Corporate governancemechanisms, accounting

results and stock valuationin Canada

Sylvie BerthelotDepartment of Accounting and Taxes, University of Sherbrooke,

Sherbrooke, Canada, and

Claude Francoeur and Real LabelleDepartment of Accounting, HEC Montreal, Montreal, Canada

Abstract

Purpose – The purpose of this paper is to investigate the relationship between corporate governancepractices or mechanisms and firm value, as measured by accounting and market data.

Design/methodology/approach – Partial least square analyses were performed on a sample of 355observations from 199 Canadian listed companies. The greater variability allowed under the Canadianprinciples-based institutional setting than under the rules-based USA SOX environment is well-suitedfor these tests.Findings – Results suggest that some governance practices, namely the percentage of independentdirectors on the board, the use of stock options and the frequency of board meetings are significantlyand negatively related to the firm’s net book value or income. However, most individual governancepractices appear to have no significant impact on the firms’ market value.Research limitations/implications – The potential interrelationships between corporategovernance practices and contextual variables are not specifically taken into account, except for thefirms’ industrial sector. It is also possible that certain governance mechanisms jointly impact firm value.Practical implications – This study does not support the current emphasis by regulators on governancepractices which mainly concern the monitoring function of the board as opposed to its strategic one.Originality/value – The paper uses Canada as a laboratory where companies are “invited” ratherthan “required” to follow corporate governance best practices. This greater corporate discretion in thechoice of governance practices provides the variability necessary to test the effect of governance onfirm value. Furthermore, in the interest of triangulation, a model seldom seen in the governanceliterature is used to examine the impact of governance mechanisms on firm value and performance, asmeasured by accounting and market data.

Keywords Canada, Corporate governance, Accounting information, Equity capital,Boards of directors, Corporate governance practices, Book value of equity, Accounting performance,Market value of equity

Paper type Research paper

1. IntroductionIn response to several financial scandals starting with Enron, the US Congress enacted theSarbanes-Oxley Act (SOX) of 2002 to, among other things, set new or enhanced corporate

The current issue and full text archive of this journal is available atwww.emeraldinsight.com/1743-9132.htm

Received April 2011Accepted April 2011

International Journal of ManagerialFinanceVol. 8 No. 4, 2012pp. 332-343r Emerald Group Publishing Limited1743-9132DOI 10.1108/17439131211261251

JEL classification – M49The authors acknowledge the financial support from the Chaire Jeanne et J.-Louis-Levesque

en gestion financiere of the Universite de Moncton, the CGA Professorship in Strategic FinancialInformation and the Stephen A. Jarislowsky Chair in Governance of HEC Montreal.

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governance standards. This led the Securities_and_Exchange_Commission (SEC) to adoptdozens of rules to implement the SOX. SOX covers issues such as auditor independence,corporate governance, internal control assessment, and enhanced financial disclosure.

Using an agency theory framework, several academic studies, mostly conductedin the USA, have since examined if these governance regulations have an effect oncorporate value and performance. From that perspective, the goal of corporategovernance is to minimize agency costs by reducing the adverse selection and moralhazard problems, thus affecting corporate value. The results of this line of researchare mixed. In this paper, we maintain that the main reason for these weak andcontradictory findings is the difficulty in examining this issue in an environment whereall listed companies are required by both the SOX and the SEC to apply the same rulesthus leaving little room for variability between them. We wish to contribute to thisinternational debate by using the Canadian institutional setting where corporategovernance guidelines are recommended rather than imposed by law. This shouldallow greater firm discretion in their choice of governance practices.

Indeed, in Canada, most corporate governance “best practices” are set throughrecommendations or guidelines (soft law) established by provincial market authoritiessuch as the Ontario Securities Commission (OSC). The only regulatory or “hard law”requirement concerns the audit committee’s responsibilities and composition(MI 52-110)[1]. In other words, firms are only required to disclose their governancepractices whatever they may be (NI 58-101).

To revisit this issue of whether governance matters from a different angle, we alsouse an agency theoretical perspective to run a partial least square analysis on a sampleof 355 observations representing 199 Canadians firms. We find that among the variouscorporate governance mechanisms recommended by the OSC, most are not valuerelevant except for the independence of directors, the use of stock options and thenumber of board meetings (NBM), which are negatively related to the book value ofequity and net income. Globally, the incidence of corporate governance practicesseems relatively limited. We interpret these findings as shedding light on the factthat governance aimed at reducing agency costs or the risk of appropriation byinsiders may only indirectly affect value and performance, which would explain thequasi-absence of significant statistical relations.

The remainder of the paper proceeds as follows. In the next section, we brieflypresent the traditional agency theory framework behind the presumption of a relationbetween governance and firm value or performance. We also review the empiricalliterature on the subject. Section 3 presents the research methodology. Findings arepresented and discussed in Section 4 while we conclude in the last section.

2. Theoretical framework and previous empirical evidenceAccording to Shleifer and Vishny (1997), corporate governance deals with the waysin which suppliers of finance to corporations assure themselves of getting a return ontheir investment. This definition takes an agency theory perspective where governancecosts must be incurred to minimize adverse selection and especially ex post moralhazard agency problems. To minimize these agency costs, a good corporate governancesystem should combine some type of large investors with legal protection of both theirrights and those of small investors (Shleifer and Vishny, 1997, p. 739). Picou andRubach (2006) also refer to corporate governance as being the construction of rules,practices, and incentives to effectively align the interests of the agents (boards andmanagers) with those of the principals (capital suppliers).

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In this perspective, corporate value can be maximized by reducing agency costs andby inducing managers to behave in the interests of shareholders. Consequently, animportant objective of governance research is to identify which particular mechanismscontribute to the maximization of corporate value. One of the prominent features ofcorporate governance that has attracted much scrutiny from academics and regulatorsis the independence of board directors from management. There is a general consensusthat independent directors are more effective at monitoring management (Kim et al.,2010) and ensuring that the competition among managers stimulates actions consistentwith shareholder value maximization (Fama, 1980).

Several studies mostly conducted in the USA before and after the enactment ofthe SOX have examined the links between the presence of independent directorson the board and corporate performance (Barnhart et al., 1994; Barnhart andRosenstein, 1998; Hermalin and Weisbach, 1991; Bhagat and Black, 2002; Bozec, 2005;Krivogorsky, 2006; Nicholson and Kiel, 2007; Bhagat and Bolton, 2011). The resultsare mixed.

Furthermore, the possibility for independent directors to hold regular meetingswithout the presence of non-independent directors or management is also encouragedby the OSC in order to reinforce their effectiveness. To date, few researches haveaddressed the impact of this corporate governance practice.

The recommendation regarding the separation of the chief executive officer (CEO)and the chairman of the board functions is also aimed at reducing agency problemsand create value. Kyereboah-Coleman and Biekpe (2006) and Krivogorsky (2006) haveobserved a significant negative relationship between CEO/chairman duality and thereturns on equity or assets. Bai et al. (2004) observed that when this leadershipstructure exists, it negatively affects the market value of the firms. Elsayed (2007)records an impact, but only in certain industries.

The participation of a CEO on other boards can also have a negative impact oncorporate value and performance. On the one hand, this participation is likely toconsume time otherwise spent on the regular activities of the firm. On the other hand, theCEO may benefit from this opportunity to develop business relationships with otherdirectors that might eventually accept a seat on the board of the firm that he manages.However, those clubby relationships between CEO and other directors can modify themotivations of the directors in monitoring the CEO and senior management.

In addition to ways of monitoring management, firms implement incentives thataim to tie the executives’ wealth to the wealth of shareholders, such as managerialequity ownership, stock options and loans to managers. Jelinek and Stuerke (2009)explore the impact of managerial equity ownership on agency costs. They find a non-linear relationship which implies that, above a certain level, managerial equityownership becomes less successful as a corporate governance mechanism, and athigher levels may even be counter-productive. Because of this phenomenon, regulatorshave encouraged firms to disclose information on these incentives.

To summarize, instead of regulating each individual practice, the OSC is requiringfirms to publish a statement of governance practices where the mechanisms discussedabove and several others are exposed. For instance, they have to disclose whether theyhave put in place a formal system to evaluate the performance of the board, list theother boards where its directors sit, cite their attendance records at board andcommittee meetings, and quote the fees the auditors receive for their audit andconsulting services. Thus, we propose to examine if corporate governance disclosure isvalue relevant.

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3. Methodology3.1 Model and variables measurementFigure 1 presents the thorough empirical model that we will be testing using a partialleast square regression analysis. Following Ohlson (1995), the market value of equity(MVEjtþ t) is regressed on the book value of equity (BVEjt) and net income (NIjt). Theeconometric model takes the form:

MVEjtþt¼a0 þ a1BVEjt þ a2NIjt þ a3CGjt þ ejt ð1Þ

where MVEjtþ t is the market value of equity of the firm j at time tþ t, BVEjt the bookvalue of equity of the firm j at time t, NIjt the net income of the firm j at time t, CGjt thevector representing the corporate governance practices, and ejt the error term. We usethe individual variables that are regulated or part of best practices to measure thequality of corporate governance rather than using an index. We believe that this is asuperior proxy to more closely mimic regulation. The following variables are includedin the vector of corporate governance practices: PIBjt is the percentage of fullyindependent directors, PIAjt the percentage of fully independent audit committeemembers, PICjt the percentage of fully independent compensation committee members,PINjt the percentage of fully independent nominating committee members, NBMjt thenumber of board meetings, MOjt the percentage of shares held by management, SOjt

the percentage of stock options outstanding on shares outstanding, CEOjt the CEO isalso chairman, COBjt the CEO sits on other boards of publicly traded companies,SYSjt¼ the firm has a formal system to evaluate the performance of the board, MEEjt

the the directors sometimes meet without management being present, SPjt the directorsown a separate option plan, LOjt the loans granted to directors or officers, SVSjt thefirm issues non-voting or subordinate voting share, DISjt the firm addresses themajority of guidelines recommended by the OSC, OBjt the firm lists the other boards in

SVSjt

PICjt

PINjt

CEOjt

PIAjt

PIBjt

NIjt

BVEjt

MOjt

NBMjt

MEEjt

COBjt

SPjt

LOjt

ATTjt

OBjt

AUDjt

SOjt

DISjt

SYSjt

MVEjt

Figure 1.Relationship studied

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which its directors participate; ATTjt the firm discloses attendance records of itsdirectors at board and committee meetings; AUDjt the firm discloses the fees paid to itsauditor for audit and consulting services.

As governance may also affect accounting equity and results, the following modelsare also simultaneously tested:

BVEjt¼a0 þ a1GGjt þ a2SIZEjt þ ejt ð2Þ

NIjt¼a0 þ a1GGjt þ a2SIZEjt þ ejt ð3Þ

We include the variable SIZEjt in these models to control for its effect. These structuredequations differ from the usual linear structural relations (LISREL) approach. LISRELanalysis estimates model parameters in an attempt to reproduce the covariance matrixof the measures (or observable variables), and incorporates overall goodness-of-fitmeasures to see how well the hypothesized model “fits” the data. The objective ofa partial least square’s regression analysis is rather to explain the variance (R2) andthe level of significance of the relationships among the constructs included in themodel. It is a better indicator of how well the model is performing (Barclay et al., 1995).

Partial least square analysis is, in fact, an iterative combination of principalcomponents analysis relating to constructs, and path analysis permitting the constructionof a system of constructs. The estimation of the parameters representing the measurementand path relationship is accomplished using ordinary least square techniques (Barclayet al., 1995). The partial least square analysis offers several advantages. First, in contrast toother structural equation model analysis, partial least square is designed to maximize thepredictive power of the model rather than to maximize the fit of the model to the data(Barclay et al., 1995). So when the objective is more to develop predictions, as is the casehere, partial least square analysis is the preferred method. Another important advantageof partial least square analysis is that it does not require a large sample size and does notrequire that the variables be normally distributed (Fornell and Bookstein, 1982). Partialleast square analysis does not provide significant tests for the path coefficients[2].However, we used a bootstrapping technique to construct a distribution of the modelparameters from sub-samples of the observations. This allowed us to determine thestatistical significance of the path coefficients. In the analyses that follow, the level ofstatistical significance of the path coefficients is based on bootstrapping 200 sub-samples.

3.2 SampleOur sample is composed of all Canadian companies operating in the manufacturingsector (SIC code between 2000 and 3999 inclusively) for which the financial statementsand the information circular were available in SEDAR (www.sedar.com) and the stockprice data were available from the Toronto Stock Exchange database[3]. To control forthe differential impact of industrial factors on value and performance, our sample isrestricted to one sector, manufacturing. This also eliminates firms with distinctivecharacteristics such as banking, mining, and petrochemical. Accounting data werecollected from the 2004 and 2005 annual reports. Data on governance practiceswere manually collected from the information circular. In total, 199 firms met thesecriteria, which represented 370 observations. Of these, 15 observations presentingnegative book value of equity were removed. The final sample is composed of theremaining 355 observations.

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4. Results4.1 Descriptive statisticsTable I presents the descriptive statistics of the variables. Panel A shows that theaveraged market value of equity (MVEjtþ 4) amounts to $1,677,937,000 while the meanbook values of equity (BVEjt) and net income (NIjt) amount to $720,041,000 and$71,370,000, respectively. The average proportion of independent directors (PIBjt) is72 percent of total board members while the percentage of independent auditcommittee members (PIAjt) is 98 percent. This high proportion is not surprising as this

Variables Mean SD Median Minimum Maximum

Panel AMVEjtþ 4 1,677,937 4,695,737 182,500 4,100 34,613,071BVEjt 720,041 1,743,479 101,128 139 12,700,332NIjt 71,370 278,771 2,343 �1,026,628 2,014,000PIBjt 0.72 0.15 0.71 0.29 1.00PIAjt 0.98 0.09 0.33 1.00 1.00PICjt 0.91 0.21 1.00 0.00 1.00PINjt 0.91 0.19 1.00 0.00 1.00NBMjt 8.27 3.70 7 3.00 23MOjt 14.38 24.72 19.34 0.00 92.54SOjt 0.05 0.04 0.05 0.00 0.22Panel BVariables %CEOjt 23.89COBjt 36.60SYSjt 80.94MEEjt 83.49SPjt 11.25LOjt 33.33SVSjt 18.31DISjt 82.27OBjt 68.60ATTjt 54.97AUDjt 43.31

Notes: N¼ 355; The accounting numbers are presented in thousands of dollars; MVEjtþ 4, the marketvalue of equity four months after the closing date of the financial statements; BVEjt, the book value ofequity at time t; NIjt, net income at time t; PIBjt, percentage of a firm’s fully independent directors;PIAjt, percentage of the fully independent audit committee members; PICjt, percentage of the fullyindependent compensation committee members; PINjt, percentage of the fully independent nominatingcommittee members; NBMjt, number of board meets; MOjt, percentage of shares held by themanagement; SOjt, percentage of stock options outstanding on shares outstanding; CEOjt, 1 if the CEOis also chairman and 0 otherwise; COBjt, 1 if the CEO sits on other boards of publicly traded companiesand 0 otherwise; SYSjt, 1 if the firm has a formal system to evaluate the performance of the board and 0otherwise; MEEjt, 1 if the directors sometimes meet without management present, and 0 otherwise;SPjt, 1 if the directors have their own separate option plan and 0 otherwise; LOjt, 1 if the firm grantsloans to directors or officers and 0 otherwise; SVSjt, 1 if the firm has non-voting or subordinate votingshares and 0 otherwise; DISjt, 1 if the firm addresses the majority of guidelines recommended by theOntario Securities Commission and 0 otherwise; OBjt, 1 if the firm lists the other boards in whichits directors participate and 0 otherwise; ATTjt, 1 if the firm discloses attendance records of itsdirectors at board and committee meetings and 0 otherwise; AUDjt, 1 if the firm discloses the fees paidto its auditor for audit and consulting services, and 0 otherwise

Table I.Descriptive statistics

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is the only mechanism which is directly regulated by the OSC. As in the USA, allmembers of the audit committee must be independent from management. The averagepercentages of independent compensation committee members (PICjt) and independentnominating committee members (PINjt) both stand at 91 percent. The number of boardmeetings per year (NBMjt) is, on average, 8.27. The mean percentage of shares held bymanagement officers (MOjt) is 14.38 percent and the percentage of stock optionsoutstanding on shares outstanding is 5 percent.

Panel B shows that 23.89 percent of our sample is composed of firms where the CEOis also the chairman (CEOjt) and 36.60 percent where the CEO sits on other boards ofpublicly traded companies (COBjt). In all, 80.94 percent of the firms have a formalsystem to evaluate the performance of their board (SYSjt) while 83.49 percent havesome meetings of their directors without the presence of management (MEEjt). Firmswhere the directors own a separate option plan (SPjt) represent 11.25 percent of oursample. 33.33 percent of the firms in our sample grant loans to directors or officers(LOjt) while 18.31 percent issue non-voting or subordinate voting shares (SVSjt). Agreat majority of firms, 82.27 percent, address all governance guidelines recommendedby the OSC (DISjt). A total of 68.60 percent of the firms list the other boards in which itsdirectors participate (OBjt), 54.97 percent disclose attendance records of its directors atboard and committee meetings (ATTjt), and 43.31 percent disclose the fees paid to itsauditor for audit and consulting services.

4.2 ResultsTable II shows the results of the partial least square regression analyses. The resultsconcerning the impact of the individual governance mechanisms on the market valueof equity (MVEjt) are presented in the second column. As expected in this model, therelations between MVE and both the book value of equity (BVEjt) and the net income(NIjt) are highly significant. Except in the case of loans granted to directors and officers(LOjt) which are only marginally (p-value level of 10 percent) and positively related toMVE, none of the other proxies for governance mechanisms show significant pathcoefficients. The model still explains 89 percent of the market value of equity. Thisresult is consistent with those of Bebchuck et al. (2009) and Brown and Caylor (2006)which conclude that few corporate governance mechanisms have a significant impacton firm valuation. The fact that we conducted our study in the more autoregulatedCanadian context does not seem to affect the relation.

Concerning the second model aimed at explaining BVE in Column 3, the proportionof independent directors (PIBjt) and the percentage of stock options outstanding onshares outstanding (SOjt) are significantly and negatively related to the book value ofequity. Past studies do not agree on the direction of the relationship between thepresence of the outside directors on the board and performance (Bhagat and Black,2002; Gani and Jermias, 2006). The usual belief is that board independence maypositively affect performance because it is an effective means of monitoringmanagement. Nevertheless, the lack of specific inside knowledge of outside directorsabout a firm and its operations may have the opposite effect on performance. Aspointed out by Bhagat and Black (2002), independence puts the emphasis onmonitoring which may translate in a lesser ability to ask good questions and providesound and knowledgeable advice. As far as the negative relationships between SO andboth BE and NI (Column 4), this may be due to the fact that the use of stock optionsentices management to take more risk which translates in a lower accounting valueand performance. This interpretation is in line with option theory and with the results

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of Jelinek and Stuerke (2009). These authors have shown that, as the level ofmanagement equity ownership increases, it becomes less successful as a corporategovernance mechanism aimed at aligning interests and may even be counter-productive. Though surprising, this result is consistent with incidents in whichexecutives with substantial options have engaged in value destruction ( Jensen, 2005).

Our analysis of the relation between governance and NI which measures the firm’saccounting performance shows also one significant relationship. The NBM appears tohave a negative effect on NI as shown in the path coefficient of this relationship. This

Path coefficientsIndependent variables MVEjtþ 4 BVEjt NIjt

BVEjt 0.61*** – –NIjt 0.41** – –PIBjt �0.02 �0.07** �0.09PIAjt 0.02 0.01 0.06PICjt 0.03 �0.03 �0.09PINjt �0.04 0.03 0.07CEOjt �0.01 �0.01 �0.05COBjt 0.00 0.02 0.01SYSjt �0.01 0.00 0.00MEEjt 0.02 0.01 0.04NBMjt 0.07 0.00 �0.11**MOjt 0.05 �0.07 �0.02SPjt �0.03 0.05 0.02LOjt 0.05* �0.02 �0.04SOjt 0.02 �0.04** �0.10**SVSjt �0.02 �0.06 �0.13DISjt 0.03 �0.04 �0.04OBjt 0.01 0.00 0.03ATTjt 0.00 �0.01 �0.05AUDjt 0.02 0.03 0.01SIZEjt – 0.86*** 0.55***R2 0.89 0.81 0.36

Notes: N¼ 355; MVEjtþ 4¼ the market value of equity four months after the closing date of thefinancial statements; BVEjt, the book value of equity at time t; NIjt, net income at time t; PIBjt,percentage of independent directors; PIAjt, percentage of independent audit committee members; PICjt,percentage of independent compensation committee members; PINjt, percentage of independentnominating committee members; NBMjt, number of board meets; MOjt, percentage of shares held bythe management; SOjt, percentage of stock options outstanding on shares outstanding; CEOjt, 1 if theCEO is also chairman, and 0 otherwise; COBjt, 1 if the CEO sits on other boards of publicly tradedcompanies and 0 otherwise; SYSjt, 1 if the firm has a formal system to evaluate the performance of theboard and 0 otherwise; MEEjt, 1 if the directors sometimes meet without management present and 0otherwise; SPjt, 1 if the directors own their own separate option plan and 0 otherwise; LOjt, 1 if the firmgrants loans to directors or officers and 0 otherwise; SVSjt, 1 if the firm has non-voting or subordinatevoting share and 0 otherwise; DISjt, 1 if the firm addresses the majority of guidelines recommended bythe Ontario Securities Commission and 0 otherwise; OBjt, 1 if the firm lists the other boards in which itsdirectors participate and 0 otherwise; ATTjt, 1 if the firm disclose attendance records of its directors atboard and committee meetings and 0 otherwise; AUDjt, 1 if the firm discloses the fees paid to itsauditor for audit and consulting services and 0 otherwise; MO2

jt, square of the percentage of sharesheld by the management; SIZEjt, total assets of the firm; *po0.10; **po0.05; *** po0.01

Table II.Partial least square results

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may be interpreted in the light of Vafeas (1999) who found that boards meet more oftenfollowing poor performance. Jensen (1993) also asserts that board meetings are morereactive than proactive measure.

Globally, the results we obtain in Canada where governance standards areprinciples-based are not very different from studies conducted in the rules-basedenvironment of the USA by authors such as Bebchuck et al. (2009) and Brown andCaylor (2006). Although some governance mechanisms seem to be related to the BVEand accounting performance, very few are related to the market value of equity, thusappear irrelevant to investors.

5. ConclusionThe objective of this study was to investigate the relationships between corporategovernance practices or mechanisms and firm value, as measured by accounting andmarket data. We resorted to a structural approach by using a partial least squareregression model. The results show that most of the individual governance practicesdo not seem to be associated with firm value. On the contrary, certain mechanismssuch as the percentage of independent directors, the NBM, and the percentage ofoutstanding stock options seem to be associated to lower performance.

This study extends the current findings by examining the presumed link betweenindividual corporate governance practices and firm value in a context of principles-based governance standards. The results show that, even in such a setting, mimetismseems to lead to the adoption of similar governance standards. This in turn maymitigate the expected relation with firm value.

Several studies have aggregated all available governance mechanisms by creating orusing existing indexes. We have gone to the other end of the spectrum by using a seriesof individual mechanisms. Future research should aim at examining the possibility thatcertain corporate governance configurations, namely a subset of governance practices,may trigger firm value.

We recognize the limits of this study. The potential interrelationships between thecorporate governance practices and the contextual variables are not taken into accountexcept for the industrial factor. Recent studies tend to show that certain governancemechanisms are connected to each other and can be more effective in certain contexts(Bozec, 2005; Gani and Jermias, 2006; Boujenoui and Zeghal, 2006). Future researchshould aim at addressing this issue.

Notes

1. MI stands for “Multilateral instrument” and means that a rule is not accepted by allprovincial jurisdictions. NI stands for “National instrument” and means that the rule is thesame across Canada.

2. In the structural models, the path coefficient indicates the amount of expected change inthe dependent variable as a result of a unit change in the dependant variable. It is the slope ofthe regression line.

3. In order to obtain an adequate sample size of firms and to eliminate the firms with clearlydistinctive characteristics such as banking, mining, and petrochemical, we only retainedfirms in the manufacturing sector.

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Further reading

Aboody, D. (1996), “Market valuation of employee stock options”, Journal of Accounting andEconomics, Vol. 22 Nos 1-3, pp. 357-91.

Aigbe, A. and Martin, A.D. (2006), “Valuation impact of Sarbanes-Oxley: evidence fromdisclosure and governance within the financial services industry”, Journal of Banking &Finance, Vol. 30 No. 3, pp. 989-1006.

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Corresponding authorSylvie Berthelot can be contacted at: Sylvie.Berthelot@USherbrooke.ca

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