Impact of Corporate Governance Mechanisms on Financial Performance

Introduction

After every financial crisis, academicians, regulators and governments often redirect their focus on corporate governance in order to regain the confidence of investigators (Aglietta & Rebérioux 2005). This is because Corporate Governance (CG) has been established to be an effective framework that can be used in promoting efficient and transparent markets (Agrawal & Knoeber 2012; Ammann, Oesch & Schmid 2011). CG outlines the rights and responsibilities of the firm’s stakeholders. In addition, CG describes the processes and structure used in guiding the business of a corporation (Baker & Anderson 2010). In this literature view, empirical and theoretical studies regarding the relationship between CG and firm performance are reviewed. First, a definition of CG is provided before delving deep into the relationship between various CG mechanisms and financial performance of the firms.

Defining CG

CG first came into prominence during the 1970s in the US (Ammann, Oesch & Schmid 2011). Following the fall of major corporations like Enron and Arthur Andersen in the US and Marconi in the UK, CG increasingly became an important aspect of corporate management. Consequently, organizations started paying attention to issues associated with CG (Clarke & Rama 2006). This is because the fall of these major corporations was attributed to unethical business practices. There is widespread consensus that ethical business practices play an important role in the firm performance (Berger 2005; Masulis, Wang & Xie 2012; Yasser, Entebang & Mansor 2011). As a result, companies embracing and demonstrating ethical conduct are likely to be more successful than companies with unethical conduct (Berger 2005). To this end, CG has been identified as one of the mechanisms through which ethical business practices in corporations can be fostered.

There are numerous descriptions of CG in literature. Aglietta and Rebérioux (2005) perceived CG as a framework for articulating the responsibilities and rights of stakeholders in a corporation. In light of this view, Aglietta and Rebérioux argue that CG has the primary objective of promoting efficient and transparent markets as well as clearly outlining the responsibilities of the enforcement, regulatory and supervisory agencies. Another definition of CG was provided by Jill (2007), who perceived CG as structures and processes used in the process of guiding the business activities of a firm. In this respect, CG has the main objective of enhancing the value of shareholders (Jill 2007). Effective CG mechanisms help in ensuring that power is divided appropriately among the firm’s shareholders, the management and the board of directors. As Jill explains, CG extends beyond corporate management to ensure a fair, efficient and transparent administration in order to achieve particular well-defined goals and objectives. CG has also been likened to a system used in structuring, operating and controlling a corporation in order to achieve its long-term strategic goals related to satisfying the needs of various stakeholders such as customers, suppliers, creditors, shareholders and employees among others (Carcello et al. 2011). CG is also used in ensuring the firm’s compliance with the legal and regulatory requirements (Nicolăescu 2012).

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CG has also been defined as the degree to which corporations are run with respect to transparency and honesty (Mallin 2011). In this respect, the spirit of CG is in promoting responsibility and transparency as well as fulfilling the stakeholders’ expectations. Moreover, CG has been identified as a tool that can be used in safeguarding the interests and needs of the various stakeholders of a firm (Mallin 2011). This involves ensuring legal compliance in both, paper and spirit, as well as exhibiting ethical business conduct. The CG framework advocates for the use of resources efficiently and accountability as regards the stewardship of the corporation’s resources (Holton & Glyn 2006). From this perspective, the three important components of CG include the firm’s management, its board of directors and shareholders (Holton & Glyn 2006). CG has also been perceived to comprise of a set of relationships existing between the company’s management, its board of directors, shareholders and stakeholders (Calder 2008). Apart from that, CG provides a framework for setting and achieving the company goals and objectives as well as monitoring the firm’s performance (Hajiha & Rafiee 2011). Good CG ought to offer appropriate incentives to the management and the board of directors to focus on objectives that are consistent with the shareholders’ and the company’s interests (Masulis, Wang & Xie 2012).

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CG functions at two levels, which include internal and external CG (Baker & Anderson 2010). Internal CG focuses on the interests of internal stakeholders; as a result, its efforts are directed towards ensuring that the board of directors monitors the company’s top management. Internal CG factors emphasize on the effectiveness of the interaction between the management of the company, its board, shareholders and other internal stakeholders (Berger 2005). For Ammann, Oesch and Schmid, good CG is not an end in itself, rather, it helps in enhancing the firm’s capacity to define and achieve its goals and objectives. It is imperative for the board to reach a consensus regarding the company’s values (what it stands for) as well as the strategy adopted to achieve the firm’s purpose (Berger 2005). Through internal CG, the company is accountable to its shareholder and responsible with respect to its relations with other stakeholders (Clarke & Rama 2006). On the other hand, external CG focuses on controlling and monitoring the behaviour of the management using external influence and regulations that involve external parties like suppliers, regulatory agencies, debtors and auditors among others (Masulis, Wang & Xie 2012). External CG factors have been acknowledged to play a crucial role in fostering good CG. According to Peni and Vähämaa, (2012), the external CG environment comprises of the takeover mechanisms together with the laws and regulations that spell out the shareholders and stakeholders tights. Good external CG also involves proper oversight by the government or any other regulatory agencies, which provide shareholders with the power to hold the management accountable (Peni & Vähämaa 2012). In addition, this accountability from the management is further reinforced by the nature of capital markets. For instance, when the corporation is not performing as expected, investors are more likely to discount the value of the company’s shares and in some cases, the company can be taken over for re-organization to ensure that it produces satisfactory returns for the shareholders (Peni & Vähämaa 2012). Apart from that, accounting standards dictate the manner in which financial reporting ought to be done with respect to accuracy and timely, which investors can use to ensure that the board and the management are accountable for their actions (Baker & Anderson 2010).

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CG Components

Before delving into the relationship between CG and financial performance of firms, it is imperative to discuss the various components of CG. The CG components that have been identified in literature include board size, board independence, CEO duality, financial knowledge of the directors, frequency of board meetings, external auditors, and board committees including the audit committee (AC), the remuneration committee and the nomination committee (Daily & Dalton 2015; Eesley & Lenox 2006). The board size is perceived to play a crucial role in influencing the performance of the corporation. With respect to board independence from the management, there is a widespread consensus that independent directors are needed to perform the role of an advisor and to monitor the firm’s management (Daily & Dalton 2015). CEO duality is concerned with separation of the board chair and the Chief Executive officer (CEO). In case when the roles of the board chair and CEO are given to the same person, cases of lessened board independence, power concentration, and conflicts of interests are likely to take place (Masulis, Wang & Xie 2012; Velnampy 2013). The frequency of board meetings is also an important aspect of CG in the sense that infrequent meetings serve as an indicator of disinterest from the board whereas very frequent board meetings may be a sign of problems in the company (Hajiha & Rafiee 2011). Regarding external auditors, they should be sufficiently independent and competent in order to be able to spot and report cases of fraud and corporate misreporting (Agrawal & Knoeber 2012). Concurrent provision of non-audit and audit services has been reported to have an effect on audit effectiveness (Khatab et al. 2011). In addition, the audit fees have also been found to influence the efficacy of the audit process (Baker & Anderson 2010). The financial knowledge of the directors is also important since it enables them to have a better understanding of the consequences of the decisions made by the company’s management, which in turn, results in effective and improved controlling (Fernando 2009). Board committees also play an important role in enhancing the effectiveness of the board control over the decisions reached by the management. They include the audit committee, which is tasked with ensuring that corporate reports are credible; the remuneration committee, which is tasked with setting the remuneration for top management; and the nomination committee which has the responsibility of assessing the expertise, knowledge and skills required for directors (Fernando 2009).

Impact of CG Mechanisms on Financial Performance

Various studies have investigated the link between CG instruments and the fiscal performance of the firms. Some of the CG mechanisms that have been empirically studied include CEO duality, board independence, structure of the firm’s ownership, AC and audit effectiveness, and board size among others. In line with the purpose of this study, the current literature review places more emphasis on the effect of the audit committee and board characteristics on financial performance. Other CG mechanisms will also be discussed.

Audit Committees

The AC has been identified as one of the most important board committees because of its unique role associated with safeguarding shareholders’ interest with respect to overseeing and controlling financial operations (Ammann, Oesch & Schmid 2011). The AC has the main role of supervising the financial reporting process, evaluating the company’s financial reports, controlling internal accounts, conducting auditing processes and risk management (Kumar & Singh 2012). As a result, independent AC is perceived as best suited to act in the interest of the public. In most countries, it is a legal requirement for S&P 300 firms to have an independent AC that has a minimum of three independent directors (Gupta & Sharma 2014). The adoption of better CG practices, like having an independent AC helps to monitor the management and lessens problems associated with information asymmetry. Numerous studies have established a link between board characteristics, board size and independence to financial performance and firm value (Ammann, Oesch & Schmid 2011; Carcello et al. 2011; Nicolăescu 2012). Higher board and AC independence have been reported to have a positive impact on the firm value (Ammann, Oesch & Schmid 2011). The conventional view is that the degree to which the AC is independent is related to the effective monitoring of the corporate reporting. On the contrary, some studies have reported findings suggesting that minimal board independence helps in enhancing the quality of the monitoring process (Carcello et al. 2011). In cases where the AC comprises of a majority of ex-employees and past associates (grey directors), there is the possibility of the auditor failing to reveal issues of going-concern. Other empirical studies have suggested that smaller AC are linked to higher quality of financial reporting when compared to larger ACs(Huang & Thiruvadi 2010).

Studies have been conducted exploring the relationship between AC characteristics such as AC size, percent of AC members that are autonomous, level of education of the members in the AC, and their experience among others, and firm performance. Regulators are increasingly demanding additional requirements with respect to the composition and the financial know-how of board and AC members. In addition, regulators are emphasizing on board and AC independence (Huang & Thiruvadi 2010; Khatab et al. 2011). The regulatory focus on AC independence and financial expertise of AC members are a clear indication that a good CG should have effective AC as well as an independent board. There is an empirical support for the regulatory emphasis on CG to improve financial reporting reliability. For instance, Huang and Thiruvadi (2010) reported that managers are increasingly forgoing long-term value at the cost of smooth revenue, which affirms managers’ active involvement in revenue management, and this is likely to have a negative impact on the quality of corporate financial reporting. In another study, Hajiha & Rafiee (2011) reported that having an AC does not have an impact on the possibility of fraud; however, a higher level of independence among the board reduces the possibility of fraud. Other studies have reported an inverse relationship existing between the size of the AC and the quality of financial reporting, that is, a smaller size of AC results in a higher quality of financial reporting (Nicolăescu 2012; Yasser, Entebang & Mansor 2011). Moreover, it has been reported that an independent AC meeting not less than two times annually reduces the chance that the company will be linked to fraud and financial misreporting (Mallin 2011).

Regulators are also stressing on the addition of experienced members in the AC. Studies have shown that including financial experts and members who have financial literacy has a positive impact on the quality of corporate financial reporting, which in turn increases the firm’s value (Masulis, Wang & Xie 2012). AC independence has been established to result in higher firm value (Fernando 2009). A higher quality of financial reporting has been found to have a positive effect on the firm performance, when measured using the significant changes in earnings before and following the establishment of an AC (Huang & Thiruvadi 2010). Agrawal and Knoeber, (2012) found out that the establishment of an AC resulted in a significantly higher earnings than before the establishment of the AC, suggesting that AC improves the firm’s financial performance through restricting the capacity of managers to smooth the company’s earnings.

Independence is usually considered as the most crucial feature of AC and the board; nevertheless, there are inconsistent findings regarding the link between AC, board independence and financial performance. For instance, Clarke & Rama (2006) reported that no relationship exists between the firm performance and the percentage of outsider board members. On the contrary, findings by Kumar and Singh (2012) suggested that including an outsider board member is likely to have a positive effect on the firm performance and shareholder returns; nevertheless, the researcher reported that no significant relationship exists between the firm performance and the independence of the board. Holton and Glyn (2006) documented evidence supporting the view that having independent and expert board and AC members has a positive effect on the firm value. This was also supported by Masulis, Wang, & Xie (2012), who revealed that including outsiders in the board tends to increase stock returns.

Internal Audit Characteristics

The internal audit department plays a crucial role in a company whereby internal audit is considered to be a core aspect regarding the accounting systems application. Internal audit has been identified as the backbone of book-keeping since it documents all financial aspects of the business. The internal audit efficiency determines the quality of the internal audit department. Moreover, internal audit influences the integrity, accuracy and reliability of operational as well as financial information produced by various units within the organization. Internal audit ought to be independent to be deemed effective (Abbott, Parker & Peters 2004). Various studies have examined the impact of internal audit characteristics (IAC) on the performance of organizations. The first IAC characteristics that has been explored relates to the chief audit executive’s qualifications. In this respect, studies have consistently reported a positive association between the chief executive auditor’s qualifications and firm performance (Clarke 2004). Studies conclude that more qualified chief auditors are in a position to make good decisions in an expedited manner without the need to consult or wait. The internal audit size (IAS) is also another important aspect of internal audit process, which is denoted by the number of members in the internal AC. In this respect, a study by Shleifer and Vishny (1997) suggested that a smaller AC results in higher concentration, discussion and involvement. Similar inferences were made by Baker and Anderson (2010) who reported that larger IAS results in the diffusion of responsibility that in turn breeds reduced group commitment, increased social loafing and higher group fractionalization. Some studies have supported the resource dependence theory, which argues that a larger IAS can lead to improved firm performance because of the diverse expertise and skills in the boardroom debate (Berger 2005; Calder 2008). Overall, there are no conclusive findings regarding IAS characteristics and firm performance.

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