Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 53

Impact of Corporate Governance Practices on Firm Profitability: A study of Selected

Industries in India

Puneeta Goel

Amity College of Commerce and Finance,

Amity University, Noida, India

puneetagoel@gmail.com

R S Ramesh

Post Graduate Department of Management Studies,

JSSATE, Bangalore., India

raekawadin@yahoo.com

Abstract

Good corporate governance standards are essential for the integrity of corporations, financial

institutions and markets and have a bearing on the growth and stability of the economy. The new

Companies Act is a major milestone in the corporate governance sphere in India and is likely to

have significant impact on the governance of companies in the country. In the opinion of the

Securities and Exchange Board of India (SEBI), the imperative for corporate governance lies not

merely in having a code of corporate governance, but in practicing it. This study explored the

extent of corporate governance practices being followed and reported by Indian companies in

different industries and analyzed its impact on financial performance. There is a significant

correlation between total corporate governance score and Tobin Q ratio of market valuation,

however, individual parameters of corporate governance doesnt have any significant relationship

and impact on market valuation and profitability of the companies. There in a call for evolving
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 54

corporate accountability movement in India through well framed mandatory corporate reporting

guidelines covering all aspects of social, environment and economic performance.

Key Words: Corporate Governance, Independent Directors, Code of Ethics, Whistle blower,

Financial Performance.

Introduction

Creating strong corporate governance framework encourages flexibility, innovation and risk

management. It helps to ensure that companies take care of the interest of wide range of

stakeholders for whom it operates and makes the boards more accountable (Chatterjee D, 2011).

Over the past decade, India has made significant strides in the areas of corporate governance

reforms, which have improved public trust in the market. These reforms have been well received

by the investors, including the foreign institutional investors (FIIs).

The enactment of the company bill 2012 is major development in the directions of corporate

governance. The new bill replaces the Companies Act, 1956 and aims to improve corporate

governance standards, simplify regulations and enhance the interests of minority shareholders

(Prasanna, 2013). This paper aims at analyzing the corporate governance performance of Indian

companies after the introduction of the reforms in India.

Good Governance in capital market has always been high on the agenda of Security Exchange

Board of India (SEBI). Corporate Governance is looked upon as a distinctive brand and benchmark

in the profile of Corporate Excellence. This is evident from the continuous updating of guidelines,

rules and regulations by SEBI for ensuring transparency and accountability (Sehgal and Mulraj,

2007).
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 55

Corporate governance reforms assume critical significance for developing economies like India,

which is moving towards a more transparent and accountable system of economic governance

(Sanan and Yadav, 2011). Enacting corporate reforms, however, is significantly difficult than

framing those reforms. Thus, if the governance reforms have to occur, they have to take place in

the larger context of political and legal reforms that can enable society to exercise control over

companies (Ananya M R, 2002). In the opinion of the SEBI, the imperative for corporate

governance lies not merely in having a code of corporate governance, but in practicing it. What

counts is the way in which these are put to use.

Prior studies have investigated the relationship between mechanism of corporate governance and

financial performance of the companies. Taking different mechanisms for corporate governance

like size of board, number of independent directors, ownership pattern etc, there have been a

contradicting findings about the relationship between corporate governance disclosures and

financial performance. Therefore, this study identifies different mechanisms of corporate

governance based on past literature review and then explores the relationship between different

mechanisms of corporate governance disclosures and financial performance of the companies in

Indian context.
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 56

Figure 1: Theoretical Framework

Meetings of
Board

Independent
Directors
Tobin
Risk Q
Management

Ethics Corporate Financial

Committee Governance ROS Performance

Code of Ethics
ROCE
Communication
of COE

Legal cases

Whistle blower

Review of Literature

Corporate Governance disclosures signify the extent of ethical practice followed by the companies.

A lot of research has been done in this field adopting varying methodologies and presenting the

extent of disclosure done by companies and its impact on financial performance of the companies.

According to Sanan & Yadav (2011) India has adopted a series of reforms in corporate governance.

But this has brought only a moderate change in disclosure by the Indian companies. Chatterjee D

(2011) found that the top Indian Companies are providing bare minimum information required as

per regulations and even some of them are not disclosing the mandatory requirement. Sharma and

Singh (2009) reported that voluntary disclosures have improved with the introduction a reforms
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 57

but the extent of disclosure vary among the different companies selected for the study. Kaur and

Misra (2010) found that independent directors and concentrated ownership didnt affect the

ranking of the companies but good relations with external auditors and inspectors are a motivating

factor for effective governance and monitoring.

Bhasin (2012) found that there is no significant difference in the extent and quality of disclosures

made by Indian companies in selected industries. Bhardwaj and Rao (2014) also revealed a mix of

response towards corporate governance disclosure by Indian Companies. On an average 80% of

the companies follow the provisions regulatory.

Abatecola et al (2012) found that association between specific corporate governance variables and

corporate performance variables may be conflicting but overall corporate governance has a

significant statistical relationship with corporate performance variables like ROC, ROA etc. Sarpal

& Singh (2013) have also tried to establish a relationship between board and corporate

performance and found that there is no significant relationship between the two. Gomper et al

(2003) established a positive relationship between share holders rights and value of the companies.

On the other hand, Bauer et al (2004) found a negative relationship between companies having

high corporate governance ratings and performance based on earning and returns. Bhagat & Bolton

(2008) also found that corporate governance measures are not correlated to future stock market

performance.

Klapper & love (2002) found that the markets where legal system are weak, the firms are placed

at low ranking but good governance has positive correlation with performance and valuation even

in weak emerging economies. Maher and Anderson (1999) found that corporate governance

depend on the legal and regulatory framework in different countries. Kumar J. (2004) studied the
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 58

relationship between CG and firm performance in India contest. It was found that there was no

significant relation between foreign shareholding and performance of the companies. Patibandla

(2006) had a contrasting view on foreign shareholdings in Indian companies. He found that as the

investment by foreign investor increases in Indian companies, the profitability increases and thus

has a positive correlation with corporate governance. On the other hand the investment by

government institution investors decreases the performance of the companies.

Prasana (2013) found that reforms in corporate governance and implementation of clause 49 by

SEBI have made a significant impact on volatility of stock market in India. Bae and Goyal (2010)

found that good corporate governance practice adopted by Korean firm have resulted in improved

equity markets and increased foreign ownership. Li & Yang (2012) stated that improved corporate

governance can help in reducing cost of equity. As corporate governance disclosure increases, the

cost of capital decreases. Botosan (2006) found in an extensive literature review that proper

disclosure of financial reporting and corporate governance practices help in reducing the cost of

equity capital. Misra and Vishnani (2012) are of the view that reforms and changes in corporate

governance have no significant impact on the market risk of the companies listed in Group A of

BSE. Kohli and Saha (2008) found that improvement in corporate governance practices leads to

increase in market valuations. Raithatha and Bapat (2012) reported that corporate governance

score had no significant influence on the different variable of financial performance. Annalisa and

Yosef (2011) did not find any significant relation between independent directors and earning of

the family controlled businesses. Halder et al (2013) reported that the pressure of majority

independent directors on board have a positive impact on the return on equity. But board size has

a negative correlation with ROE and EVA. Bijalwan and Madan (2013) found that following good

corporate governance practice and having transparency in disclosure has a positive impact on
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 59

financial performance of the company. Hermes and Katsigianni (2011) also observed that good

governance practice leads to improved financial performance of the companies. Subramanian and

Reddy (2012) found that the disclosure related to the board practice result in improving market

share and growth rate but the ownership related disclosures are negatively associated with market

share.

Objective of the Study

1. To study the extent of corporate governance practices being followed and reported by the

selected companies on the defined parameters.

2. To analyze the relationship between parameters of corporate governance on financial

performance.

3. To study the impact of corporate governance on financial performance.

Hypothesis

H0: There is no significant relationship between different parameters of corporate governance

and financial performance.

H1: There is a significant relationship between different parameters of corporate governance

and financial performance.

H0: There is no significant impact of different parameters of corporate governance on financial

performance.

H2: There is a significant impact of different parameters of corporate governance on financial

performance.
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 60

Sample Size

A sample of 120 companies has been taken from the list of ET 500, 2012. This study is covering

manufacturing and IT industries in India. The top 15 companies based on revenue from different

sectors of Iron and steel, IT and computers, Engineering and electrical, Auto and ancillaries,

Pharmaceuticals, Chemicals and fertilizers, Oil refineries and power and Diversified and consumer

appliances were taken for the study.

Data Collection

Data regarding corporate governance has been collected using the annual reports, sustainability

reports and business responsibility reports available at the websites of the companies. Financial

data has been collected from moneycontrol.com and prowess database for an average of three years

(2010-11 to 2012-13).

Data Analysis

To address hypothesis, an analysis of corporate governance score of each company in every

industry has been done based on eight parameters of corporate governance. The corporate

governance score was calculated for the selected companies on the basis of following parameters:

1. Number of Meetings of Board of Directors

2. Number of Independent Directors on Board

3. Risk Management

4. Compliance and Ethics Committee

5. Well defined Code of Ethics

6. Communication and Distribution of code of ethics

7. Legal cases pending against company

 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 61

8. Whistle blower policy

Item wise score of each industry is calculated for each parameter using the following formula:

Total Score of an Item of all Companies in an Industry

Industry Score for Each Item of Disclosure = ----------------------------------------------------- X 100

Maximum Score of Each Item X Number of Companies

Descriptive statistics like mean and standard deviation have been used for analysis. Correlation

analysis has been done to study the relationship between different parameters of corporate

governance and financial performance. Market valuation ratio of Tobin Q and profitability ratios

of ROS and ROCE have been taken as measures of financial performance. Regression analysis has

been applied to study the impact of corporate governance on financial performance.

Result and Analysis

Table 1: Descriptive Statistics

Std.
Minimum Maximum Mean Deviation
BOD Meetings 2.00 3.00 2.3167 .46713
Ind Directors 1.00 3.00 2.4583 .68472
Risk Management .00 1.00 .6917 .46374
Ethics Committee .00 1.00 .2000 .40168
Code of ethics .00 2.00 1.2000 .46018
Communicating Ethics 1.00 3.00 2.1083 .48152
Legal Case .00 1.00 .2500 .43483
Whistle Blower 1.00 3.00 2.0167 .92567
Source: Calculated by Author using SPSS 16

Table 1 shows the descriptive statistics of different parameters of corporate governance which

reveal that, independent directors on board and conducting more than requisite number of board
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 62

meetings has been rigorously followed by most of the selected Indian companies. It is very

encouraging to see that following the recent norms many companies have set up whistle blower

policy and communicating the ethical codes to their employees. However, Indian companies show

very poor performance on account of having separate ethics committee and on disclosing legal

cases pending against them. Risk management has not been a separate area of concern among the

functions of board of directors. Higher standard deviation on whistle blower policy signifies

difference in companies in following the norm of corporate governance.

Table 2: Spearman Correlations

Tobin Q ROS ROCE
Total Corporate Governance
0.205 0.133 0.085
Score
0.025 0.146 0.354
CG1 Number of Board meeting -0.135 -0.078 -0.099
0.143 0.398 0.282
CG2 Number of Independent Directors 0.072 0.092 0.027
0.434 0.318 0.766
CG3 Risk Management 0.212 -0.013 0.137
0.021 0.885 0.136
CG4 Ethics Committee 0.049 0.128 0.000
0.594 0.163 0.997
CG5 Code of Ethics 0.172 0.070 -0.034
0.062 0.449 0.715
CG6 Communication of Code of Ethics 0.208 0.012 -0.013
0.023 0.896 0.885
CG7 Legal cases Pending 0.148 0.233 0.127
0.108 0.011 0.167
CG8 Whistle Blower Policy 0.125 0.080 0.052
0.175 0.385 0.574

Table 2 describes the relationship between different parameters of corporate governance and

profitability. It has been observed that there is no significant relation between the individual

parameters of corporate governance and variables of financial performance. However, the total

score of corporate governance has a significant correlation with only the market valuation measure
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 63

of Tobin Q where the p-value 0.025 is less than significant level of 0.05. In all other cases the

significant value is more than 0.05 and thus we can accept the null hypothesis 2 that there is no

significant correlation between different parameters of corporate governance and financial

performance of the companies.

Table 3: Regression Model Summary

R R F Sig.
Square
Tobin
0.345264 0.119207 1.860935 0.073404
Q
ROS 0.250734 0.062868 0.930805 0.494193
ROCE 0.266928 0.071251 1.064446 0.393232

Table 4: Regression Coefficients

(Constant) CG1 CG2 CG3 CG4 CG5 CG6 CG7 CG8
Standardized
Coefficients -0.232 -0.046 0.165 -0.048 0.036 0.101 0.204 -0.078

Tobin T 1.781 -2.419 -0.502 1.709 -0.465 0.225 0.645 2.099 -0.738
Q Sig. 0.078 0.017 0.617 0.090 0.643 0.822 0.520 0.038 0.462
Standardized
Coefficients -0.082 0.102 0.113 0.123 0.029 -0.138 0.146 -0.109
T 1.737 -0.836 1.082 1.143 1.150 0.177 -0.862 1.462 -1.004
ROS Sig. 0.085 0.405 0.282 0.256 0.252 0.860 0.391 0.147 0.318
Standardized
Coefficients -0.122 0.056 0.184 -0.074 -0.010 0.034 0.174 0.015
T 1.666 -1.243 0.594 1.867 -0.693 -0.062 0.214 1.752 0.138
ROCE Sig. 0.099 0.217 0.554 0.064 0.490 0.951 0.831 0.082 0.890

Table 3 and 4 show the results of regression analysis for the impact of independent variables of

corporate governance on the dependent variables of financial performance. The analysis clearly

illustrate that there is no significant impact of parameters of corporate governance on market

valuation ratio of Tobin Q and even on profitability ratios of ROS and ROCE as the significant

pvalue in all cases is more than 0.05. Thus the null hypothesis 3 is accepted that there is no

significant impact of corporate governance practices on financial performance of the companies.

 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 64

Discussion

The result of the extent of disclosures reveal that refineries and power sector along with I T and

pharmaceutical sector have done maximum disclosure on corporate governance. The result are

consistent with Sharma and Singh (2009) and Bhasin M. (2012) as they have also concluded that

I T Sector has maximum disclosure of corporate governance in India and the degree of disclosure

differs from company to company in different sectors (Chatterjee D, 2011). Since the mean score

of all the industries is nearly 50% - 60% only, the results are consistent with Reddy D M (2013),

Sanan and Yadav (2011) where in they have also found that disclosure have improved after

implementation of corporate governance reforms and clause 49 but most of the Indian companies

are not able to maintain average performance level in disclosure of corporate governance practice.

The presence of risk management, whistle blower policy and ethics committee as special functions

of boards, Indian Companies still have a long way to go to achieve excellence in corporate

governance (Shukla, 2009). Although the code of ethics is defined by every company in its own

way but a comprehensive code of ethics should be made mandatory for better transparency and

sustainable business (NRHC, 2012). Moreover, it has been observed that most of the companies

are disclosing the positive aspect of performance as the number of law cases pending against the

companies have been reported by only approx. 25% of the companies under study.

In consistent with the results of study by Klapper and Love, 2002, Mohanty P., 2003; Bauer et at,

2004, Kumar Jayesh, 2004, there was a positive correlation between corporate governance and

market valuation measurement through Tobin Q ratio. However, only a moderate or low impact of

corporate governance was observed on profitability measures of corporate performance. This study

confirms that good corporate governance offers better market valuations and returns as compared

to the companies with bad corporate governance (Cheung et al, 2010).

 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 65

The results are consistent with Sarpal and Singh, 2013, Tata and Sharma, 2012, Annalisa and Yosef

(2011), where the individual parameters of corporate governance have no significant relation with

financial performance. The results of the study show very weak impact of corporate governance

on market valuation. Misra & Vishnavi (2012) also confirm that regulations on corporate

governance have not been able to provide any significant benefit to the investors by way of

reducing market risk or increasing returns. However, the results of this study are inconsistent with

Bae and Goyal (2010), Li and Yang (2012) Botoson (2006) where they have reported that good

corporate governance improves equity market and reduces cost of capital.

The present study is a further enhancement of the study done by Abatecola et al, 2012 where they

have studied the impact of individual attributes of corporate governance on market and profitability

variables. As called by them, this study tries to study the overall impact of corporate governance

and results indicate that although there is a positive and moderate correlation between corporate

governance and market valuation indicator Tobin Q ratio but it was observed that there was no

significant correlation between corporate governance and profitability variables of ROS and

ROCE.

Findings and Conclusion

Most of the companies are conducting more than four meetings of the board of directors every

year and are having requisite number of independent directors on the board. The study found that

risk management is not an integral part of the functions of the board of directors. Very few

companies have a separate ethics committee for taking care of the ethical implication of its

operations. Most of the companies have developed a code of ethics as it is mandatory by SEBI but

only some companies have developed a detailed code of ethics for all levels of management and
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 66

operations. Code of ethics is being communicated to the employees through their website by most

of the companies. It was found that most of the companies have not reported the law suit pending

against them. This implies that companies are trying to report only the positive aspects of their

operations but are concealing the negative aspects from the investors and general public. Although

it has been made mandatory by SEBI to have a whistle blower policy, it was found that only 60%-

70% of the companies have made a separate whistle blower policy for their organization. Over all

corporate governance score of different industries lies between 60% to70% which implies that

there is lot of scope of improvement and strict compliance with regulations and norms is required.

There is a positive impact of corporate governance practices on market valuation and profitability

although the relationship may not be very strong and significant in all cases. Tshe future study on

the impact of improvement in corporate governance practices and disclosures over the period of

time may highlight its impact on improved financial performance.

India has proactively initiated corporate governance norms but the biggest challenge ahead is its

enforcement and implementation in true sense. The results of the study clearly indicate that most

of the companies have started following the provision of clause 49 and other mandatory provision

of company law act, 2013; however, this is restricted to only top few companies in each sector.

The performance in disclosing and following the corporate governance norms is very poor for rest

of the companies.

This study recommends that market regulators should be made more powerful and given a free

hand to prosecute the companies involved in frauds and high penalties should be imposed for not

following the mandatory requirements on time. Different functional committees of the board of

directors like ethics committee, audit committee, remuneration committee, investor protection

committee etc and also well defined whistle blower policy can play an effective role in ensuring
 Journal of Finance, Accounting and Management, 7(2), 53-74, July 2016 67

good corporate governance. There in a call for evolving corporate accountability movement in

India through well framed mandatory corporate reporting covering all aspects of social,

environment and economic performance. Moreover the corporate needs to understand the

implications of implementing good governance strategies and the actions that would help in

improving financial performance as well.

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