing its assets and the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.Â
Furthermore, according to the trade-off theory of capital structure, having a higher leverage (using more debt), will increase the firm value because of the tax deductibility of interest. The debt-to-equity ratio being used as a measure of financial leverage here indicates what proportion of equity and debt the company is using to finance its assets.
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