The Effects of Corporate Governance on Firm Performance

Ming-Cheng Wu
Department of Business Education, National Changhua University of Education No. 1, Jin-De Road, Changhua 500, Taiwan, R.O.C. mcwu@cc.ncue.edu.tw

Hsin-Chiang Lin
Department of Business Education, National Changhua University of Education No. 1, Jin-De Road, Changhua 500, Taiwan, R.O.C. octopusdevilfish@msn.com

I-Cheng Lin
Department of Business Education, National Changhua University of Education No. 1, Jin-De Road, Changhua 500, Taiwan, R.O.C. finicl@yahoo.com.tw

Chun-Feng Lai
Department of Business Education, National Changhua University of Education No. 1, Jin-De Road, Changhua 500, Taiwan, R.O.C. m97322002@hotmail.com

ABSTRACT
The main purpose of this study is to examine the impact of the corporate governance mechanism on firm performance. The variables, employed in this study to measure firm performance, include return on assets, stock return and Tobins Q. The empirical results indicate that firm performance is in negative and significant relation to board size, CEO duality, stock pledge ratio and deviation between voting right and cash flow right. On the other hand, firm performance is in positive and significant relation to board independence and insider ownership. Keywords: board structure, ownership structure, firm performance

Field of ResearchFinance

I. INTRODUCTION
Since 2001, Enron Xerox, WorldCom had been caught of getting involved in accounting scandals, which leads to the credibility of corporate financial reports under suspicion, furthermore, shocking investors confidence. Consequently, corporate governance mechanism has been a crucial issue discussed again. Sarbanes-Oxley Act was enacted in 2002 to enhance corporate government mechanism which is viewed as the priority of financial revolution, in the expectation that governance mechanism may be reinforced, public confidence retrieved, accuracy and reliability of financial information assured. This research conducts empirical analysis to examine the effect of corporate governance mechanism upon firm performance among listed and over-the-counter firms in Taiwan. The ownership of the listed and OTC firms in Taiwan is most held by controlling shareholders; accordingly, this paper considers the degree of deviance of shareholders ownership as well. The purpose of this research is to examine the impact of corporate governance mechanism upon corporate performance.

II. LITERATURE A. The Impact of Corporate Governance on Firm Performance

The World Bank, in 1999, states that corporate governance comprises two mechanisms, internal and external corporate governance. Internal corporate governance, giving priority to shareholders interest, operates on the board of directors to monitor top management. On the other hand, external corporate governance monitors and controls managers behaviors by means of external regulations and force, in which many parties involved, such as suppliers, debtors (stakeholders), accountants, lawyers, providers of credit ratings and investment bank (professional institutions).

a) Board Structure
Veliyath (1999) pinpoints that the board serves as a bridge between owners and managers; its duty is to protect shareholders interests. Specifically speaking, taking responsibility for managing and supervising, the board should monitor managers behaviors for shareholders interests, make important decisions, employ management team and superintend firms to obey the law. Jensen (1993) finds out that directors in a large board have diverse opinions and

consensus is difficult to reach, then the efficiency being lower, the situation could deteriorate if directors increaseLipton and Lorsch, 1992. Yermack (1996), Eisenberg, Sundgren and Wells (1998) and Singh and Davidson (2003) unveil that board size is negatively related to corporate performance. Nevertheless, Bacon (1973) holds an opposite opinion that larger board implies members with diverse background and viewpoints, which is helpful for the quality of decisions; additionally, a wide range of their interests may neutralize decisions. Also, Zahra and Pearce (1989) and Kiel and Nicholson (2003) reveal board size is positively related to corporate performance. A board includes internal and external directors. Fama and Jensen (1983) detect that internal directors, by virtue of their positions, possess much more information, are likely to collude with managers and make decisions against shareholders. By comparison, external directors in neutral position, acting as supervisor, are good for eliminating principal-agency problem. Beasley (1996) investigates the relation between board composition and financial scandals, revealing that the ratio of independent directors in the firms with no scandals is higher than the firms which have been caught manipulating financial reports. Bhagat and Black (2002) take the ratio of independent directors minus the ratio of inside directors as a proxy, and the result discloses that board independence, significantly and negatively, correlates with short-term performance, but board independence makes no difference in improving corporate performance. According to Agency Theory, when a chairman assume the role of CEO, namely acting as decision maker and supervisor at the same time, the function of the board to minimize agency cost could be weaken tremendously; in the end, corporate performance goes down.Jensen and Meckling, 1976Fama and Jensen, 1983 Patton and Baker, 1987Empirical studies by Daliy and Dalton (1993) and Dahya, Lonie and Power (1996) unveil that CEO duality could bring about negative effects for corporate performance. Nevertheless, according to stewardship theory, executives responsibility may neutralize self-interest behaviors derived from CEO duality, and they are even much more devoted to advance corporate performance. Boyd (1995) agrees to that CEO duality brings in positive effects for corporate performance.

b) Ownership Structure
Berle and Means (1932) set forth that ownership dispersion implies management is distinguished from ownership, which, as Jensen and Meckling (1976) emphasize, may contribute to agency problems between managers and shareholders or

shareholders and debtors. On the other hand, Shleifer and Vishny (1986) and Morck, Shleifer and Vishny (1988) detect the phenomenon of ownership concentration. La Porta et al. (1999) and Claessens et al. (2000) usher in the conception of ultimate controller; they define firm ownership as voting rights, unearthing that many controlling shareholders of listed firms predominate firms by means of pyramid structure and cross holding, which could result in central agency problem. Kao, Chiou and Chen (2004) reveal that firms in financial distress are closely related to high ratio of the shares pledged by directors, causing concern about the agency problem resulting from the pledge of corporation shares. Chiou, Hsiung and Kao (2002) indicate that, directors and supervisors could fund by the collateralized shares and further purchase more firm stocks to manipulate stock price or enhance their power. Directors and supervisors financial stress, because of the collateralized shares, is closely related to share price. Share price slumping, the value of the collateralized shares depreciates and even drops below the standard of the required margin; correspondingly, collateralizing shareholders will be requested to collateralize more shares, while debtors fail to afford more shares as collaterals, financial institutions as creditors will close the position of collateralized shares. As a result, collateralizing shareholders, making use of their position, may make a prey of small shareholders or embezzle company funds.

III. METHODOLOGY A. Hypotheses

a) Board Size
Boards of directors may have a difficulty communicating with each other in a large size board, which causes great detriment to firm performance. Yermack (1996), Eisenberg et al. (1998) and Singh and Davidson (2003) prove that board size has a negative relation with firm performance. Based on the statement abovementioned, this paper proposes the hypotheses as follows. H1Board size is negatively related to firm performance.

b) Board Independence
As for the relation between board independence and firm performance, if outside directors are independent and have professional ability, they could be more objective to make decisions and monitor managers. Empirical research by Weisbach (1988),

Rosenstein and Wyatt (1997) and Huson et al. (2001) corroborate that the higher ratio of independent directors accounts for boards, the better firm performance could be. H2Board independence is negatively related to firm performance.

c) CEO Duality
As the chairman serves as the executive, playing roles of decision-maker and supervisor simultaneously, the board could lose its independence and monitoring power, consequencely performing a weak function as a bulwark against agency problems. Daliy and Dalton (1993), Dahya et al. (1996) attest to that CEO duality seems to deteriorate firm performance. In light of the statement abovementioned, this paper proposes the hypotheses as follows. H3CEO duality is negatively related to firm performance.

d) Insider Ownership
About firm performance, according to convergence of interest hypothesis, higher insider ownership could reconcile managers and outside shareholders interests, which would lessen agency problems. Empirical results by Kesner (1987), Oswald and Jahera (1991), Eng and Mak (2003) bear evidence of that insider ownership has a positive relation with firm performance. On the basis of the statement above, this paper proposes the hypotheses as follows. H4Insider ownership is negatively related to firm performance.

e) Stock Pledge Ratio

As to firm performance, Chiou et al. (2002) discover that the proportion of shares collateralized by board of directors is high, directors may distract from operating business because the fluctuation of stock price is closely related to their finance, leading to poor firm performance. Yeh and Lee (2002) back up that the higher ratio of collateralized shares, the worse firm performance could be. In terms of the statement above, this paper proposes the hypotheses as follows. H5Stock pledge ratio is negatively related to firm performance.

f) Deviation between Voting Right and Cash Flow Right

In terms of firm performance, when ownership is highly concentrated, controlling shareholders may make use of their vantage to benefit themselves, for example, transferring profits to other firms totally controlled by them. La Porta et al. (2002),

Claessen et al. (2002), and Cronqvist and Nilsson (2003) detect that when the deviation between controlling shareholders voting rights exceed cash flow rights is larger, they may have more incentives to misappropriate firm assets, which would not only damage small shareholders interests but also debase firm value. Based on the statement represented above, this paper proposes the hypotheses as follows. H6Deviation between voting right and cash flow right is negatively related to firm performance.

B. MODEL
According the hypotheses proposed above, this study constructs a regression model for carrying out empirical analysis. Model The relation between governance mechanism and firm performance
Performanceit = a0 + a1 Board sizeit + a2 Independentit + a3 Dualityit + a4 Insider ownershipit + a5 Pledgeit + a6 Control minus ownershipit + a7 Firm sizeit + a8 R & Dit + a9 Capital expenditureit + a10 Leverageit + it

where
Performanceit

is the return of assets, the return of stocks and Tobins Q of firm i in year

t
Board sizeit is the board size of firm i in year t

Independentit is the ratio of independent directors and supervisors of firm i in year t

is a dummy variable for CEO duality of firm i in year t Insider ownershipit is the ratio of insider ownership of firm i in year t Pledgeit is stock pledge ratio of firm i in year t
Dualityit

Control minus ownershipit

is the deviation between voting right and cash flow right of firm

i in year t. is the size of firm i in year t R & Dit is the expenditure of research and development of firm i in year t Capital expenditureit is the capital expenditure of firm i in year t Leverageit is the leverage ratio of firm i in year t
Firm sizeit

C. Sampling
This study, excluding banking, finance and insurance industries, examines all the other listed and over-the-counter firms in Taiwan over the period from 2001 to 2008. Incomplete information disclosure and cross-sectional data are omitted.

D. Procedure
The characteristic of the sample is cross-sectional and of time series, therefore panel data model being employed to analyze data to eliminate the autocorrelation of variables in time series and heteroskedasticity of individuals in cross section. Panel data are of two regression models, fixed effect model and random effect model, respectively.

IV. RESULTS A. Descriptive Statistic

This study takes ROA, stock return and Tobins Q as the proxies to measure accounting performance, market performance and firm value, respectively. Table 1 shows that the average of return of assets is 7.451%, the average of annual stock return is 10.214%. The average of Tobins Q is 1.298.

Table 1 Descriptive statistic

Variable ROA (%) Stock return (%) Tobins Q Board size Independent Duality Insider ownership (%) Pledge (%) Firm size R&D Capital expenditure Leverage (%) N Mean Std. dev. Min 10.876 0.766 0.168 0.155 0.464 Median Max 55.190 821.428 11.951 2.214 0.750 1.000 95.330 100.000 74.680 20.290 0.641 22.027 111.510

7130 7.451 7130 1.298 7130 0.624 7130 0.114 7130 0.313

-91.210 7.110 -94.279 -0.421 0.280 0.191 0.000 0.000 0.190 0.000 0.000 11.553 0.000 0.000 1.460 1.083 0.606 0.000 0.000 23.280 0.000 1.240 15.023 0.009 0.017 39.100

7130 10.214 64.300

7130 25.984 13.959 7130 10.183 19.183 9.237 0.033 0.397 7130 15.187 1.310 7130 0.020 7130 0.067

Control minus ownership (%) 7130 5.264

7130 39.458 17.148

B. Correlation Coefficient Analysis

Table 2 demonstrates the variables of the matrix of Pearson correlation coefficient. ROAt 1 and ROAt 2 are significantly related because of the same variable measured in different periods. The absolute value of the correlation coefficient of other variables is between 0.001 and 0.414, showing no significant relation.

Table 2
variable 1.Board size

Pearson Correlation coefficient matrix

1 1 0.046** -0.125** 0.138** 2 0.046 1 0.048** 0.049**
**

3 -0.125 1 -0.056**
**

4 0.138
**

5 -0.077
**

6 0.117
**

7 -0.024
*

8 -0.030
*

9 0.001 0.013 0.017

10 -0.090
**

11 0.023
*

12 0.039** 0.292** 0.110**

2.Independent 3.Duality 4.Insider ownership 5.Pledge 6.Control minus ownership 7.Firm size 8.R&D 9.Capital expenditure 10.Leverage 11.ROAt-1 12.ROAt-2

0.048**

0.049** 1

-0.199** -0.147** 1 -0.039**

0.025* 0.414** -0.039** 1

-0.207** -0.158** 0.227** 0.133**

0.265** 0.053** -0.015

-0.014 -0.082** -0.009 -0.037** 0.175**

0.249** 0.104**

-0.056** -0.043** -0.153** -0.145**

-0.045** -0.045**

-0.077** -0.199** -0.043** -0.147** 0.117** 0.025* -0.153** 0.414**

-0.118** 0.026* 0.074**

-0.133** -0.150** 0.042** 0.036**

-0.002 -0.034**

-0.024* -0.030* 0.001

-0.207** -0.145** -0.158** 0.265** -0.014 0.053** 0.013 -0.009 -0.045** -0.045** -0.015 0.017 -0.037** 0.104** 0.110**

0.227** -0.118** 0.026* 0.175** -0.133** -0.150**

0.133** 0.074** -0.002 -0.034** 0.042** 0.036**

1 -0.214** 0.018 0.099** 0.149** 0.105**

-0.214** 1 -0.018

0.018 1

0.099** -0.014 1

0.149** 0.072** -0.010

0.105** 0.128** -0.009

-0.018 -0.206**

-0.090** -0.082** 0.023* 0.039** 0.249** 0.292**

-0.206** -0.014 0.072** 0.128**

-0.317** -0.291** 1 0.737** 0.737** 1

-0.010 -0.317** -0.009 -0.291**

C. The Correlation Between Corporate Governance and Firm Performance

Table 3 illustrates the empirical results regarding the correlation between corporate governance mechanism and firm performance. In the first column, ROA is a dependent variable to measure financial performance, stock return in the second column to measure market performance, and Tobins Q in the third column to measure firm value. The explanative ability of three empirical models is 0.248, 0.204, and 0.218, respectively. To sum up, in terms of board structure, 1. board size is negatively and significantly related to ROA, stock return and Tobins Q; 2. Board independence is positively and significantly related to ROA and Tobins Q; 3. CEO Duality is negatively and significantly related to ROA. Hypotheses 1a, 2a and 3a are confirmed; that is, board size and CEO duality are in negative relation to corporate performance, however, board independence is in positive relation to corporate performance. As for ownership structure, 1. insider ownership is positively and significantly related to ROA and Tobins Q; 2. Stock pledge ratio is negatively and significantly related to ROA and Tobins Q. 3. Deviation between voting right and cash flow right is negatively and significantly related to ROA and Tobins Q. Hypotheses 4a, 5a and 6a are supported; namely, insider ownership is in positive relation to corporate performance, whereas stock pledge ratio and deviation between voting right and cash flow right are in negative relation to corporate performance.

Table 3 The relation between governance mechanism and corporate performance

Dependent variable Independent variable Intercept ROA Predicted sign (1) 22.0294*** ( 0.000 ) 2.5932*** ( 0.000 ) 14.0590*** ( 0.000 ) 0.7148*** ( 0.004 ) 0.1158*** ( 0.000 ) 0.0391*** ( 0.000 ) 0.0817*** ( 0.000 ) 2.3708 ( 0.000 ) 25.5477*** ( 0.000 ) 0.3902 ( 0.168 ) 0.2218*** ( 0.000 ) Industry Year 7130 0.248
***

Stock return (2) 34.2821*** ( 0.001 ) 12.0933*** ( 0.005 ) 2.5872 ( 0.610 ) 0.3103 ( 0.839 )

Tobins Q (3) 0.0965 ( 0.433 ) 0.1272** ( 0.013 ) 0.6159*** ( 0.000 )

Board size

Independent

Duality

Insider ownership Pledge

0.0081 ( 0.651 ) 0.0341 0.0041*** (0.000) ( 0.555 ) 0.0418 ( 0.276 ) 0.0023*** ( 0.000 ) 0.0028*** ( 0.005 ) 0.0771*** ( 0.000 ) 4.7590*** ( 0.000 ) 0.0087 ( 0.668 ) 0.0059*** ( 0.000 ) Industry Year 7130 0.218

Control minus ownership Firm size

0.1237 ( 0.149 ) 0.6346 ( 0.258 ) 23.8172 ( 0.306 ) 1.6343 ( 0.342 ) 0.2336*** ( 0.000 ) Industry Year 7130 0.204

R&D

Capital expenditure Leverage

Fixed effect Fixed effect Sample size Adjusted R2

V. CONCLUSION, LIMITATION AND SUGGESTION

In respect of board structure, board size is significantly and negatively related to firm performance, implying that, in a large size board, the diversity of insiders opinion has a negative impact on making decisions, which is detrimental to firm performance. Nevertheless, board independence is positively and significantly related to firm performance, suggesting that the more independent the board is, the better firm performance would be. On the other hand, CEO duality is negatively and significantly related to firm performance, inferring that, under the condition that CEOs serve as executives, the board would likely fail to be an objective supervisor, correspondingly putting firms at a disadvantage. Concerning ownership structure, insider ownership has a positive and significant relation with firm performance, suggesting that higher insider ownership may reconcile authorities and outside shareholders interests, consequently making firm performance better. The ratio of stock pledged by directors and supervisors is negatively related to firm performance, implying that the higher ratio of pledged stock, the closer relation between directors individual finance and stock price would be; therefore, directors could benefit themselves at the sacrifice of small shareholders interest, resulting in poor firm performance. The deviation between voting right and cash flow right is negatively and significantly related to firm performance, implying that the larger gap between voting rights and cash flow rights, the more incentives controlling shareholders could have; thus they may embezzle firm asset, causing damage to small shareholders interest and deteriorating firm performance.

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