The Relationship Between Corporate Governance
and Firm Value: Role of Discretionary Earnings
Management
By
Sajid Nazir
CIIT/FA10-PMS-001/LHR
PhD Thesis
In
Management Sciences
COMSATS Institute of Information Technology
Lahore Campus - Pakistan Spring, 2015
ii
COMSATS Institute of Information Technology
The Relationship Between Corporate Governance
and Firm Value: Role of Discretionary Earnings
Management
A Thesis Presented to
COMSATS Institute of Information Technology
In partial fulfillment
of the requirement for the degree of
PhD (Management Sciences)
By
Sajid Nazir
CIIT/FA10-PMS-001/LHR
Spring, 2015
iii
The Relationship Between Corporate Governance
and Firm Value: Role of Discretionary Earnings
Management
A Post Graduate Thesis submitted to the Department of Management Sciences as
partial fulfillment of the requirement for the award of Degree of PhD Management
Sciences.
Name Registration Number
Sajid Nazir CIIT/FA10-PMS-001/LHR
Supervisor
Dr. Talat Afza Professor Department of Management Sciences COMSATS Institute of Information Technology (CIIT) Lahore Campus
Co-Supervisor
Dr. Muhammad Qaiser Shahbaz Professor Department of Statistics COMSATS Institute of Information Technology (CIIT) Lahore Campus February 2016
iv
Final Approval
This thesis titled
The Relationship Between Corporate Governance and Firm Value: Role of Discretionary Earnings
Management
By
Sajid Nazir CIIT/FA10-PMS-001/LHR
Has been approved
For the COMSATS Institute of Information Technology, Lahore Campus
External Examiner 1: ______________________________________________________
Prof. Dr. Rukhsana Kalim, School of Business and Economics, University of Management and Technology, Lahore
External Examiner 2: ______________________________________________________
Prof. Dr. Abdul Qayyum Quaid-e-Azam University, Islamabad
Supervisor: ______________________________________________________________
Prof. Dr. Talat Afza Department of Management Sciences/Lahore Campus
HoD: ___________________________________________________________________
Dr. Abdus Sattar Abbasi Head, Department of Management Sciences/Lahore Campus
Chairperson: _____________________________________________________________ Prof. Dr. Farzand Ali Jan Department of Management Sciences/Islamabad Campus
Dean, Faculty of Business Administration: _____________________________________
Prof. Dr. Khalid Riaz
v
Declaration
I, Sajid Nazir (CIIT/FA10-PMS-001/LHR) student of the department of management sciences, hereby declare that I have produced the work presented in this thesis, during the scheduled period of study. I also declare that I have not taken any material from any source except referred to wherever due that amount of plagiarism is within acceptable range. If a violation of HEC rules on research has occurred in this thesis, I shall be liable to punishable action under the plagiarism rules of the HEC.
Date: _________________ Signature of the student:
______________________ Sajid Nazir
CIIT/FA10-PMS-001/LHR
vi
Certificate
It is certified that Sajid Nazir (CIIT/FA10-PMS-001/LHR) has carried out all the work related to this thesis under my supervision at the Department of Management Sciences, COMSATS Institute of Information Technology, Lahore and the work fulfills the requirement for award of PhD degree.
Date: _________________
Supervisor
_____________________________
Prof. Dr. Talat Afza Professor Department of Management Sciences
Head of Academics and Research
Head of Department:
_______________________________ Dr. Abdus Sattar Abbasi, HoD Department of Management Sciences
vii
DEDICATION
To my Parents and Teachers
viii
ACKNOWLEDGEMENT
All praises to The Allah Almighty Who has created this world of knowledge for us. He
is The Gracious, The Merciful. He bestowed man with intellectual power and
understanding, and gave him spiritual insight, enabling him to discover his “Self” know
his Creator through His wonders, and conquer nature. Next to all His Messenger and the
last Holy Prophet Hazrat Muhammad (SAW) Who is an eternal torch of guidance and
knowledge for whole mankind.
Many individuals have been supportive and instrumental in assisting me with this
dissertation, and I owe them a debt of gratitude. I am deeply thankful to my research
supervisor, Prof. Dr. Talat Afza, whose continuous guidance, feedback, advice and
encouragements have been truly exceptional. It would not be an exaggeration to say that
if she had not been there, I may not have reached the finishing line. I have learnt
enormous from her about conducting research as well as thinking about new problems
not only in my MS but also in PhD. She is truly a REAL MENTOR. I would appreciate
Prof. Dr. Muhammad Qaiser Shahbaz, whose teaching methodology and research support
helped me greatly to complete my MS program. I would also like to thanks Dr. Mahmood
Ahmad Bodla, who always has opened his doors to facilitate us and used to spend a lot of
time for sharing and discussing about the new ideas in research.
It has been a great privilege for me to study at COMSATS and I have been fortunate to
get study scholarship which made my studies very comfortable. I am also thankful to
COMSATS. I am also thankful to Iftikhar, Sadaf, Kaleem, Asma, and Jam for helping me
in data collection, particularly, Mr. Ahsan Qureshi from AKD Securities who was really
helpful in optimizing my efforts in data collection. Finally, it would not be justified if I
do not mention the support of my fellows. Some of my friends who have played a vital
role in the completion of this dissertation are Danish, Shakeel, Kashif, Hammad, Jam,
Usman, Atia and Naveed. All of my friends have been very encouraging and
accommodating during my whole doctorate program.
Sajid Nazir CIIT/FA10-PMS-001/LHR
ix
ABSTRACT
The Relationship Between Corporate Governance and Firm Value: Role of Discretionary Earnings Management
Corporate governance practices help in enhancing firm value by effectively monitoring
the managerial decisions as well as reducing the level of information asymmetry and
agency problem between empowered managers and dispersed minority shareholders. The
present study investigates the relationship between corporate governance and firm value
for the developing economy of Pakistan. The study has also taken into consideration the
moderating role of discretionary earnings management in corporate governance-firm
value relationship, which is considered to be a relatively ignored research issue in
corporate finance literature. In addition to focusing on individual mechanisms of
corporate governance (i.e. audit, board, compensation, ownership), the present study has
also constructed a composite corporate governance index to investigate the role of
effective corporate governance in mitigating earnings management and enhancing firm
value. The data of 208 firms listed at Karachi Stock Exchange for a time period of 2004-
2011 has been used for analysis and accounting, market and economic measures of
performance have been used as firm value. The study finds that corporate governance
plays a vital role in enhancing firm value in long as well as short run. Constitution of
internal audit committees as an effective internal audit system is essential for the enriched
progress of a firm. The monetary incentives and compensation paid to the top executives
motivates them to work in the best interests of the company which increases not only
short term accounting value of firm but also long term market and economic value. The
findings reveal that discretionary earnings management practices by corporate managers
damage the firm value in long term and it could be mitigated by effective corporate
governance mechanisms. Moreover, this value damaging role of discretionary earnings
management negatively moderates between effective corporate governance and firm
value. Firms with earnings manipulation weakens the impact of effectiveness of
governance system and leads to lower firm value. Finally, the study suggests some
practical implications based upon the findings for investors, policy makers and manager.
x
TABLE OF CONTENTS
1. INTRODUCTION …………………………………………………………….1
1.1 Overview of Corporate Governance …………………………………...2
1.2 Corporate Governance Mechanisms …………………………………...5
1.2.1 Audit Structure ……………………………………………….6
1.2.2 Board Structure ……………………………………………….7
1.2.3 Compensation Structure ……………………………………...8
1.2.4 Ownership Structure ………………………………………….9
1.2.5 Corporate Governance Index .………………......…………...10
1.3 Corporate Governance and Firm Value ...…………………………….12
1.4 Theoretical Background of Value Relevance of CG ..………………..13
1.4.1 Agency Theory …...…………………………………………13
1.4.2 Stewardship Theory …………………………………………15
1.4.3 Resource Dependence Theory ………………………………16
1.5 Corporate Governance in Pakistan .….…………………..…………...17
1.6 Corporate Governance and Discretionary Earnings Management .......19
1.7 Significance of the Study ……….….……………..…….…………....22
1.8 Research Objectives ……………...….………………….…………....23
2. LITERATURE REVIEW…...…………………………………………….... 25
2.1 Corporate Governance and Firm Value……………………………….26
2.1.1 Audit Structure and Firm Value .……..…………………..…26
2.1.2 Board Structure and Firm Value ………………………….…31
2.1.3 Compensation Structure and Firm Value ……...……………41
2.1.4 Ownership Structure and Firm Value ……....…………….…49
2.1.5 Corporate Governance Index and Firm Value .……...………59
2.1.6 Reverse Causality between CG and Firm Value ……………61
2.1.7 Corporate Governance and Firm Value in Pakistan ………...62
xi
2.2 Corporate Governance and Discretionary Earnings Management …...65
2.3 Discretionary Earnings Management and Firm Value ……………….76
2.4 Moderating Role of DEM in CG-Value Relationship ………………..79
2.5 Summary and Research Gap ………………………………………….80
3. RESEARCH METHODOLOGY ..….……………………………………... 82
3.1 Data and Sample Description..………………………………………..83
3.2 Research Model ...…………………………………………………….85
3.2.1 Corporate Governance and Firm Value.……….…………… 85
3.2.2 Corporate Governance and DEM ...…………………………87
3.2.3 Impact of DEM on Firm Value..................................……… 93
3.2.4 Moderating Role of DEM in CG-Value Relationship ………94
4. RESULTS AND DISCUSSION ...……………………………..…………….96
4.1 Descriptive Statistics ………………………………………………....97
4.2 Empirical Results.....…………………………..……………………..106
4.2.1 Corporate Governance Mechanism and Firm Value ………107
4.2.2 Nonlinear Relationship between Ownership Structure and
Firm Value ………..….…………………………………….125
4.2.3 Corporate Governance Index and Firm value……………...133
4.2.4 Endogenous Relationship between CG and Firm Value…...134
4.2.5 Corporate Governance and Discretionary Earnings
Management ………………………………….………....…135
4.2.6 Is Discretionary Earnings Management Opportunistic or
Beneficial?...............………………………………...…………....144
4.2.7 Moderating Role of DEM in CG-Value Relationship……...149
5. CONCLUSION.……………………………………………………………. 150
6. REFERENCES ...……………………………………………………………157
Appendices ..……………………………………………………………………193
xii
LIST OF FIGURES _____________________________________________________________ Fig 1.1 Corporate Governance Mechanisms………………………………………….… 11
xiii
LIST OF TABLES _____________________________________________________________ Table 3.1 Distribution of Population and Sample ………………………………………84
Table 3.2 Estimation of Discretionary Earnings Management (DEM) Variable .............91
Table 4.1 Descriptive Statistics ………………………………………………………....99
Table 4.2 Overall Descriptive -- Frequency Tables for Dichotomous Variables ……...101
Table 4.3 Industry wise DEM analysis – one way ANOVA …………………………..104
Table 4.4 Sector wise DEM analysis – t-test…………………………………………...105
Table 4.5 Years wise DEM analysis – one way ANOVA ……………………………..105
Table 4.6 Pearson Correlation Analysis ………………………………………………..109
Table 4.7 Audit Characteristics and Firm Value ………………………………………110
Table 4.8 Board Structure and Firm Value …………………………………………….118
Table 4.9 Managerial Compensation and Firm Value …………………………………119
Table 4.10 Ownership Structure and Firm Value ……………………………………...122
Table 4.11 Nonlinear Relationship between Inside Ownership and Firm Value ……...……...129
Table 4.12 Nonlinear Relationship between Ownership Concentration and Firm
Value …………………………………………………………………………………...130
Table 4.13 Nonlinear Relationship between Institutional and Firm Value ……..……..131
Table 4.14 Institutional Shareholders’ Activism and Firm Value ……………………..132
Table 4.15 Corporate Governance Index (CGI) and Firm Value ……………………...136
Table 4.16 Endogenous Relationship between Corporate Governance and Firm
Value (Reverse Causality) ……………………………………………………………..137
Table 4.17 Corporate Governance and DEM ……………………………………..142-143
Table 4.18 DEM and Current Firm Value ……………………………………………..146
Table 4.19 DEM and Firm Subsequent Value…………………………………………147
Table 4.20 Moderating Role of DEM in CG-Value Relationship……………………..148
xiv
LIST OF ABBREVIATIONS _____________________________________________________________ AC Audit Committee ANOVA Analysis of Variance ASX Australian Stock Exchange beta BDS Board Development Series BI Board Independence CCAR Core Capital Adequacy Ration CEO Chief Executive Officer CFO Chief Financial Officer CG Corporate Governance CGBPP Corporate Governance Best Practices Principles CGI Corporate Governance Index CLSA Credit Lyonnais Securities Asia CPERPS California Public Employees’ Retirement Pension System DEM Discretionary Earnings Management DERO Discounted Equity Risk Option DLLP Discretionary Loan Loss Provisions DOW Directors Orientation Workshop DRSGL Discretionary Realized Securities Gains and Losses E-Index Entrenchment Index EAQ External Audit Quality EPS Earnings per Share EVA Economic Value Added GAAP Generally Accepted Accounting Principles G-Index Governance Index ICAP Institute of Chartered Accountants of Pakistan ICMAP Institute of Cost and Management Accountants of Pakistan IFC International Financial Corporation IFRS International Financial Reporting Standards IPO Initial Public Offering KCGI Korean Corporate Governance Index KSE Karachi Stock Exchange LLP Loan Loss Provisions NPL Nonperforming Loans LLA Loan Loss Allowances OC Ownership Concentration OECD Organization for Economic Cooperation and Development OS Ownership Structure PICG Pakistani Institute of Corporate Governance PKR Pakistan Rupee RSGL Realized Securities Gains and Losses Q Tobin’s Q ROA Returns on Assets
xv
ROE Returns on Equity S&P Standard & Poor SBP State Bank of Pakistan SECP Securities and Exchange Commission of Pakistan SOX Sarbanes-Oxley Act URSGL Unrealized Securities Gains and Losses
xvi
LIST OF RELEVANT PUBLICATIONS _____________________________________________________________
1. Afza, T. and Nazir, M.S., Theoretical Perspective of Corporate Governance: A Review, European Journal of Scientific Research, Vol. 119, No. 2, pp. 255-264 (2014).
2. Afza, T. and Nazir, M.S., Does Audit Quality Augment Firm Performance in
Pakistan? Research Journal of Applied Sciences, Engineering and Technology, Vol. 7, No. 9, pp. 1803-1810 (2014).
3. Afza, T. and Nazir, M.S., Role of Institutional Shareholders’ Activism in
Enhancing Firm Performance: The Case of Pakistan, Global Business Review, Vol. 16, No. 4, pp. 557-570.
4. Afza, T. and Nazir, M.S., Corporate Governance and Firm Value: The Role of
Discretionary Earnings Management, Economic Research, under review.
5. Afza, T. and Nazir, M.S., Impact of Corporate Governance on Discretionary
Earnings Management: A Case of Pakistani Firms, Working paper.
1
Chapter 1
INTRODUCTION
2
The evolution of the locution “corporate governance” as an independent academic
discipline has been experienced since the last three decades. The corporate scandals and
downfall of corporate giants in the United States, increased awareness of investments and
number of active institutional investors, increasing tendency of privatization in last two
decades, concept of conglomerates through mergers and acquisitions since 1980s,
collisions in South East Asia due to the 1997 Asian Financial crisis, and operational
integration of capital markets were the basis of transforming Corporate Governance (CG)
into increasingly researched academic topic during the current millennium (Mitton,
2002). Owing to the growing scope of this topic, CG has become multi-disciplinary
combination of law, business ethics, accounting and finance, organizational behavior,
business management, economics, and politics, having no commonly accepted definition
around the globe (Solomon, 2007).
1.1 Overview of Corporate Governance
Increased globalization, business competitiveness, and corporate failures in the 21st
century emphasized the importance of CG vividly. These adversities were the outcome of
structural reasons which intensify the prominence of CG. King Report (2002, para 24 14)
described the significance of CG as:
“The 19th Century saw the foundation laid for modern
corporations; this was the century of the entrepreneur. The 20th
Century became the century of management … The 21st Century
promises to be a century of governance, as the focus swings to the
legitimacy and effectiveness of the wielding of power over
corporate entities worldwide.”
The concept and approaches towards CG improved with the passage of time. Academic
researchers, regulators and policy makers considered the concept of CG both in narrow
and broader perspectives. In the narrow/traditional perspective, also known as
shareholder approach in different agency related theories, CG is described as a system of
contractual association of firm’s shareholders and its hired management only. With
respect to narrow perspective, the shortest and brief definition was given by Shleifer and
Vishny (1997) as “corporate governance deals with the ways in which suppliers of
3
finance to corporations assure themselves of getting return on their investment”.
However, the modern approach of CG considers not only shareholders and managers of a
firm as two related parties but also the other stakeholders of society which may directly
or indirectly influence or been influenced by the activities of a firm (Fernando, 2011).
These stakeholders may include shareholders, managers, employees, customers,
regulators, government, society at large, and environment etc.
However, the most notable and broadly acknowledged definition was given by Sir Adrian
Cadbury in his Cadbury Committee Report (1992, p. 2) as:
“Corporate governance is the system by which companies are directed and
controlled. Boards of directors are responsible for the governance of their
companies. The shareholders' role in governance is to appoint the directors
and the auditors and to satisfy themselves that an appropriate governance
structure is in place. The responsibilities of the directors include setting the
company's strategic aims, providing the leadership to put them into effect,
supervising the management of the business and reporting to shareholders
on their stewardship. The Board's actions are subject to laws, regulations
and the shareholders in general meeting.”
The corporate structure is based upon the concept of separation of ownership from its
managers due to which conflict of interests between the managers and shareholders
arises, particularly in large organizations. The core objective of the shareholders is return
on their invested capital whereas managers are likely to be focused on their own personal
goals such as consummation of perquisites of the position (Jensen & Meckling, 1976),
power and prestige of running a large organization (Hubbard & Palia, 1995), or their job
security by not investing in risky but rewarding projects (Amihud & Lev, 1981). In this
context, managers’ superior access and control over the firm’s resources give them upper
hand and they take decisions which are aligned with their personal objectives instead of
those of shareholders.
The researchers in corporate finance have long recognized the widespread separation of
ownership and control in firms that has created the potential agency problem which could
be for the firms. The mangers have substantial freedom to pursue their personal benefits
4
at the expense of shareholders wealth due to limited incentive of shareholder to monitor
the behavior and performance of agents. The principle of shareholders’ wealth
maximization will not motivate corporate decision making in the absence of effective CG
mechanisms (Nazir et al., 2009). Since the publication of “The Modern Corporation and
Private Property” by Berle and Means (1932), immense literature has been stimulated on
the agency theory. Since then, researchers in finance have tried to explore the potential
adverse effects of absence of effective control mechanism and misalignment of interests
of shareholders and managers.
Along with the agency phenomenon, the global financial catastrophe and investors’
desire for companies to have good CG system also amplified its importance. The Asian
Financial Crisis of 1997, which was triggered from Thailand in early 90’s, had adversely
hindered many corporations in South East Asian countries putting long last effect on their
economies (Sachs, 1998). Generally, poor CG structure is assumed to be the source of
these crises up to a certain extent (D'Cruz, 1999). Moreover, the financial collapse of
world’s big companies such as Enron, Etoys, Adelphia, World Com, Parmalat,
Commerce bank, XL Holidays have ruined the investor confidence in the capital markets
and cautioned the world for the need to have a transparent and fair governance system in
corporate firms, despite of the fact that The Cadbury Report (1992) put stress on the
significance of good CG structure for effective monitoring of managers and enhanced
corporate value.
Furthermore, some institutions such as McKinsey, Standard and Poor (S&P), California
Public Employees’ Retirement Pension System (CPERPS) and Credit Lyonnais
Securities Asia (CLSA) have also worked to make significant contributions in the
practices and reforms of CG. McKinsey Investors’ Opinion Survey (2000), a landmark
survey in CG, reported that worldwide investors are willing to pay extra value for the
companies practicing good CG. Accordingly, CG had been focused as the principal
emphasis of the legislatures including Sarbanes-Oxley Act in USA (2002), Combined
Code of Corporate Governance presented by Financial Reporting Council (2003) in UK
and Principles of Good Corporate Governance and Best Practice Recommendations in
Australia (ASX, 2010).
5
During the last couple of decades, regulators, investors, policy makers and other capital
market participants have focused on the need for firms to have an effective monitoring
and accountability system of CG in order to minimize the misalignments of interests
between shareholders and managers, commonly known as agency problem (Epps &
Ismail, 2009). CG is a set of policies and mechanisms that affect how a firm is operated
efficiently and profitably. This system of CG ranges from practices and institutions, from
accounting standards and laws concerning financial disclosure, to executive
compensation and shareholdings, to size and composition/independence of corporate
boards as well as patterns of shareholdings in the corporation (Javid & Iqbal, 2007). CG
focuses on the issue of bringing accountability and transparency into the operations of
firm with an overall objective of welfare of all its stakeholders including managers,
shareholders, regulator, society and the economy as a whole.
In general, CG is not only important in legislations but also have immense significance in
corporate world as well. CG is a comprehensive organizational arrangement of
effectively managing and controlling the firm financial resources in order to realize the
corporate goals as well as socio-economic purpose of the organizations. Effective CG
system ensures informative and transparent information disclosures which boosts
investors’ confidence and improves liquidity position of emerging capital markets by
enhancing future opportunities of investment. Therefore, effective CG is of significant
importance for all the stakeholders of a business firm (Navissi & Naiker, 2006).
1.2 Corporate Governance Mechanisms
In order to ensure the implementation of effective CG system in any organization,
different tools and techniques have been introduced by the regulators and used by
academic researchers for empirical analysis. These governing tools and mechanisms are
helpful in monitoring the controlling the organizational agents where cost of actively
monitoring by principals is relatively high. The governance apparatus for the
organizations may differ for different countries based upon their law and regulatory
system. For example, Japan follows the internal governance mechanism based upon
keiretsu (business) networks with the main bank. Similar model of CG is applicable in
Korean firms with the name of Chaebol. German and east European countries have
6
adopted two-tiered board model of CG introduced by Germany. Most common is Anglo-
Saxon approach of CG which is applicable in most of the countries in the world with
common law. This system is based on both internal and external CG mechanisms.
However, in general, these mechanisms may include audit structure, board structure,
managerial compensation structure and ownership structure prevalent in the organization.
Figure 1.1 provides a summary for these CG mechanisms in graphical representation.
1.2.1 Audit Structure
Audit structure is a primary mechanism of CG which protects the stakeholder’s interests
by ensuring the integrity and transparency of disclosed financial information and help in
resolving the agency problem (Griffin et al., 2008). The system of audit can be
implemented in any organization by two means; internal audit and external audit. Internal
audit function makes it sure that internal control system is working efficiently and
effectively whereas external auditor, being an independent audit firm, is responsible for
transparency, accuracy and fairness of the reported financial statements. External auditor
also confirms that firm is complying with the best practices of code of CG enforced by
Securities and Exchange Commission. Thus, reputation and goodwill enhances the
quality of an external auditor whereas an audit committee of board consisting mainly of
non-executive directors governs the matters of internal audit in order to make its
functions fully independent of managerial influence.
Internal audit committee is a sub-committee of board of directors and internal CG
mechanism of audit which makes decisions regarding the internal audit function and
monitors executives’ decision making. According to Chambers (2005), audit committee
ensures reliability and accuracy of financial information, provide guidance to board
regarding internal control, have liaison with external auditor of the company, and
supervises the functions of internal audit system. The existence of audit committee in
firm is considered to be most dependable tool for safeguarding the stakeholders’ interests
and Cadbury Committee Report (1992) also put substantial emphasis on the formation of
audit committee consisting of at least three board members which should meet three to
four times a year. Same has also been underscored by Public Oversight Board (1993) and
Blue Ribbon Committee (1999) recommendations.
7
An independent and effective audit committee can boost the firm value, being a
significant CG mechanism. Vicknair et al. (1993) reported that absence of an independent
audit committee may cause several financial problems and fraudulent activities in the
organization. Moreover, DeZoort and Salterio (2001) argued that CG practices could be
strengthened by the functioning of an effective audit committee and firm value can be
enhanced. Brown and Caylor (2006) highlighted that independent audit committee may
increase firms’ dividend yield; however, it is not improving operating performance
significantly. Size and composition of audit committee have been considered important
characteristics of an effective audit committee whereas its meeting intensity is an
imperative tool of the well-functioning of an audit committee.
1.2.2 Board Structure
Board of directors is considered as a source of power, authority, vision and strategic
policy making for attaining the long term organizational goals. Being the elected
representative of disbursed shareholders of the firm, board of directors is supposed to
safeguard the interests of scattered stakeholders by effectively supervising the activities
performed by firm’s management. Board is delegated with the responsibility of making
the resources available for firm’s operation to achieve organizational objectives and
administering the managers (Hillman & Dalziel, 2003). Board structure, as CG
mechanism, consists of various aspects that may ensure effective implementation of CG
and enhance firm value. These include size and composition of board, board leadership
and dominance, characteristics of CEO (age, tenure, qualification, and experience), board
committees, activity and participation rate of directors in meetings etc.
The board of directors is elected by the shareholders to effectively monitor management’s
performance and for strategic planning. It is essential for the firm that it should have a
board that is independent from the influence of the management for effective monitoring
of executives and managers. For the autonomy of the board, presence of outside
independent/nonexecutive directors on the board has been highly emphasized by
professionals and academic researchers which would help in value creation for firm
(Belkhir, 2009). The rationale behind this belief is that the interests of outside
shareholders are better defended by outside directors. Furthermore, the researchers in CG
8
literature believe that value can be improved and agency cost can be reduced by
separating the positions of CEO and chairman of the board, called CEO duality (Jensen &
Ruback, 1983). The decision making power will be concentrated in one hand if one
person is serving as CEO and chairman of the board. Contrarily, the stewardship theory
argues that CEO duality may create strong and visionary leadership by having unity of
command and hence, leads to superior firm value. It is also believed that board power can
be delegated to sub-committees of board which can perform organizational tasks in a well
manner. Similarly, as board meets more frequently with higher participation rate, the
corporate decisions can be better supervised and directed which leads to improved
organizational value.
1.2.3 Compensation Structure
Compensation structure is one of the oldest mechanisms of CG even Adam Smith (1776)
and Berle and Means (1932) recommended that solution to the conflict of interests issue
between managers and shareholders is to effectively compensate the managers so that
they can work in the best interests of the shareholders. Fama and Jensen (1983)
mentioned that owner-manager agency issue can be resolved by providing managers
equitable market based and stock option based compensation plans. Managerial
compensation can be cash (salary, bonuses, and allowances) as well as non-cash
(perquisites, fringe benefits, stock options, employee stock ownership plans). It may also
be short term (current cash and non-cash rewards) as well long term (postretirement
benefit plans i.e. pension schemes, gratuity). Both short and long term compensation
plans are equally important as Naraayanan (1996) argued that if compensation of
managers consist only the short term benefits, managers may involve in under investment
activity. So in order to achieve the long term organizational goal of value creation for
shareholders, managerial compensation must contain some portion of long term incentive
plans.
The CG literature has documented the enormous significance of managerial
compensation as an important tool for CG (Core & Larcker, 2002; Fama & Jensen, 1983)
and its impact on firm value (Firth et al., 2006; Jensen & Murphy, 1990; Shleifer &
Vishny, 1997). Some researchers have considered managerial compensation as an
9
imperative tool to enhance the accounting as well market value (Firth et al., 2006; Jensen
& Murphy, 1990; Ozkan, 2011) whereas Boyd (1994) and Brick et al., (2006) did not
find any significant association between managerial compensation and firm value. Jensen
and Murphy (1990) further contended that only short term salary plans are insufficient
and ineffective governance mechanism to reduce agency cost and enhance firm value
because when salary is linked to firm value, managers are more induced towards
manipulating and managing reported earnings to meet performance targets. Brennan
(1995) added into it by suggesting that only monetary incentives are not enough to
motivate the manager rather some perquisites other than cash salary in the form of fringe
benefits must be the part of managerial compensation plan.
1.2.4 Ownership Structure
Ownership structure of the firms also serves as an important tool for the effective
implementation of CG. Its significance was augmented when Berle and Means (1932)
presented the concept of separation of ownership from its managers and Jensen and
Meckling (1976) discussed the agency issue between these parties due to the conflict of
interests. These landmark efforts laid the foundation of plentiful academic research on
ownership structure and debate started on how ownership structure can ensure
transparency and accountability in firms and safeguard shareholders’ interests by
increasing firm value.
Generally, ownership structure is categorized in two main groups; ownership
concentration and ownership identity. Ownership concentration is holding majority of the
ownership stake in the hands of few shareholders usually large owners (Sciascia &
Mazzola, 2009). It is believed that ownership concentration and existence of a block
holder (having more than 10% ownership) may enhance the firm value as these block
holders may affect the corporate decision making in a sturdier form. Existence of block
holders also resolves the manager-shareholder conflict of interests as they are in better
position to force manager to take value-maximizing decisions well as majority-minority
shareholders issue by not allowing the insiders to exploit the external shareholders’ rights
(Jensen, 1986).
10
Moreover, ownership identity can be categorized into inside and outside ownership
(Jensen & Meckling, 1976). Inside ownership includes managerial ownership
(McConnell & Servaes, 1990; Singh & Davidson III, 2003), CEO ownership (Demsetz &
Villalonga, 2001), directors ownership (Farrer & Ramsay, 1998), family ownership
(Anderson & Reeb, 2003; Fama & Jensen, 1983). Outside ownership encompasses
individual ownership, institutional ownership, government ownership and foreign
ownership. Institutional ownership structure has been researched most among all outside
ownership mechanisms. Shleifer and Vishny (1997) argued that presence of institutional
investor leads to superior market value of firms because of their effective monitoring.
1.2.5 Corporate Governance Index
Along with above mentioned four singular CG mechanism, some authors have also
suggested composite measures of CG. Gompers et al. (2003) was the pioneer to explore
the relationship of equity prices and CG index, a composite measure of 24 various CG
provisions. Fauver and Naranjo (2010) also used same G-Index of Gompers et al. (2003)
to derive a relationship between corporate hedging instruments and firm value. Bebchuk
et al. (2009) introduced Entrenchment Index (E-Index) consisting of six charter
provisions of shareholders rights by using Investor Responsibility Research Center
(IRRC) database where lower E-index value depicts weaker shareholders rights
protection or more entrenched management. Similarly in Pakistan, Javid and Iqbal (2007)
used 23-item CG index to examine the firm value in Pakistan. This index was based on
three dimensions of CG i.e. board, ownership and disclosures requirements. Yasser and
Ahsan (2011) also developed a scoring index of CG based upon shareholders rights,
board composition, equity structure, and disclosures requirements.
11
Ownership Structure
Compensation Structure
Board Structure
Audit Structure
CG Mechanisms
Board Activity (meeting frequency, meeting participation)
Board Composition (board independence, non-executive and Independent directors)
Board Characteristics (board size, CEO duality, dominance, tenure,age, experience, qualification etc.)
Directors Compensation
Executives Composition
CEO Compensation
Ownership Type (concentration vs. diffusion and block-holding)
Ownership Composition
Outsiders Ownership (individual, institutional, corporate, government and foreign)
Insiders Ownership (managerial, family, and associated companies)
External Auditor Quality (reputation as big auditor)
Audit Committee Characteristics (size, independence, meetings, qualification)
External Audit
Internal Audit
Figure 1.1: Corporate Governance Mechanisms (Source: Author)
12
1.3 Corporate Governance and Firm Value
The relationship between CG and managerial choices for value creation is a topic of
continuing interest for the academicians. It is believed that the practices of CG are value
enhancing and a firm with effective governance system can increase its value by lowering
the conflict of interest between dispersed minority shareholders and empowered
managers of firms as well as by reducing information asymmetry and increasing
management efficiency. After the implementation of Sarbanes-Oxly (SOX) Act of 2002
in the United States, most of the countries had begun to understand the importance of
effective CG mechanisms in order to reduce agency cost and create value for
shareholders. This realization has also ignited research in developed as well as
developing countries of the world to investigate the impact of CG on firm value (Afza &
Nazir, 2012; Brickley et al., 1994; Core et al., 2006; Rosenstein & Wyatt, 1997; Sami et
al., 2011), however, findings are still indecisive. Most of the researchers had documented
a strong positive association between CG and firm value (Bebchuk et al., 2009; Black et
al., 2006; Cremers & Nair, 2005; Gompers et al., 2003). On contrary, some also found
mixed or no evidence of relationship between CG and firm value (Klapper & Love, 2004;
Singh & Davidson III, 2003; Yermack, 1996). However, Gompers et al. (2003) and
Cornett et al. (2009) suggested that relationship between CG and firm value is
endogenous which has not received much attention of researchers in existing CG
literature.
Firms possessing good CG practices may outperform their counterparts due to two main
reasons. Firstly, better governed firms utilize their financial and human resources in an
efficient manner in order to make profitable investments. Investors feel secure while
investing in these types of firms as they believe that less cash flows will be diverted due
to mitigated agency problem and expect higher payouts which ultimately leads to
increased stock price and enhanced firm value (Jensen & Meckling, 1976; La Porta et al.,
2002). The findings of the popular McKinsey Survey (2000) also reported that majority
of the investor respondents assigned more value to the firms with good CG practices.
Secondly, firms with good CG may have lower required rate of return on equity (cost of
equity capital) as shareholders’ costs of monitoring the managers and auditing the
13
reported earnings are much lesser (Shleifer & Vishny, 1997). Good governance practices
of companies may prove to be helpful in building optimistic market reputation in capital
markets and hence, funds can be acquired at lower costs. However, some researchers
have also raised the question mark on this positive relationship of CG and firm value due
to high cost associated with the implementation effective CG mechanism in the company
which may counterbalance its benefits (Bruno & Claessens, 2010).
1.4 Theoretical Background of Value Relevance of CG
The existence of conflict of interests between mangers and shareholders has increased
attention of researchers toward effective CG of firms. In this context, different theories
have emerged to understand the whole mechanism of corporate governance and provided
different views and solutions towards these conflicts to reduce agency problems among
the stakeholders and enhancing the firm value. Some of the relevant theories are
discussed below briefly for better understanding of CG necessary for building up an
academic background for research.
1.4.1 Agency Theory
Much debate on CG issues of business firms rely on the concept of Managerialism and
principal-agent emanating from the work of Adam Smith (1776) and Berle and Means
(1932) who identified the issue of separation of ownership and control in modern
corporations and provided the base to understand the agency theory assumptions, agency
cost, use of incentives and control mechanisms. It is highly recognized that agency theory
is the starting point whenever any debate is enduring on the topic of CG and its
mechanisms. Berle and Means (1932) highlighted that this separation of ownership and
control creates problems when managers neglect the concerns of their principals
(shareholders’ value maximization) and put their self-interests on priority line and collect
private benefits by building empires, enjoying perquisites, get pecuniary benefits by
manipulating accounting records. This divergence in agents’ actions and principals’
interests create agency problem at the cost of shareholders’ value (Shleifer & Vishny,
1997). One possible solution to this issue is that give right and sufficient incentives to the
managers that must linked with their performance of doing best in the favor of their
principals (Berle & Means, 1932). These comprise monitoring expenditures by the
14
owners such as auditing, budgeting, control mechanism, incentives and compensation
systems, bonding expenditures by the agent and residual loss due to interest difference
between owner and agent (Jensen & Meckling, 1976). If firm is successful in mitigating
the agency problem, the firm value increases (Hart, 1995).
In addition to above discussion, Jensen and Meckling (1976) gave a comprehensive
explanation of principal-agent relationship. They described agency relationship as an
agreement between two parties, in which owners (principals) assign various tasks or
responsibilities to the mangers (agents) for execution on their behalf. More precisely it
can be defined as shareholders delegate some responsibilities to a team of experts while
keeping in mind that they will perform best for the success of their organizations.
Generally conflict due to difference of both parties’ interests and difference of attitude of
risk taking between shareholders and managers are two main problems occurred in the
relationship of principal and agent (Eisenhardt, 1989). In addition, Chrisman et al. (2004)
highlighted that conflict between management and owners take place due to the
asymmetry of information as well.
On the whole, agency theory laid emphasis on the opportunistic behavior of managers
who try to put their interest first by forgoing shareholders’ interests of value
maximization. As a result, cost of resolving this problem increases due to the
involvement of several CG mechanisms and monitoring systems like auditing, budgeting
and hiring outside directors on the board and giving monetary and non-monetary benefits
to managers etc. Moreover, agency theory argues two main aspects: corporate boards
must have independent directors because they are affective monitor of the management
and fair in decision making which is in favor of shareholders interest; and there must be
non-existence of CEO duality in the organizations as separate individuals on the post of
chief executive and chairperson of board are more prone toward reducing the unjustified
influence of some board members and particular managers (Fama, 1980; Fama & Jensen,
1983). Further, Eisenhardt (1989) concluded that incentive schemes for managers help to
maximize shareholder interest and reduce managerial opportunism which may lead to
enhance firm value. However, contradictory views also exist on this issue. Some authors
consider managerial compensation as part of agency problem. They argued that it gives
15
more power to agents and compensation is only partial remedy of agency problem
(Bebchuk & Fried, 2003).
1.4.2 Stewardship Theory
Contrary to agency theory, another important theory of CG is stewardship theory. The
roots of the stewardship theory are stemmed out from organizational psychology and
sociology. Davis et al. (1997) refined the concept of stewardship theory and articulates
that managers are hired for handling the firm’s operations in a well manner and a
manager’s achievement and success is measured by satisfaction he gets from the value of
the firm; therefore the manager’s primary objective is to maximize the firm value. Higher
firm value is a motivational spot for corporate managers who are stewards of firm and
consider the organizational objective as their own. Thus, managers choose pro-
organizational behavior that is aligned with wealth of shareholders rather than their self-
serving objectives (Davis et al., 1997).
The most distinctive feature of stewardship theory is to impart more trust in managers
which is lacking in the perspective of agency theory (Davis et al., 1997; Muth &
Donaldson, 1998). This theory implies, first; executive (insider) directors have more
knowledge about their companies and are more likely to enhance the value of their
organizations instead of non-executive (outsider) directors. Outside directors only
enhance the decision making of the board. Inside directors are more trustworthy and
thought to be the best stewards of the company’s resources (Nicholson & Kiel, 2007).
Second, same individual resides at the board chairman and as chief executive is good for
value enhancement of firm value by a quicker decision making and avoidance of
unnecessary organizational bureaucracy.
In comparison with agency theory, stewardship theory argued that managers and inside
directors are best to serve and act in favor of shareholders in any circumstances.
Moreover, Daily et al. (2003) argued that managers and directors safeguard shareholders’
interests by making right decisions to increase firm value, because they also want to
protect their market reputations as good decision makers. Fama (1980) argued that
managers and executives are also managing their careers in order to be perceived as
effective stewards of their respective companies. That’s why stewardship theory insisted
16
on the lesser independence of boards which is associated with the higher value of the
companies.
1.4.3 Resource Dependence Theory
Resource dependence theory emphasizes on the need of different resources for the
success of business. Agency theory discussed about the managers but this theory
introduces accessibility to resources that is a critical dimension of CG debate. The
origination of resource dependence theory laid in the work of Jeff Pfeffer who
demonstrated the importance of relationship between power and exchange with in and
around organization (Pfeffer, 1972). According to Pfeffer (1972), resource dependence
theory argues that company’s success is dependent upon maximizing its power over
certain resources which are necessary for running smooth operations. Basically, the
resource depending theory concentrates on role of board that help to secure and acquire
the crucial resources of the organization by their external linkage to business
environment. Through these linkages, it brings in different resources, such as
information, skills, access to key constituents like supplies of raw material, buyer of
outputs, public policy makers, social groups as well as legitimacy (Hillman & Dalziel,
2003). So, under this theory, board of directors is the key source of various resources that
enhances firm value (Daily, et al., 2003).
Johnson et al. (1996) highlighted the main feature of resource dependence theory. They
said that independent directors on the boards provide more assistance in gaining the
desirable resources. As an outside director who is related to a law firm will provide the
legal services and advises in the board meetings with executive directors which is very
costly for the firm to obtain otherwise. Independent directors have more linkages with the
outdoor environment that is necessary for organization’s survival and future growth
(Hillman et al., 2001). Generally, resource dependence theory argues the availability of
efficient skills of boards that are involved in the accessibility of resources. On one hand,
agency theory suggests the importance of boards in monitoring the managerial activities,
on the other; resource dependence theory highlighted another role of board directors as
the resource providers. Furthermore, Aguilera et al. (2008) argued that the other theories
of CG cover the restraining assumptions of the agency perspective and do not provide the
17
broader view of the CG that make it connected with the diverse organizational
environments. Hence, this space has been covered by resource dependence theory.
1.5 Corporate Governance in Pakistan
The awareness of CG is not very old in Pakistan. Following the enforcement of the code
of CG developed by Securities and Exchange Commission of Pakistan (SECP) with the
collaboration of Institute of Chartered Accountants of Pakistan (ICAP) in March 2002,
the provisions of code of CG were incorporated into the listing requirements of firms in
all stock exchanges (i.e. Karachi, Lahore, and Islamabad) in Pakistan. The code which
was implemented in capital markets of Pakistan under the directions of SECP
encompasses the “best corporate practices” along with compulsory requirements of
Companies Ordinance of 1984. These best practices provide a wide-ranging charter by
which firms listed on Pakistan capital markets are to be directed and controlled in order
to protect the shareholders’ interests and enhance the confidence of capital market
participants. The code is based upon the experiences learnt from the other economies
particularly those of having same common law applicable in Pakistan too. The important
documents in this regards are Cadbury Committee Report on Financial Aspect of
Corporate Governance of UK (1992), Hampel Committee Report on Corporate
Governance of UK (1998), King Committee Report on Corporate Governance of South
Africa (2002) and the Principles of Corporate Governance (1999) by Organization for
Economic Cooperation and Development (OECD).
The ICAP took the initial step to conceptualize the framework of code of best corporate
practices regarding governance in December 1998 by establishing a working committee
of nosiness from SECP, ICAP, the Institute of Cost and Management Accountants of
Pakistan (ICMAP) and the stock exchanges. The draft of code of CG was finalized and
issued on March 28, 2002 after mutual consultation of stakeholders as a part of listing
requirements of all capital markets of Pakistan in order to ensure accountability,
transparency, strict audit compliance and protection of minority shareholders’ interests.
Compliance to the best practices mentioned in the code was mandatory with exception of
two provisions. The obligatory requirements of the code include qualifications and
eligibility criteria of directors (including tenure, powers, functions, and responsibilities),
18
directors’ interest disclosure, training and meetings of board of directors, education,
duties of company secretary, chief financial officer and audit committee, internal and
external auditors’ appointment criteria etc. The voluntary provisions were regarding the
appointment of independent director and restrictions for the brokers to be board
members.
SECP has issued a revised code of CG on April 2012 which incorporates nine revisions
in the earlier code of 2002 and three introductory clauses. The voluntary provision of
independent director appointment made compulsory for at least one director. The other
revisions and new clauses include minimum number of executive directors, number of
directorships, board evaluation, appointment of non-executive chairman separated from
CEO position (no CEO duality), training of board directors, appointment criteria for CFO
and company secretary, qualification and removal of head of internal audit, director’s
remuneration, audit committees characteristics, and internal audit policy.
Since its inception, SECP has been charged with the responsibility to promote good CG
and best corporate practices in Pakistani firms. Along with implementation of code of
CG, SECP also established Pakistan Institute of Corporate Governance (PICG) with the
collaboration of State Bank of Pakistan (SBP) and International Financial Corporation
(IFC) in 2004. PIGC is a nonprofit public-private initiative, limited by guarantee with
zero share capital setup under section 42 of Companies Ordinance 1984 in order to
stimulate good CG practices and principles in the corporate sector of Pakistan. PIGC has,
till now, a total of 107 members including 16 founding, 24 full, 45 associate, 5
institutional and 17 individual members. PIGC is a platform to provide leadership skills
of CG, directors’ education through Board Development Series (BDS), Directors
Orientation Workshop (DOW), advisory and assessment services on CG, accredited
directors’ placement services, and some other various research facilities along with
conduction of symposiums and seminars for general awareness of CG in Pakistan.
Since then, CG has become an important research area in Pakistan and investigation of
impact of CG mechanisms on firm value is of enormous importance; however, the
research on this issue in Pakistan is still limited. A few research studies are conducted on
this issue but these were focusing on the fractional aspects of CG in isolation. Some of
19
these aspects include family ownership (Yasser, 2011); managerial ownership and
concentration (Afza & Slahudin, 2009; Javid & Iqbal, 2010); institutional ownership
(Afza & Slahudin, 2007); Board Composition and CG Index (Afza & Nazir, 2012; Javid
& Iqbal, 2007, 2008) etc. However, these studies have focused on a single dimension of
CG and none of these studies have addressed the possibility of endogeneity between CG
and firm value.
1.6 Corporate Governance and Discretionary Earnings Management
One of most significant value enhancing managerial decisions is Discretionary Earnings
Management (DEM). Earnings management is the judgmental adjustments/alteration in
firm’s reported accounting earnings by managers in order to upsurge firm performance
temporarily (Cornett, et al., 2009). Earnings management has been defined by Healy and
Wahlen (1999, p.6) as:
“[…] when managers use judgment in financial reporting and in structuring
transactions to alter financial reports to either mislead some stakeholder
about the underlying economic performance of the company, or to influence
contractual outcomes that depend on reported accounting numbers”.
Managing the earnings is a choice of accounting rules, voluntary earnings estimates or
information disclosures in order to affect the level or quality of reported earnings
deliberately. This intentional alteration and manipulation of accounting earnings
emasculate the reliability and trustworthiness of disclosed financial reports, which
otherwise may be very beneficial to the stakeholders of capital markets, have underlined
earnings management as much important research area. In general, two methods of
earnings management have been discussed in empirical literature which may be used for
the judgmental manipulation of earnings; earnings management through accounting
accruals and real-time earnings management. Discretionary accounting accruals can be
used to detect earnings management through provisions of bad debt losses, estimated
value of raw material and finished goods inventories, unusual item’s timing and value
etc. (Healy, 1985; Jones, 1991). The other type of is real-time earnings management by
the mutable real economic activities; however this method may be very expensive to
disturb firm’s long term stakes (Graham et al., 2005). Many of the earlier studies have
20
used accrual method to detect earnings management practices of managers (Shah et al.,
2009).
One can argue that how managers can alter reported earnings? Under the Generally
Accepted Accounting Principles (GAAP) applicable in most of countries of the world,
firms use accrual method of recording and reporting accounting information. Under this
accrual method of accounting, financial information and its effect is recorded only when
these actually occur instead of when cash has been received or paid. This capricious
nature of the accounting accruals gives rise to the managerial discretion in determining
the earnings levels a firm report in a given accounting period due to information
asymmetry between management and all other stakeholders of the firm.
The varying nature of accounting accruals provide corporate executives the discretion in
the determination of firms’ reported earnings during a particular period due the universal
fact of information asymmetry between the inside controllers and outside owners of the
firm. Inside managers can alter the reported earrings either to maximize their own
benefits or to affect the informativeness of reported earnings by signaling private
information to the outsiders (Healy, 1985). The reliability and informativeness of
reported accounting earnings is depended on the quality and effectiveness of CG
implemented through different monitoring mechanisms in a firm (Dechow et al. 1996).
After the world renown corporate collapses of Enron, Xerox, or WorldCom etc., a wave
has been initiated to control and mitigate the opportunistic behaviors of manages and to
enhance the credibility of the financial reporting through development and
implementation of effective CG systems all over the word.
Previous studies in corporate finances have found several motives for DEM including
obtaining personal benefits like compensation plans (Gaver et al., 1995; Healy, 1985;
Holthausen et al., 1995); job security (DeFond & Park, 1997), meeting debt covenants
(Bowen et al., 1995; DeFond & Jiambalvo, 1994; Sweeney, 1994), achieving investors’
expectations (Barton & Mercer, 2005; Bartov et al., 2002; Kasznik, 1999), setting a better
listing price after going public or initial public offering (Clarkson et al., 1992; Teoh et al.,
1998), maximizing merger premium and minimizing acquisition cost when stock
21
consideration is used by acquiring firm (Louis, 2004), and reducing loan loss (Beaver &
Engel, 1996).
Earnings management may be used as tool to show better firm value by managers
especially when their incentives and remuneration is associated with their companies’
value. Managers can pursue their personal benefits by manipulating earnings or signaling
their private information to capital market participants, and hence influencing the
earnings informativeness and consequently market value of firm (Healy, 1985).
Moreover, management has substantial control over the actual expenses timing and they
try to alter the timing of recognition of revenues and expenses, to some extent (Teoh et
al., 1998). Healy (1985) was the forerunner to provide the evidence that managers, as
they possess inside confidential information, manipulate the current period earnings on
the cost of long term firm value based upon their contractual motivation in order to
increase their bonuses and salary increments. DeFond and Park (1997) argued that
securing the job is another reason for the managers to upsurge the current period
earnings.
Usage of debt in firms has produced different explanations for managers’ motivation for
earnings management. Earnings may be manipulated upward when managers want to
avoid the violation of debt covenants and increase their bargaining power during new
debt negotiations to obtain low cost debt (DeFond & Jiambalvo, 1994; Othman & Zeghal,
2006; Sweeney, 1994). On the other side, effective monitoring and control by the debt
holders and bondholders in high leveraged firms makes it difficult for managers to
manipulate reported earnings through earnings management (Chung et al., 2005).
Similarly, achieving investors and analysts expectations may also give a strong reason to
managers to alter the reported earnings, particularly for the firms which issue earnings
forecasts. Rappaport (2006), in his ten principles to create firm value, suggested that
firms should not give earnings guidance to the capital market participants as they have to
manage earnings to meet the prospects when earnings are falling below the required
targets of investors and analysts.
There are both good and bad facets of DEM. Stocken and Verrecchia (2004) has
discussed that it can disclose insider information and blocked communication between
22
firm and capital market participants can be minimized. Earnings management is
specifically important for banking industry in which investors and capital market
positively respond to incremental loan loss reserves that shows signaling effect instead of
managerial opportunism (Beaver & Engel, 1996; Wahlen, 1994). However, on the
contrary, DEM can result an opportunistic behavior of managers (Dechow et al., 1996)
and earlier studies found that greater earnings manipulation and a reduced level of
earnings informativeness are the topographies of a fragile investor protection framework
(DeFond et al., 2007; Leuz et al., 2003).
The fundamental issue of CG is how to ensure accountability of top management to their
stakeholders while concurrently providing executives with the autonomy and incentives
to exploit wealth producing strategies. Effective CG structure to control the opportunistic
behavior of mangers can presumably make accounting earnings more reliable and more
informative for the stakeholders and hence, increases firm value (Dechow, et al., 1996).
The academicians and professionals in the field of finance had started emphasizing the
need of strict corporate control and monitoring structure to resist against the opportunistic
managerial behavior, particularly after several recent financial scandals of Enron, Xerox,
Etoys, Worldcom and many more. Cheng and Warfield (2005) provided evidence on the
link between earnings management and CG by reporting that the propensity for earnings
management is lower when management interest’s and owners’ interests are more closely
aligned through effective governance structure. Liu et al. (2015) also argued that better
transparency and disclosure ensured by governance practices can significantly reduce the
earnings management practices. In addition to controlling the opportunistic behavior of
managers in managing earnings, Kang and Kim (2011) suggested that DEM may
moderate the relationship between CG and firm value. They argued that as DEM might
be influenced by CG mechanism and also effect firm value in turn, DEM might also
moderate the relationship between CG and firm value; however more conclusive analysis
is still required.
1.7 Significance of the Study
During the last couple of decades, regulators, investors, policy makers and other capital
market participants have been increasingly focusing on the need for firms of have an
23
affective monitoring and accountability system of CG in order to minimize this
misalignments of interests between shareholders and managers, commonly known as
agency problem. Along with the agency phenomenon, the global financial catastrophe
and investors’ desire for companies to have good CG system also amplified its
importance. CG focuses on the issue of bringing accountability and transparency into the
operations and information reporting of firm with an overall objective of welfare of all its
stakeholders including managers, shareholders, regulator, society and the economy as a
whole.
Academic researchers have tried to explore the potential adverse effects of absence of
effective control mechanism and misalignment of shareholders and managers interest.
However, these studies had focused only on one or two dimensions of CG ignoring the
others. The present study is unique in its nature to investigate the relationship of CG and
firm value by taking into consideration more comprehensive measures of CG practices
and alternative firm value measures. As suggested by Gompers et al. (2003), it also takes
care the problem of endogeneity and investigates the bi-directional relationship between
CG and firm value. In addition, the study also incorporates influence of earnings
management practices into the relationship of CG and firm value and intends to see
whether earnings management strengthens the relationship between effective CG and
enhanced firm value. Moreover, it will also be interesting to know that whether DEM
play a moderating role in CG and firm value which has been a relatively ignored research
area in existing empirical research.
1.8 Research Objectives
The objectives of the current study include:
To validate the relationship between the CG and firm value by covering more
comprehensive measures of CG as well as market and accounting measures of
firm value in Pakistan as well as to reconnoiter the possibility of endogeneity
between CG and firm value and check for institutional shareholders’ activism;
To investigate the impact of effective CG on the DEM practices of managers;
24
To examine the role of DEM in enhancing the accounting and market value of
firms and;
To analyze the moderating role of DEM in established relationship between good
CG and firm value.
The remainder of the dissertations is organized as follows; Chapter 2 briefly reviews the
relevant literature on CG, earnings management and firm value; Chapter 3 provides the
research framework and methodology; Chapter 4 analyzes and discusses the empirical
results; whereas the last chapter presents findings and concludes the dissertation.
25
Chapter 2
LITERATURE REVIEW
26
Importance of CG and its mechanisms in boosting the firm value is not a refuting fact and
it has sturdy impact on corporate value. Policymakers as well as academic researchers in
finance have consensus that CG is the main prop for wealth maximization for
shareholders and corporate value while plummeting the agency costs (Demsetz, 1983).
Generally, in order to minimize the agency cost and maximize the firm value, effective
CG system is implemented into firms by four mechanisms, namely audit structure, board
structure, managerial compensation and ownership structure (Fernando, 2011). The
academic researchers have used one or a set of these four CG mechanisms to evaluate
their impact of business decisions and firm value. This chapter reviews relevant literature
on impact of CG elements on firm value as well as its effect on controlling the
opportunistic behavior of manager in managing corporate earnings.
2.1 Corporate Governance and Firm Value
Focusing on the relative importance of CG, extensive work has been carried out to find
the impact of CG on firm value; however, mixed and contradictory results have been
found. Several researchers have found positive association (Brown & Caylor, 2006;
Gompers et al., 2003), some found mixed results (Pi & Timme, 1993; Rechner & Dalton,
1991) and some found no connection between value of firms and CG (Baliga et al., 1996;
Bhagat & Black, 2001; Pham et al., 2011). The literature on CG and firm value is
categorized according to its mechanism of audit, board, compensation and ownership
structure as well as the composite measure of CG.
2.1.1 Audit Structure and Firm Value
CG is considered as the mean of improving the economic efficiency in the economy of
whole world. It has significant impact on the firm value, because its mechanisms reduce
the agency problem that causes due to, the separation of ownership and management.
Previous literature showed that establishment of audit committee can play a significant
role in the areas of internal auditing, deal with external auditing, risk management and
financial reporting process. The board of directors delegates its authority to oversee the
financial activities of a firm to its audit committee, thus making it a type of monitoring
tool which enhances the quality of information flow between the stakeholders. An
effective audit committee minimizes the agency conflicts, protect shareholder’s right,
27
safeguard stakeholder’s issues and in this way maximize the firm value. The literature on
audit committee and firm value is scarce and not very old. Most researchers have focused
on role of internal and external audit structure on the quality of reported earnings and
fraud detection etc. However, there is growing number of studies that provide evidence
on the audit committee and its characteristics (size, independence, meeting frequency) in
improving the value of the firm (Szczepankowski, 2012).
Several researches showed that audit committees that are independent and active are
more likely to reduce frauds and misleading financial reporting process (Beasley, 1996).
Dechow et al. (1996) focused on the presence of audit committee and its relationship with
the occurrence of the financial statements and reporting frauds. These studies found the
inverse relationship between the existence of audit committees and monetary frauds in
the corporations. Furthermore, DeZoort (1997) explained in his study that audit
committee enhance the financial reporting process, auditing and in general the corporate
value. The main role of audit committee is to hire the external auditors, provide them
support with the help of internal auditors work and supervise their work.
The size and internal structure regarding the level of independence of an audit committee
has remained a topic of interest in CG literature (Cadbury Committee Report, 1992).
Generally it is believed that a smaller audit committee can be more effective in
performing its monitoring roles and to reduce the fraudulent activities in firms and hence
improving value. The empirical studies have reported that the optimal size of audit
committee ranges from seven to nine and this small audit committee is associated with
higher firm value (Eisenberg et al., 1998; Lipton & Lorsch, 1992). However, Bedard et
al. (2004) argued that large audit committee can ensure more effective control and
monitoring on the accounting and operational processes. Moreover, Olivencia Report
(1998) stated that audit committee should have majority of independent members that
complete this responsibility in an unbiased manner. In addition, Blue Ribbon Committee
(1999) and National Association of Corporate Directors (1999) both recommended that
audit committees should be independent then they are more likely to protect the
credibility of the financial reporting of the firms.
28
Chan and Li (2008) examined the association between the independence of audit
committee and the firm value by selecting a sample of 200 fortune companies. Results
illustrated that independent directors on the board and audit committee has positive
impact on the firm value. Moreover, study evidenced that expert independent directors on
audit committee enhance the firm’s value five times more than an audit committee having
only independent directors alone. Hutchinson and Zain (2009) explored the relationship
between internal audit quality and audit committee effectiveness on firm value. Data on
internal audit quality and audit committee effectiveness was gathered through a
questionnaire mailed to 60 listed companies on Bursa Malaysia. Having a 20% response
rate on questionnaire and using secondary data for firm value, the study reported that
there is a strong positive relation between firm value and internal audit quality for the
firms having higher growth opportunities. However, this positive association weakens
when audit committee independence increases raising a question about the governance
suggestion for having all non-executive directors on the audit committee. The study also
argued that conflict of interests may arise between internal auditor and inside-dominated
audit committee that may deteriorate firm value. They recommended that having all the
non-executive directors on audit committee does not increase value rather firms should
have a right mix audit committee members with appropriate skills to assess uncertainties
confronted by a company.
Mohiuddin and Karbhari (2010) developed a theoretical model on the effectiveness of
audit committee after reviewing the previously carried out studies. Previous studies
showed that independent, knowledgeable and expert audit committees play an important
role in the areas of internal auditing, financial reporting, and dealing with external
auditors, risk management and compliance issues. Audit committee is an effective
mechanism for ensuring good and better CG in the corporations. Moreover, audit
committee enhances the earnings quality and financial reporting process which
resultantly recognized more earnings. Therefore, literature suggests that effective audit
committee has significant positive influence in minimizing the agency issues,
safeguarding stakeholder’s interests and hence maximizing the overall value of firms.
In the same way, Lama (2010) studied the audit committee in Australia after the
introduction of Australian Stock Exchange (ASX) guidelines for the establishment of
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mandatory audit committees in the top 500 ASX listed corporations. The main aim of this
study was to investigate whether establishment of audit committees are economically
justified or simply a window dressing. A sample of 100 firms was used in this study.
Firm’s beta () was used to calculate the firm’s stock volatility and return on assets
(ROA) was used to measure the operational efficacy of the firms. In short, both measures
were used as the substitute of economic benefits. Results showed that corporations who
have formed audit committees are more and better able to manage the firm’s risk.
Moreover, these firms are better utilizing the resources for generating returns as compare
to those firms who have not formed audit committees.
Al-Matari et al. (2012) investigated the relationship of various internal CG mechanisms,
including audit committee size, activity and independence, and firm value in Saudi
Arabia. They have obtained the data for 135 Saudi listed companies for the year 2010
only. The results also confirmed the notion that small audit committees can boost the firm
value based upon the argument of Yermack (1996) and Karamanou and Vafeas (2005)
that larger audit committees have diffusion of responsibility and they can agonize from
process losses. Audit committee independence and activity were found insignificantly
related to firm value for Saudi companies. However, Ojulari (2012) stated that investors
pay more premiums for some of the audit committee characteristics that others even all
put together. Using a sample of 25FTSE companies for two years, he investigated the
relationship between several audit committee features like size, independence, meeting
frequency, financial literacy of members and firms’ accounting and market measures of
value. The results supported that small sized more independent audit committees generate
more returns for the shareholders.
Bouaziz (2012) explored the effect of audit committee characteristics and firm value
measured by Returns on Assets (ROA) and Returns on Equity (ROE) for 26 publically
listed Tunisian firms from 2004-2007. The results reported that size of audit committee,
nomination of more independent directors on audit committee, and members financial
expertise have positively relationship with firm value measures of ROA and ROE.
Aldamen et al. (2012) examined the relationship between audit committee features and
value of firms for Standard and Poor (S&P) 300 firms during global financial crisis of
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2008-09. A total of fifteen audit committee characteristics related to size and
independence have been used as predicting variables for firm value. They have reported
that small audit committees are associated with improved firm value whereas, presence of
more experienced and financially expert directors on audit committee also enhance the
value of firms. They further argued that independent and short-serving chairman of audit
committee can positively influence the firm value, particularly during the period when
firms are in the phases of financial distress.
Hamdan et al. (2013) examined the relationship of audit committee size, independence
and financial expertise with operating, financial, and market value of Jordanian firms.
Taking a sample of 106 firms listed at Amman Stock Exchange for the period of 2008-09,
the study reported that audit committee characteristics are affecting market and financial
performance but not the operating performance of firms in Jordan. Audit committee size
and independence both are positively leading firm value. Recently, Saibaba and Ansari
(2013) analyzed the effect of audit committee characteristics on the corporate value of 30
Bombay Stock Exchange listed companies using panel data for the period of 2008 to
2011. They have formed a composite measure of CG based upon audit committee
features and board committee structure and found that audit committee characteristics are
significantly related to the value measures of selected firms. This is due to the fact that
after the implementation of International Financial Reporting Standards (IFRS) in Indian
firms, the existence and role of independent committee has formed an integral part of CG
mechanism for both internal and external stakeholders in India.
The effectiveness of audit committee can be assessed by its meeting frequency. More
diligence is associated with the higher audit committee meeting frequency (DeZoort et
al., 2002) and audit risk can be minimized if audit committee meets more frequently
(Stewart & Munro, 2007). In this regard, Azam et al. (2010) analyzed the impact of audit
committee meeting frequency on the equity returns of firms listed in Australian Stock
Exchange. Data was collected for 119 top firms of Australian Stock Exchange for the
period of 1999 to 2007. Using linear regression, results showed that audit committee
meeting frequency is significantly and positively related to firm value in Australia,
however; authors claimed that findings could not be generalized due to several study
limitations. Al-Matari, et al. (2012) and Aldamen et al. (2012) have also confirmed this
31
positive relationship between audit committee meeting frequency and firm value,
however; Ojulari (2012) failed to find any association between audit committee activity
and firm value.
The role of external auditor size and reputation in mitigating the agency problem is
proven, however; research on external audit quality is very limited. Willenborg (1999)
first raised the issue that external auditor may perform a significant part to reduce the
level of information asymmetry between the stakeholders of a firm which may cause due
to the separation of ownership and management. Later on, DeFond and Francis (2005)
have argued that external audit quality may contribute to be an important dimension and
mechanism of an effective CG structure. Since the reputation and negotiation power of
big auditors may provide them greater freedom to detect errors and fraudulent activities
and to ensure more accountability and transparent informational disclosures by a firm,
they may affect firm value (Fan & Wong, 2005). Managers feel hesitant while misusing
company resources and indulging into opportunistic behaviors if they know that external
audit is to be performed by big auditor with honest and good market reputation. Earlier
researchers have also reported that that big audit firms deliver greater audit performance
(Fuerman, 2006; Krishnan & Schauer, 2000).
In this regards, Fooladi and Shukor (2012) provided empirical evidence on the
relationship of external audit quality and firm value in Malaysia. The study analyzed a
sample of 400 randomly selected companies from Bursa Malaysia for the cross sectional
investigation for year 2009. The authors documented empirical evidence that big four
auditors have significant positive impact on returns on assets of sample companies in
Malaysia. Further, market value is also higher for the firms getting their accounts audited
by big four audit firms indicating capital market participants also consider the reputation
and size of external auditor to be an effective controlling and monitoring CG mechanism
in Malaysian stock market.
2.1.2 Board Structure and Firm Value
It has been strongly argued in literature that effectiveness of board of directors as the
mechanism of governance is fundamental for the enhancement of the profitability and
value of the firm (Bhagat & Black, 2001; Johnson et al., 1996). Board of directors is the
32
most superior authority in organizations to monitor and keep managers accountable as
well as for the smooth operations of the company along with providing the managers a
long term vision and strategies. The earlier academic researchers have found mixed
evidence on the relationship of firm value and different elements of board structure as a
mechanism of CG structure. Predominantly, board, size, board composition and
independence, CEO duality, board meeting intensity and participation along with
characteristics of directors have been examined in finance literature mostly.
Regarding board size, Yermack (1996) conducted the study to find out the relation
between the value of the firm and the board size. For 452 US largest public and industrial
firms for the eight years from 1984 to 1991, a negative correlation was found between
size of the board and value of the firm by employing various regression models. The
Tobin’s Q was used as a market value estimate. The major portion of lost figure occurs
when size of the board is increased from smaller to average as suggested by the U-shaped
relationship evidence between them. After controlling for the size of firm, alternative
structures of ownership and governance, growth opportunities’ existence robustly proved
the main results. When board size increases, financial ratios concerning efficiency of the
operations and profitability decline and when the size of board rises, the CEO’s dismissal
threat functions less firmly. There was found that considerable additional returns on
stocks were realized by the firms near the dates of announcements who announced
diminution in the size of the board whereas less returns was gained by the firms who
declared extension in the board size .
In consistent with above, Eisenberg et al., (1998) ascertained the influence of size of the
board on the profitability of firms in Finland. An inverse relation between size of the
board and the profitability for the 94 insolvent and 785 solvent Finnish mid- and small-
cap companies as the sample was found. The hypothesis was supported by the evidence
that the smaller companies lead towards smaller board size as the coordination and
communication problem occur between the directors due to selection of sub optimal
structure of the board by the owners in closely held companies. Moreover, higher number
of outside directors in large board promotes cautious policies related to decision making.
Owners make selection of the boards which corresponds with their inclination due to risk
preferences so it does imply that they have made suboptimal sizes of the board. The
33
composition of the board related to the cautious decision making might be preferred by
the owners who have made investment in specific company whereas board structures of
board related to bold investment plans might be preferred by the diversified investors.
Differently, Coles et al. (2008) reexamined the affiliation between the structure of the
board and value of the firm for the period of 1992-2001 for the ExecuComp firms. It was
found that simple companies hold smaller boards consisted of fewer directors from
outside than the complex companies that hold more advising requirements. Favorability
of either of the very big board size and very small board size was suggested by the U-
shaped link between the size of board and Tobin’s Q. The number of directors from
outside drove the decrease of Tobin’s Q by the board size of simple companies or
increase of Tobin’s Q by the board size of complex companies. The view that value of
the firm is enhanced by the representation of insiders and limitations on the size of board
was challenged by the findings of this study. With the different view, low variance in the
value of the firm by having more directors on the board was empirically evidenced by
Cheng (2008). On the other side, Abdullah et al. (2008) found positive while direct
relation of board size for one and inverse for other measure of value was found out by the
study of Kajola (2008). Quite opposite to it, negative and strong relation was found by
Palmberg et al. (2009) and also Switzer and Tang (2009) argued that value of the small
cap firms is harmed by the larger board size. At the same time as, O’Connell and Cramer
(2010) also came across with the negative and significant in Ireland but conflicting
results were evidenced by Christensen et al. (2010) in Australia.
On the contrary, Topak (2011) centered his attention on the connection between size of
the board and value of manufacturing firms in Turkey. From 2004 to 2009 as the sample
period, the 122 companies quoted on the Istanbul Stock Exchange were chosen as the
sample size. No association was found between value of the firm and size of board
significantly which was dissimilar in findings the previous researches conducted in this
regard. This insignificant association might be the reason of distinctive laws, culture and
ownership structure of firms in Turkey. Particularly, during the process of decision
making, the board sizes are made irrelevant by the family members’ dominance on the
board. The value of the company would be impacted by the members of the family who
make ultimate decisions upon the important matters of the company, irrelevant to the
34
board size. In the context Canadian firms, Gill and Mathur (2011) contended that value is
inversely related with the size of board.
Another tool of effective board structure is board composition and independence which is
measured through presence of outside/non-executive/independent directors on the board.
Agrawal and Knoeber (1996) empirically investigated the relationship between the value
of the firm and mechanisms of controls and interdependency among them. For the
purpose to gauge the corporate control activity, external labor market usage, debt
financing, outside directors representation on the board, ownership by large block
holders, ownership by institutions and ownership by insiders as the control mechanisms,
about large 400 US companies had been employed in the sample. The results found the
inverse relation of outside directors on board with the value of the firm when
interdependency among mechanisms is accounted for in simultaneous system estimation.
Bhagat and Black (1999) provided the proof on the connection between the value of the
corporation and composition of the board. In the duration of 1985 to 1995, the effect of
board independence was tested for a variety of value measures by including the 928 large
public US firms in the sample. On the whole, the view that profitability of the firm
increases with the increase in the independence level of the board, provided no persuasive
evidence by the presence of different board compositions in large firms of America.
Particularly, they argued that companies should have independent directors with super-
majority. In contrast, a little evidence was found that companies earn more profits when
boards of those companies do not consist of independent directors with supermajority as
compared to other companies. Three to five directors as the average quantity of insiders
on the board might be benefited to companies was suggested by this study. With
dissimilar results, Barnhart and Rosenstein (1998) found weak curved connection
between value of the company and outside directors’ fraction.
Consistent with earlier studies, Kiel and Nicholson (2003) carried out the research with
the objective to investigate the rapport between the demographics of the board and value
of the corporations in Australia. For the year of 1996, the sample included the largest 348
firms based on market capitalization and listed on the Australian Stock Exchange. The
recommendations concerning the equilibrium between the outsiders and insiders on the
35
board by reports of various experts were supported by the results of the study. Moreover,
the results found direct correlation between the inside directors on board and profitability
based on market measure also confirmed a few prophecies of stewardship theory. Once
more, this finding was in harmony with the notion that suitable mix of skills is necessary
for board as argued by the resource dependence theory. The results also implicated that
composition of the board might have greater significance with regard to the measures of
market as compared to performance based on accounting. By employing the return on
assets as the accounting measure, results were insignificant with regard to board
demographics where as significant in case of Tobin’s Q as the market measure. There are
some studies which found positive associations (Abor & Biekpe, 2007; Kyereboah-
Coleman, 2007), however; Cho and Kim (2007) found weak positive in Korea while
Shan and Qi (2007) evidenced no direct and significant association between the firm
value and outside directors in China.
In similar way, Rashid et al. (2010) inspected the effect on value of the firm by outside
directors which represent the board composition in Bengali firms. For the 2005-2009, the
274 observations from the 90 quoted companies of Dhaka stock exchange were
considered for the sample. In order to test the link between the firm value and
composition of the board, the development of two hypotheses were made and these were
tested by making use of analysis of linear regression. Outside directors which represent
the composition of the board showed no correlation with the value of the firm
significantly and made indication that in order to create value; the outsider directors do
not have any potential in Bengali firms. Opposite to this, Christensen et al., (2010) and
Stanwick and Stanwick (2010) evidenced the negative link between the value and board
independence but O’Connell and Cramer (2010) witnessed positive and significant effect
in Ireland. Further, various studies found direct and significant relation (Ameer et al.,
2010) where as others found no significant results (Kajola, 2008; Wang & Oliver, 2009).
Paul et al. (2011) pored over the effect on firm value by the board composition of
Nigerian companies. For the year 2009, the 38 companies listed on Nigerian stock
exchange were included in the sample by using the cross-sectional design. The fraction of
outside directors on the board of Nigerian companies made representation of the board
composition. No direct and significant correlation amid the value of the firm and
36
composition of the board was suggested by the study. It had been argued that autonomous
recommendations given by outside directors make an important contribution in the
process of decision making. Despite the fact that CG might be enhanced by such
recommendations and such recommendations might not sufficient in the value addition of
CG economically. It might be for the reason of asymmetry of information or that outside
directors have limited information and they have to hinge on the information provided by
the inside directors for the purpose of making decisions based on information. These
might have few advantages in spite of the fact that outside directors make no contribution
in the value addition of the firms economically as showed by the results. An inverse link
(Pombo & Gutiérrez, 2011; Sahin et al., 2011) as well as insignificant relation
(Chatterjee, 2011) has also been observed between the board independence and value of
the firm.
The dual of CEO as chairman of board has been remained a research topic of continuing
interest in board structure. Baliga et al. (1996) examined the status of CEO duality for all
of the Fortune 500 firms for the period of 1980-1991. It was suggested by the results that
no change had been made in the duality status by the market. Also alterations had been
made in the structure of duality with the changes of operating performance as little
evidence has been obtained. The continuing performance was affected by the status of
duality as provided by the weak evidence. At last, due to the deficient variances in the
long term value of the firm among the companies having different leadership structure of
the board was in consistent with the reasons given supporting the non-duality structure.
Though, possibility for misuse by the management might be increased by the duality and
it is not necessary that abuse by the management is manifested tangibly. On the contrary,
Sridharan and Marsinko (1997) said that higher value of the firms having duality of CEO
is indicated in the superior market value but negative association was demonstrated by
Mir and Nishat (2004).
Judge et al. (2003) empirically investigated the correlation between structure of the board
as the governance mechanism and value of the firm and developed a number of
hypotheses in relation to association of the structure of the board and value of the firm by
making use of the institutional and agency standpoints. By employing the survey
instrument hypotheses were tested and the sample size of 113 firms was used in the
37
context of Russia. The anticipations from the views of both institutional and agency
theories were held up in spite of use of a comparatively small sample. Specially, they
observed an inverse impact of CEO role as the Chairman of the board on the value of the
firm. The inverse link was notable and worth mentioning because the dual role of CEO
also as the chairman of the board is prohibited by the Federal law of 1996 of Russia.
In the same way, Kang and Zardkoohi (2005) tested the link between the value of the
firm and CEO duality by taking publicly listed firms as sample. It was argued that the
vague and unclear results regarding the impact on the value of the firm by the structure of
board leadership were due to the differences of concepts and methodologies used. It had
also been stressed that reduction or enhancement of firm value by the structure of board
leadership is contingent on the external and internal circumstances of the firm that best fit
with them. Argument had been made that adoption of duality status by the firms is made
in suitable circumstances whereas this adoption of duality status is made in unsuitable
circumstances. Consequently, it had been said that it is very important and necessary to
give detail explanations with regard to the suitable and unsuitable circumstances in order
to test the influence on value by duality empirically because no existing researches
focused on the circumstances for the adoption of duality. In the favor of stewardship
theory, Abor and Biekpe (2007) observed positive relation of CEO duality with value.
Likewise, Peng et al. (2007) found the same in China during the institutional transition.
Defending the agency theory, inverse correlation was revealed by Kyereboah-Coleman
(2007) in African, and Kholeif (2009) in Egyptian listed firms.
Kyereboah-Coleman (2007) investigated the impact of CG on the value of the companies
operating in the African countries. For the five years from 1997 to 2001, analysis was
done on the panel data of 103 listed companies of Kenya, Nigeria, South Africa and
Ghana by employing both accounting and market estimates of value. The magnitude and
direction regarding the governance effect was contingent upon the measure of value as
indicated by the results. Particularly, it was found that corporate value was inversely
affected by CEO duality. It was suggested that the titles of chairman of the board and
CEO should be separated in order to enhance the corporate value. This study showed
overall mixed results but on the contrary other researches done in Ghana, Greece and
38
Korea on the whole showed that value of the firm is positively linked with CG (Kim &
Yoon, 2007).
In a different way, Yu (2008) intended to look into the link between the duality of CEO
and value of the firm by using OLS regression analysis in China. For the period of 2000-
2004, 1,965 companies from the manufacturing sector publically listed on the Shanghai
stock exchange were included in the study as a sample size. The results showed that the
relationship of structure of board leadership with the value of the firm was moderately
affected by the external environment and industrial characteristics. For the years 2000
and 2001, no relation was found between the value of the firm and CEO duality.
Whereas, for the years 2002 and 2003, positive relationship was seen between the value
of the firm and CEO duality and this relationship was robust in low munificence and
highly volatile situation after the compliance of rules and regulations related to the
separation of status of CEO and chairman in China. The positive improvements in the
structures of board leadership and progress of public listed firms of China were revealed
by the research findings. On the other extreme, Ponnu and Karthigeyan (2010) and
Mashayekhi and Bazaz (2008) demonstrated insignificant results.
Iyengar and Zampelli (2009) carried out the research by compiling the sample of
nonutility and nonfinancial companies from the database of ExecuComp. The 1,880 firm-
year observations were chosen as the final sample from 1995 to 2003. The argument that
in order to optimize the performance, structure of CEO duality is adopted by the firm was
not supported by any evidence from robust findings. It was argued that the structure of
CEO duality is adopted by the firms when they are adopting the duality structure not for
the optimization of performance but for the other reasons attributed to the opportunistic
behavior of insiders. Actually, a significant partiality with regard to selection biasness
was evidenced which lessened the value of the firm measured by earning per share and
market return. Also no marginal value and selection biasness was proved significantly
when the CEO duality effect on the Return on Assets and Tobin’s Q which measure the
value was tested. Evidence of adverse negative impact was found out by the Ehikioya
(2009) and Leung and Horwitz (2010) while conflicting results were observed by the
Christensen et al. (2010)
39
On the contrary, Amaral-Baptista et al. (2011) researched the connection between the
duality of CEO and firm value in Brazil. The 121 firms listed on the BOVESPA (Sao
Paulo Stock Exchange) were chosen as the final sample and cross sectional data were
taken for the year of 2008. Market to book value, return on equity, return on capital and
return on assets were used as the proxies of firm value. The findings reported that in
order to act in response of global financial crisis worldwide, structure of duality was
adopted by few companies in Brazil during 2008. In this study, the hypotheses were
tested by making use of the views of stewardship and agency theories for the firms in
Brazil. CEO duality in the firms had higher returns on equity as indicated by the
empirical findings. A statistically significant direct link was found between the MTBV,
ROE, and ROA as the estimates of the value and CEO duality. Equally, Gill and Mathur
(2011) disinterred positive correlation for Canadian firms; Lin and Chuang (2011) found
the same for the firms in Taiwan but Yasser et al. (2011) and Malik (2012) insignificant
impact of CEO duality on firm value.
It has been contended that greater number of meetings of board of directors increases the
chance of effective monitoring and control by the board; hence enhancing firm value. For
the first time, Vafeas (1999) studied the link between the value of the firm and frequency
of board meetings for the period 1990 to 1994 and for 307 companies. An inverse relation
was found between frequency of board meetings and value of the firm and the market
participants gave less value to the boards that held more board meetings. When the
previous value of the share price is incorporated in the model, the link does not remain
same and suggested that the increase in the board meetings was happened after the
decline in the price of the share not vice versa. In addition, there was found that after the
very unusual activity of the board, the operating performance enhances as supported by
the event time tests. The enhancements in the operating performance were mostly related
to companies those who were not involved in transactions related to corporate control and
had poor value before that time. There was found that in order to respond the hard times,
more number of board meetings is one way for the board. On the whole, it was suggested
that frequency of board meeting which represents the activity of the board is a significant
aspect of the operations of the board. Likewise, the negative association was found
40
between the board meeting frequency and value of the firm by some authors (Jackling &
Johl, 2009; Ma & Tian, 2009).
Conversely, Lishenga (2010) carried out the research with the dual purpose to find the
determinants of board meeting intensity and effect of frequency of board meeting on the
value of the firm. The 48 firms listed on the Nairobi Stock Exchange (NSE) had been
chosen as sample for the six years from 1998-2003. The correlation was found between
the mechanisms of CG and frequency of board meeting which measure the board activity.
The activity of board had made contribution in the value addition of the shareholders and
the firm. The lag was seen regarding the interaction of intensity of board meeting and
firm value however positive association entailed that when low value is given by the
market, board of directors intervene more by holding more meetings which results in
positive impact on value of the firm. Overall, positive and direct association was seen for
activity of the board on the market value. The study suggested that meetings of the board
are the significant facet of board operations that enhances the capability of the board in
the effective supervision and monitoring of management which ultimately benefit the
investors and shareholders. However, Ponnu and Karthigeyan (2010) found no significant
relation among them.
Moreover, Brick and Chidambaran (2010) examined the determinants of board activity
and the impact of frequency of board meeting on the value of the firm. This effect was
studied for the 5,228 firm-year observations as the large sample for the six years of 1999-
2005. In the framework of structural equations, various board monitoring proxies and
association among the value of the firm and the activity of board monitoring was
examined and developed. It has been showed that the important determinants of board
activity are characteristics of governance, characteristics of firm and the previous firm
value. Events of the corporation like restatements of financial reports or acquisition drove
the monitoring of the board. The positive and direct effect of board activity was found on
the value of the firm. Opposite to this inverse relation between the firm value and the
frequency of board meeting for non-family controlled firms was found by Yasser
(2011b).
41
Mixed evidence on the board meeting frequency and firm value raised the issue of
participation of board of directors in the meetings. Cho and Kim (2007) analyzed the
effect of directors from the outside on the value of the corporation for the period of 1999
when the movement of reforms concerning the governance was undertaking. The active
participation of the individual outside director in the meeting of board gave measurement
regarding the effectiveness of the outside director in Korea. The 347 companies listed on
the Korea stock exchange were included in sample and data related to the rate of meeting
participation of outside directors on the board was collected for the period of 1999. A
direct correlation between the rate of participation of outside directors as the
effectiveness of the outside directors and profitability of the firm was hypothesized in the
study. The results supported the notion that the effectiveness of directors from the outside
positively affected the profitability of the corporation but the association between them
was moderated by the ownership of block holders and large shareholders inversely.
In the same way, Kim and Yoon (2007) investigated that the effect of participation
proportion of outside directors in the meetings of the board as the variable of CG
effectiveness on firm value in Korea. For the 2004 and 2005, the total of 622 firm-year
observations listed on the Korea Stock Exchange were taken as the sample size and
multiple regression model was employed to check the dependency between the variables.
The activity level of board of directors is measured by the number of meetings of the
board and participation proportion of outside directors was used to measure activity level
of outside directors in the board meeting. The study suggested that higher operating
performance is accomplished when outside directors actively participate in the meetings
of the board. This result suggested that in order to reduce the agency problem among the
diverse shareholders and management, directors from outside could make contribution by
actively participating in board meetings.
2.1.3 Compensation Structure and Firm Value
Compensation structure is one of the oldest mechanisms of CG even Adam Smith (1776)
and Berle and Means (1932) recommended that solution to the conflict of interests issue
between managers and shareholders is to compensate the managers so that they can work
in the best interests of the shareholders. The debate on managerial compensation and its
42
relationship with the firm value began with Taussig and Barker (1925) study after the
industrial revolution and shifting of sole proprietorships to limited companies. This study
focused on executive’s salary of 400 large corporations during the pre-war period from
1904 to 1914. The findings demonstrated that salaries of management were increased
speedily as compared to organization earnings and in case of poor management, the
executives were fired but salaries still remain high. The important conclusion was the
managers must have the ability to recognize the distinction between salary and firm profit
so they received not only salary but also get some percentage of net profit. This
revelation impelled the study of Berle and Means (1932) which noted that the separation
between ownership and control imposes bad aspects on the corporations. This modern
corporation system gave full freedom to management to take action in personal interest
rather than interests of firm without any constraint.
In prior research, the managerial compensation is discussed in different perspectives.
Baumol (1962) examined that the managerial salaries have great connection with the
firms’ operations that leave ultimately its effect on corporate prosperity. In 1962, Baumol
noted that different actions of executives such as maximization of sales and firm
diversification through mergers and acquisition is taken on the cost of firm value and that
action also justify their high pay. Moreover it was noted that management has anxiety
about increasing the sale growth instead of firm profitability. This aspect of study
supported the result of Roberts (1956) that showed positive correlation between
managerial compensation and sales. The managerial compensation is examined in the
different outlook by Jensen and Meckling (1976) who suggested mixed compensation to
be used as mechanism for resolving the agency problem between managers and
shareholders. There are three leading decision makers and operating staff which is helpful
in creating and enhancing firm value, so the research on managerial compensation can
also be categorized into three broad areas namely; executive, CEO and directors
compensation.
Firstly, the prior studies on executive compensation are included for overview and better
understanding of its linkage with the firm value, which are conducted at different time
periods. In this regards, Murphy (1985) analyzed the relationship between executive
compensation and firm value and highlighted that the positive linkage between top
43
management pay and shareholders’ value can only be seen by using the time series
approach while controlling the specific firm characteristics. But later study of Jensen and
Murphy (1990) found only the weak association between managerial pay and
shareholders returns by applying the same research techniques.
Anderson et al. (2000) focused on practices of executive compensation in IT industry in
order to examine how mix compensation structure, compensation level and firm value
affect each other. This study used a model that shows interconnections among
compensation level, compensation mix and firm value. The variable of compensation was
measured by considering the total pay of top 5 executives, stock option and bonus options
separately. On the basis of 3258 observations during the time span between 1992 and
1996, the results disclosed the stock returns were changed due to change in total pay;
however, firm value was highly affected by bonus pay. Additionally, different economic
factors that affect the pay level decisions proved that stock options were found to be more
common as compensation in IT firms as compare to non-IT firms. The same result was
found in the study of Conyon and Schwalbach (2000) in UK and Germany while
considering only the managerial cash pay. The final conclusion revealed that cash pay
and company value has positive and significant relation, although both countries have
different CG arrangements and mechanisms. However, pay growth in UK is faster than
Germany and it was also noted that stock options are widely used in UK as compare to
Germany.
Brunello et al. (2001) conducted a study in Italy to observe the executive compensation
and firm value relationship. The survey method was used to collect information from
executives from 107 firms for 1993 to 1996. The managerial compensation was taken as
hierarchy wise by considering the top managers, middle managers and lower manager’s
gross earnings. The real accounting profit after taxes was used as firm value. The results
showed that the managers’ incentive schemes affect the firm’s profitability and along that
exposed high sensitivity in pay-performance relationship. Therefore, this sensitivity was
higher in listed firm that belongs to multinational groups and foreign owned firms.
Likewise, Conyon and Sadler (2001) also adopted the same technique for examining the
impact of executive compensation on firm value. A sample of 100 large UK listed
companies was used that provided data on 532 executives working in distinct
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organizational level during the year 1997. The results showed that managerial incentives
have positive link with the firm value while using ROA.
For the first time in China, Kato and Long (2006) study provided evidence on influence
of executive compensation on shareholders wealth. The data of Chain’s listed firms in the
Shanghai and Shenzhen Stock Exchanges from the time span of 1998 to 2002 was used.
The Chinese firm structure showed positive and stronger relationship with compensation
and value whereas; state ownership both in direct shareholding and through legal person
(indirect state ownership) weakens the pay-performance relationship. The CG reforms in
china like CEO duality and independent directorship had no significant effect on pay-
performance connection. The other studies (Conyon & He, 2011; Firth et al., 2006; Firth
et al., 2007) also demonstrated positive relationship between managerial cash
compensation and firm value in China while Unite et al. (2008) documented the same
evidence for Philippines.
Contrarily, Yan et al. (2011) provided evidence on nature of relationship between
executives’ incentive mechanism and firm value. The sample of 432 Chinese listed
companies was used for analysis by taking data from 2006 to 2008. The elements like top
management annual salary and shareholding ratio was considered as managerial
incentives, and firm value was measured using earning per share and net assets yield. For
data analysis, the companies were divided into four categories namely: giant, large,
medium and small on the basis of their size. The results found no remarkable association
between top management incentives and firm value. This conclusion is consistent with
the study of Wei (2000). However, Dogan and Smyth (2002) found the negative
relationship between board compensation and firm value in Malaysian listed companies.
Secondly, the compensation mechanism of CEO is very much important he is the chief of
all executive officers and most superior authority in running the business affairs. With
reference to CEO compensation, Jensen and Murphy (1990) conducted a study to
examine the linkage between variability of CEO compensation and incremental trend in
shareholders wealth in tend to test the alignment of interest between owner and agents
along with pay-performance relationship. The result concluded that CEO wealth
increased by $3.25 for every $1000 change in shareholders wealth. The firm value is
45
measured by change in market value of shares, accounting earning, earning per shares.
Additionally, the results showed that although bonus pay has 50% proportion in CEO
total salary, however; it did not show any tendency of sensitivity with firm value.
In addition, Mehran (1995) investigated that whether incentive compensation has any
impact on firm profitability in manufacturing sector of India? The compensation was
measured through cash, equity and stock options separately whereas ROA and Q were
taken as firm value. The results showed that the equity based compensation had positive
relationship with the firm value and pay-for-performance sensitivity has also showed
positive result. Moreover, Bhattacherjee et al. (1998) revealed the positive association
between these variables by showing that if sales and shareholders wealth is increased by
Rs. 100 then CEO pay is automatically increased by 0.15 to 0.22 rupees in India. This
finding is also supported by the study of Duru and Iyengar (1999) that not only disclosed
the positive and same direction movement of CEO compensation variation with change in
firm value but also showed that market returns are changed with the alteration of
bonuses. Likewise, Eriksson and Lausten (2000) by evaluating Danish firms also found
the positive and strong relationship between firm value and CEO total compensation.
They revealed that rate of return on capital is moved with the movement in amount that
paid to CEO.
Zhou (2000) examined to which extent the CEO compensation has effect on
shareholders’ wealth in Canada. The analysis is conducted by taking the two variables of
pay like cash compensation and total compensation of CEO from 1993 to 1995 and three
variables were used to measure the shareholders wealth which was ROE, ROA and stock
returns. The result showed that the compensation has influence on the shareholder’s
wealth and compensation moves with the firm size. Similarly, Gu and Choi (2004) also
found that firm revenue increases by appreciation of CEO compensation while studying
the sample of U.S casino companies. However, the contradictory results shown by Reiter
et al. (2009) in Canada who found that a negative linkage between executive inflation
adjusted salary and hospital performance.
In (2006), Kato and Kubo used personal wealth of individual CEO that includes the
actual salaries and bonuses amounts paid to CEOs and firm value 1986-1995. The data of
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18 public firms and 33 unlisted firms in Japan was used. In conclusion, results have
shown positive association between Japanese CEO Pay and firm value that was measured
by using ROA. In the same way, Mitsudome et al. (2008) studied the relationship
between CEO compensation and firm value in Japan. The data of the study was imputed
from the personal income taxes paid by CEOs. A sample of 154 listed firms was used
during the period of 1992 to 1996 and results verified the association between CEO
compensation and firm value by using the individual CEO compensation. The results
disclosed that the change in compensation is moved with different short term and long
term value measurements of firm. Correspondingly, same test was applied on US firms
over a similar time period. Both, Japanese firms and U.S firms showed significant
positive relationship between compensation change and change in firm value.
Morlino (2008) conducted research to investigate the relationship of CEO compensation
for year 2002-2006 with firm value in US airline industry. By applying Spearman’s rank
correlation, the study concluded that the rank ordered CEO compensation have
statistically negative relationship with ROA. Cornett et al. (2008) argued that CEO’s
incentive based compensation is positively and significantly associated with the firm
value in US firms. This judgment is also supported by Bebchuk and Grinstein (2005)
which showed that level of CEO cash compensation is increased by 166% faster than
firm value while assessing USA public firms during the period of 1993 to 2003. In
addition, Marin (2010) examined the relationship of CEO total compensation with firm
wealth by observing US automotive firms from time span of 2006 to 2007. The firm
value was measured in broader spectrum by grouping it in three categories such as
profitability (EPS, ROA and ROE), shareholder equity variable and stock value. The
results by applying the Pearson correlation, ANOVA, Factor analysis, Ordinary least
square, showed that CEO compensation has no linear relationship with any measurement
of firm value.
However, Ghosh (2010) selected the cross-sectional data of 690 manufacturing firms of
India for investigating the relationship of compensation structure and firm value. In this
study, the dependent variable was executive compensation which was defined as: salary
and other perquisites received by CEO/Managing director and firm value was taken as
ROA and market to book value ratio. The results showed positive association between
47
these two variables and also revealed that the relationship is present between firm value
variance and executive pay-performance sensitivity during the period of 2007. On the
contrary, Firth et al. (1996) studied the relationship between CEO compensation and firm
value of Norwegian stock exchange listed companies. Results stated negative relationship
between CEO compensation and firm value reflected by accounting profitability (return
on capital employed, return on assets) and also by stock returns.
Bengtsson and Hand (2011) research has focused on CEO cash compensation impact on
firm value for venture-backed US firms from 2002 to 2006. The study determined that
CEO cash compensation is positively associated with firm value. Although in this study,
firm value was taken in form of growth in employees and firm revenues. In 2011, Sigler
conducted a study to investigate the relationship of CEO compensation with corporate
value. A sample of 280 companies was selected for analysis which is listed at New York
stock exchange and also appears in Forbes and S&P during the period of 2006-2009.
Findings revealed the significant and positive link between compensation and return on
equity.
Thirdly, executive directors also receive compensation for their services rendered in the
organization which is a topic of research in governance literature. Conyon (1997)
investigated the association between firm value and cash compensation of directors and
scrutinized impact of CG mechanism on directors pay. The sample of 213 large UK firms
was selected from the time span of 1988 to 1993. The findings showed that director
remuneration has positive correlation with current shareholders return but not with pre-
dated returns. These results supported the findings of Gregg et al. (1993) who also
exhibited a positive correspondence between directors pay and market return in UK for
the period of 1983 to 1991. Additionally, separation of CEO and chairman position in UK
has no effect on pay level of directors which is consistent with the findings of Conyon
and Leech (1994) that discovered CEO/chairman duality has no influence on pay growth.
Abdullah (2006) in his study detected the elements that determine the director’s
remuneration like firm value, interest of nonexecutive directors, CEO duality and
ownership structure. The data was selected from a sample of 86 financially distressed
firms of Malaysia for the period of 2001 which was also compared with the results of 86
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non-distressed firms. In this study, cash pay of directors was taken as dependent variable
and firm value was measured through ROA and internal growth (firm size). The findings
showed that the directors’ remuneration has no association with firm profitability in
distressed firm as well as in non-distressed firm. This study showed contradictory results
with the findings of Hassan et al. (2003) that revealed positive but weak relationship
between remuneration paid to directors and firm value, and also between director and
internal growth by analyzing the data of 100 listed Malaysian firms that cover the period
between 1996 and 1998.
Kato et al. (2007) used the sample of 246 Korean firms with consideration of chaebol and
non-chaebol group affiliation covering the time span during 1998 to 2001 in order to
analyze the firm value and director remuneration. Findings revealed that the stock return
coefficient is positively significant with the amount of total cash compensation of
directors. The pay and performance sensitivity are presented in non-chaebol firms but not
in the chaebol firms. Furthermore, Krauter and De Sousa (2009) analysis nature of
relationship among remuneration of directors, vice presidents, presidents and the firm
value with the help of 28 manufacturing companies inspection. The independent variables
are measured by average monthly salary, average variable pay of executive and benefit
index that consist of 13 executives’ accessible benefits. The result by applying Mann-
Whitney test showed the existence of relationship between average variable salary and
firm performance. However, result of Pearson correlation test pointed out that there is not
a significant linear association among variables.
Zhou et al. (2011) examined the relationship between executive compensation of Chinese
bank and firm value along by comparing the pay-performance sensitivity of managers
and director for the period 2001-2009 for a sample of 18 Chinese banks. The bank
performance was indicated by return on equity, non-performing loans and core capital
adequacy ratio. Results illustrated that ROE has significantly positive relationship with
directors’ remuneration but the NPL is negatively associated with pay and CCAR has no
link with director’s remunerations. Additionally, results showed that director’s pay and
bank performance sensitivity is low in state-owned banks as compared to non-state
owned banks while controlling the variable of ownership structure. Similarly,
49
Doucouliagos et al. (2007) also used the data of Australian banks to investigate the
relationship between directors’ remuneration and firm value by covering the time period
from 1992 to 2005. The results highlighted the absence of association between director
pay either with current and one year lagged measurement of firm performance but
appeared positive result in two year lag.
In general, managerial compensation relationship with firm value is investigated in three
different ways. Firstly, literature highlight the studies of managerial compensation in
which compensation of all executives included then literature separately revealed the
relationship of CEO compensation and director remuneration with firm value. The
relationship of executive compensation with firm value is positive in some studies
(Brunello et al., 2001; Conyon & Schwalbach, 2000; Murphy, 1985) and also negative in
other some studies (Krauter & De Sousa, 2009; Yan et al., 2011). Some studies showed
positive association between CEO compensation and firm value (Ghosh, 2010; Mehran,
1995; Mitsudome et al., 2008) and also some studies documented opposite results (Firth
et al., 1996; Marin, 2010, Morlino, 2008). Likewise, the results about relationship of
director remuneration and firm value are also mixed. Some studies showed positive
association (Conyon, 1997; Hassan et al., 2003) and some drawn negative or mixed
results (Abdullah, 2006; Wang & Ong, 2002).
2.1.4 Ownership Structure and Firm Value
The importance of ownership structure in corporate value can’t be overlooked as it is one
of significant variable of CG. There is a long debate in the literature to study the impact
of ownership structure on value and many researchers have performed commendable
work on different elements of ownership structure. Generally, the research on ownership
structure can be classified into two major sections; how ownership is composed in the
hands of internal and external shareholders, and the type of ownership (i.e. ownership
concentration vs. diffusion and block holding). Internal or insiders can be managers,
directors, CEO, family whereas external or outsiders owners may be institutional,
foreign, corporate, or scattered individuals.
Insider ownership plays vital role in enhancing the value of any corporation as this is the
way of transforming owners and manager’s distinct interest into similar interests. Most
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researches provided evidence of strong association between insider ownership and firm
value. Jensen and Meckling (1976) first brought the issue into consideration that how rise
in managerial ownership positively influenced the value of firm. He segmented
shareholders into two groups: first group consisted of inside shareholders, who are
managers as well as owners, and second group consisted of outside shareholders. Both
groups have right to receive dividends but the decision making right only rests with
former. Insiders are in strong position to not only involves in nonmarketable perquisite
consumption, but also selecting investment projects more beneficial for themselves as
compared to outside shareholders. As managers do not have significant stake in
ownership so only a small percentage of cost of these actions is born by them. So
increasing inside ownership would decrease the probability that managers would take
such perquisites or invest in such projects as they have to bear more cost relative to
ownership proportion. Thus their arguments provide support to the convergence of
interest hypotheses.
Moreover, entrenchment effect of high managerial ownership was first discussed and
analyzed by Morck et al. (1988). Two contradictory forces that pull managers to behave
accordingly are: first their natural aptitude to utilize firm resources for their personal
interest which jeopardize shareholders interest. Second is to put maximum efforts to
maximize owner’s wealth and increase managers’ stake in ownership. Former is
negatively while later is positively related to the firm value. This study argued that when
one outweighs the other in any level of manager’s ownership then value changes
respectively. Outcome was very unusual as value curve first moved upward when
ownership increased from 0% to 5%, then downward when increased from 5% to 25%
and again upward in case when increase was more than 25%. So the managers get
entrenched within the range of 5% to 25% and outside this range convergence of interest
holds.
Then significant contribution in the work of Morck et al. (1988) is made by Stulz (1988)
by analyzing relation between manager’s ownership and firm value in different context.
This study primarily focused on voting power of managers and firm value in case of
takeover. A firm with increasing stake of managerial ownership has high probability to
receive high premium in case of hostile takeover and low probability that takeover will
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take place while when ownership stake is low then premium offered through tender
would be very low along with high probability of takeover success. When managers own
half of firms share (50%) there is zero probability of hostile takeover. It indicated
curvilinear relation as value first moved upward then downward as ownership increased
and very small increase in the case, when manager owns half of shares.
McConnell and Servaes (1990) tested the relation between equity ownership and
corporate value on the sample of 1173 firms in 1976 and 1093 firms in 1986. The
analysis revealed the curvilinear relation and it was found that slop moved in upward
direction unless managerial ownership reached 40% to 50% and after this limit slop
moved in downward direction supporting entrenchment theory. This study was again
conducted by McConnell et al. (2008) and similar findings were drawn. Holderness et al.
(1999) studied the same relation for US firm and reached at the same conclusion. In
addition, Agrawal and Knoeber (1996) carried out the research to resolve agency conflict
between principal and agent and used seven CG mechanisms including insider
shareholding. Results showed that when each mechanism was regressed separately then
there was a positive relation between insider shareholding and firm value and it was also
evident that analyzing all mechanisms jointly caused the effect of insider ownership on
value to be disappearing. For the further analysis, Han and Suk (1998) analyzed this
relation and results demonstrated that there is positive relation between insider ownership
and stock return while higher insider ownership may badly affect the Value.
After that, Sarkar and Sarkar (2000) conducted the research in developing country of
India by taking 1675 manufacturing firms as sample. The results showed that when
insiders hold shares more than 25%, it leads to enhanced firm value. Moreover, Mitton
(2002) conducted the research on Asian economies during 1997 East Asian financial
crises. Results indicated that when managers are also shareholders, they have authority as
well as opportunity to take decisions to improve value of the firm. Afterwards, Chen et al.
(2003) found that value is decreasing function of manager’s ownership at lower level and
vice versa. The findings supported the curvilinear relation between insider shareholding
and market value. In the same year, Welch (2003) reported nonlinear relation between
managerial shareholding and firm value. Contrarily, Seifert et al. (2005) reported no
significant impact of inside ownership on firm value for US, UK and Japanese firms.
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Consistent with this, Cheung and Wei (2006) also documented no relation between level
of inside ownership and value of firms for US firms during the period of 1991-2000.
Beiner et al. (2006) analyzed the impact of insider ownership on firm value for cross-
sectional analysis of 109 Swiss firms. Results indicated that increase in managerial
shareholding up to a certain limit lead to enhanced firm value. After that certain threshold
level, increases insider shareholding may causes the value to be dwindled confirming a
curvilinear relation between insider shareholding and firm value. One more recent study
on the same issue was done by Chen et al. (2012), in which the effect of manager’s
shareholding was tested in publicly traded Taiwanese hotels for the period of 1997-2009.
Insider’s ownership consisting of managers and directors shareholdings was found to
have an inverted U-shaped relationship with firm value showing that managers and
directors stockholding is positively associated with value but up to a certain point and
these threshold levels were: Tobin’s Q (44.81%), ROA (27.54%), and ROE (27.99).
Family business is very common around the world, such as in US 85% businesses are
family firms (Yu, 2001). Moreover in Asia and in India, majority firms are family owned
(Iyer, 1999) and similarly Pakistani corporate sector is also dominated by family firms
(Yasser, 2011c). Prior researches focused on comparing family firm’s value with non-
family firms and provide with the understanding that association between family
ownership and firm value can be positive as well as negative based on two factors such as
to which generation family belongs and their level of involvement/ownership stake.
One of the earlier studies addressing this issue which amplified the interest of researchers
in this area is of Anderson and Reeb (2003), who examined the link between founding
family ownership and firm value. Large publicly listed S&P 500 firms were selected for
collecting data on years ranges from 1992-1999. By the comparison of the value of
family and nonfamily firms, it was evident that in family firms ROA was 6.5% higher
and Tobin’s was 10% higher than the nonfamily firms. The study also provided evidence
for the existence of non-monotonic relation between both types of firms under study.
Another result drawn from this research was that family firms falling whether in young
firms category (less than 50) or old firm’s category (more than 50 years) exhibit good
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value in comparison to nonfamily firms. Active involvement of family members such as
playing the role of both CEO and Chairman leads to enhance the value.
Chen et al. (2005) investigated 412 listed firms in Hong Kong and dealt with three
questions among which family ownership effect on firm value was the most important
one. Results revealed that family ownership does not show any significant positive
association with any of the three value measures used in this study (ROA, ROE, Tobin’s
Q). In the same year, Barth et al. (2005) study considered Norway for investigating the
family firm’s value and found that family owned firms in with management is also in the
hands of family members are poor performers when compared to nonfamily firms.
Furthermore, Bertrand and Schoar (2006) provided evidence for downfall in firm value
with increased family ownership.
Maury (2006) study provided the evidence on value differences between family-
controlled and nonfamily-controlled firms using sample of 1672 firms. Overall results
supported the notion that family-controlled firms left behind nonfamily-controlled firms
in superior value. However, results further disclosed that active and passive family
control also plays a major role in affecting the firm profitability. Active family control
leads to higher profitability but no effect on profitability was found with passive family
control. In the same year, Villalonga and Amit (2006) also provided mix results. They
argued that if family control exceeds the level of ownership, it leads to drop in
shareholders’ value whereas on the other hand, family management adds value to firm in
case if founder of the firm himself took the position of CEO/Chairman in comparison to
descendants occupying the CEO/Chairman position.
Miller et al. (2007) compared Fortune 1000 US firms and randomly selected 100 US
small public firms. This research analysis revealed poor market valuation earned by
family firms as these firms never gave best value during the research period because of
presences of relatives in management or ownership. Furthermore, sample of small US
public firms did not support either founder or family firms in enhancing firm efficiency to
perform better. Kortelainen (2007) selected Norway for testing the relationship by using
two samples; firstly random sample of non-listed 416 SMEs, and secondly 5 major
industries. Empirical results of first sample disclosed that the value of family firms was
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almost same as the value of nonfamily firms. However, results from second sample
disclosed opposite results where family firms were observed to be more profitable than
firms with non-family ownership. In contrast to the above results, support for negative
effect of family involvement in ownership on firm value have been provided by Achmad
et al. (2008) in Indonesia whereas Lam and Lee (2012) in Hong Kong family firms.
“Bigger is better” is a statement which seems very true in the case of institutional
investors as the role played by institutional investors in corporate value is a worldwide
accepted phenomenon. A plenty of research has been conducted in this regard but
findings are contradictory. Majority of work support the notion that institutional
shareholding is beneficial for company value and thus effective monitoring hypothesis of
institutions holds true. McConnell and Servaes (1990) provided evidence about the nature
of relation between value of the firm and institutional shareholding and demonstrated a
positive influence of extent of shares held by institutions and value of firms. This positive
influence was attributed to the monitoring by institutions in an effective manner. Further,
Han and Suk (1998) and Guercio and Hawkins (1999) also reported positive influence of
institutions (pension funds) ownership on firm value. On the other hand, some researches
proved that there is no relation between institutional ownership and firm value. Craswell
et al. (1997) analyzed the relation between structure of ownership and value of 349
corporations in Australia for the period of 1986-1989. The analysis did not reveal any
significant relation between shareholding by institutional investors and value of firms.
Similar findings were drawn by Black (1998) in the US market.
Another dimension of institutional shareholding was explored by Kumar (2004) in India
for the period of 1994-2000 by taking 2478 firms as sample. It was observed using panel
data analysis that different ownership pattern in different firms were caused by
unobserved firm heterogeneity. After controlling this unobserved firm heterogeneity and
firm specific characteristics, the nonlinear relation is found between institutional
ownership and firm value. Furthermore, Navissi and Naiker (2006) supported the nature
of non-monotonic relation between institutional ownership and value of firm in New
Zealand. The study divided institutional investors into two groups: First was active
institutional investors (have nomination in board), and second was passive institutional
investors (do not have nomination in board). The findings showed that active institutional
55
shareholders have nonlinear relation with firm value as up to the level of 30% ownership,
firm value increased and above this level, firm value decreased whereas passive
investors’ shareholdings did not prove to have any significant relation with firm value.
Furthermore, Cornett et al. (2007) also examined the nature of relation between
institutional investor shareholding and value of 676 firms for the period 1998-2000 in
US. It was proved that firm operating cash flows are positively influenced by institutional
stockholding. Percentage of stock held by unaffiliated institutions and number of these
institutional shareholders proved to have positive effect on operating cash flows
(pressure-insensitive). In addition, Tsai and Gu (2007) examined this relation in
restaurant industry of United States. It was evident that there is significant positive
impact of institutional ownership on firm value. Mizuno (2010) studied the role played by
institutional investor in CG and examined the relation between institutional investors and
value of firms in Japan for the sample of 189 firms listed at Tokyo Stock Exchange
during the period 2004-2007. Findings revealed that institutional investors play a
significant role in enhancing CG in any firm but it was found that their ownership stake
in the firm did not put any impact on value of corporation.
Most recent work is done by Salehi et al. (2011) to examine the role of institutional
investors in corporate value. Study proposed two hypotheses, first assumed the positive
influence of level of institutional investor and value of corporation, and second assumed
the negative influence asserted by concentrated institutional investor ownership and value
of corporation. For the purpose of testing proposed hypothesis the required data was
obtained through Tehran Stock Exchange and study period was 2001-2008. The multiple
regression analysis revealed the results that first hypothesis was accepted and results
supported the effective monitoring theory while second hypothesis was also accepted and
results supported the profit theory.
Besides institutional ownership, there are many other outsiders who have significant
influence on firm value such as foreign investors, associated company and individual
owners but very limited work has been done on these variables. Attracting investment
from other corners of the world not only brings money but also many valuable resources
in the form of knowledge and technology. A very skinny research has been done on this
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topic and most of the time this aspect of ownership is overlooked. Douma et al. (2006)
explored the impact of foreign ownership on value of firms in India and results proved
that value of firms tend to increase by the influence asserted by foreigners because of
their long term involvement and commitment in the firms. Aydin et al. (2007) studied the
impact of foreign shareholdings on firm value in Turkey. Empirical results provided an
evidence of positive association between foreign ownership and value of Turkish firms.
The reason can be their effective monitoring or their resource inputs in the form of new
technology and expertise.
Moreover, Petkova (2009) investigated the relation between foreign shareholding and
operating value of firms in India using total factor productivity as value measure. The
finding did not reveal any significant difference between firms with foreign investment
and firms without foreign investment. Chai (2010) studied moderating effect of firm
value in the relationship of foreign ownership and labor costs in Korean firms. The
results demonstrated positive association between foreign ownership and labor cost and
this relation proved to be weak for the firms having good value. Ongore (2011) also
documented a significant positive association between foreign ownership and firm value
in Kenya. Uwuigbe and Olusanmi (2012) further argued that ownership stake held by
foreign individuals or corporation is accompanied by foreign expertise and knowledge
thus ensuring high firm value.
A few studies studied other owners such as associated companies, joint stock companies
and individual. Alipour and Amjadi (2011) examined the impact of individual ownership
on firm value in Tehran Stock exchange. Sample of 68 companies was chosen and the
period of analysis was April 2006 to March 2010. ROA, ROE, Tobin’s Q and market-to-
book value ratio were used as value measure. By using panel data analysis it was
discovered that there is a statistically significant negative relation between individual
shareholding and firm value. Bajwa and Bashir (2011) supported the positive association
between associated companies/ related parties ownership and firm value whereas
Abdullah et al. (2011) reported no statistically significant relationship between associated
company ownership with firm value.
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Along with the ownership structure and composition, concentration of shares in hand of
few members had also been a topic of interest for researchers in CG literature. In prior
researches, concentration was measured differently by different researchers such as
fraction of shares owned by majority of shareholders, Top 5 shareholders, Top 10
shareholders, or single (individual) block holder; however, the relationship of
concentration with firm value remained inconclusive. Holderness and Sheehan (1988)
studied two equal samples of 101 firms each with large shareholders and dispersed
shareholders and results revealed that factors such as accounting returns, investment
policies, the frequency of corporate control transactions and Tobin’s Q does not vary with
ownership structure. In line with these findings Murali and Welch (1989) draw same
results. This study covered the period of 1977-1981 for 83 firms with diffused ownership
structure and 43 firms with concentrated ownership structure and concluded that there is
no value difference between closely held and widely held firms.
Later on, Shleifer and Vishny’s (1997) survey on CG is very helpful in this regard as the
results are drawn from a very large sample; data was collected taking 1196 firms from all
around the world. Survey revealed that concentration of ownership and firm value
positively relates to each other. Consistent with these results, Nickell et al. (1997)
explored British market by taking sample of manufacturing firms and provided support
for positive association between company value and large shareholder’s stake in the firm.
Claessens and Djankov (1999) examined the association between ownership structure and
firm value. Study was conducted on Czech firms taking a sample of 706 firms for the
years 1992-1997. Concentration was measured as percentage of shares held by top 5
shareholders and value was measured through profitability and labor productivity.
Empirical analysis revealed a more significant and positive relation between these
variables. It can be explained in another way as lesser the ownership disbursement,
greater the labor productivity and profitability. In line with these findings, Xu and Wang
(1999) also provided evidence for positive correlation between ownership concentration
and firm value in Chinese economy. Moreover, Claessens et al. (2000) also supported the
positive association between concentrated ownership and value for nine Asian economies
by analyzing value of closely held vs. widely held firms and confirmed the presence of
“convergence of interest hypothesis”.
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Afterwards, Sarkar and Sarkar (2000) explored the change in firm value with the
involvement of large shareholders in India by considering 1567 firms from
manufacturing sector as sample for 1995-1996. A positive relationship was found and
between ownership concentration and value. Mitton (2002) also confirmed the above
findings for East Asian economies during 1997 Asian financial crisis. Later on, Claessens
et al. (2002) further researched on CG and done meta-analysis of all previous researches
soon after the Asian financial crisis of 1997. Findings revealed that firms having
concentration of ownership perform more efficiently in comparison with firms having
dispersed ownership. As holding greater proportion of shares enables them for efficient
monitoring and make sure that good governance is present in organization.
Rashid (2011) conducted a study in Bangladesh with the aim to explore the association
between single largest shareholder and firm value. Ninety four nonfinancial firms were
selected from 2000-2009. Empirical results provided evidence for positive linear relation
between blockholders and firm value. As ownership and control separation is harmful for
firms and largest blockholding reduces this agency problem which leads to improved
economic value. Likewise, Becker et al (2011) took sample 1500 firms and collected data
for 1996-2001. This study also proved that existence of individual outside blockholders
in a firm improves firm value. Another study was conducted by Boone et al. (2011) to
investigate the effect of block ownership on firm value and results revealed that block
ownership is favorable for value of firms. Findings further uncovered the fact that
financial institutions and foreigners as largest shareholders improve the firm value more
prominently as compared to directors, corporate, individuals as largest shareholders.
Pervan et al. (2012) considered Croatian firms for investigating the relation between
ownership type as concentrated and its effect on firm value and examined the relation
between different types of ownership and their role in level of value. Sample data was
collected during the period of 2003-2010 from all listed firms. Empirical analysis section
of this paper explored that firms with disperse owners exhibit superior level value than
firms with concentrated owners, which means that no significant relation was found
between concentrated ownership and firm value.
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2.1.5 Corporate Governance Index and Firm Value
Along with the individual dimensions of CG, some researchers have also formed
composite measures of CG and investigated its relation with firm value. Initially, Black
(2001) analyzed whether the CG behavior impact the market value of firms in Russia.
Data for analysis was gathered through the rankings given to 21 firms in 1999 by an
investment bank where higher the ranking lower will be the governance in that firm.
These rankings were considered as independent variables and “value ratio” as dependent
variable. Then regression analysis was performed which indicated that CG behavior has
significant positive influence on market value of firms.
The highly influential work in this regard was done by Gompers et al. (2003) who
developed the very first firm-level Corporate Governance Index (G-Index) to investigate
the relation between CG and equity prices in the US. They used 24 governance
provisions specifically focusing on takeover defenses were taken for 1500 firms and
period of investigation was 1990’s. The provisions were divided into 5 subgroups and an
index was formed based on these groups mainly focusing on shareholder’s rights. The
selected firms were analyzed against these provisions and one point was allotted to the
firm when one provision related to weaken shareholder right was found. Two groups
were formed on this basis: Democracy Group: Firms having high degree of shareholder
right (low points); Dictatorship Group: Firms having low degree of shareholder rights
(High points). Then value of the groups in relation to profitability, sales, acquisition,
value of the firm was tested. It was found that democracy group outperforms by 8.5% per
year than dictatorship group. In line with Gompers study, Drobetz et al. (2004) studied
this relation in German market by forming governance ratings and found similar results.
Afterwards, Brown and Caylor (2006) argued that the index formed by Gompers et al.
(2003) was not reliable as it is mainly based on anti-takeover measures. They found the
relation between CG and value by establishing a broader ‘Gove-Score’ by taking 2327
firms and a strong positive association was found between these factors of CG and value
of firms (sales growth, ROE, net profit margin, share repurchases, dividend yield and
Tobin’s Q). Moreover, it was found that individual factors are more associated with firm
value. Managerial compensation and board members were highly related to value of firm
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while charters/bylaws proved to have a negative relation with the firm value. Brown and
Caylor (2006) provided additional evidence in support of their previous work and found
positive association between Gov-Score and Tobin’s Q.
Black et al. (2006) has investigated the question whether CG predicts the market value of
firms in Korea? They constructed the Korean Corporate Governance Index (KCGI) in the
spring 2001 and selected a sample of 560 respondents from different Korean firms.
Evidence showed that CG index is of significant importance for the market value of
Korean corporations. Results of ordinary least square depicted that KCGI better predicts
and increase the value of Tobin’s Q. Resultantly, CG index is a main and causal factor
that can be used to enhancing the market value of Korean publicly listed companies.
Similarly, Clacher et al. (2008) also formulated a CG index and found that those firms
having CG as a mandatory part of their organizational functions enjoy high investor‘s
confidence along with improved value.
Bauer et al. (2008) research work inspected Japanese firms to see the same relationship of
CG index and firm value. With the help of unique governance index, results showed that
firms with high quality governance level outperform than firms with poorly governed
firms. However when the results of each sub-index were tested, it was found that
categories related to rights of shareholders, disclosure and transparency, internal control
and compensation impact stock return significantly while no impact on value was found
for categories related to behavior of firms, accountability and market for control.
Bebchuk et al. (2009) revised the Gompers et al. (2003) governance index and
constructed a new index with name of Entrenchment Index (E-Index) which included 6
governance provisions regarding shareholders’ rights where a lower score indicates
strong CG.
In recent years, Cheung et al. (2010) selected Hong Kong for providing evidence on
whether CG quality matter in moving company stock return and risk. An index of CG
was formed and results revealed that quality of CG significantly linked with company
stock returns and risk. Further, Viggósson (2011) targeted the micro market of Iceland to
verify the relation between CG and firm value. An index of CG was formed containing
significant variables of CG. The sample was selected based on their existence on the
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stock exchange for period 2002 to 2007 and value was measured by using ROA, ROE
and Tobin’s Q. Results indicated positive relation between CG and firm value.
Another study was carried out by Sami et al. (2011) in an emerging economy of China to
determine the relation between CG and firm operating value. Governance score, a
composite measure of CG was constructed by using factor analysis. There are also some
other researchers who used a composite measure of CG index while analyzing firm value
(Aman & Nguyen, 2008; Bozec & Bozec, 2012; Garay & González, 2008; Renders et al.,
2010). Findings revealed that higher the quality of CG, greater value of firms. Recently,
Black et al. (2015) used Korean CGI as a measure of better CG quality and provided
evidence that effective governance of firms plays a moderating role in the relationship of
related party transactions and firm value as well as enhances the sensitivity of firm-
industry profitability.
2.1.6 Reverse Causality between Corporate Governance and Firm Value
Although much literature has been produced in both developed and developing countries
regarding the impact of effective CG structure on the firm value; yet most of those have
ignored the possibility of reverse causality and endogenous relationship between CG and
firm value. Several studies have pointed out the possibility of reverse and bi-directional
relationship between CG and value of firms (Cornett et al., 2009; Demsetz, 1983;
Demsetz & Lehn, 1985; Demsetz & Villalonga, 2001; Gompers et al., 2003). Demsetz
(1983) was the first who raised the question of possibility of this reverse relationship and
argued that CG mechanism structure should be considered as endogenous. Ownership
structure is not to influence the value but to be influenced by firm value. Required data
was gathered through 500 fortune firms for a period ranging from 1972 to 1982. Market
value of firms was compared to different shareholding patterns to know the effect of
changes in market value to pattern of shareholding. Results indicated that ownership
structure is influenced by two things; one is the frequency of sale and purchase of shares
in market and second is shareholders decision making. Similarly, Demsetz and Lehn
(1985), and Morck et al. (1988) empirically proved the endogenous nature of ownership
structure. Furthermore, Demsetz and Villalonga (2001) contended that due to information
asymmetry between managers and other stakeholders might create incentives for the
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insiders to change their shareholdings according to their expectation for firm’s future
value.
On the other hand, McConnell and Servaes (1990) claimed that ownership structure was
exogenous in the relationship between ownership structure and corporate value. Bhagat
and Bolton (2008) also considered the issue of endogeneity between firm value and CG.
Cornett et al. (2009) used 2-stage least square regression to evaluate the impact of CEO
pay for value sensitivity and board independence on the reported earnings of firm and
concluded that these variables are positively related confirming the endogeneity between
the CG and firm value. However, Toledo (2009) confirmed the non-existence of
endogeneity in the Spanish firms for CG and firm value. Moreover, Park and Jang (2010)
also raised the question of endogeneity among CG variables and firm value and
considered this endogenous effect in his study as an important issue to be investigated in
corporate finance research. They further concluded that the theoretically discussed issue
of endogeneity needs more comprehensive and intensive investigation.
2.1.7 Corporate Governance and Firm Value in Pakistan
From the past few years, CG is a significant and important area of research in Pakistan.
Many researchers have carried out different studies on the area of CG but still there is
need of research to identify and explore some uncovered areas to contribute to Pakistani
literature. In this regards, a noteworthy work in Pakistan on CG and its related issues has
been carried out by Cheema (2003) who suggested that better CG attracts the foreign
direct investment and activate greater savings in the country through capital providers.
CG practices are compatible for the money raising from outside the country capital
markets. Mainly Pakistani corporate culture is described as concentrated, family owned,
cross-shareholdings, pyramidal and directorships interlocking etc. The major concern of
investors is to safeguard the minority shareholders and protection of all stakeholders’
rights. CG has covered all these aspects and its regulatory codes of practices enforce the
firms to follow. Therefore, CG is now an indicator of value maximizing for all
shareholders in Pakistan and provide right protection to all stakeholders. In addition, Rais
and Saeed (2004) analyzed the role of CG code 2002 in Pakistani firms. Their analysis
revealed that mostly listed firms are following the code recommendations, while it has
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some reservations and constraints. But overall, it is better for the value of Pakistani
corporations.
The cross sectional study of Mir and Nishat (2004) could be considered as the pioneer
empirical research to check the role of effective CG on 248 Pakistani firms by
incorporating board composition and blockholding structure on ROA, ROE and Tobin’s
q. They found positive relationship with external/family block holding and firm value and
negative relationship with internal block holding and firm value. Ashraf and Ghani
(2005) described that judicial inefficiencies, weak enforcement and lack of investor
protection especially minority shareholders rights are main factors that explain the
condition of accounting practices in Pakistan as compare to cultural factors. They further
enlightened the concept that enforcement of mechanisms regarding accounting practices
is necessary for improving the financial disclosures and information quality in the
developing nations including Pakistan.
In the same way, Khalid and Hanif (2005) studied the CG in the banks of Pakistan and
found significant changes in the CG of banks and their value in Pakistan and India but not
found noteworthy change in banks of Bangladesh. Afterwards, Chaudary et al. (2006)
surveyed 42 commercial banks in 2005 about the implementation of CG provisions
through a questionnaire. Moreover, another study by Javid and Iqbal (2007) was carried
out in Pakistan while using the data of 50 firms listed at Karachi Stock Exchange to
examine the relationship between indicators of CG (i.e. CG index) and firm value.
Results indicated that CG matters in the value of firms in Pakistan. Findings showed that
ownership structure and board composition can enhance the corporate financial value
whereas transparency and financial disclosures has no significant influence on firm’s
value. Shah et al. (2008) conducted a cross sectional study on 67 KSE-100 listed firms in
2005 to evaluate on the role of non-executive directors; Abdullah et al. (2008) used a
sample of 50 firms for a period of 2002-2005 and checked the impact of board
composition on firm value and both the studies had found a positive impact on firms’
value whereas Afza and Slahudin (2009) investigated the role of inside ownership on
value for KSE listed firm.
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In another study by Javid and Iqbal (2007), the authors proved that ownership
concentration is the outcome of weak legal protection of investors in Pakistan. Similar
results have also been produced by Javid and Iqbal (2008) focusing on 23-items CG
index ownership concentration and firm value on a limited sample of Karachi Stock
Exchange listed KSE-100 index firms. Nazir et al. (2009) took a different approach and
studied the impact of board mechanism on the firm value in Pakistan. Their study
investigated the board structure related variables like board composition, size and CEO
duality, and firm value related measurements like ROA and Tobin’s Q. They have used
the sample of 53 Pakistani cement and sugar manufacturing corporations from the phase
of 2005 to 2007. Results revealed that moderate board size is positively linked with the
firm value whereas, value badly affected if the same person works on both seats (CEO
and board chairperson). In addition, outside directors on the board could play important
role in the firm’s better value particularly in Pakistan.
In Contrast, Javid and Iqbal (2010) examined the relationship between ownership
structure, need of external financing and corporate valuation by taking the sample of 60
non-financial firms listed on Karachi Stock Exchange from the period of 2003 to 2008.
Results showed that larger firms need more external financing and external financing
required good practices of CG. Moreover, concentrated ownership has negative relation
with external financing and good CG practices improve the overall firm valuation.
Another study on CG and firm value was carried by Khatab et al. (2011). They selected
the sample of 20 firms that were listed on Karachi Stock Exchange. CG effect on firm’s
value was measured through Tobin’s Q, Return on Assets and Return on Equity. Data
was gathered from the financial annual reports of companies for the years of 2005 to
2009. Results indicated that better governed firms have good value measures as compare
to the firms who has less compliance with practices of CG. Similar study was carried by
Dar et al. (2011) in Pakistani oil and gas companies that were listed on Karachi Stock
Exchange. Findings revealed that Board size and their meeting frequency has positive
link with ROE and has negative linkage with audit committee and CEO status.
Additionally, board size also has positive association with profit margin but meeting
frequency has not significant relation with profit margin. To sum up, results indicated
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that size of board should be of moderate level and the different persons occupy the seats
of CEO and board chairperson.
Likewise, Yasser et al. (2011) examined the impact of corporate mechanisms on firm
value in KSE-30. They have selected a sample of 30 firms that was listed on Karachi
Stock Exchange from the period of 2008 and 2009. Results provided a significant
positive association between three governance related variables namely board
composition, size and audit committee with Return on Equity and Profit margin.
Implication of this study showed that board should be of normal size and has a right
combination of executive and non-executive directors. Furthermore, study could not
provide any significant association between CEO duality and firm value measures
namely ROE and PM which is consistent with the previous studies.
Furthermore, there are many studies in Pakistan which used almost similar methodology
and research objectives to explore the relationship of CG with firm value. For instance,
Shah et al. (2011) used cluster analysis on 67 firms on 2005 data; Abdullah et al. (2011)
studied ownership structure of 158 firms for the period of 2003-2008; Bajwa and Bashir
(2011) done a cross sectional study of 200 firms for year 2009 to investigate the role of
ownership structure; Yasser (2011c) investigated 132 family and non-family controlled
firms for a period of 2003-2008; and Yasser and Ahsan (2011) cross sectionally
examined 28 sugar sector firms. Along with these, Azam et al. (2011) used oil and gas
sector companies for 2004-2005; Yasser (2011a) analyzed 10 communication sector
firms; Khan et al. (2011b) surveyed only 8 textile firms; Mahmood and Abbas (2011)
investigated 21 commercial banks for 2006-2009; Shahab-u-Din and Javid (2011) looked
into the effect of managerial ownership on firm value. Moreover, Khan et al. (2011a)
evaluated the role of CG on firm value for 3 tobacco sector firms; Afza and Nazir (2012)
examined the role of CG in enhancing post-merger value in financial sector of Pakistan;
Jabeen et al. (2012) tested the impact of family ownership stakes and firm value; and
Latif et al. (2013) evaluated the firm value influenced by board composition.
2.2 Corporate Governance and Discretionary Earnings Management
The varying nature of accounting accruals provide corporate executives the discretion in
the determination of firms’ reported earnings during a particular period due the universal
66
fact of information asymmetry between the inside controllers and outside owners of the
firm. Inside managers can alter the reported earrings either to maximize their own
benefits or to affect the informativeness of reported earnings by signaling private
information to the outsiders (Healy, 1985). Morck et al. (1988) reported that ownership
concentration in the hands of managers creates entrenchment effect and they are induced
to manipulate the reported accounting profits to hid this entrenchment behavior because
of futile CG mechanisms applicable in firms including board composition and structure
and lack of external capital market control over the firms (La Porta et al., 1999; Shleifer
and Vishny, 1997).
The reliability and informativeness of reported accounting earnings is dependent on the
quality and effectiveness of CG implemented through different monitoring mechanisms
in a firm (Dechow et al., 1996). After the world renown corporate collapses of Enron,
Xerox, or WorldCom etc., a wave has been initiated to control and mitigate the
opportunistic behaviors of managers and to enhance the credibility of the financial
reporting through development and implementation of effective CG systems all over the
word. Mostly, the literature on the role of CG and earnings management did not focused
on only single dimension of CG rather mixture of different mechanisms have been used
to investigate the impact of good CG in mitigating the earnings management practices.
However, the present study do not categorized the earlier literature based upon CG
mechanisms, hence organized in a chronology.
With reference to the empirical studies on CG and DEM practices, a study was carried by
Abbott et al. (2000) by using a variable namely audit committee activity. This study
examined the impact of audit committee independence and activity in identifying
corporate frauds. A sample of 156 firms was selected that was listed on New York Stock
Exchange and from which 78 was sanctioned by SEC. The study results showed that
firm’s audit committees which are composed of more independent directors and meet
twice a year are less likely to be sanctioned by the SEC. Moreover, these firms are less
involve in the fraudulent activities and are less prone towards showing misleading
financial reports.
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Xie et al. (2003) examined the role of board structure variables and audit committee in
mitigating the opportunistic behavior of managers to manage reported earnings using 282
firm-year observations for S&P indexed firms. The results stated that board composition
and monitoring role performed by the audit committees can significantly related to the
earnings management practices of a firm. The firms with qualified and financially expert
directors present on the board and audit committee may tend to have lower level of
discretionary accruals. Frequent meetings of board and audit committee can also have a
storing monitoring mechanism for lower earnings management. On the other hand, Klein
(2002) reported a negative relationship between audit committee independence and
earnings management. In addition, Koh (2003) investigated the link between
discretionary accrual-based earnings management and institutional investors in Australian
firms for a period of 1993-1997. Fan and Wong (2005) and Anderson et al. (2004) also
contended that ownership structure and earnings quality and informativeness are
interrelated.
Jeong and Rho (2004) investigated the impact of big six auditors on the audit quality in
Korea. Sample which is used in this study was 2117 firms listed at Korean Stock
Exchange from period of 1994-98. From these firms, 806 were those who were audited
by non-big 6 auditors, remaining 1311 were audited by big six auditors. Results of the
study revealed that there is no significant difference between both firm’s accruals that are
audited by big six and from non-big six auditing firms. These study findings were same
like other studies carried out in Korea. However, these findings are not consistent with
the studies (Becker et al., 1998; Palmrose, 1988) in other countries on audit quality and
big auditors. Reason for such inconsistent results may be incentives of auditors that are
different in Korea as compare to other countries. Moreover, Abbott et al. (2004) studied
another facet of audit committee in which they examined the impact of audit committee
characteristics on restatements for 88 American firms for the period of 1991-1999.
Results revealed that if audit committee only consists of independent directors then it has
negative relation with earnings restatements. They further illustrated that if audit
committee is independent, include as a minimum one member with financial expertise
and meet at least 4 times a year then it has negative association on the occurrence of
restatements in the corporations. In addition, they did not find any association between
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size of audit committee and earning restatements. In the same way, Bedard et al. (2004)
study provided evidence that an effective and independent audit committee enhance the
reporting quality of a firm and lower the earnings management.
Park and Shin (2004) examined the role of board composition and independence in
lowering the earnings management practices for a sample of 202 Canadian firms for the
period of 1991-1997. They argued that outside directors failed to reduce the earnings
management practices in a firm whereas this opportunistic behavior of managers can be
marginally controlled by the presence of nominee directors of financial institutions due to
their long term stakes and association with the firm. Consistent with this, Saleh et al.
(2005) also did not find any association between independent directors and earnings
management practices in Malaysia. They argued that presence of directors in the firm
with multiple directorships and separate positions of CEO and chairman can also mitigate
the opportunistic behavior of managers to manage the reported earnings. On the other
hand, Peasnell et al. (2005) confirmed the predictions of agency theory that presence of
outside directors on the board and audit committee make sure the integrity of financial
reports and income increasing manipulation of earnings tends to lower in these firms.
Davidson et al. (2005) also found empirical support for the effective role of independent
directors in refraining earnings management in Australian firms; however, Yang and
Krishnan (2005) and García-Osma and Noguer (2007) documented no association
between audit committee independence and earnings management; Bradbury et al. (2006)
failed to find any relationship between board independence and DEM practices.
Shen and Chih (2007) used governance index of Credit Lyonnais Security Asia (CLSA)
based upon discipline, transparency, independence, accountability, responsibility, fairness
and social awareness aspects of CG for nine Asian counties. As suggested by Leuz et al.
(2003), this study also used country level governance factors in addition to the firm
specific governance factors to explore the earnings management practices in poorly vs.
good governed firms. The empirical results reported that firm level CG is strong factor to
mitigate the earnings management practices in large-sized and highly-leveraged firms in
Asia. However, firms in countries’ with stronger anti-director rights exhibited more
income smoothing practices which was found to be contrary with Leuz et al. (2003)
findings.
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Liu and Lu (2007) investigated the tunneling perspective for the emerging economy of
China. CG variables of board structure (CEO duality and board independence) and
ownership concentration have been used as to measure CG in a firm and its relationship
with earnings management was examined. The study claimed that earnings management
is conspicuous in Chinese firms due to two main reasons either in order to avoid delisting
from stock exchanges which could eliminate the private benefits of controlling
shareholders or they manage earnings to meet the threshold level of returns on equity
which may give the firm incentive to issue more shares in an overvalued stock markets of
China; both of the cases indicated agency conflict between minority and controlling
shareholders. Good CG reduced this agency conflict and mitigated the chances for
earnings manipulation in Chinese firms. Similarly, Yeo et al. (2002) argued that
ownership concentration and presence of external blockholder is essential in controlling
and monitoring the earnings smoothing practices; although Davidson et al. (2005) and
Sánchez-Ballesta and García-Meca (2007) did not find any significant relationship
between blockholding and earnings management.
Chen et al. (2007) examined the effectiveness of Corporate Governance Best-Practices
Principles (CGBPP) implemented in Taiwan in 2002 for reducing earnings management
practices in 654 Taiwanese firms for the period of 2000-2003. The results suggested that
financial expertise and independence of directors and independent supervisor are
effective in reducing earnings management practices particularly after the
implementation of CGBPP. Moreover, the tendency of earnings management was found
to be lower for the firms being audited by big 5 auditors indicating the role of auditor
quality in reducing earnings management. Similarly, Hutchinson et al. (2008) also
explored the impact of CG reforms implemented in Australia on the link between
earnings management and good CG practices for 200 firms listed at Australian Stock
Exchange. The results of the study described that increased shareholdings of mangers
provide them with the incentive to manage the current period reported earnings upward to
expatriate their private benefits; however, this behavior can be alleviated by independent
board and audit committees which have been increased after the implementation of CG
reforms in Australia. However, Cardoso et al. (2008) find no significant differences
between the firms with good quality of CG and their counter parts in Brazil whereas
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Bowen et al. (2008) did not find any significant relationship between inside ownership
and earnings management.
Another diverse study was carried out by Mitchell et al. (2008) by examining the
relationship between independent audit committee member’s human resource based
features and underpricing. For completion of this study a sample of 410 initial public
offering firms were selected on the listing of Singapore stock exchange during the period
of 1997 to 2006. Overall empirical findings revealed that there is no association between
human resource based features of audit committee independent members and IPO’s
underpricing. However, presence of independent audit committee member with financial
and accounting expertise has significance association whereas, gender diversity has no
association. Furthermore, other features namely qualifications, credentials, business and
IPO launching experience etc. has association with the underpricing.
Epps and Ismail (2009) evaluated US context in order to determine relationship of
earnings management and board structure as a mechanism of CG. The study used a large
sample of US firms categorized into firms with highly positive, highly negative and
relatively lower level of earnings management and examined the impact of board
composition and independence on DEM of three different types of firms. Results stated
that firms with 100% level of board independence and board committees tend to have
more negative discretionary levels. However, firms with 75-90% independence levels,
discretionary accruals level was found to be more positive. Further, no significant impact
was found of CEO duality on DEM practices of selected sample firms. Some other
related studies also confirmed the role of board independence in mitigating the
opportunistic behavior of managers with respect to manage reported accounting earnings
(Lai & Tam, 2007; Niu, 2006; Rahman & Ali, 2006).
Jaggi et al. (2009) explored another dimension of ownership structure i.e. family
ownership and family control. They investigated the moderating role of family
involvement into the business between the size and independence of corporate boards and
propensity to manage the reported earnings in Hong King for 1998-2000. The claimed
that, like other economies, board independence also plays important role in controlling
earnings management activity in Hong Kong. This negative relation between board
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independence and earnings management is further moderated by family involvement
either through high ownership stake in business or presence as directors on the board.
Moreover, CEO duality and external auditor quality is also found to be negatively related
to earnings management practices; however, these results were not statistically
significant. In line with this study, some earlier studies had also documented the negative
relation between family involvement into business and DEM practices (Jiraporn and
DaDalt, 2009; Ali et al., 2007; Wang, 2006; Siregar & Utama, 2008).
Furthermore, Mustafa and Youssef (2010) investigated the association between audit
committee member’s financial expertise and assets misappropriation. Sample of 28 USA
firms were selected from the period of 1987 to 1998 those experiencing assets
misappropriation. Logistic model was used to examine the impact of interaction between
financial expertise of members and their independence on assets misappropriation.
Results depicted that assets misappropriation can only be reduce if audit committee has
independent members with accounting knowledge and financial expertise. This study is
similar with the research of Chapple et al. (2009) who researched in Australia and New
Zealand on assets misappropriation and its relation with AC director’s independence.
Their findings revealed that independent directors on audit committees have inverse
relationship with the occurrence of misappropriation whereas Bronson et al. (2009) and
Tsui (2009) also confirmed these findings.
Banderlipe and Reynald (2010) focused on the link between CG practices and earnings
management practices of Philippines firms by selecting 114 publically listed companies
for the period of 2005-2006. They concluded that presence of independent directors with
multiple directorships and increased managerial ownership are more than enough to limit
managerial incentive of managing earnings. Mitani (2010) investigated the relationship
between multiple internal and external factors of CG and DEM practices of 799 large
Japanese manufacturing firms for the period of 1999 to 2004. The results of internal CG
mechanism indicated that there is a nonlinear U-shaped relationship between inside
ownership concentration and earnings management whereas managerial stock
compensation is not linked with DEM behavior. Moreover, institutional shareholdings of
financial institutions have capacity to control and reduce the earnings management
practices. This is consistent with earlier researchers which found the effective role of
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institutional investors in influencing, monitoring and controlling managers and not letting
them to manipulate the reported accounting numbers (Jiraporn & Gleason, 2007).
Moreover, Laux and Laux (2009) also argued that earnings management activity does not
necessarily increases with the CEO equity based compensation.
Several researchers have identified the importance of audit committee establishment in
the improvement of earnings quality. Baxter and Cotter (2009) investigated whether audit
committees improved the quality of earnings in the firms or not. A sample of 72
Australian listed companies was selected before the introduction of mandatory AC’s
requirements in 2003. Results depicted that formation of audit committee reduces the
number of intentional earnings management but not reduce the accruals errors. Other
audit committee characteristics namely independence, size and activity has no significant
link with the quality of earnings. Moreover, audit committee characteristics have
different impact on different models of earnings quality. Companies generally choose
those characteristics of audit committees which has strong influence to strengthen their
earnings quality. Whereas, García-Meca and Sánchez-Ballesta (2009) study evidenced
that independent audit committee has potential to maintain the quality of earnings and
credibility of financial reporting process.
One important study in this regards is Cornett et al. (2009) who evaluated the earnings
management practices at 46 large US bank holding companies headquartered in US and
have been in operation during the period of 1994-2002. The study first established that
the relationship between CG and earnings management is endogenous in nature. Once the
endogeneity had been established, the authors used simultaneous equations approach to
assess the relationship between board independence, pay-for-performance sensitivity and
earnings management practices of bank holding companies. In order to detect earnings
management in banks, Beatty et al., (2002) approach has been used instead of traditional
accrual based earnings management measures. Contrary to earlier studies, the results
reported that board independence and pay-for-performance sensitivity are positively
associated with higher earnings management practices in US large banks.
Iqbal and Strong (2010) tried to find any association between CG and earnings
management practices in UK when firms announce right issues. The effect of board
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structure and ownership structure has been analyzed for the period of 1991 to 1995. The
results indicated that composition of board with more independent directors and presence
of outside blockholder on the ownership structure reduced the likelihood of a firm to
engage in earnings management practices around the right issues in UK. They argued that
investors can rely more on the financial disclosures of firms having external block holder
and more independent board of directors. Furthermore, Rusmin (2010) focused on the
role of external auditor quality in ensuring the integrity of financial statements of a firm.
By cross-sectionally analyzing 301 Singaporean firms for the period of 2003, the results
provided evidence that magnitude and propensity of earnings management is much lower
in firms being audited by specialist and big 4 auditor.
Magrane and Malthus (2010) carried out a qualitative research to explore the
effectiveness of audit committees in public sector of New Zealand. This research has
used the case study approach in which only District health Board of New Zealand was
targeted to investigate the operations of audit committee. Secondary data like annual
reports were used and semi structured interviews were conducted for the completion of
this research. The findings of the paper revealed that District Health Board audit
committee operations were very effective. The reason behind the effectiveness of audit
committee was the characteristics of its members namely competence, independence,
tenure and remuneration which call upon the overall effectiveness in the operations of
District health Board audit committee. As a result this committee has valuable ability in
providing assistance to DHB for achieving its proper governance. Similarly, Abbott et al.
(2010) found in their study a strong association between effective audit committee and
internal control functions of the business. Presence of independent directors in audit
committee oversight the internal control functions more effectively thus improves the
firm value.
In addition to investigating the role of different CG mechanism on earnings management
separately, Bekiris and Doukakis (2011) used a composite measure i.e. an index based
upon 55 CG provisions. They analyzed 427 firms listed at Athens, Milan and Madrid
stock exchanges for the period of 2008 and found that CG was seemed to lower the
earnings management practices in the firms from all three countries. The study also
suggested using the composite and comprehensive measure of CG in examining the
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earnings management practices which certify the financial integrity and credibility of
reported firm value. Yaghoobnezhad et al. (2011) also used CGI constructed from six
different CG mechanisms and confirmed the findings of Bekiris and Doukakis (2011) that
CGI is inversely related to earnings management practices in a sample of 102 selected
Iranian firms for the period of 2003-2008. They further argued that adequacy of CG is
more important than its strength in mitigating the opportunistic behavior of managers.
Roodposhti and Chashmi (2011) investigated the monitoring role played by independent
outside block holders and found that opportunistic earnings management decreases in the
presence of these blockholders and earnings are more informative for the external
stakeholders and prospective investors. Moreover, the authors argued that concentration
of ownership stakes in few hands also reduced the motive to manage the earnings.
However, institutional shareholdings and CEO duality are the two important CG
mechanisms which are leading to have higher earnings management practices in firms.
This is attributed to Pound (1988) strategic alliance hypothesis between institutional
shareholders and management which argue that institutional investors with high
ownership stake make commitments with the internal management and collectively they
exploit the rights of minority shareholders. In addition, Neffati et al., (2011) also
supported that good CG practices leads to lower risk and hence; lower earnings
management practices. Further, Gulzar and Wang (2011) found strong association
between earnings management and different characteristics of CG like board size, CEO
duality, board meetings, board diversity, and ownership concentration. However, there
was lack of evidence between earnings management and role audit committee and board
independence.
Likewise, Kang et al. (2011) investigated the effectiveness of audit committees after the
recommendations of Australian Stock Exchange (ASX) whether it improves the financial
reporting quality of Australian low and mid-cap firms or not. 288 low and mid-cap firms
were selected as sample of the study; these firms are not mandated to comply with the
requirements of the ASX. Audit committee characteristics namely independence,
expertise, size and activity were used to investigate the earnings management. All
characteristics have significant impact on the lower earnings management. This study
provides evidence on ASX requirements that are mandated for high and mid-cap firms
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could also improve the financial reporting quality and lower the earnings management of
low and mid-cap firms.
In contrast, Siagian and Tresnaningsih (2011) investigated the impact of independent
directors and independent audit committees on the earnings quality of Indonesian firms.
Study sample consisted upon 80 firms that were listed on Jakarta Stock Exchange during
the period of December 31, 1999 to December 31, 2004. Discretionary accruals and
earnings response coefficients were used as the proxies for earnings quality. Multivariate
Regression analysis was used to examine the improvement in both earnings quality
measures. Results of the study revealed that both proxies of earnings quality has
improved after the corporations hire the independent directors and established
independent audit committees. On the whole, findings implied that after fulfilling the
requirements of Jakarta stock exchange of having independent directors on the board and
independent audit committees, Indonesian firms have improved their earnings quality.
Similar results were also found by Ikechukwu (2013) for ownership concentration and
earnings management
The research study on the role of CG and DEM is González and García-Meca (2014) who
analyzed this relationship for four Latin American countries of Brazil, Argentine, Chile
and Mexico for the period of 2006-2009. The Latin America is characterized as having
weak investors’ protection and mainly family-oriented businesses. The study focused on
different variables of ownership type and board structure and investigated whether these
internal CG mechanism control the earnings management behavior of managers in
selected firms. The results documented the evidence that the role of board composition
and independence is rather limited in Latin American firms; however, if board meets
more frequently, this activity may reduce earnings management in the firms. Moreover,
the study also found a nonlinear relationship between inside ownership and earnings
management indicating that ownership concentration with insiders may enhance
manipulative activities only when certain threshold is crossed.
Recently, Hsu and Wen (2015) investigated the impact of ownership structure and board
composition on real and accrual based discretionary earnings management practices of
Chinese listed companies for a period of 2002-2012. The study have pointed out that
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there a greater propensity to manipulate earnings by corporate managers in firms with
higher shareholdings and greater concentrations by financial institutions in China which
is an outcome of strategic alignment between managers and financial institutions on short
term basis. Along with this, inside ownership mitigate the opportunistic behavior of
managers to judgmentally manage earnings convergence of interest exist; however, this
opportunistic behavior is higher in firms where boards have CEO duality because of
entrenchment effect. They authors have argued that large size of the board gives them an
opportunity to better supervise and monitor these activities in Chinese firms.
In the domestic literature, role of CG quality in minimizing earnings management in
Pakistani firms is investigated by Shah et al. (2009). They used board structure,
ownership structure and audit committee independence as measures of quality of CG for
a small cross sectional sample of 53 KSE-100 index firms for year 2006. Their findings
revealed positive relation between CG and earnings management which is
unconventional and opposite to the expectation. CG is found positivity related with the
earnings management practices in Pakistani firms. They give justification of their
unconventional results that Pakistan is passing through its transition phase so that’s why
unusual results have been seen as well as due to small sample for one year data.
2.3 Discretionary Earnings Management and Firm Value
Literature has documented different motives of earnings management either income
increasing or income decreasing; however the empirical evidence on these motive is not
truly convincing (Beneish, 2001). The income increasing incentive may be due to the
debt contracts (DeAngelo et al., 1994; Dechow & Skinner, 2000; Sweeney, 1994),
compensation contracts (Gaver et al., 1995; Healy, 1985; Holthausen et al., 1995), new
issues in capital market (Rangan, 1998; Teoh et al., 1998), and inside trading (Beneish,
1999; Summers & Sweeney, 1998). On the other side, the managers may indulge in
temporary income decreasing earnings management because of increasing likelihood of
desired rate obtain by utilities (Jarrell, 1979), to obtain import benefits (Jones, 1991), to
expatriate the wealth from minority shareholders (Beneish, 2001).
The research on the role of DEM on firm value is deficient in corporate finance literature.
One school of thought in the literature has focused on actual/real practices of earnings
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management like sale of investment/fixed assets to improve earnings growth (Herrmann
et al., 2003) and minimization of reported earning loss by giving price discounts or
reporting lower costs and reducing the discretionary expenditures of research and
development. Empirical studies argued that earnings management activities have a
significantly negative impact on future value, earnings growth and future cash flow
which may be attributed to opportunistic earnings management (Healy & Palepu, 1993).
The other school of thought argues that managers exercise earnings management
behavior in order to enhance the reported earnings due to which shareholders benefit
from managed earnings (Arya et al., 2003; Bowen et al., 2008; Guay et al., 1996). Some
authors also tried to identify the incentive for DEM in capital markets, such as
outstanding number of shares, external audit quality, or compensation (Cohen &
Zarowin, 2010; Liu & Lu, 2007).
With reference to empirical relationship between earnings management practices and
firm value, Teoh et al. (1998) analyzed accrual based earnings management and firm
value new seasoned equity issues. Based on the sample of 1265 equity issues, the study
testified that managers manage firm earnings upward before equity an offering which is
significantly causing lower post equity firm value. In line with this, Rangan (1998)
provided the parallel evidence for 230 seasoned new issues that firms experienced
significantly lower earnings and negative stock return in the period of post equity
offerings. Similarly, Mizik and Jacobson (2007) also proved this negative relationship
between real earnings management and long term negative value due to income
increasing activity based earnings management near new stock offerings.
Furthermore, Gunny (2005) examined the impact of real activity based earnings
management on the subsequent value of large sample of US firms for the period of 1988
to 2000. He argued that real earnings management in the form of manipulated research
and development and discretionary marketing expenses, overproduction and sales of
fixed assets is a source of reduced future operating value. Bhojraj et al. (2009) described
that meeting forecasts in short run on the cost of long term value produced lower earnings
in second and third year of analysis of 1367 US firms. Moreover, Taylor and Xu (2010)
investigated a matched sample of 18,267 US firms for the period of 1988-2003 also
provided the same results that firms which are involved in real earnings management
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have lower subsequent value in coming years. Leggett et al. (2009) predicted similar
results for US firms.
An important study in this regards is Jiraporn et al. (2008) who contended that earnings
management behavior of managers may not always be opportunistic rather it may be
beneficial. If earnings management activity is increasing the information asymmetry
between the stakeholders, it is causing to upsurge the level of agency cost in the firms.
However, if earnings management is associated with enhanced fundamental value of
firm, it is notated as beneficial earnings management. The latter case may be attributed to
the fact that beneficial earnings management increase the informational content and value
of earnings by communicating the inside private information to the public. They provided
empirical evidence on the type of earnings management by investigating the effect of
DEM on firm’s market value in US firms. The results described that firms with higher
discretion abnormal accruals have greater market value confirming the notion of
beneficial earnings management and positive relations between earnings management
and firm value.
Matching results have been confirmed by Liu and Lu (2007) that DEM increases firm
value (i.e. abnormal market returns) for Chinese firms; Siregar and Utama (2008) found
Indonesian firms to be involved in efficient earnings management which increases future
value of firms. Contrary to his earlier findings; and Gunny (2010) confirmed the same
efficient and beneficial earnings management proposition for US firms that real earnings
management is associated with higher value. However, Chen et al. (2010) reported that
accrual based earnings management was found negatively impacting firm value in
comparison to real earnings management which is positively associated with firm future
value. They defined this real earnings management as a positive signal about firm future
value. Francis et al. (2011) investigated US firms for the period of 1994-2009 in order to
analyze the effect of real earnings management on stock price crash of firm. The study
reported that when firms involve in real earnings management, the probability of stock
price crashes is high due to negative expectations of capital market participants about the
future of company.
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In the local context, Iqbal et al. (2011) documented the evidence that firms do involve in
income increasing earnings management both in terms of short and long term abnormal
discretionary accruals around privatization in Pakistan using a sample of 33 firms for the
period of 1991-2005. They further argued that this enhanced firms is temporary and
revered back in post-privatization period. Anjum et al. (2012) studied the association
between DEM and value of Pakistani firm. Using a sample of 98 Karachi Stock
Exchange listed firms, the authors identified a negative linkage firm value and earnings
management for the period of 2002-2006. Recently, Tabassum et al. (2014) examined the
impact of real earnings management on financial value of manufacturing firms listed in
Karachi Stock Exchange. Overproduction was taken as measure of real earnings
management and four measures of financial value; ROE, ROE, EPS and Price Earnings
Ratio (PE) were considered in this study. A panel data analysis of 119 firms from the
year 2004 to 2011 revealed that earnings management through overproduction caused
poor financial value in the subsequent years and there is no long term value benefit of
managing earnings through real-time activity based earnings manipulation. Similar
findings were reported by Tabassum et al. (2015) with respect to earnings management
through sales manipulation and future performance.
2.4 Moderating Role of DEM in CG-Value Relationship
Keeping in view the mixed findings on association of DEM and firm value, Kang and
Kim (2011) claimed to be first study to capture the moderating role of real earnings
management between the relationship of CG and firm value. Using 1104 Korean firms’
data for a period 2005 to 2007, the authors applied 2 stage-least square regressions to
capture the impact of board structure on the firms’ market value (Tobin’s q) in the
presence of DEM. They concluded that managers will engage in less DEM practices
when board structure is stronger enough to mitigate their discretion powers. The results
are also robust to endogeneity issue between CG and earnings management. Further, the
study also confirms the earlier notion that earnings management leads to lower the value
of Korean firms. Finally, this discretionary behavior of managers to manage reported
earnings also moderates the relationship between CG and market value of firms and
hence, strengthens the casual link between CG and firm value. However, they also argued
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that this relationship should be further verified by taking into consideration the other
variables and mechanisms of CG and firm value using longer time series data.
2.5 Summary and Research Gap
In summary, the literature on audit committee characteristics provided a review that very
less evidence found that audit committee characteristics influence has been investigated
on firm’s financial value in developed countries as well as in developing countries.
Moreover, studies have also found mixed evidence on the audit committee size and firm
value, however; more independent committee meeting more frequently may positively
affect firm value. Furthermore, external audit quality is also supposed to be positively
associated with the firm value. The literature on board structure and firm value is still
inconclusive and has produced mixed findings. There are many studies who documented
positive relationship between firm value and board size, independence, duality structure,
and board activity. However, negative relationship has also been established in various
studies whereas no association between firm value and board structure variables is also
present in governance literature. Moreover, limited empirical evidence is found for board
participation rate and firm value.
Additionally, managerial compensation relationship with firm value is investigated in
three different ways. Firstly, literature highlight the studies of managerial compensation
in which compensation of all executives included then literature separately revealed the
relationship of CEO compensation and director remuneration with firm value. The
relationship of executive compensation with firm value is positive in some studies and
also negative in other some studies. Some studies showed positive association between
CEO compensation and firm value and also some studies documented opposite results.
Likewise, the results about relationship of director remuneration and firm value are also
mixed. Some studies showed positive association and some drawn negative or mixed
results. However, most of the studies have focused on investigating firm value as a
determinant of managerial compensation; however, very few studies have considered the
impact of compensation structure as a governance mechanism on firm value.
The studies related to CG and firm value have confirmed the positive and significant role
of CG variables on firm value. Moreover, most of the studies have focused only on one
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dimension of CG (i.e. board or ownership structure) while omitting the other parameters
of CG as well as firm value. In case of Pakistan, almost all of the studies have used a
small sample from a specific sector whose results cannot be generalized to all firms.
Furthermore, very few studies had considered the endogenous role of CG in enhancing
firm value and results of these studies are also inconclusive. So this creates a significant
research gap still available to be researched and generalized. In literature, CG and DEM
all over the world produced mixed and inconclusive results as well as there is a great
dearth of research for Pakistani firms in more generalizable form using further
comprehensive measures of variables and on large set of data. The empirical studies on
the relationship of the earnings management and firm value are rare and inconclusive.
The moderating role of DEM in CG-firm value relationship is also one ignored research
area in finance literature.
The present study fills this research gap in the corporate finance literature by validating
the relationship between CG and firm value in the presence of DEM as a moderator. The
current study is different from the earlier literature in many ways. Firstly, it will
corroborate the relationship between CG and firm value by incorporating all four CG
mechanisms (i.e. Audit structure, Board structure, Compensation structure and
Ownership structure) and more comprehensive measures of firm value. These four
mechanisms have not been discussed and investigated in earlier literature simultaneously.
Secondly, this study also considers the reverse causality between CG and firm value and
will address the endogeneity issue. Thirdly, the relationship between CG and DEM will
be thoroughly investigated. The present study is expected to contribute significantly in
the existing literature on the role of CG in controlling the opportunistic earnings
management behavior of Pakistani corporate managers. And finally, the significant
contribution of the present research is to explore moderating role of DEM within the
established premise of CG and firm value.
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Chapter 3
RESEARCH METHODOLOGY
83
This chapter describes the population, sample and date to be used in analysis purpose to
investigate the impact of CG on firm value considering the moderating role of DEM
practices in Pakistani firms for a period of 2005 to 2011. Section 3.1 provides the details
of data and sample firms whereas section 3.2 narrates the research models to be
investigated in following of data analysis at different sub levels i.e. impact of CG on firm
value and DEM followed by DEM and firm value relationship as well as moderating role
of DEM in CG-Firm value relationship.
3.1 Data and Sample Description
The total population of the study is the listed firms of Karachi Stock Exchange
(Guarantee) Limited on December 31, 2012 which are 572 financial and nonfinancial
firms. Some filtering techniques were applied to refine the sample of underlying study.
Firms which were not remained operational and listed at the stock exchange throughout
the study period were excluded as the study intends to analyze the market value of the
firms. So only those firms are selected which have complete data of market as well as
firm specific information such as governance and accounting numbers. After applying
these filters, the initial sample was 240 firms where 200 firms were from 14 non-financial
sectors, which was 42% of the total population of the study. The data regarding the
sample firms has been obtained for the period of 2004 to 2011 generating a total of 1920
firm year cross-sectional observations1. The rationale for taking 2004 as base year is that
the code of CG was implemented in Pakistan in later 2002, the effective implementation
could be assumed from year 2004 which is the first financial year after the
implementation of code. The data has been collected from the annual reports of firms,
respective websites of companies and stock exchange, and business recorder etc.
1 Keeping the objectives and the time period of the study in consideration, the filtering criteria ensure that sample should be selected out of those companies which remain listed, unmerged during the study period. This simply means that the study attempts to make inference about companies which observe normal course of business. This selection criteria is supported by existing literature in corporate finance research. For instance, Gugler (2003) narrated that the dynamics of firm governance as well as other characteristics of unlisted companies become different from those of listed companies. Moreover, data availability is a serious concern for researchers in developing countries such as Pakistan where there is no data stream is available and manual data collection from annual reports of the sample companies is a norm. Hence there is some data missing and firms with missing data have to be excluded from the sample (Kumar, 2006).
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Table 3.1 Distribution of Population and Sample
Sr. # Industrial Sectors Total Listed Firms*
Initial Sample %age Final
Sample** %age
1 Automobile and Parts 16 12 75% 11 69% 2 Chemicals 31 22 71% 18 58% 3 Construction and Materials 36 20 56% 14 39% 4 Electricity and Power (Gas) 18 8 44% 7 39% 5 Electronic and Electrical Goods 8 5 63% 5 63% 6 Engineering 11 10 91% 10 92% 7 Fixed Line Telecommunication 5 4 80% 4 80% 8 Food Producers 57 40 70% 32 56% 9 Forestry (Paper and Board) 4 4 100% 4 100%
10 Industrial Transportation 13 6 46% 3 23% 11 Oil and Gas 12 12 100% 12 100% 12 Personal Goods (Textiles) 190 44 23% 42 22% 13 Pharmaceutical and Bio Tech 11 7 64% 7 64% 14 General Industries 20 6 30% 4 20%
Non-Financial Sub Total 432 200 46% 173 40% 15 Banks 23 18 78% 17 71% 16 Insurance 32 22 69% 18 56% 17 Equity and Financial Services 85 0 0% 0 0%
Financial Sub Total 140 40 28% 35 25%
Grand Total 572 240 42% 208 36% * Total listed firms at KSE as on 31-December-2012. ** Final sample after excluding outliers
Moreover, after data collection on different variables of the study, the initial screening
has observed some outliers in the data which could disturb generalizability of the results.
So data trimming techniques of standardized variables (z-score) was applied and this
process has eliminated further 32 more firms with extreme values from the sample. The
non-financial sample was reduced by 27 firms from different sectors whereas 4 insurance
and one bank was also removed from the initial sample containing disturbing values in
the data. Table 3.1 summarizes the details of population screening and sample of the
study. The final sample of the study used to produce the results in upcoming section of
this research is 208 firms whereas 173 non-financial and 35 financial firms. This final
sample overall represents 36% of population of KSE listed firms during the study period.
Furthermore, the year 2004 was used as lag year to calculate and estimate some study
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variables (i.e. to estimate earnings management accruals and stock returns); hence a total
1456 firm year cross sectional observations were used for 208 firms and seven years for
the subsequent analysis for evaluating the impact of CG practices on firms value
incorporating the moderating effect of DEM practices on this CG-Value relationship2.
3.2 Research Model
In order to cater the research objectives mentioned in first chapter of this study, the
present study is based on four levels of analysis. First, the current study investigates the
relationship between CG mechanisms and firm value incorporating the reverse causality
between these variables. Second, it examines the impact of CG mechanisms on DEM
practices of sample firms. Third, role of DEM is examined on the firms accounting,
market and economic value to identify the efficient or opportunistic behavior of
managers. Finally, it explores the moderating effect of DEM practices on the established
relationship of CG and firm value.
3.2.1 Corporate Governance and Firm Value
To serve the first objective of assessing the comprehensive relationship of CG and firm
value, the following empirical models are estimated using multiple measures of CG and
alternative measures of firm value:
Valueit = 0 + 1(AC Sizeit) + 2(AC Indit) + 3(AC Activityit) + 4(EAQit) + 5(Firm_Sizeit) +
6(LVRGit) + 7(Riskit) + it …………….………………..……. (1);
Valueit = 0 + 1(BoSit) + 2(BoIit) + 3(CEO Dualityit) + 4(CEO Domit) + 5(B_Activityit) + 6(B_Partit)
+ 7(Firm_Sizeit) + 8(LVRGit) + 9(Riskit) + it .. (2);
Valueit = 0 + 1(CEO_Compit) + 2(Dir_Compit) + 3(Exe_Compit) + 4(Firm_Sizeit) + 5(LVRGit) +
6(Riskit) + it …………………………………………………..... (3);
2 Hsiao (2007) mentioned that data collected on panel basis has several advantages over cross sectional in terms of greater data availability because of low cost and time saving as well as greater capacity for modeling the complexity of data than a single cross-section or time series.
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Valueit = 0 + 1(Insideit) + 2(Familyit) + 3(Institutioanlit) + 4(Blockit) + 5(Foreignit) + 6(Associated
Coit) + 7(Own_Conit) + 8(Firm_Sizeit) + 9(LVRGit) + 10(Riskit) + it …...…… (4);
Additionally, in order to check for nonlinear relationship between ownership structure
and firm value, following regression models 4.1-4.3 are estimated for Inside ownership,
ownership concentration, and Institutional ownership, respectively. Moreover, model 4.4
intends to explore the role of institutional shareholders’ activism in enhancing the firm
value in Pakistan, both of which are sub-objectives of objective 1.
Valueit = 0 + 1(Insideit) + 2(Inside2it) + 3(Inside3
it) + 4(Firm_Sizeit) + 5(LVRGit) + 6(Riskit) + it
…...…… (4.1);
Valueit = 0 + 1(Own_Concit) + 2(Own_Conc2it) + 3(Own_Conc3
it) + 4(Firm_Sizeit) + 5(LVRGit) +
6(Riskit) + it …...…… (4.2);
Valueit = 0 + 1(Institutionalit) + 2(Institutional2it) + 3(Institutional3it) + 4(Firm_Sizeit) + 5(LVRGit) +
6(Riskit) + it …...…… (4.3);
Valueit = 0 + 1(Institutionalit) + 2(Institutional_Activismit) + 3(Firm_Sizeit) + 4(LVRGit) + 5(Riskit)
+ it …...…… (4.4);
And model for examining the impact of integrated corporate governance index on firm
value is;
Valueit = 0 + 1(CGIit) + 8(Firm_Sizeit) + 9(LVRGit) + 10(Riskit) + it ……...… (5);
Whereas: Valueit = Firm value including Accounting, Market and Economic Value variables for firm i for
time t; AC Sizeit = Size of internal audit committee for firm i for time t AC Indit = Independence of internal audit committee for firm i for time t AC Activityit = Total number of meetings internal audit committee for firm i for time t EAQit = External auditor quality for firm i for time t BoSit = Size of board of directors for firm i for time t BoIit = Independence of board of directors for firm i for time t CEO Dualityit = CEO duality for firm i for time t CEO Domit = CEO dominance for firm i for time t B_Activityit = Total number of board meetings for firm i for time t B_Partit = Rate of participation of directors in board meetings for firm i for time t
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CEO_Compit = Total compensation of CEO of firm i for time t Dir_Compit = Total compensation of executive directors of firm i for time t Exe_Compit = Total compensation of key management personnel of firm i for time t Insideit = Fraction of shares held by all insiders of firm i for time t Familyit = Fraction of shares held by family members in firm i for time t Institutioanlit = Fraction of shares held by financial institutions in firm i for time t Institutioanl_ =Dummy variable which take the value of 1 if there is nominee director of financial Activismit institutions on the board of ith company for time t, and zero otherwise Blockit = Dummy for existence of external blockholder in firm i for time t Foreignit = Fraction of shares held by foreigners in firm i for time t Associated Coit = Fraction of shares held by associated and related companies of firm i for time t Own_Concit = Fraction of shares held by top 5 shareholders of firm i for time t CGIit = CG index of firm i for time t Firm_Sizeit = Size of the company as control variable for firm i for time t LVRGit = Leverage ratio of firm i for time t Riskit = Systematic risk faced by firm i for time t = Intercept for firm i for time t n = Estimated parameters of the models it = residual Appendix I describes the variables measurement and some earlier studies used the same
measures
3.2.2 Corporate Governance and Discretionary Earnings Management
For the second research objective, the impact of CG mechanism on DEM practices of
firms is estimated through following empirical models:
DEMit = 0 + 1(AC Sizeit) + 2(AC Indit) + 3(AC Activityit) + 4(EAQit) + 5(Firm_Sizeit) + 6(LVRGit)
+ 7(Riskit) + it ……………………………………. (6);
DEMit = 0 + 1(BoSit) + 2(BoIit) + 3(CEO Dualityit) + 4(CEO Domit) + 5(B_Activityit) + 6(B_Partit) +
7(Firm_Sizeit) + 8(LVRGit) + 9(Riskit) + it ….. (7);
DEMit = 0 + 1(CEO_Compit) + 2(Dir_Compit) + 3(Exe_Compit) + 4(Firm_Sizeit) + 5(LVRGit) +
6(Riskit) + it …………………………………………………….. (8);
DEMit = 0 + 1(Insideit) + 2(Familyit) + 3(Institutioanlit) + 4(Blockit) + 5(Foreignit) + 6(Associated
Coit) + 7(Own_Concit) + 8(Firm_Sizeit) + 9(LVRGit) + 10(Riskit) + it …...…… (9);
DEMit = 0 + 1(CGIit) + 8(Firm_Sizeit) + 9(LVRGit) + 10(Riskit) + it …….... (10);
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Whereas:
DEMit = DEM for firm i for time t estimated as residual of anyone to of the model 11-16. = Intercept for firm i for time t n = Estimated parameters of the models it = residual
Discretionary accruals are commonly used as a proxy to detect earnings management in a
firm. Earlier studies have used two different approaches to detect earnings management
through the use to accruals (discretionary + non-discretionary) in a firm namely balance
sheet approach and cash flow approach (Shah et al. 2009). However, Collins and Hriber
(1999) argued that balance sheet approach to calculate accruals and detect earnings
management is proven to be inferior in most of the cases and researchers should follow
the cash flow approach to calculate total accruals which is less sensitive to economic
conditions in a country. Therefore, following Collins and Hriber (1999), the present study
uses cash flow approach to measure the Total Accruals (TA) as:
TAit = EATit - OCFit Whereas:
TAit = Total Accruals for firm i for time t EATit = Earnings after tax for firm i for time t OCFit = Operating Cash flows for firm i for time t
In order to estimate the non-discretionary portion of total accruals, Jones (1991) proposed
the following model:
TAit = 0Assetsit-1) + 1(REVit) + 2(PPEit) + it ………………...………...… (11); Whereas:
Assetsit-1 = lagged value of total assets for firm i for time t-1 REVit = Change in revenues (REVit – REVit-1) PPEit = gross property, plant and equipment for firm i for time t n = Estimated parameters of the models it = residual
All variables are to be scaled by beginning level of total assets However, Dechow et al. (1996) argued that simple cross sectional Jones model (1991) is
not much effective in its current form because of less explained variation and they
proposed a modified Jones model (1996) as:
TAit = 0Assetsit-1) + 1(REVit - RECit) + 2(PPEit) + it …………...........… (12);
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Whereas: RECit = Change in receivables (RECit – RECit-1) PPEit = gross property, plant and equipment for firm i for time t n = Estimated parameters of the models it = residual
All variables are to be scaled by beginning level of total assets Furthermore, Kasznik (1999) argued that operating cash flows variations may cause
misspecifications in estimating the abnormal accruals so he proposed another variation in
modified Jones model of Dechow et al. (1996) as:
TAit = 0Assetsit-1) + 1(REVit - RECit) + 2(PPEit) + 3OCFit + it……... (13); Whereas:
OCFit = change in operating cash flows of a firm i for time t n = Estimated parameters of the models it = residual
All variables are to be scaled by beginning level of total assets
In order to mitigate the estimation error associated with abnormal discretionary accruals,
Larcker and Richardson (2004) further add the growth factor and operating cash flows to
the modified Jones model where growth calculated through book to market ratio controls
for expected growth in firm and it will be chosen as discretionary accruals if left
uncontrolled. CFO controls for current operating value because discretionary accruals are
likely to be misspecified for firms with extreme levels of value. Larker and Richardson
(2004) note that their model is superior to the modified Jones model because it has
greater explanatory power, identifies unexpected accruals that are less persistent than
other components of earnings and the estimated discretionary accruals detect earnings
management identified in Securities and Exchange Commission enforcement actions.
TAit = 0Assetsit-1) + 1(REVit - RECit) + 2(PPEit) + 3Growthit + 4OCFit + it…(14); Whereas:
Growthit = growth in firm measured by book to market ratio for firm i for time t n = Estimated parameters of the models it = residual
All variables are to be scaled by beginning level of total assets
In addition to the above researchers, Kothari et al. (2005) also contended that estimating
discretionary accruals without controlling for firm accounting value may produce biased
and unreliable results. In order to alleviate the problematic heteroskedasticity and
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misspecified issues which are prevalent in other accruals models and proposed following
model to estimate discretionary accruals:
TAit = Assetsit-1)+1(REVit - RECit) + 2(PPEit) + ROAit-1 + it ……… (15);
Whereas: ROAit-1 = Firm value measured by ROA for firm i for time t-1 n = Estimated parameters of the models it = residual
All variables are to be scaled by beginning level of total assets The modified Jones model (1995) has been widely accepted and used in literature to
measure the earnings management practices of firms. However, Yoon and Miller (2002)
and Yoon et al. (2006) argued that Modified Jones Model (1995) does not fit in the
developing economies of Asia and it was proven to be valid for western developed
economies and they proposed a new version of Modified Jones Model. Recently, Islam et
al. (2011) has also confirmed the findings of Yoon et al. (2006) by applying the same
model on Bangladeshi Firms and documented that explanatory power of accrual model
increases up to 84% by using the Yoon et al. (2006) model while it was just 9% with
Modified Jones model for Bangladeshi firms. So the present study also incorporates the
model proposed by Yoon et al. (2006) to find the DEM in Pakistani firms as;
TAit = 0 + 1(REVit - RECit) + 2(EXPt - PAYit) + 3(DEPit - RETit) + it ... (16); Whereas:
TAit = Total Accruals for firm i for time t REVit = Change in revenues (REVit – REVit-1) RECit = Change in receivables (RECit – RECit-1) EXPit = Change in Cost of goods sold + operating expenses (excluding noncash
expenses) (EXPit – EXPit-1) PAYit = Change in payables (PAYit – PAYit-1) DEPit = Depreciation expenses RETit = Retirement benefit expenses incurred for employees by firms it = residual
All variables are to be scaled by REVit
The fitted values of model 11-16 are the non-discretionary accruals and residual (it) are
the discretionary portion of total accruals. The present study has estimated all six models
(11-16) to estimate the discretionary accruals and has preferred the model with greater
explanatory power (higher values of adjusted R2) as suggested by Sireger and Utama
(2008) to be used as DEMit in models 6-10 as well as models 19-20.
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In order to estimate the residuals of model 11-16 which could further be used as a
measurement of DEM, panel regression have been run and results are reported in Table
3.2. It is clear from the tabulated results that Adjusted R2of Kasznik (1999) model for
estimating accruals is 20.65% which is the highest among all six aggregate accrual
models along with lowest root mean square error of 10.118. The predictive power of
Kasznik (1999) model is even greater that widely used modified Jones model of Dechow
et al. (1996) and Kothari et al. (2005) as well as it is also higher that Yoon et al. (2006)
accrual model which was argued to be best fit in emerging economies of Asia. So, the
residuals predicted by Kasznik (1999) model are hereby used in further analysis in next
chapter as the proxy of DEM in models 6-10 as well as 19-20.
Table 3.2: Estimation of Discretionary Earnings Management Variable
Variables Jones (1991)
Dechow et al. (1996)
Kasznik (1999)
Larcker and
Richardson (2004)
Kothari et al. (2005)
Yoon et al. (2006)
Constant 0.0023 (0.24) 1/Assetst-1 3035.496 2943.136 3745.193 2211.482 3925.904 (1.34) (1.30) (1.64) (0.99) (1.77)* REV -0.0036 (-0.67) REV - REC -0.0093 0.0025 0.0087 -0.0110 0.0102 (-1.72)* (0.53) (1.76)* (-2.05)** (1.22) PPE -0.0256 -0.0253 0.0471 0.0459 -0.0197 (-2.72)*** (-2.70)*** (5.08)*** (4.93)*** (-2.12)** OCF -0.2735 (-21.19)*** Growth 0.0006 (0.35) OCF -0.2914 (-19.82)*** ROAt-1 0.1728 (4.80)*** EXP - PAY -0.0020 (-1.57) DEP - RET -0.0225 (-0.21) Wald 9.96** 12.51*** 458.91*** 403.65 36.66 4.07 Adjusted R2 0.0112 0.01331 0.2065 0.2003 0.0317 0.0036 RMSE 11.345 11.336 10.118 10.162 11.226 21.908 z-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively.
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However, as suggested by Greene (2005), the model 11-16 contains multiple lag values
in variables, particularly in dependent variable and if we estimate these accrual models,
the problem of autocorrelation between the residual and lagged endogenous variables
might arise. This problem makes estimation with the Ordinary Least Square (OLS)
method biased and unreliable for all estimated models 11-16. Boujelben and Fedhila
(2011) suggested using the “Arellano-Bover/Blundell-Bond linear dynamic panel data
estimation”, which is an estimation procedure with system GMM. This method includes
the lagged differences of the dependent variable as instruments in the level equation and
resolves the problem misspecification. So, the Kasznik (1999) model, being the best fit
model for Pakistan case because of lowest RMSE and highest adjusted R2, has been
estimated again using “Arellano-Bover/Blundell-Bond linear dynamic panel data
estimation” and its predicted values have been used as DEM for onward analysis3.
In addition, as discussed by Cornett et al. (2009), the banking sector is unique in its
nature and operations as these financial institutions face high regulatory monitoring. In
case of commercial banking sector, loan loss provisions possess both non-discretionary
and discretionary components (i.e. earnings management). Moreover, Beatty et al. (2002)
observed that earnings can be managed in banking sectors through the realization of
security gains and losses which are usually unregulated and unaudited DEM actions. So
following Beatty et al. (2002) and Cornett et al. (2009), earnings management practices in
commercial banks are detected through discretionary portion of loan loss provisions and
realized security gains and losses. In this regards, following econometric models are
estimated:
LLPit = t + 1LASSETit + 2NPLit + 3LLAit + 4LLOANit +it……………….. (17);
Whereas: LLPit = loan loss provisions as a percentage of total loans for bank i for time t; LASSETit = the natural log of total assets for bank i for time t; NPLit =nonperforming loans as a percentage of total loans for bank i for time t; LLAit = loan loss allowance as a percentage of total loans for bank i for time t;
3 Pooled OLS estimation for model 11-16 is only used to identify the best fit model with respect to highest predictive power (Adjusted R2) and lowest RMSE. Once the best model is identified using OLS estimations for all accrual models, i.e. Kasznik (1999), it was re-estimated using “Arellano-Bover/Blundell-Bond linear dynamic panel data estimation” and predicted residuals were used as a proxy variable for DEM in subsequent estimations.
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LLOANit = the natural log of total loans for bank i for time t; = Intercept for firm i for time t n = Estimated parameters of the models = error term.
The discretionary component of loan loss provisions (DLLPit) is:
DLLPit = (it × LOANSit)/ASSETSit
Moreover, discretionary realized security gains and losses (RSGLit) are estimated through
following regression: RSGLit = t + 1LASSETit + 2URSGLit + it …………………………………… (18) Where: RSGLit = realized security gains /losses as a percentage of total assets for bank i for time t LASSETit = the natural log of total assets banki for time t; URSGLit = unrealized security gains/losses as a percentage of total assets for bank i for time t
= Intercept for firm i for time t n = Estimated parameters of the models = error term.
The error term of model (18) is discretionary component of realized security gains and
losses (DRSGLit). Now the discretionary earnings management in commercial banks has
been defined as higher levels of loan loss provisions decrease earnings while higher
levels of realized securities gains and losses increase earnings. Accordingly, DEMitis:
DEMit = DRSGLit − DLLPit
High levels of DEM amount to underreporting loan loss provisions and higher levels of
realized securities gains, which, ceteris paribus, increase income. Low levels of EM,
which are often negative, suggest that loan loss provisions are over-reported and fewer
security gains are realized, which decreases operating income. This definition is only
applicable for earnings management proxy in case of commercial banks whereas, as
proposed earlier, Kasznik (1999) model is used to measure discretionary earnings
management practices for all remaining companies.
3.2.3 Impact of Discretionary Earnings Management on Firm Value
Sireger and Utama (2008) and Kang and Kim (2011) argued that opportunistic behavior
of managers may influence the accounting and market value of the firm by affecting the
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earnings informativeness and signaling to the market. Managers may be efficient in
managing reported earnings so it may enhance firm value. On the other side, firm value
may deteriorate if opportunistic behavior is shown by firm managers. In order to validate
this relationship, the present study also examines the impact of DEM on the firm value,
which is third research objective of the study, by estimating the following model;
Valueit = 0 + 1(DEMit) + 2(Firm_Sizeit) + 4(LVRGit) + 4(Riskit) + it ……… (19); Where: Valueit = Firm value including Accounting, Market and Economic Value variables for firm i for
time t; DEMit = DEM for firm i for time t estimated as residual of any one to of the models 11-16. Firm_Sizeit = Size of the company as control variable for firm i for time t LVRGit = Leverage ratio of firm i for time t Riskit = Systematic risk faced by firm i for time t = Intercept for firm i for time t n = Estimated parameters of the models it = residual
3.2.4 Moderating Role of DEM in CG-Value Relationship
For fourth research objective, the present study explores the moderating role of DEM in
the established relationship of CG and firm value. In order to perform this analysis, the
moderating regression analysis is done for empirical models 1-4 with the interactional
effect of DEM.
Valueit = 0 + 1(CGIit) + 2(DEMit)3(CGIit)*(DEMit)+ 4(Firm_Sizeit) + 5(LVRGit) + 6(Riskit) + it …… (20); Where: Valueit = Firm value including Accounting, Market and Economic Value variables for firm i for time t; CGIit = CG index of firm i for time t DEMit = DEM for firm i for time t estimated as residual of any one of the model 11-16. CGIit*DEMit = Interaction term of CGI and DEM to incorporate the moderating effect of DEM in CG-
Value relationship for firm i for time t Firm_Sizeit = Size of the company as control variable for firm i for time t LVRGit = Leverage ratio of firm i for time t Riskit = Systematic risk faced by firm i for time t = Intercept for firm i for time t it = residual
If the coefficient of these models () is found to be significant, there will be a moderating
effect of DEM on the relationship between effective CG mechanisms and firm value as
measured in terms of accounting, market and economic value added.
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In corporate finance and governance literature, standard multiple least square regression
method is commonly used to predict the relationship between dependent and independent
variables which intends to minimize the overall sum of square of errors in every equation
estimated (Cornett et al. 2007, 2008; Gompers et al., 2003; Nguyen, 2011; Park and Jang,
2010; Westman, 2011). Least square regression equations are normally estimated either
in linear (ordinary least square) or nonlinear form. The selection of linear or nonlinear
regression depends on linearity of the residuals of the regression. According to various
statisticians and econometricians, there are number of assumptions of least square
methods which must be fulfilled in order to avoid its limitations (Gujrati, 2012; Greene,
2005; Leng et al., 2007). For instance, a sample selected should be a true representor of
the population, the error of the least square regression are random with zero mean
conditional on predictors. Moreover, the independent variables should be measured with
zero error and if this condition does not meet then errors-in-variables models is used in
replacement of ordinary least square estimation. In addition, the predicting variables
should be linearly independent of each other, absence of which may lead to nonlinear
regression analysis. Another assumption of the ordinary least square estimation technique
is that the errors should be uncorrelated with dependent variable and its variance should
be constant across observations (also known as homoscedasticity).
In order to ensure the appropriateness of the estimation method, certain diagnostic tests
must be performed before discussing the results of estimation technique. For example, the
variables of the regression model (particular response variables) must be normally
distributed which can be checked by 1-sample KS Kolmogorov-Smirnov (KS) test.
According to Greene (2005), the estimated coefficients produced by OLS are still
consistent and unbiased even under the violation of normality and consistent variance
conditions if the data set converges to a large sample. Moreover, goodness of fit of the
model should be test by F-test which is outcome of sum of squares of the model and
residuals. Moreover, the explanatory power of the model, as predicted by Adjusted R2,
needs to be viewed before interpreting the estimates of predicted regression model.
Moreover, multicollinearity between independent variables needs to be checked through
Variance Inflation Factor (VIF) and Tolerance.
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Chapter 4
RESULTS AND DISCUSSION
97
The chapter four presents and discusses the results drawn from the data collected in order
to make inferences about the relationship of CG and firm value while considering the
moderating role of DEM in this CG-Firm value relationship. The chapter has been
divided into two main sections. First section narrates some descriptive statistics about the
sample data whereas second section includes comprehensive regression analysis for CG
and firm value relationship.
4.1 Descriptive Statistics
Overall descriptive statistics for scale variables are reported in Table 4.1 whereas
particulars of dichotomous variables are presented in Table 4.2. The data used for the
whole analysis is about 208 firms for seven year period of 2005-2011. The year 2004 was
omitted in analysis as this was lag year used in calculation and measurement of various
variables of the study. The sample firms are quite profitable in terms of accounting
measures of ROA and ROE as well as market measure of Tobin’s q. The average ROA
for all firms is 5.53% with a median value of 4.20% and standard deviation of 8.12%.
The firms have earned minimum of negative 21.11% during the sample period and
maximum of 37.89% on the other extreme. The shareholders of sample firms are earnings
11.68%, on average, on their equity provided in terms of ROE with a close median value
of 11.85%. However, standard deviation is quite higher due to wide range of minimum
and maximum values of ROE.
The general perception of the market participants is also positive about the fundamental
position of sample firms and investors are placing a higher value on book assets of firms
in terms of Tobin’s q. The Tobin’s q value is 1.4049 which is greater than par indicating
that there are positive perceptions and anticipations about the future of the firms. This
could be more consistent as standard deviation value of 1.2612 is less than mean value of
1.4049. In addition to the earlier studies which used only accounting (ROA, ROE) and
market measures (Tobin’s q), the present study added EVA as economic value measure
of firm. EVA is not used frequently in empirical research of finance as value measure,
particularly, with reference of CG and firm value relationship.
The average economic value as measured by EVA is PKR-936 million for the sample
firms during study period. This is only 1.82% of the total assets. However, there is a
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greater variation in this variable as indicated by its higher standard deviation. The
extreme positive value of EVA is 45 billion PKR which is for one of the banking firm in
the sample. Average EVA has been remained positive for year 2006 and 2008 where it
was 452 and 824 million PKR, respectively. With respect of Discretionary Earnings
Management (DEM) practices, banks are indulged in income decreasing earnings
management activities with mean DEM of -0.0040 and -0.0024 median values. The range
for DEM is -0.0307 to 0.0127 with standard deviation of 0.0085. These descriptive
statistics of bank earnings management are very close to those reported by Cornett et al.
(2009) who also reported that banks are involved in income decreasing activities by
0.4%. For non-banking sample firms, however, are managing their earnings upward with
0.0259 mean value whereas the overall sample has detected earnings management
practices in Pakistani firms which is on average 2.35% which income increasing earnings
management.
Table 4.1 also reports descriptive statistics of three control variables of the study which
are firm size, leverage and market risk. The sample firms are relatively highly leveraged
where the average leverage ratio is around 60%. This leverage ratio ranges from 0.35% to
161% for the sample firms with the standard deviation of 22.31% only. The leverage ratio
greater than one is for firms which have negative equity during any year. Similarly,
sample firms are also of moderate size with average total assets of 25 billion PKR. The
smallest firm contains assets of PKR64 million whereas largest firm of the sample have
total assets of PKR653 billion. The standard deviation of total assets is quite higher
which is PKR65 billion. Third control variable is market systematic risk measured by
using Bloomberg data through single factor Capital Assets Pricing Model (CAPM) for a
particular year. The descriptive of discloses that selected firms are relatively low risky
as compared to market where mean is 0.43 and median is 0.53. The standard
deviation of is also quite higher i.e. 1.668 making this control variable more volatile.
The reason for such a low mean value of beta might be attributed to the fact that the study
considered only 208 firms in the sample (which is only 36% of the total population of the
sample). In addition, the filtering of initial sample also excluded some big companies
from the sample which were considered outliers with extreme values that forced average
beta value to be relatively lower as compared to the market.
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Table 4.1: Descriptive Statistics
Variable Mean Median SD Minimum Maximum
ROA 0.0553 0.0420 0.0812 -0.2111 0.3789
ROE 0.1168 0.1185 0.2094 -0.8975 1.2115
Tobin's Q 1.4049 1.0855 1.2612 -2.2625 8.8337
EVA (Million PKR) -935.68 -2572.58 6,297.56 -48,432.03 44,855.01
EVA/TA -0.0182 -0.0022 0.2304 -1.9243 1.6420
DEM - Non Banks 0.0259 0.0221 0.0666 -0.1785 0.2265
DEM – Banks -0.0040 -0.0024 0.0085 -0.0307 0.0127
DEM - full sample 0.0235 0.0173 0.0644 -0.1785 0.2265
Leverage 0.5819 0.5969 0.2231 0.0035 1.6158
Total Assets (Million PKR) 25,078 3,634 65,364 64 653,233
Market Risk () 0.4302 0.5280 1.6680 -8.1241 8.2076
AC Size 0.4144 0.43 0.0736 0.2308 0.7500
AC Independence 0.8256 1.0000 0.1906 0 1
AC Activity 4.1380 4 0.6077 2 11
Board Size 8.1765 8 1.5816 7 15
Board Independence 0.4331 0.3571 0.3176 0.0179 0.9333
Board Activity 5.5337 5 2.8396 2 35
Board Participation Rate 0.8016 0.8125 0.1224 0.3344 1.0000
CEO Comp. (Million PKR) 10.5740 5.3230 24.6410 0 586.3320 Director Com. (Million PKR) 7.3390 2.2850 15.2650 0 224.5090
Exe. Comp. (Million PKR) 148.6550 22.0660 397.9510 0 4506.4000
Inside OS 0.1786 0.0831 0.2199 0 0.9955
Family OS 0.1868 0.0807 0.2351 0 0.9983
Institutional OS 0.1280 0.0984 0.1173 0 0.7812
Foreign OS 0.0573 0.0000 0.1485 0 0.9466
Associated Co. OS 0.2891 0.1924 0.2984 0 0.9899
OS Concentration 0.7845 0.8116 0.1366 0.1831 1.0000
CG Index 14.6861 15 2.6853 6 22
Next, CG related variables are mentioned in Table 4.1 and Table 4.2. The average size of
an internal audit committee in sample firms is 41% of its total board of director size. It
varies from one-fourth to three-fourth of the total board of director size with lesser
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variation in it. Independence of the internal audit committee as measured by ratio of non-
executive directors on audit committee to total audit committee members is quite high for
the sample firm i.e. 82.56%. Mostly, the internal audit committees of sample firms
constitute of non-executive directors to oversee the operations of a firm as indicated by
its median value which is exactly 1.00. The code of CG issued by SECP also encourages
the participation of non-executive members on audit committee and board of directors.
However, there are a few firms which have all the executive members in its internal audit
committee as minimum AC Independence is 0 for some cases. The audit committee
meets 4 times a year, on average, which ranges from minimum of 2 audit committee
meetings to 11 meetings in a financial year. Moreover, as for as the reputation and quality
of external audit is concerned, a total of 61% firms get their annual financial accounts
audited by any one of big five external audit firms.
The second dimension of CG is structure of its board of directors. This may include board
size, board independence, CEO power, boar activity etc. Descriptive statistics regarding
board size, independence, board activity, and board participation rate are reported in
Table 4.1 whereas CEO duality and CEO dominance, being the dichotomous variables,
are presented in Table 4.2. The board size ranges from minimum regulatory requirement
of 7 members to 15 members of board whereas the average median size of the board is 8
directors. The level of intendance of board of directors is relatively lower in Pakistani
firms as compared to other earlier researches conducted in the different economies of the
world. The average level of independence of board is just 43.31% indicating the fact that
more than half of the directors on the board are executive directors. However this
variable is quite more volatile as standard deviation is 31.76%.
With respect to CEO power, 27% of firms have duality of CEO position where CEO
holds the office of chairman of the board as well and in 22% firms CEO is present in
different board committees like audit committee, remuneration committee, management
committee etc. indicating CEO dominance and power. The board meets, on average, 5
times in a financial year to discuss the operational and strategic issues of firms with the
range of 2 to 35 meetings in a year for some sample firms as well. The average
attendance rate of board of directors in board meetings is 80.16% pointing out the fact
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that directors do participate in the meetings of board of directors. There are few occasion
when number of directors in meetings is just one-third in order to just fulfill the quorum
of board meeting, however, the tendency of attendance is more towards greater
participation rate.
The third and important mechanism of CG is managerial compensation structure which
includes compensation of CEO, executive directors and key management executives.
Table 4.1 reports the annual compensation of these three categories measured in million
PKR. The average annual CEO compensation is 10.5 million with the large variation of
24.64 million ranges from zero to 586.33 million PKR. The compensation to executive
directors varies from zero to 244.5 million with average of 7.34 million and standard
deviation of 15.27 million PKR. The average monetary and non-monetary annual
compensation of key management personnel is 148.65 million with variation of 397.95
million. The maximum amount paid to executives of a firm in any year is 4506 million
with minimum value of zero rupees. There are some firms in the sample which are not
paying any compensation to its CEO, executive directors. These may the firms where
family members may be serving on the positions of CEO and directors and do not require
any monetary or non-monetary benefits from the business.
Table 4.2: Descriptive -- Frequency Tables for Dichotomous Variables
Variable Frequency Case = 1 %age Median Std.
Deviation
External Audit Quality 887 60.9 1 0.488 CEO Duality 393 27.0 0 0.444 CEO Dominance 319 21.9 0 0.414 Institutional SH Activism 496 34.1 0 0.474 Block holder Dummy 967 66.4 1 0.472
The ownership structure variables of CG are describes next. The study includes fraction
of shares held by inside, family, institutional, foreign, and associated companies as
composition of ownership whereas external block holder dummy and ownership
concentration have been used as a measure of ownership type in a firm. The shares held
by insiders (manager, CEO, directors etc.) are used as most common measure of
ownership structure in earlier empirical researches. The average level of Inside ownership
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in our sample firms is 17.86% of total shares outstanding with the variation of 21.99%.
The inside ownership ranges from 0 to 99.95% wholly inside dominated firms. However,
the level of ownership held by managers and other insider is not much higher and they
only own less than 20% stake in firms which they are managing. The average family
ownership level in sample firms is also close to 20% with the maximum of wholly owned
family firms (99.83% family ownership level). With the passage of time, the level of
family ownership is declining in Pakistani firms and these are converging towards more
market oriented governance and control structure from family controlled firms (Yasser,
2011). Similarly, the level of shareholdings of financial institutions is 12.8% on average
with low standard deviation of 11.73%. The maximum percentage of shares held by
financial institutional in any firm during the window period is 78.12% of the total shares
which may be the case of banking and insurance sector where much of the shares are held
by their counterparts in the same industry. Moreover, banking is considered to be much
stable and successful sector of Pakistani economy so institutional investors prefer to
invest in this sector as compared to volatile and crunched manufacturing sector of
Pakistan. In addition to this, institutional investors have nominated their nominee
directors in 34% firms where they have invested block of their capital indicating their
long term orientation with these firms.
Furthermore, foreigners are considered to be important as they bring capital as well as
technological skills to the firms where they invest. The average level of foreign
shareholdings in Pakistani sample firm is only 5.73% which may be attributed to lower
capital inflow through foreign direct and portfolio investment because of the unstable
political conditions and unfavorable business environment of Pakistan. The median value
of foreign ownership is zero indicating that no foreign investment in more than half of
sample firms whereas maximum 94.66% foreign shareholdings which may be in
multinational companies. Along with this, the associated companies (parent, subsidiary,
related party) own approximately 29% ownership in the sample firms indicating the
influential role of group affiliation and parent-subsidiary benefits of economies of scale.
Naqvi and Ikram (2004) have also argued that Pakistani firms affiliated to a group are
significantly different from un-affiliated firms in terms of value.
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Ownership concentration and block holder dummy are used as a tool to measure the
ownership type in the sample firms. Ownership concentration is measured by Herfindahl
Index (also known as Herfindahl–Hirschman Index, or HHI) which uses sum of squared
shareholdings of top 5 shareholders of a firm. The average ownership concentration level
is 78.45% on mean value and 81.16% on median value with 13.66% variation in
observations. There are few firms which are completely owned by only 5 shareholder
making ownership concentration approximately 100%. The other measure of ownership
type is the presence of external block holder to protect the interests of minority
shareholders from insiders. In the sample firms, external independent block holder is
present in 66.4% of the firms. Lastly, in order to have more integrated and
comprehensive analysis, a CG index (CGI) was constructed using 28 CG provisions. The
CGI was measured on an internal scale which may range from zero to 28 where higher
score is indicating better quality of CG. Table 4.1 reports that the median value of CGI is
15 where some firms score a maximum of 22 on this scale. Overall, the descriptive
pointed out that the sample firms possess on average good quality CG on different
mechanism as well as on CGI. The sample firms are of moderate size with better value
and these are somewhat involved in DEM practices.
Table 4.3 to 4.5 report different elements of DEM. Industry wise descriptive are
presented in Table 4.3. Banks and Industrial Transportation are only two industries that
are involved in income decreasing earnings management with an average DEM of -
0.0040 and -0.0119 while remaining all industries are found to be managing their
reported accounting earnings upward. The highest level of earnings management is
prevalent in Forestry and Paper industry with an average DEM of 4.99% followed by
Electronics and Electrical Goods (mean DEM is 4.25%) and Non-Life Insurance
industry (mean DEM is 4.19%).
On the other hand, Oil and Gas industry is involved in least income increasing earnings
management activity with an average DEM of 0.21% only followed by Fixed Line
Telecommunication (mean DEM is 1.3%) and Pharmaceutical and Bio Tech. industry
(mean DEM is 1.6%). There is obvious reason for this lower level of earnings
management in these industries as these are stable and profitable sectors of Karachi Stock
Exchange so they do not need to manipulate their earnings much. While, Forestry are
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Paper, Non-Life Insurance, Electronics and Electrical goods industries are not much
profitable so corporate managers of firms in these industries are making their firms
profitable through temporary income increasing discretionary earnings manipulation.
Further, one way ANOVA has been used to check for significant differences in among
industries and F-value of 4.656 indicates that there are statistically significant differences
in the DEM practices across different industries in Pakistan.
Table 4.3: Industry wise DEM analysis – one way ANOVA
***, **, and * denote significance levels at 1%, 5% and 10%, respectively.
Moreover, sector wise analysis has also been performed using independent sample t-test
and results are given in Table 4.4. The upper panel of Table 4.4 provides mean
comparison for financial and non-financial sector of sample data with respect to DEM
practices during the window period. The positive value of mean difference is the
evidence of the fact that non-financial sector is more involved in DEM practices
however; the t-value for mean differences is not statistically significant shows that this
Industry n Mean Std. Deviation Minimum Maximum
Automobile and Parts 77 0.0275 0.0729 -0.1529 0.2143 Chemicals and Fertilizers 126 0.0371 0.0675 -0.1262 0.2112 Construction and Materials 98 0.0187 0.0578 -0.1350 0.2187 Electronics and Electrical Goods 35 0.0425 0.0616 -0.0848 0.1922
Engineering 70 0.0332 0.0678 -0.1717 0.1856 Food Producers 224 0.0285 0.0751 -0.1785 0.2251 Misc. 28 0.0294 0.0733 -0.0878 0.1826 Oil and Gas 84 0.0021 0.0712 -0.1703 0.2077 Forestry (Paper and Board) 28 0.0499 0.0415 -0.0130 0.1418 Personal Goods (Textile) 294 0.0203 0.0603 -0.1719 0.2020 Pharma. and Bio Tech 49 0.0166 0.0519 -0.0937 0.1605 Electricity and Power (Gas) 49 0.0246 0.0754 -0.1052 0.2265 Fixed Line Telecommunication 28 0.0130 0.0616 -0.1176 0.1772
Industrial Transportation 21 -0.0119 0.0734 -0.1600 0.1168 Non-Life Insurance 126 0.0419 0.0599 -0.1116 0.1829
Commercial Banks 119 -0.0040 0.0085 -0.0307 0.0127
Total 1,456 0.0234 0.0644 -0.1785 0.2265 F-Value 4.656***
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difference is marginal. The lower panel provides mean comparison of bank and non-
banking DEM practices. This analysis is done because we have estimated discretionary
accruals as a measure of earnings management in different manner for banks and non-
banking sample. The results reported that banks are involved in income decreasing
earnings management as estimated by approach used by Beatty et al. (2002) and Cornett
et al. (2009) whereas all other non-banking sectors are engaged in income increasing
DEM as estimated by discretionary component of accrual method proposed by Kasznik
(1999). The value of t-test contends that there are statistically significant differences in
discretionary earnings practices in banks and their counterparts.
Table 4.4: Sector wise DEM analysis – t-test Sector n Mean SD Minimum Maximum
Non-Financial 1211 0.0243 0.0671 -0.1785 0.2265 Financial 245 0.0196 0.0491 -0.1116 0.1829 Total 1,456 0.0234 0.0644 -0.1785 0.2265 Mean Difference 0.0047 t-value 0.2091
Non-Banks 1337 0.0259 0.0666 -0.1785 0.2265 Banks 119 -0.0040 0.0085 -0.0307 0.0127 Total 1,456 0.0234 0.0644 -0.1785 0.2265 Mean Difference 0.0299*** t-value 4.889
***, **, and * denote significance levels at 1%, 5% and 10%, respectively.
Table 4.5: Years wise DEM analysis – one way ANOVA
Years n Mean SD Minimum Maximum
2005 208 0.0245 0.0311 -0.0792 0.1397 2006 208 0.0237 0.0747 -0.1719 0.2251 2007 208 0.0298 0.0603 -0.1148 0.2187 2008 208 0.0431 0.0671 -0.1519 0.2265 2009 208 0.0046 0.0713 -0.1655 0.2154 2010 208 0.0112 0.0727 -0.1785 0.2112 2011 208 0.0293 0.0565 -0.1088 0.1886
Total 1,456 0.0234 0.0644 -0.1785 0.2265 F-value 8.142***
***, **, and * denote significance levels at 1%, 5% and 10%, respectively.
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Table 4.5 presents the year-wise results of DEM practices for the sample firms. It is
evident from the results that the year 2008 was escorted with highest level of earnings
management activity in Pakistan (mean is 4.31%) followed by year 2007 (mean is
2.98%). The reason may be ascribed as 2007-2008 was the period of global financial
crisis and Pakistani economy was also hit by these global crises even Karachi stock
market activity remained suspended due to its credit crunch and lack of investor
confidence which was later recovered when regulator injected liquidity into the market.
So, in order to avoid from losses during this financial crunch period, firms might be
indulged in income increasing earnings manipulation which was quite low in 2007 but
was at its peak during 2008. Later on, upon the recovery from the crisis, the tendency of
earnings management was decreased as shown by lowest level of DEM in the year 2009
and 2010 followed by 2007-2008 financial crunch period (mean DEM is 0.46% and
1.12%). The ANOVA F-value indicates that these yearly practices of judgmental
earnings manipulation are statistically and significantly different from each other on
different years of study period.
4.2: Empirical Results
In order to cater the research objectives mentioned in first chapter of this study, the
present study is based on four levels of empirical analysis. Firstly, it investigates the
relationship between CG mechanisms and firm value incorporating the reverse causality
between these variables. Secondly, it examines the impact of CG mechanisms on DEM
practices of sample firms. Thirdly, role of DEM has been examined on the firms
accounting, market and economic value to identify the efficient or opportunistic behavior
of managers. Finally, it explores the moderating effect of DEM practices on the
established relationship of CG and firm value4.
The empirical analysis is done using STATA® which is considered to be a very powerful
analysis tool for secondary data. In order to establish to relationship of CG measures,
4 For all models, two regressions equations have been estimated, i.e. one is with control variables and other is without control variables to conduct a better analysis for relationship of corporate governance with firm value and earnings management. By estimating regression equations without control variables, the researcher intends to explore the impact of only main study variable, i.e. CG or earnings management, on firm value. Moreover, the study used both versions to verify whether or not the regression results have omitted variable bias. For this purpose the study used control variables in the light of existing literature
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earnings management and firm value, pooled regressions have been applied. Table 4.6
reports the results of Pearson correlation analysis and it is evident that there is no issue of
multicolinearity between the independent variables of CG as well as the control variables.
It is argued by econometricians that correlation above 0.60 between independent
variables to be run in one single regression may cause multicolinearity problem and
results of that regression model may be biased ungeneralizable. The correlation
coefficients reported in Table 4.6 do not cross the threshold level of 0.60, however; the
correlation between AC Ind and BoI is 0.582 but it cannot cause multicolinearity because
both the independent variables to be estimated in separate regression. Similarly, the
Pearson correlation coefficient between EAQ and CGI is 0.505 and these two
independent variables are also included in two separate models. Overall, there is no issue
of multicolinearity between the predicting variables of study5.
4.2.1 Corporate Governance Mechanisms and Firm Value
For first research objective, the present investigates the relationship between various CG
mechanisms (audit, board, compensation, ownership, CGI) and firm value (accounting,
market, and economic). In this regards, Table 4.7 reported the results of audit
characteristics and firm value where audit characteristics have been measured through
internal audit committee features i.e. size of the audit committee, (AC Size),
independence of audit committee, (AC Ind), audit committee efficiency and activity (AC
Activity) as well as quality of external auditor of the firms (EAQ). As discussed in
previous chapter, 4 measures have been used to establish the relationship between CG
and firm value i.e. accounting measures (ROA, ROE), market measure (Tobin’s q) and
long term economic value (EVA). Model 1 reports the results of CG and firm value
whereas model 2 incorporates the influence of control variables into the regression as
well.
AC Size is the first variable of audit structure which was found to have significant
positive relationship only with Tobin’s q. Larger size of the audit committee is perceived
positively by investors and they assign higher Tobin’s q value to the firms having larger
5Multicolinearity has also been checked through VIF and Tolerance scores for each regression model estimated. Both VIF and Tolerance scores (unreported) are close to 1 which are considered to have no multicolinearity between the variables of regression model.
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audit internal committees. Similarly, long term economic value EVA is also been
positively influenced by large internal audit committees. This is consistent with the view
that larger internal audit committees can ensure more effective monitoring and
supervision of the firms operations and hence increase the firm value.
Although the results of AC Size and accounting value measures are also heading towards
same positive directions, however, these are not statistically significant at any level of
significant. Larger the size of the audit committee, charged with the responsibility of
overseeing the operational issues of firm, and hence increased firm value. More directors
on internal audit committee may monitor the firms’ disclosures more effectively with
shared and resources and it may reduce the accounting misrepresentation and errors in
reporting which may lead to enhance market and long term economic value. These results
are consistent with the resource dependence argument of Zahra and Pearce (1992) and
those of Bedard et al. (2004), Bouaziz (2021), and Hamdan et al. (2013) who also found
larger internal audit committees leading to enhanced firm value.
The role independence of the audit committee has remained significant in CG research as
audit committee independence ensures the credibility of financial reporting and
enhancing firm value. The present study also incorporated the effect of AC Ind on firm
value and results supported the early notion that independence of the audit committee
leads to improved value6. As the ratio of non-executive directors on the internal audit
committee increases, firm accounting, market and EVA all are leading towards positive
direction. Presence of non-executive directors not only ensure the short term accounting
value by reducing the probability of errors and accounting misrepresentation but also
creates and positive image of firm in capital markets through better supervision and
control which may lead to higher Tobin’s q value and long term economic value.
Majority of the earlier researchers have also found the same positive relationship between
AC Ind and firm value including Chan and Li (2008), Al-Matari et al. (2012), Aldamen et
al. (2012) and Saibaba and Ansari (2013).
6 Along with ratio of non-executive directors to total audit committee members as a measure of AC Independence, the present study also examined the effect of non-executive chairman of audit committee as AC Ind variable, however; results are quite similar.
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Table 4.6: Pearson Correlation Analysis
Sr. No. Variables 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
1 DEM 1
2 LVRG -.076** 1
3 Firm_Size -.220** .284** 1
4 Risk -.023 .041 .215** 1
5 AC Size .027 -.019 .020 -.032 1
6 AC Ind .032 .043 .149** .035 -.102** 1
7 AC Act -.039 .136** .245** .026 .141** .074** 1
8 EAQ -.082** -.035 .358** .109** .033 .226** .122** 1
9 BoS -.093** .101** .356** .084** -.431** .266** .198** .250** 1
10 BoI -.051 .113** .231** .044 -.016 .582** .192** .267** .269** 1
11 CEO Dual .075** .015 -.219** -.018 .022 -.192** -.118** -.318** -.196** -.270** 1
12 CEO Dom -.048 .012 .231** .005 .078** .067* .183** .084** .163** .163** -.094** 1
13 B_Activity .000 .094** .190** .102** .050 -.173** .104** .029 .028 -.006 -.001 .069** 1
14 B_Part -.052* .009 -.018 .043 .041 -.043 -.024 .016 -.167** -.045 .027 -.048 -.176** 1
15 CEO Comp -.120** .039 .396** .036 .017 .108** .131** .361** .212** .185** -.271** .162** .029 .020 1
16 Dir Comp -.102** -.131** .212** .007 -.011 -.259** -.007 .038 .038 -.419** .007 .031 -.031 .002 .328** 1
17 Exec Comp -.189** .110** .338** .061* .027 .217** .171** .373** .291** .233** -.231** .120** .031 -.033 .391** .191** 1
18 Inside .059* .049 -.270** -.023 .011 -.288** -.124** -.303** -.250** -.380** .246** -.104** -.049 .097** -.285** .000 -.321** 1
19 Family .061* .033 -.287** -.050 -.031 -.321** -.142** -.332** -.235** -.391** .254** -.098** -.027 .101** -.297** .000 -.372** .920** 1
20 Institutional -.013 .032 .066* .005 -.105** .078** .090** .089** .170** .124** -.118** -.005 -.107** -.096** .097** .051* .123** -.172** -.191** 1
21 Block -.058* -.084** .149** -.024 -.017 .094** .090** .146** .152** .179** -.128** -.024 -.035 -.074** .214** .112** .230** -.533** -.491** .155** 1
22 Foreign -.064* -.056* .078** -.080** .096** .049 .044 .205** .035 -.057* -.146** .096** -.069** .012 .114** .082** .162** -.174** -.172** -.043 .174** 1
23 AssociatedCo. -.066* -.036 .233** -.036 -.045 .203** -.001 .237** .126** .202** -.204** .120** .040 -.038 .291** .051 .349** -.432** -.441** -.055* .354** .057* 1
24 Own_Conc -.038 .006 .107** -.084** .048 .067* .078** .218** -.003 .099** -.072** .102** .035 .007 .143** .013 .217** -.088** -.136** -.083** .239** .119** .493** 1
25 CG Index -.067* -.005 .387** .063* .054* .358** .138** .505** .264** .319** -.426** -.071** -.005 .095** .458** .182** .495** -.371** -.455** .344** .406** .180** .277** .112**
* and ** represent the level of significance at 5%, and 1%, respectively.
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Table 4.7: Audit Characteristics and Firm Value
Variables ROA ROE Tobin’s Q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0350 0.0611 0.0021 -0.6540 0.0703 -0.3748 18.7544 -0.0352 (1.70)* (2.81)*** (0.04) (-1.00) (0.23) (-0.98) (17.58)*** (-0.48) AC Size 0.0203 0.0001 0.0200 0.0020 1.2394 1.2252 -0.8347 0.1005 (0.70) (0.01) (0.27) (0.03) (2.87)*** (2.84)*** (-0.56) (1.90)* AC Ind 0.0273 0.0156 0.0438 0.0325 0.4275 0.4088 1.4032 0.0246 (3.41)*** (2.28)** (2.10)** (1.65)* (2.36)** (2.26)** (2.23)** (1.06) AC Activity -0.0031 0.0043 0.0211 0.0237 -0.0094 -0.0254 1.0138 -0.0474 (-0.91) (1.41) (2.31)** (2.59)*** (-0.18) (-0.47) (5.57)*** (-0.41) EAQ 0.0312 0.0191 0.0578 0.0367 0.8174 0.7610 2.5260 0.0026 (7.02)*** (4.75)*** (5.02)*** (3.04)*** (12.36)*** (10.7)*** (10.97)*** (0.19) Firm_Size 0.0049 0.0127 0.0450 2.0478 (4.26)*** (3.69)*** (2.22)** (6.41)*** LVRG -0.2003 -0.1982 -0.2052 -3.3547 (-3.05)*** (-7.83)*** (-1.39) (-2.40)** Risk 0.0002 -0.0001 -0.0082 0.0393 (0.19) (-0.05) (-0.43) (0.94) F-Value 11.69*** 81.59*** 7.27*** 12.67*** 37.99*** 24.48*** 38.83*** 18.00*** Adjusted R2 0.0354 0.3071 0.0211 0.0603 0.1128 0.1143 0.1150 0.0855 RMSE 0.0797 0.0676 0.2072 0.2030 1.1879 1.1869 4.1338 6.1525
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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The effectiveness of audit committee can be assessed by the its meeting frequency.
More diligence is associated with the higher audit committee meeting frequency and
audit risk can be minimized if audit committee meets more frequently. The
relationship of AC Activity and both accounting value measures has been reported as
positive although it is significant with ROE only. More frequently the audit
committee meets, it may improve the financial worth of accounting reporting and
increase returns on equity. Along with this, EVA is also found to be positively and
significantly related to the meeting frequency of internal audit committee which is
consistent with the view that AC Activity is associated with reliable, transparent and
trustworthy accounting disclosures which increases the firm long term economic
value. Azam et al. (2010), Al-Matari et al. (2012) and Aldamen et al. (2012) have also
confirmed this notion that there is a positive association between AC Activity and
firm value, however; Ojulari (2012) has failed to establish any significant connection
between meeting frequency of internal audit committee and value measures (ROA
and Tobin’s q). The results of Ojulari (2012) also provide the justification of
insignificant relationship of ROA and Tobin’s q with audit committee meeting
frequency.
The role of external auditor size and reputation in mitigating the agency problem is
proven, however; research on external audit quality is very limited. Willenborg (1999)
first raised the issue that external auditor may perform a significant part to reduce the
level of information asymmetry between the stakeholders of a firm which may cause
due to the separation of ownership and management. The current research has also
incorporated the effect of external auditor quality and size measured by a dummy
variable if the firm is being audited by any one big 5 auditors operating in Pakistan.
The results strongly supported the earlier notion that good quality external audit not
only reduce the chances of errors and accounting misrepresentation in the firm but
also ensure transparent and fair disclosures to the external stakeholders. The
significant positive relationship of EAQ and all measures of firm value indicates that
quality of external audit not only refrains the managers to be involved into
manipulating activities but also provide confidence to external stakeholders that the
accounting information they are receiving is fair, transparent and unbiased. If the
managers are aware of the fact that one reputable external auditor will audit their
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accounting information at the end of financial year, they will make sure that
accounting information must be free of errors and misrepresentation before going to
external auditor. This positive relationship between EAQ and firm value has been
strongly supported by earlier studies of Francis et al. (1999), Krishnan and Schauer
(2000), Fuerman (2006), DeFond and Francis (2005), Fan and Wang (2005), and
Fooladi and Shukor (2012).
The Table 4.7 also reports the effect of some control variables on firm value7. Size of
the firm is positively related to accounting, market and economic value measures
whereas leverage is negatively related to the firm value. Large size firms have more
economies of scale along with experience, technical expertise in the form of materials
and human capital which may lead to enhanced firm value. Increased debt ratio
always create an obligatory burden on the firms paying capacity which not only
reduce the current economic value but also put a negative impression of firm into
capital markets which reduces firm’s market and long term value. Along with this, the
third variable of market risk has been found insignificant in all estimated models
generating no effect of as a measure of market systematic risk on the firm value.
Further, the F-values of all models are statistically significant demonstrating that
regression models are mathematically appropriate and results drawn out of these
models are reliable and can be interpreted. The adjusted-R2 values of the regression
models are moderately low (particularly for ROA and ROE), however; Rahmat and
Iskandar (2009) argued that low adjusted-R2 values are mostly common in CG related
studies and there is no issue with lower adjusted-R2 values for CG research.
The second important CG mechanism is board structure and composition. It has been
strongly argued in literature that effectiveness of board of directors as the mechanism
of governance is fundamental for the enhancement of the profitability and value of
firm (Zahra & Pearce, 1989; Johnson et al., 1996; Bhagat & Black, 1999). Board of
directors is the most superior authority in organizations to monitor and keep managers
accountable as well as for the smooth operations of the company along with providing
the managers a long term vision and strategies. The present study uses board size,
7 Along with Size, LVRG and Risk, all the estimated models also included industry dummy and financial dummy to explore industrial variations and difference between financial and non-financial firms with respect to CG-Value relationship. However, the results (unreported) for both dummy variables depicted that that there were no industrial or financial differences for CG-value relationship.
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board independence, CEO duality, CEO dominance, board meeting intensity, and
participation as measures of board structure to evaluate its impact on firm accounting,
market and economic value and results are reported in Table 4.8.
Board Size (BoS) has been found positively impacting the ROA, ROE, Tobin’s q and
EVA. Larger boards are associated with better firm value in terms of accounting,
market and economic value measures. As the size of the board of directors increases,
firms in Pakistan experience superior value. Generally, it is believed that large board
of directors can be a better monitor of managers and this effective monitoring and
supervision leads to better value. Earlier theories of CG and many empirical studies
have also provided support for this positive relationship between board size and firm
value. The agency theory of CG also supports the notion that there may be a conflict
of interests between managers and shareholders and this conflict of interest may be
resolved by effective monitoring by larger boards (Yawson, 2006).
Moreover, the resource dependence theory is a great supporter for this positive
relationship which believes that larger boards may also have greater and diverse skill
of board members coming from difference industrial experiences and they may be
proven as the key resource for the firm. Further, members of larger boards may have
greater external linkages and excess to capital market which may reduce uncertainties
for the firm (Goodstein et al. 1994; Haniffa & Hudaib, 2006). Along with this,
interlocking of board of directors (i.e. presence on other firm boards) can also provide
better solutions to business problems (Stearns & Mizruchi, 1993). The overseeing
capacity of the larger board is also greater (John & Senbet, 1998) and it balances the
authority of CEO if duality exists in the firms (Kiel & Nicholson, 2003). Some other
studies which concluded a positive relationship between board size and firm value
include Brown and Caylor (2006), Kyereboah-Coleman and Biekpe (2006), Belkhair
(2009), and Christensen et al. (2010).
Another tool of effective board structure is board composition and independence from
the influence of the management for effective monitoring which is measured through
presence of non-executive/independent directors on the board. Table 4.8 also reports
mix evidence on board independence and firm value where BoI is inversely related
with historical accounting value (ROA and ROE) and positively associated with
market value (Tobin’s q) and economic value (EVA). The independence of board of
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directors is positively perceived by external stakeholders and investors who assign
greater Tobin’s q value to firm assets and require lower rate of return which enhance
market value and EVA. Bhagat and Black (1999), Mashayekhi and Bazaz (2008), Ma
and Tian (2009), Ameer et al. (2010) and O’Connell and Cramer (2010) witnessed
positive and significant relationship between BoI and firm value whereas Ibrahim et
al., (2010), Christensen et al. (2010) and Stanwick and Stanwick (2010) and Yasser et
al. (2011a) found negative relationship. However, Kiel and Nicholson (2003) argued
that board composition should have greater significance with regard to the measures
of market as compared to value based on accounting measures (ROA and ROE) and
he found insignificant negative relationship between ROA and BoI. Moreover,
Consistent with stewardship theory, Weisbach (1988) and Barnhart and Rosenstein
(1998) also find weak curved relationship between ROA and BoI whereas Rashid et
al. (2010) contended that the outsider directors do not have any potential in Bengali
firms’ value.
The power of CEO in dual role has been remained a research topic of continuing
interest in board structure. The position of CEO along with chairman of the board
may increase the power of CEO where he can act upon his own believe and according
to agency theory, may cause inferior value. The results of the present study are also in
favor of agency theory where CEO duality is found to be negatively and significantly
related with accounting, market and value measures of Pakistan firms. If CEO also
holds the position of chairman of the board, it may enhances his powers and he might
take some decision which are not the in the favor of the business, hence damaging
firm value. Monks and Minow (2001) claimed that splitting the positions of CEO and
chairman into two different persons may enhance firm value because chairman can
remove the CEO who is not performing his job according to the shareholder wealth
maximization proposition. Similar negative results are also found by Pi and Timme
(1993), Yermack (1996), Judge et al. (2003), Mir and Nishat (2004), Brown and
Caylor (2006), Yu (2008), Nazir et al. (2009), and Leung and Horwitz (2010). Along
with this, CEO dominance on the management committees is positively linked to
ROA, Tobin’s q and EVA which may be attributed to the effective role performed by
CEO on the management committees.
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It has been contended that board activity impact firm value by effective monitoring
and control by the board. The present study documented an inverse link between
board activity as measured by number of board meeting in a financial years and firm
value for the sample of Pakistani firms. Negative relationship has been developed
between board activity and firm value (i.e. ROA and EVA). The possible reason for
this negative relation might be specified as conducting board meetings may be costly
due to director fee, travels expenses, refreshments, and managerial time which may
lead to decreased value (Vafeas, 1999). Jensen (1993) has argued that it is not
necessary that larger number of board meetings improve firm value because the
agenda of board meetings is set by CEO, so role of CEO is more important in firm
value. Lipton and Lorsch (1992) reasoned that much of the board meetings time is
wasted due to formalities and management reports presentation as the routine tasks
and effective monitoring is not possible due to lack of time. Similar negative results
have also been reported by Vafeas (1999), Jacking and Johl (2009), Ma and Tian
(2009) and Yasser (2011a).
The last variable of board structure is the participation rate of board members in
meetings. Table 4.8 reports positive association between board participation rate and
firm value (ROA, ROE and EVA). Increased participation by directors in board
meetings may be linked with increased value as various issues are being discussed in
board meetings. Only larger number of meetings conduction is not enough to improve
firm value rather participation is more important in this regards. Greater participation
by directors in board meetings is not only increasing firm value by sharing strategic
views about business operations but it also enhance long term economic value of
form. However, investors do not consider this participation rate important while
valuing the firm so no significant relationship was found for Tobin’s q. Cho and Kim
(2007) and Kim and Yoon (2007) claimed that superior value is accomplished when
directors actively participate in the meetings of the board and in order to reduce the
agency problem among the diverse shareholders and management, directors from
outside could make contribution by actively participating in board meetings, thus
supporting the resource dependence theory of CG. With respect to control variables of
model, size is positively and leverage is negatively leading the firm value whereas
has remained positive but insignificant just like in previous results of Table 4.7.
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Managerial compensation structure is one of the oldest mechanisms of CG even
Adam Smith (1776) and Berle and Means (1932) recommended that solution to the
conflict of interests issue between managers and shareholders is to compensate the
managers so that they can work in the best interests of the shareholders. Many earlier
studies have investigated firm value and compensation structure to determine the level
of CEO pay whereas little has been done on the managerial compensation structure8
as an effective tool of CG to enhance value. In earlier literature, CEO compensation
structure is discussed most, however, the present study has included executive
director compensation as well as key executive compensation as disclosed in
remuneration section of annual financial reports in Pakistan.
Table 4.9 reports the results of CEO, director and executive compensation and firm
value for the sample firms. First of all, CEO compensation is strongly and positively
related with all firm value measures and these results are highly significant at 1%
level of significance. As the compensation level of CEO increase, they are monetarily
motivated to perform better for the organization and hence firm value increases. The
CEO compensation is of much importance as he is “The Chief” of all the executive
officers and it is necessary to provide him monetary benefits and align his interests to
those of shareholders’ in order to induce him for better perform. These positive results
are in accordance with the earlier studies of Jensen and Murphy (1990), Eriksson and
Lausten (2000), Seifert et al. (2005), Cornett et al. (2008), Fahlenbrach and Stulz
(2009), Ghosh (2010), and Sigler (2011).
The relationship between executive compensation and firm value is significant
positive but only for market measure of Tobin’s q and EVA. The motivational level of
key management personnel increases when they are rewarded compensation in
monetary terms and the effect of their best value is shown in long term economic
value added. Further, the investors also consider this phenomenon as positive when
firms is rewarding monetary compensation to not only CEO but also its top executives 8 The present study uses total compensation as disclosed in the annual financial reports of Pakistani firms. Although, many earlier researchers have separately used cash compensation i.e. salary, bonuses, perquisites etc. (Conyon & Schwalback, 2000; Brunello et al., 2001; Conyon & Sadler, 2001; Bebchuk & Grinstein, 2005; Firth et al., 2006,2007; Chen et al. 2010; Conyon & He, 2011), stock options as compensation measures (Mehran, 1995; Wei, 2000; Yan et al., 2011) and total compensation (Anderson et al., 2000; Ericksson & Lausten, 2000; Zhou, 2000; Marin, 2010). However, due to limited availability of data and limited disclosures of accounting information related to stock options and incentive schemes, the present study only used total compensation as a measure of managerial compensation of CEO, directors and executives.
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as CEO is not alone to lead the firm in a profitable manner but its team has equal
contribution. The present study documented the positive relationship with top
executive personnel compensation and firm long term economic value and market
value measured by Tobin’s q which is consistent with Anderson et al. (2000), Conyon
and Schwalback (2000), Conyon and Sadler (2001), Kato and Long (2006), Firth et al.
(2006, 2007), Chen et al. (2010), and Conyon and He (2011). The accounting value
measures of ROA and ROE are positively related with executive compensation,
however; both are statistically insignificant. Wei (2000), Yan et al. (2011) also failed
to find any significant relationship between accounting value and executive
compensation arguing that this impact can be observed in long term and future value
may be effecting by executive compensation.
Executive directors also receive compensation for their services rendered in the
organization which is a topic of research in CG literature so the present study also
included director compensation into regression models. The results presented in Table
4.9 are mixed and interesting. Compensation to directors is found to be significantly
positively associated with ROA and EVA but negatively with Tobin’s q. It may
argued that payment of compensation may be leading towards positive value as
executive directors are working in the best interest of shareholders because they are
also shareholders of the same firm as well. So it is favorable to work for their own
interests even they have not been paid for this because their long term wealth is
augmenting if firm perform better. This persuasion is augmented when they are also
being rewarded for their work. Hassan et al. (2003) and Krauter and Souse (2009) also
found positive link between accounting returns and executive director compensation.
Contrary to this, investors in stock market are giving negative value to the firms
which are paying compensation to executive directors. This may because of the
investors’ understanding that executive directors are rewarding themselves and doing
nothing for the betterment of firm and do not creating value for investors. These
results are in accordance with Conyon (1997) who also showed that director
remuneration has positive correlation with current shareholders return but not with
pre-dated returns whereas Doucouliagos et al. (2007) documented no relation between
current and one year lag value with director compensation. In addition, the results of
control variables and firm value as similar to our previous results.
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Table 4.8: Board Structure and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant -0.0354 -0.0285 -0.3419 -0.3791 -0.5292 -0.9001 9.1338 -4.9275 (-1.08) (-0.98) (-4.07)*** (-4.37)*** (-1.06) (-1.71)* (5.45)*** (-4.40)*** BoS 0.0385 0.0484 0.1830 0.1748 0.0839 0.6974 6.017 0.2155 (2.96)*** (4.23)*** (5.51)*** (5.13)*** (4.24)*** (3.38)*** (9.06)*** (0.49) BoI -0.0194 -.0064 -0.0495 -0.0403 0.3305 0.3267 0.7208 -0.1917 (-2.75)*** (-1.06) (-2.74)*** (-2.25)** (3.06)*** (3.01)*** (1.99)** (-0.83) CEO Duality -0.0474 -0.0164 -0.0645 -0.0535 -0.4300 -0.3860 -1.2266 -0.1008 (-5.00)*** (-3.89***) (-5.10)*** (-4.26)*** (-5.70)*** (-5.07)*** (-4.86)*** (-0.62) CEO Dom 0.0012 0.0068 0.0183 0.0097 0.1916 0.1471 1.2878 -0.0506 (2.22)** (1.55) (1.39) (0.74) (2.42)** (1.84)* (4.86)*** (-0.30) B_Activity -0.0012 0.0001 -0.0023 -0.0019 0.0037 -0.0004 -0.2119 -0.0050 (-1.66)* (-0.30) (-1.20) (-1.03) (0.33) (-0.04) (-5.53)*** (-0.20) B_Part 0.0370 0.0480 0.1555 0.1593 0.1165 0.0769 2.7471 0.6497 (2.10)** (3.22)*** (3.45)*** (3.59)*** (0.43) (0.29) (3.05)*** (1.13) Firm_Size 0.0045 -0.1953 0.0629 2.0461 (3.86)*** (2.96)*** (2.98)*** (5.52)*** LVRG -0.2032 -0.1953 -0.4179 -3.3391 (-4.43)*** (-7.88)*** (-2.78)*** (-9.44)*** Risk 0.0005 0.0023 0.0020 0.0394 (0.02) (0.07) (0.11) (0.94) F-Value 8.73*** 75.36*** 13.10*** 16.12*** 18.50*** 13.94*** 39.74*** 306.87*** Adjusted R2 0.0309 0.3151 0.0475 0.0855 0.0673 0.07441 0.1378 0.6542 RMSE 0.0799 0.06723 0.2043 0.0026 1.218 1.213 4.0804 2.584
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Table 4.9: Managerial Compensation and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0149 0.0807 0.02188 -0.0255 0.3282 0.5270 18.2703 -3.6502
(2.07)** (4.67)*** (1.17)* (-0.49) (3.04)*** (1.73)* (55.69)*** (-5.55)***
CEO_Comp 0.0022 0.00261 0.0082 0.0076 0.10839 0.1095 0.2333 0.0451
(2.69)*** (3.58)*** (3.74)*** (3.47)*** (8.52)*** (8.48)*** (6.03)*** (1.62)*
Dir_Comp 0.0027 0.0001 0.00242 -0.0002 -0.0296 -0.0342 0.0750 -0.0209
(3.95)*** (0.41) (1.37) -(0.17) (-2.89)*** (-3.28)*** (2.41)** (0.93)
Exe_Comp 0.0004 0.0008 0.0015 -0.0005 0.0476 0.0495 0.5217 0.0276
(0.82) (1.37) (1.05) (-0.28) (5.46)*** (4.64)*** (19.64)*** (1.20)
Firm_Size 0.00411 0.0135 0.0020 1.9860
(2.87)*** (3.17)*** (0.08) (36.81)***
LVRG -0.2022 -0.2018 -0.3983 -3.3406
(-23.7)*** (-7.90)*** (-2.65)*** (-10.30)***
Risk 0.0009 0.0007 0.0140 0.0489
(0.82) (0.24) (0.72) (1.17)
F-Value 13.19*** 106.60*** 9.96** 15.80*** 52.11*** 27.48*** 219.25*** 462.50***
Adjusted R2 0.0245 0.3103 0.0181 0.0575 0.0953 0.0985 0.3103 0.6555 RMSE 0.0802 3.6492 0.2075 0.2033 1.1996 1.197 3.6492 2.579
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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The importance of ownership structure in enhancing firm value cannot be overlooked
as it is very important and one of the most researched elements of CG. There is an
ongoing debate in the literature to study the impact of ownership structure on value
and many researchers have performed commendable work on different elements of
ownership structure. Generally, the research on ownership structure can be classified
into two major sections; how ownership is composed in the hands of internal and
external shareholders, and the type of ownership (i.e. ownership concentration vs.
diffusion and block holding). Internal or insiders can be managers, directors, CEO,
family whereas external or outsiders owners may be institutional, foreign, corporate,
or scattered individual general public. The present study also considers the ownership
structure an important tool of effective CG system and analyzes the impact of two
internal (Inside and Family) and four external (Institutional, Block, Foreign,
Associated Co) element of ownership structure along with ownership concentration
measures on the firm value of sample selected from the developing economy of
Pakistan. Table 4.10 reports the results of regression models estimated for ownership
structure and firm value for sample data of Pakistani firms.
Inside ownership is found to have negative and statistically relationship with the
accounting measure of firm value only in the present study. The increased level of
inside ownership by managers, executives, CEO and directors leads to lower returns
on assets and shareholders’ equity. This value decreasing phenomenon was first
discussed by Morck et al. (1988) as the “Entrenchment Effect” where manager’s
interests are being entrenched when their level of ownership stake rises in the
organization. Although literature on inside ownership and advocates of agency theory
have proposed that insiders must be rewarded with stock ownership which may create
a sense of belongingness in managers and will induce them to work for optimal
shareholder wealth and firm value (Jensen and Meckling, 1976; Agrawal and
Knoeber, 1996). In order to mitigate this agency problem between insiders and
outsiders, different ownership schemes (i.e. Employees Stock Ownership Plans or
ESOP) has also been formulated as a part of monetary compensation system of key
management personnel. However, the interest-alignment hypothesis has not been
supported for Pakistani firms for accounting measures of firm value (ROA and ROE)
which are found to be negatively and significantly related to inside ownership. This
effect is found significant only for accounting measures of value whereas positive link
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is there for Tobin’s q and EVA, however; those results are not statistically significant
and cannot be interpreted statistically. The negative results of inside ownership
presented in current study are also supported by Chen et al. (2003), and Seifert
(2005). However, in accordance with suggestion of earlier researchers, there is a need
to check for a nonlinear impact of inside ownership on firm value which is being
discussed later on.
Family ownership is another type of ownership structure investigated in this study.
Family ownership has mixed findings in our results and this variable is positively
related with internal accounting measures of ROA and ROE whereas negatively
associated with market measure of Tobin’s q and long term economic value added.
Increased family ownership may enhance firm short term accounting value, however;
neither investors are giving value to firm in the form of Tobin’s q nor family members
performing their role in enhancing long term economic value of firm. Family owned
culture is very much prevalent in Pakistan and most of the business firms are
controlled by family members (Yasser, 2011). Family drawing private benefits and
perquisites and being sole decision making and controlling authority is the major
cause of the destruction of long term value. Moreover, most of family businesses are
run by decedents which are the second or third generation of founders that is another
reason of lower value (Jabeen et al. 2012).
The lack of interest and inability of decedents to run the empire built by founder may
sustain some short term accounting returns but it is not value creating in longer time
period as there is a famous Mexican quote “Father, founder of the company, son rich,
and grandson poor”. Villalonga and Amit (2006) argued that if family control
exceeds the level of ownership, it leads to drop in shareholders’ value whereas on the
other hand, family management adds value to firm in case if founder of the firm
himself took the position of CEO/Chairman in comparison to descendants occupying
the CEO/Chairman position. This argument is very much applicable in Pakistan where
average family ownership is less than 20% but majority of the businesses are
controlled by few family members and most of these businesses have decedents on
the top managing positions. Furthermore, Barth et al. (2005), Bertrand and Schoar
(2006), Achmad et al. (2008) and Lam and Lee (2012) also found that family firms
sustain negative market returns.
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Table4.10: Ownership Structure and Firm Value
Variables ROA ROE Tobin’s q EVA Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0346 0.0580 0.0801 -0.0527 0.4768 -0.2744 24.8292 -4.0531 (0.11) (2.98)*** (2.25)*** (-0.90) (2.37)** (-0.81) (34.23)** (-5.42)*** Inside -0.06332 -0.0497 -0.1295 -0.1141 0.2087 0.2037 -0.1506 0.5468 (-2.52)** (-2.3)** (-1.97)** (-1.77)* (0.56) (0.55) (-0.11) (0.67) Family 0.04933 0.0434 0.0986 0.1096 -0.7072 -0.5851 -3.5759 -0.6757 (2.13)** (2.21)** (1.63)* (1.84)* (-2.08)** (-1.72)* (-2.91)*** (-0.90) Institutional -0.0288 -0.0157 -0.0660 -0.0587 -0.1101 -0.1111 -0.2966 -1.1589 (-1.55) (-1.00) (-1.36) (-1.23) (-0.40) (-0.41) (-2.46)** (-1.92)* Foreign 0.0733 0.0588 0.1362 0.1183 1.6170 1.6105 1.6827 0.6590 (5.05)*** (4.76)*** (3.87)*** (3.16)*** (5.72)*** (7.51)*** (2.18)*** (2.48)** Associated Co 0.0185 0.0103 0.0232 0.0090 0.8467 0.8167 1.5344 0.2158 (1.84)* (1.20) (0.89) (0.35) (7.56)*** (5.51)*** (2.87)*** (2.15)** Block 0.0112 0.0032 0.0122 0.0055 -0.1041 -0.1051 -0.0957 -0.0265 (2.09)** (0.71) (0.87) (0.40) (-1.31) (-1.32) (-2.78)*** (-2.49)** Own_Conc 0.0118 0.0265 0.0353 0.0453 0.9798 1.001 0.9543 0.4303 (0.63) (1.67)* (0.70) (0.94) (3.54)*** (3.63)*** (0.96) (0.70) Firm_Size 0.0056 0.0157 0.0545 2.0237 (5.04)*** (4.69)*** (2.84)*** (47.47)*** LVRG -0.1992 -0.1956 -0.2209 -3.2676 (-23.80)*** (-7.73)*** (-1.52) (-10.18)*** Risk 0.0580 0.0022 0.2744 0.0523 (1.51) (0.69) (1.76*) (5.42***) F-Value 10.65*** 68.01*** 4.69*** 10.23*** 1.67* 26.46*** 18.70*** 278.40*** Adjusted R2 0.0444 0.3153 0.0174 0.597 0.0030 0.148 0.0785 0.655 RMSE 0.0794 0.0672 0.207 0.203 0.3784 1.16 4.2188 2.57
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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“Bigger is better” is a statement which seems very true in the case of institutional
investors as the role played by institutional investors in corporate value is a
worldwide accepted phenomenon. A plenty of research has been conducted in this
regard and literature has provided mix and inconclusive evidence on the relationship
between the level of institutional ownership and firm value. The present study
documented a negative relationship of institutional ownership and firm value but
these results are statistically significant only for EVA. Higher the level of institutional
ownership, lower the long term economic value of firm for the Pakistani context. This
negative relationship gives support to agency conflict between majority and minority
shareholders as proposed by Jensen and Meckling (1976) and the strategic alliance
hypothesis proposed by Pound (1988). Jensen and Meckling (1976) argued that large
shareholders may expropriate the rights of small disbursed investors which is a value
damaging phenomenon. Moreover, Pound (1988) contended that large informed
institutional investors have strategic alliances with the internal management of firms
and put their influence in voting process by their existing relationship with the
management, implying a lower probability of rebellious success in proxy contests
which leads to a negative relation between institutional shareholding and firm value.
Craswell (1997), Navissi and Naiker (2006)), Afza and Slahudin (2007), Alipour and
Amjadi (2011) also predicted a negative firm value for higher level of institutional
shareholdings.
The level of shareholding owned by foreign individuals and institutions posits a
positive relationship with all value measures of the study. Increased foreign
ownership not only enhanced accounting value but also been perceived positively by
investors and sustain long term economic value. The statistically significant positive
relationship between foreign ownership and firm value is attributed towards many
reasons and well supported by the published empirical literature. The increased
accounting value is because the effective monitoring of foreigners as they have high
ownership stakes and long term involvement into business in which they are
investing. Most of foreign direct investment in Pakistan is done through Greenfield
investment which is on long term (Afza & Khan, 2009).
Foreign investors are investing cross border and facing many risk (like political risk
and foreign exchange risk), so they cannot afford to have governance and business
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risk which ultimately force them to effectively monitor the firm operations. Moreover,
foreign investment is always associated with advance technologies, capital resources,
and efficient managerial skills that are helpful in enhancing the firm operations and
returns on the invested capital. On the other hand, investors show confidence in firms
having foreign investment due to the fact that foreign investors are effective monitor
and only invest in those firms which have great potential to generate returns leading to
superior market value and ultimately long term value. Douma (2002), Aydin et al.
(2007), Ongore (2011), Uwalomwa and Olamide (2012) also supported this same
positive relationship between foreign ownership and firms’ accounting and market
value.
The present study also establishes a positive relationship between ownership by
associated companies (i.e. parent, subsidiary, group) and firm value. Firm value is
enhanced if there is large fraction of shares of firm owned by its associated
companies. Abdullah et al. (2011), Bajwa and Bashir (2011) has supported this
positive link between association company ownership and firm value by providing
some reasonable arguments. The high level of ownership of associate companies
mitigates the potential agency conflict by minimizing the information asymmetry.
Shared skills and resource integration by same group companies also deliver benefits
of economies of scale and reduced transaction costs of business operation which leads
to increased return on capital. Moreover, affiliation of the firm with some recognized
groups also enhance investors’ confidence and create positive perceptions in capital
market regarding big size and group affiliation which eventually improves the market
value as well.
In order to examine the impact of ownership type on firm value, two variables have
been used in the present study i.e. presence of external block holder who own block of
more than 10% ownership stake in the firm and ownership concentration measured by
Herfindahl Index (also known as Herfindahl–Hirschman Index, or HHI) as ownership
stake of top 5 shareholders. The results reported that both the measures of Block and
Own_Conc are positively and significantly related to ROA. This is consistent with
efficient monitoring hypothesis where presence of single largest shareholder or few
concentrated owners are better monitoring the firm’s operations which leads to
improved firm value in terms of accounting measure. This shows that if the ownership
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is concentrated in the hands of few shareholders, manages are given with free hand to
pursue their own personal benefits on the cost of external shareholders (Davis et al.,
1997). Manager may be held accountable for any biased or value damaging initiatives
taken and a close watch forced them to work in the best interests of the shareholders.
Presence of block holder in the firm may be helpful to mitigate the agency problem
and information asymmetry by not letting the managers a free-ride (Sarkar and
Sarker, 2000; Claessens et al., 2002; Bebchuk and Freid, 2003, 2004; Boone, 2011)
and this will converge managers’ interests with those of shareholders (Jensen, 1993).
However, on the contrary, presence of block holder is not considered good by capital
market participants and the investors assign a negative value to firms with existence
of block holder. Although this result is not statistically significant but in comparison
to Own_Conc it can be interpreted that investors feel more secure if ownership is
concentrated in more than one shareholder (positive relationship between ownership
concentration and Tobin’s q). This may be contended that agency cost of equity
between major and minor shareholders may be applicable in this case where investor
may consider presence of single large block holder harmful for them who may
expropriate the minority shareholders rights from them. So investors assign greater
value for those firms whose ownership is concentration in the hands of more than one
single largest shareholder. So the firms may sustain negative long term economic
value if the block holder is present with them in comparison to firms who have
ownership concentration in the hands of top five shareholders (Alipour and Amjadi,
2011).
4.2.2 Nonlinear Relationship between Ownership Structure and Firm Value
Morck et al. (1988) was the first to raise the issue of curvilinear effect of ownership
structure on the firm value which was further supported by Stulz (1988) and
McConnell and Servaes (1990). In line with the earlier notable studies in CG
literature, the current research also attempts to identify the nonlinear relationship
between ownership structure and firm value measures in the Pakistani context. For
this purpose, three ownership structure variables namely inside ownership (Inside),
ownership concentration (Own_Conc) and institutional ownership have been tested
for possible nonlinear effect on firm value. The reason behind the selection for only
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these three variables for identifying nonlinear relationship is that approximately all of
the earlier studies have used only these variables for this impact. So in accordance
with the methodology adopted by prior researches, this study estimated a quadratic
regression models (i.e. econometric model 4.1-4.3) incorporating the single, squared
and cubic levels of Inside, Institutional and Own_Conc, respectively, on the different
value measures of study and results have been presented in Table 4.11-4.14.
Table 4.11 reports the nonlinear model estimation for inside ownership variable with
ROA, ROE, Tobin’s q and EVA. It has been found a statistically significant
curvilinear relationship between inside ownership and ROA, Tobin’s q, and EVA
whereas results for ROE are not significant, although same relationship is there. If the
inside ownership (Inside) remains up to certain level, firm value decreases, however;
as inside ownership (Inside2) increases, firm value tends to increases and further
declines at extreme level of insider ownership (Inside3). The hypothesis proposed by
Morck et al. (2003) regarding curvilinear effect of inside ownership and firm value is
strongly supported and present study argues that a nonlinear U-shaped inside
ownership-value relationship exists in Pakistani firms where firm value first decreases
at lower level of inside ownership, certainly increases up to some level and eventually
decreases at higher level of ownership by insiders. The argument that managers must
be given stock ownership in order to induce to work in best interests of shareholders
and mitigate the agency problem is still valid in our results.
However, there are certain limits to this. If managers are not given some ownership
stake, they will neither own the firm nor work optimally and firm value will decline.
In order to resolve this agency issue, managers are imparted into the ownership by
allocating ownership, which motivates them to work for shareholders wealth
maximization and their interests are better aligned to shareholders’ interests. This
phenomenon is named is convergence of interest hypothesis. In this case, agency issue
is mitigated and firm value is enhanced. However, if this level of ownership crosses a
certain limit9, managers’ hubris behavior, self-overconfidence and overinvestment in
9 The present study has also tested for the inflection points of inside ownership where it converges to increasing trend. It has been found that at less than 15% inside ownership, firm value is negatively related to Inside, whereas 15%-25%, insiders’ interests are converged and firm value increases and finally, firms with inside ownership greater than 25% may have inferior value in terms of ROA, Tobin’s q and EVA. These threshold points are similar to Morck et al. (1988), however; direction is inverse. Morck et al. (1988) proposed an inverted U-shaped curve where value increases, then
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risky projects without taking appropriate evaluation may lead to value destruction
both in short term and long term value. At higher levels of ownership, managers get
powerful and feel secure enough to take decisions in their own self-interest and hence
they are entrenched from enhancing firm value. This nonlinear relationship of inside
ownership is accordance with earlier studies of Morck et al. (1988), Stulz (1988),
McConnell and Servaes, (1990), Sarkar and Sarkar (2000), Welch (2003), Chen et al.
(2012). In Pakistan, Afza and Slahudin (2009) tried to establish the same nonlinear
relationship, however; their results were insignificant.
On the same lines, Table 4.12 and Table 4.13 present the nonlinear relationship of
ownership concentration and institutional ownership, respectively. Ownership
concentration is found to have inverted U-shaped nonlinear effect on firm value where
firm value firm increases at lower level of ownership, then decreases at moderate
level of concentration and consequently increases at higher level of concentration.
However, this nonlinear relationship is only applicable for ROA and Tobin’s q and
this study unable to establish any significant nonlinear relation of concentration with
ROE and EVA. These results are consistent with our earlier results of ownership
concentration and firm value discussed in Table 4.10.
Table 4.13 reports the results of nonlinear relationship of institutional ownership with
firm value and mixed evidence has been found. The results of ROA, ROE and Tobin’s
q are similar to our earlier results of nonlinear relationship between insider ownership
and firm value. Firm value increase only if institutional ownership remained within a
moderate limit otherwise too low or too high institutional ownership depresses firm
value. Pound (1988) proposed three hypotheses namely efficient monitoring, conflict
of interest, and strategic alliance hypothesis for this type of relationship. At lower
level of institutional ownership, financial institutions are not much concerned much
with firm value as they have minimal ownership stake in firm so firm value is
increased. As the level of institutional ownership increases, financial institutions put
their expertise and resources into the firm along with efficient monitoring which leads
to improved value in the form of ROA, REO. Investors also positively perceive the
monitoring role played by financial institutions (as their own cost of monitoring
decreases and finally increases and managers entrenched between 5 to 25% level of inside ownership. Contrarily, the present study has found a U-shaped which is –ve, +ve, and –ve relationship of inside ownership and firm value.
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managers is too high) and they consider it satisfactory for them if financial institutions
have greater stake into the firm which also give superior market value to the firms.
Moreover, at higher level of institutional ownership, conflict of interest may arise
between financial institutions and insiders which may leads to value destruction.
On the other hand, Table 4.13 also reports some contradictory results in the case of
EVA value measure. According to the estimation by taking EVA as dependent value
measure, the results find that EVA increases with low and high level of institutional
ownership and decreases at moderate level of institutional ownership. This
relationship is in accordance with earlier studies but contradicting to the other models
results. In order to investigate this issue in more detail, the present study has used
institutional shareholders’ activism as an independent variable. Institutional investor
is different from atomistic investor in many respects such as: size of shareholding,
proficiency in monitoring mangers as well as incentive to keep an eye on mangers
and, low cost of monitoring. Therefore, institutional investors influence on firm value
and value is much larger as compared to atomistic investors.
Institutional shareholders’ activism is measured by a dummy variable which equals to
one if financial institutions have nominee directors in firms where they have block of
investment and zero otherwise results are presented in Table 4.14. It is clear from the
table 4.14 that active role played by institutional investors converges the negative
value into positive one in terms of ROA and ROE by efficient monitoring and active
participation in managerial affairs by the nominee director. Interestingly, EVA is
found to be negative and insignificant if institutional shareholders activism is
imparted into the model which is consistent with Pound’s (1988) strategic alliance
hypothesis. Institutional investors may increase the level of accounting value by their
presence on corporate boards and efficient monitoring of the managers but along with
this the nominee director also strategically aligned financial institutions’ interests with
those of insiders and collectively minority shareholders’ rights are exploited which
lead to lower level of economic value measured by EVA.
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Table 4.11: Nonlinear Relationship between Inside Ownership and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0681 0.0980 0.1382 0.0042 1.7938 0.8356 26.8194 -3.8423 (20.69)*** (5.66)*** (16.18)*** (0.08) (36.01)*** (2.70)** (155.78)*** (-5.83)*** Inside -0.1537 -0.1699 -0.2474 -0.1569 -5.3598 -4.7257 -21.2507 -1.1212 (-2.81)** (-3.59)*** (-1.75)* (-1.10) (-6.49)*** (-5.58)*** (-7.44)*** (-0.62) Inside2 0.2681 0.4270 0.3606 0.2805 10.3753 9.1551 45.3114 2.2825 (1.49) (2.77)** (0.77) (0.61) (3.80)*** (3.32)*** (4.81)*** (0.39) Inside3 -0.1529 -0.2998 -0.1359 -0.1224 -5.8093 -5.0569 -29.4824 -1.2926 (-1.00) (-2.30)* (-0.34) (-0.31) (-2.51)** (-2.17)** (-3.68)*** (-0.26) Firm_Size 0.0055 0.0157 0.0717 2.0334 (4.94)*** (4.66)*** (3.57)*** (47.43)*** LVRG -0.2037 -0.2035 0.3299 -3.3314 (-24.26)*** (-8.05)*** (-2.20)** (-10.41) Risk 0.0006 0.0003 0.0033 0.0425
(0.58) (0.12) (0.17) (1.02) F-Value 10.25*** 106.43*** 4.28*** 14.09*** 37.00*** 21.14*** 45.57*** 460.41***
Adjusted R2 0.0187 0.3030 0.0067 0.0512 0.0691 0.0767 0.0842 0.6545 RMSE 0.08048 0.06782 0.20872 0.20399 1.2168 1.2119 4.2053 2.5829 t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Table 4.12: Nonlinear Relationship between Ownership Concentration and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0083 0.0570 0.1864 0.0649 1.1834 -0.4299 31.3978 -5.4227 (-0.13) (1.00) (1.13) (0.38) (1.24) (-0.43) (9.11)*** (-2.49)* Own_Conc 0.4095 0.1466 0.2330 0.1472 3.8776 5.1417 -23.7868 8.2360 (1.740)* (0.59) (0.31) (0.20) (1.89)* (1.18) (-1.51) (0.88) Own_Conc 2 -0.8375 -0.3768 -1.2105 -0.9711 -13.3758 -14.6760 22.1914 -15.3621 (-1.86)* (-0.99) (-1.04) (-0.85) (-1.99)* (-2.20) (0.92) (-1.06) Own_Conc 3 0.5212 0.2706 0.9819 0.8104 10.7907 11.0936 -2.8352 9.0857 (2.30)** (1.42) (1.68)* (1.42) (3.20)*** (3.31)*** (-0.23) (1.25) Firm_Size 0.0064 0.0159 0.0984 2.0339 (6.04)*** (4.99)*** (5.25***) (50.00)*** LVRG -0.2050 -0.2031 -0.3922 -3.3174 (-24.62)*** (-8.14)*** (-2.68)** (-10.48)*** Risk 0.0008 0.0006 0.0142 0.0494 (0.77) (0.19) (0.74) (1.18) F-Value 7.37*** 106.62*** 7.18*** 16.31*** 49.48*** 30.6***8 12.16*** 462.76*** Adjusted R2 0.0130 0.3034 0.0126 0.0594 0.0909 0.1091 0.0225 0.6557 RMSE 0.08071 0.0678 0.2081 0.20311 1.2025 1.1904 4.3446 2.5785
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Table 4.13: Nonlinear Relationship between Institutional and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.06717 -0.0721 0.1498 -0.01773 1.6012 -0.1574 25.0055 -3.3949
(16.24***) (4.62)*** (14.09) (-0.38) (25.00)*** (-0.55) (111.48)*** (-6.65)***
Institutional -0.2854 -0.2872 -0.8713 -0.9382 -3.8152 -4.4925 9.0833 -2.0052
(-3.69)*** (-4.41)*** (-4.38)*** (-4.82)*** (-3.18)*** (-3.80)*** (2.16)** (-0.81)
Institutional2 1.1918 1.1551 3.9076 4.1294 11.1224 13.7046 -43.6356 -0.3738
(3.48)*** (4.02)*** (4.44)*** (4.81)*** (2.10)** (2.62)*** (-2.35)** (-0.03)
Institutional3 -1.2824 -1.1514 -4.4613 -4.6231 -4.8624 -7.5681 53.20261 5.7937
(-3.27)*** (-3.49)*** (-4.42)*** (-4.70)*** (-0.80) (-1.67)* (2.50)** (0.46)
Firm_Size 0.0075 0.0189 0.1354 2.0510
(7.10)*** (6.00)*** (7.04)*** (50.97)***
LVRG -0.2067 -0.2061 -0.4906 -3.3682
(4.86)*** (-8.30)*** (-3.2)*** (-10.6)***
Risk 0.0006 0.0007 0.0032 0.0433
(0.64) (0.22) (0.16) (1.04)
F-Value 10.25*** 106.75*** 7.43*** 18.12*** 7.21*** 12.74*** 2.24** 463.20***
Adjusted R2 0.0187 0.3037 0.0131 0.0659 0.0126 0.0462 0.0026 0.6559 RMSE 0.0804 0.0677 0.2080 0.2024 1.2532 1.2317 4.3886 2.5777 t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Table 4.14: Institutional Shareholders’ Activism and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0606 0.0667 0.1309 -0.0296 1.4339 -0.3072 25.2089 -4.0289
(18.88)*** (4.28)*** (15.85)*** (-0.64) (28.70)*** (-1.08) (144.79)*** (-6..82)***
Institutional -0.0829 -0.0665 -0.2385 -0.2416 -0.0840 -0.2497 1.5319 -1.6430
(-3.05)*** (-2.90)** (-3.40)*** (-3.53)*** (-0.20) (-0.60) (1.04) (-1.89)*
Institutional_ Activism
0.0714 0.0568 0.2210 0.2172 -0.2469 -0.1689 -1.1321 0.5448
(2.70)** (2.56)** (3.25)*** (3.27)*** (-0.60) (-0.42) (-0.79) (0.65)
Firm_Size 0.0073 0.0183 0.1327 2.0524
(6.93)*** (5.78)*** (6.86)*** (51.07)***
LVRG -0.2060 -0.2051 -0.4735 -3.3464
(-24.71)*** (-8.23)*** (-3.11)*** (-10.58)***
Risk 0.0005 0.0003 -0.0028 0.0410
(0.47) (0.11) (-0.14) (0.99)
F-Value 4.85*** 125.07*** 6.35*** 19.10*** 0.65 10.32*** 0.54 555.25***
Adjusted R2 0.0053 0.2989 0.0073 0.0585 -0.0005 0.0310 -0.0006 0.6557
RMSE 0.08103 0.06802 0.20866 0.2032 1.2615 1.2415 4.3956 2.5783 t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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4.2.3 Corporate Governance Index and Firm Value
Along with the individual dimensions of CG, some researchers have also used
composite measures of CG and investigated its relation with firm value. On the same
line, after investigating individual impact of each CG mechanism on firm value and
reaching on mixed conclusion, the present study is also tempted used some integrated
CG measures. Earlier studies like Gompers et al. (2003) and Brown and Caylor
(2004) have established Gov_Index which was according to US governance
provisions. In Pakistan, Javid and Iqbal (2007) have used a composite measure of CG
index comprises of 23-items based upon governance proxies related to board of
directors, ownership and shareholdings, and transparency, disclosure and auditing
aspects10. The present study has prepared a composite and integrated measure of CG
index (CGI) which is based upon 28 items11 of each individual CG mechanism (such
as audit structure, board structure, compensation mechanism and ownership
structure) where a higher CGI score is indicating good quality of CG12. So this CGI
score could be called as true integrated measure of CG quality based upon individual
mechanism of CG.
Table 4.15 presents results of CGI impact on four different measures of firm value for
the sample data. There is positive and statistically significant relationship between
CGI and all the value measures of ROA, ROE, Tobin’s q and EVA. It can be noted
that as the overall quality of CG increase, whether this improvement may be in any of
individual mechanism of CG, this increased CGI leads to superior short term 10 Javid and Iqbal (2007) constructed weighted corporate governance index, however weights given were based on subjective and personal judgments which is normally not encouraged in finance literature. 11 CGI comprises of 28 governance provisions from four different CG mechanism. These are 5 audit structure provisions, 6 board structure provisions, 3 provisions are from managerial compensation structure and 14 items are from ownership structure. Following earlier studies (such as Gompers et al., 2003; Brown and Caylor, 2006; Aman & Nguyen, 2008; Toledo, 2009), the index was created based on these 28 items of effective corporate governance of firm on equal weights. According to Gompers et al. (2003), this simple technique of constructing governance index can easily be reproducible and transparent. Moreover, in comparison to Javid and Iqbal (2007), the focus of governance index used in current study is more on the mechanism and tools of effective corporate governance related to accountability, transparency, disclosures, control and compensation. 12 In order to deal with the shortcoming of equally-weighted CG index, the present study also applied the Polychoric correlation technique to construct weighted CG index where weights of each individual item are to be automatically selected through factor loading. Lee et al. (1995) proposed a two-step technique for factor analysis to assess the factor structure of tests involving ordinally-measured item to reduce the impact of statistical artifact such as subjective judgments. However, the test failed to have appropriate loading scores for CG index as well as sub-indices, and the study used equally-weighted CG index throughout the study.
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accounting, market and long term economic value addition to the firm. These positive
results are in accordance with some earlier studies who also used similar CG index to
evaluate its impact on firm value i.e. Black (2001), Gompers et al. (2003), Drobetz et
al. (2004), Brown and Caylor (2006), Beiner et al. (2005), Balck et al. (2006), Clacher
et al. (2008), Cheung et al. (2010), Sami et al. (2011), Viggósson (2011).
4.2.4 Endogenous Relationship between CG and Firm Value
Although much literature has been produced in both developed and developing
countries regarding the impact of effective CG structure on the firm value; yet most of
those have ignored the possibility of reverse causality and endogenous relationship
between CG and firm value. The present study also tests theoretically highlighted
issue of endogeneity between CG and firm value. For this purpose, CGI, as an
integrated measure of CG quality, has been regressed as determinants variable against
our four value measures. Table 4.16 presents the results of these estimated models
where CGI is dependent and firm value is independent. The given results declared that
firm value is an important factor in determining the quality of CG. Higher the value of
a firm, better the quality of its CG structure. This is consistent with Demsetz and
Villalonga (2001) who contended presence of information asymmetry between
managers and other stakeholders might create incentives for the insiders to change
their shareholdings according to their expectation for firm’s future value.
However, econometricians (e.g. Davidson & MacKinnon, 1993; Greene, 2005) argued
that a test of endogeneity must be performed before confirming a bisectional
relationship and reverse causality between two variable. So, the present study applies
Durbin-Wu-Hausman specification test to check for endogeneity13 and this test has
confirmed that there is no issue of endogeneity between firm value14 and CGI and
13 In order to perform Hausman specification test to detect endogeneity between firm value and CGI, the present study estimated model (i) as; Perfit = + CGIit + it ………………….(i) The, the unstandardized predicted values of CGI and residual are saved as CGI_pre and CGI_res. At the second stage model (ii) is estimated as; CGIit = + CGI_preit + CGI_res + it ………………(ii) The coefficient is found statistically insignificant, that means that there is no endogeneity between firm value and CGI and both are exogenously determined. 14 The Hausman specification test of endogeneity has been performed for all the firm value measures i.e. ROA, ROE, Tobin’s q and EVA and same inferences are drawn that there is no endogeneity between CGI and ROA, ROE, Tobin’s q and EVA.
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both the variables are exogenously determined. The Hausman test confirms that
although results of Table 4.16 are indicating that firm value predicting the levels of
CG quality; however, both the variables are exogenous and results of Table 4.16 are
could not be generalized for Pakistani firms. So it is confirmed that there is no
endogeneity issue while investigating CG-Value relationship in Pakistani capital
markets and all above discussed results should be interpreted in the same manner.
These results are in contradiction with Demsetz (1983), Demsetz and Lehn (1985),
Morck et al. (1988), Demsetz and Villalonga (2001), and Cornett et al. (2009);
however, McConnell and Servaes (1990) claimed that ownership structure was
exogenous in relation to firm value in US and Toledo (2009) confirmed the
nonexistence of endogeneity in the Spanish firms for CG and firm value.
4.2.5 Corporate Governance and Discretionary Earnings Management
The varying nature of accounting accruals provide corporate executives the discretion
in the determination of firms’ reported earnings during a particular period due
information asymmetry between the inside controllers and outside owners of the firm.
Inside managers can alter the reported earrings either to maximize their own benefits
or to affect the informativeness of reported earnings by signaling private information
to the outsiders (Healy, 1985). The reliability and informativeness of reported
accounting earnings is depended on the quality and effectiveness of CG implemented
through different monitoring mechanisms in a firm (Dechow et al. 1996). In
accordance with second research objective, the present study also analyzes this
effective role played by governance system in reducing judgmental and DEM and
results are reported in Table 4.17 where four elements of CG along with CG index
have been regressed against DEM (DEM).The first panel of Table 4.17 examines and
reports the results of internal audit committee characteristics and external auditor
quality on DEM. Only two variables have been found to be statistically significant i.e.
AC Ind which is positively and EAQ which is negatively impacting the malpractices
of earnings management in the sample data of Pakistani firms. In contradiction to the
expectation, the results show that more independent internal audit committees are
related to higher earnings management practices in firms. Mitchell et al. (2008) and
Baxter and Cotter (2009) found that independence of the audit committees is not
relevant in reducing the earnings management activity in the firms.
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Table 4.15: Corporate Governance Index (CGI) and Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0051 0.0555 0.0166 -0.04813 -0.1171 -0.8128 17.2570 -4.206
(0.43) (3.44) *** (0.55) (-1.00) (-0.65) (-2.8)*** (28.59)*** (-6.88)***
CGI 0.0034 0.00017 0.0068 0.0025 0.1036 0.0831 0.5491 0.0184
(4.43)*** (2.39)** (3.35)*** (1.18) (8.63)*** (6.36)*** (13.58)*** (2.10)*
Firm_Size 0.0006 0.0160 0.0782 2.034
(5.24)*** (4.63)*** (3.76)*** (46.42)***
LVRG -0.2042 -0.2041 -0.3492 -3.333
(-24.)*** (-8.09)*** (-2.31) (-10.45)***
Risk 0.0005 0.0003 0.0007 0.042
(0.50) (0.10) (0.04) (1.01)
F-Value 18.76*** 155.4*** 11.19*** 20.7*** 74.43*** 0.01 184.5*** 691.30***
Adjusted R2 0.0121 0.2979 0.0070 0.0514 0.0487 -0.0007 0.1120 0.6549
RMSE 0.08075 0.06807 0.2086 0.203 1.23 21.444 4.1409 2.5814 t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Table4.16: Endogenous Relationship between Corporate Governance and Firm Value (Reverse Causality)
Variables CGI CGI CGI CGI Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 14.4799 5.1421 14.5552 5.293 14.0260 5.4340 9.4938 5.3408 (17.71)* (8.76)*** (18.7)*** (9.04)*** (13.11)*** (9.39)*** (24.47)*** (8.99***) ROA 3.7303 2.1694 (4.33)*** (2.30)** ROE 1.1206 0.3066 (3.35)*** (0.97) Tobin’s q 0.4698 0.3178 (8.63)*** (6.21)*** EVA 0.2050 0.0167 (13.58)*** (2.04)** Firm_Size 0.6297 0.6398 0.6029 0.6111 (16.27)*** (16.58)*** (15.74)*** (9.60)*** LVRG -0.9460 -1.3307 -1.2536 -1.3357 (-2.64)*** (-4.31)*** (-4.19)*** (-4.25)*** Risk -0.0290 -0.0280 -0.0281 -0.0284 (-074) (-0.71_ (-0.072) (-0.72) F-Value 18.76*** 60.77*** 11.19*** 59.71*** 74.43*** 68.78*** 184.44*** 59.60*** Adjusted R2 0.0121 0.1704 0.0070 0.1679 0.0480 0.1889 0.1120 0.1676 RMSE 2.669 2.4458 2.6759 2.4495 2.6200 2.4184 2.254 2.44
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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The positive results of AC Ind and DEM may be attributed to the lack of real
independence in Pakistani firms where even non-executive directors are serving more
on the internal audit committees who are affiliated with some other company of the
group. Consequently they involved in income increasing activities which is the
ultimate goal of a parent company. Further, outside non-executive directors have less
information about the current operational level activities of the business where
earnings management is being occurred and they have to depend on the information
given by executives of the company (Paul et al., 2011). Moreover, Xie et al. (2003),
Mustafa and Youssef (2010) and Chapple et al. (2009) claimed that earnings
management can only be reduced if audit committee has independent members with
accounting knowledge and financial expertise and this phenomenon is also present in
Pakistani firms where qualified and accounting expert directors are rarely found
serving as director on the board of firm, particularly on the internal audit committee.
The other significant variable of audit structure is quality of external audit performed
for professional audit firms. It is strongly believed that a well-reputed audit firm helps
in ensuring the creditable and reliable accounting information disclosures for external
stakeholders which is free from errors and misrepresentations. The same expected
negative and statistically significant results have been found where EAQ is mitigating
the earnings management practices negatively. If the managers are aware of the fact
that their firms is being audited by an unbiased and reputable audit firm, they will
focus on true value enhancement instead of judgmental and temporary earnings
management practices. These negative results are in accordance with the earlier
literature where Palmrose (1988), Becker et al. (1998), Chen et al. (2007), Jaggi et al.
(2009) and Rusmin (2010) also found the role of audit quality in mitigating DEM
practices. The other two variables of internal audit committee characteristics namely
AC Size and Activity are found statistically insignificant. However, the negative sign
of AC Activity is supported by García et al. (2010) and Kang et al. (2011) who argued
that number of meeting of internal audit committee helps in reducing earnings
management practices in firms. On the other hand, Abbott et al. (2004) stated that AC
Size has no significant relationship with DEM.
In addition, Board size and board activity are found negatively related with the DEM
practices whereas board independence and CEO dominance on management
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committees are impacting earnings management positively. Larger boards and greater
number of meetings conducted by the board is helpful in reducing the earnings
management practices. Consistent with stewardship of larger boards, earnings
management can be minimized if there are more directors on the board. Moreover,
Xie et al. (2003) supported that frequent meetings of board can also have a strong
monitoring mechanism for lower earnings management. González and García-Meca
(2014) also contended that effective monitoring can be done by board if board meets
more frequently, and this activity may reduce earnings management practices in the
firms.
Opposite to the expectations, independence of the board of directors is found to be
positively associated with DEM practices in sample of study reported in second panel
of Table 4.17. Presence of more non-executive directors to total board members is
leading towards increase in malfunctioning of earnings smoothing. The present study
again presents the same argument given for positive relationship between audit
committee independence and earnings management. There is a lack of real
independence in Pakistani corporations where serving non-executive directors are
affiliated with some other company of the group and they are not truly independent.
Consequently they involved in income increasing activities which is the ultimate goal
of a parent company. Further, outside non-executive directors have less information
about the current operational level activity of the business where earnings
management is being occurred and they have to depend on the information given by
executives of the company (Paul et al., 2011).
Moreover, Epps and Ismail (2009) firms with less than 75% independence levels,
discretionary accruals level was found to be more positive. Cornett et al. (2009) also
found a positive association between board independence and DEM and they also
attributed this positive link to the lack of real independence. On the other hand, Park
and Shin (2004) reported that outside directors failed to reduce the earnings
management practices and opportunistic behavior of managers. Consistent with this,
Saleh et al (2005), Bradbury et al. (2006) and Gulzar and Wang (2011) did not find
any association between board independence and earnings management practices.
González and García-Meca (2014) also documented the evidence that the role of
140
board composition and independence is rather limited in Latin American firms to
control the opportunistic behavior of managers.
Along with these factors, dominance of CEO on the management committees is found
positively and significantly impacting the level of earnings quality flattening. As CEO
is present on the greater number of working committees of board, his power to
influence the operational executives increase, which ultimately produce negative
outcomes with respect to earnings manipulation in the firm. Level of board meeting
participation rate is also mitigating the earnings management towards the lower end,
however; this variable is not statistically significant. CEO duality is also found to be a
statistically insignificant variable impacting the level of earnings management
activity. These results are in accordance with Rahman and Ali (2006), Epps and
Ismail (2009) and Jaggi et al. (2009) who also concluded no significant relationship
between CEO duality and the level of earnings quality.
The results of compensation structure to CEO, directors and key executives and DEM
are reported in the third panel of Table 4.17. As per the common expectation, all three
compensation variables are negatively related to DEM practices of firms in Pakistan,
however; CEO compensation is not statistically significant at any level of
significance. Compensation is the easiest, although costly, way to induce the insiders
to work in the best interests of shareholders. Once they get motivated, the
compensation of executive directors and managers is leading to control their
opportunistic behavior and monetary benefits restrict them to indulge in judgmental
manipulation accounting numbers. Some earlier studies like Gao and Shrieves (2002),
Bergstresser and Philippon (2006), Shuto (2007) and Chu and Song (2012)
determined that propensity to manipulate the accounting earnings is lower in firms
where compensation to insiders is linked to the market value of equity and it is
strongly related to DEM activity either to increase or decrease current earnings.
The present study also investigated the impact of ownership structure, as a mechanism
of CG, on the DEM practices of the sample firm. In this regards, Inside, Family,
Institutional, presence of blockholder and ownership concentration are found to be
negatively impacting DEM, however; family ownership and ownership concentration
is not statistically significant. Higher inside ownership tends to reduce the
opportunistic behavior of managers and if they have ownership stake into the firm,
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they are concerned with the long term value of firm not short term temporary increase
in accounting returns. These results are in accordance with Banderlipe and Reynald
(2010) who documented that increased managerial ownership is more than enough to
limit managerial incentive to manage earnings. Further, Wang (2006), Jiraporn and
DaDalt (2007), Siregar and Utama (2008) also supported the negative relationship
between family ownership and DEM.
Institutional shareholding, presence of external block holder in the firm and
concentration of the ownership in fewer hands are also negatively related to the
earnings management practices of firms. Higher level of institutional stake in business
is restraining the earnings management activity because of efficient monitoring
performed by financial institutions on operational affairs. It is documented in the
literature that monitoring cost of institutional investors is relatively lower and these
institutional investors also have an incentive to monitor the managers due to their long
term substantial ownership stake in business which leads to lower earnings
management practices. Koh (2003), Jiraporn and Gleason (2007) and Mitani (2010)
also supported the efficient monitoring hypothesis of institutional investors in
mitigating the earnings management practices.
Presence of external block holder and ownership concentration also reduces the DEM
practices in firms. Block holders may affect the voting process and proxy fighting
with their block of shareholdings and this threat can be used as an influential factor to
reduce the earnings management (Liu & Lu, 2007). Ownership in the hands of few
members and presence of external block holders also reduce the motive to manage the
earnings and investors can trust more on the credibility and informativeness of
accounting information of firms (Iqbal & Strong, 2009; Roodposhti & Chashmi,
2011). Shareholdings by foreigners and associated companies are found to positively
but insignificantly related with DEM of firms. Foreign investors invest in firm with
the motive of greater returns and they force managers to manage the earnings upward.
Similarly, associated group companies are also inducing the managers to manage the
current period earnings for earnings smoothing as they want to capitalize their
investment as early as possible and are not concerned with the long term earnings
quality of the firm.
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Table4.17: Corporate Governance and DEM Variables Audit Board Compensation Ownership CGI
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Constant -0.0114 0.0109 0.0049 0.0189 0.0001 0.0202 -0.0006 0.0265 -0.0039 0.0157 (-4.08)*** (3.24)*** (1.07) (4.02)*** (0.11) (7.24)*** (-0.31) (8.41)*** (-2.39)** (6.04)*** AC Size 0.0048 0.0043 (1.18) (1.09) AC Ind 0.0083 0.0095 (5.20)*** (6.19)*** AC Activity -0.0006 -0.0005 (-1.27) (-1.08)
EAQ -0.0002 0.0019 (-0.30) (-3.06)*** BoS -0.0052 0.0004 (-2.86)*** (0.24) BoI 0.0038 0.0049 (3.83)*** (5.14)*** CEO Duality -0.0001 -0.0009 (-0.12) (-1.42) CEO Dom 0.0011 0.0023 (1.68)* (3.25)*** B_Activity -0.0002 0.0001 (-1.69)* (0.55) B_Part -0.0002 -0.0018 (-0.11) (-0.78) CEO_Comp -0.0001 -0.0001 (-1.07) (-0.33) Dir_Comp -0.0003 -0.0003 (-3.32)*** (-3.10)*** Exe_Comp -0.0002 -0.0001 (-3.00)*** (-1.83)*
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Table4.17: Corporate Governance and DEM – continued
Variables Audit Board Compensation Ownership CGI
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Inside -0.0064 -0.0069 (-1.82)* (-2.03)** Family -0.0010 -0.0036 (-0.33) (-1.16) Institutional -0.0058 -0.0047 (-2.22)** (-1.88)* Foreign 0.0013 0.0021 (0.65) (1.06) Associated Co 0.0002 0.0013 (0.18) (0.98) Block -0.0027 -0.0029 (-3.65)*** (-4.05)*** Own_Conc -0.0011 -0.0002 (-0.40) (-0.08) CGI -0.0001 -0.0003 (-1.79)* (-2.88)*** Firm_Size -0.0018 -0.0018 -0.0015 -0.0017 -0.0016 (-10.10)*** (-9.82)*** (-6.87)*** (-9.89)*** (-8.86)*** LVRG -0.0009 -0.0015 -0.0021 -0.0006 -0.0010 (-0.68) (-1.17) (-1.68)* (-0.49) (-0.78) Risk 0.0001 0.0001 0.0001 0.0001 0.0001 (0.38) (0.50) (0.41) (0.52) (0.42) F-Value 7.17*** 19.62*** 4.23*** 15.62*** 11.63*** 16.69*** 4.40*** 14.87*** 13.62*** 23.84***
Adjusted R2 0.0167 0.0929 0.0132 0.0829 0.0214 0.0608 0.0161 0.0870 0.0352 0.0591 RMSE 0.0112 0.0108 0.0112 0.01087 0.0112 0.0110 0.0112 0.01084 0.0113 0.0110
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
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Lastly, the integrated measure of CG quality (as measured by CG index) is negatively
and significantly associated with the malpractices of judgmental earnings
manipulation. As the overall quality of CG increases, monitoring and supervision of
managers’ increases which force them generate long term value for firm and not
indulge in short term earnings smoothing. Some earlier studies also used CG index as
quality of CG and found similar negative results between CGI and DEM (Leuz et al.,
2003; Shen & Chih, 2007; Cardoso et al., 2008; Bekiris & Doukakis, 2011;
Yaghoobnezhad et al., 2011). In addition to governance variables, size as control
variable is found to be negatively related with DEM activity of sample firms. Large
size firms are not managing their earnings in either direction as they do not have any
motive to manipulate their earnings. Their large size is enough to generate capital
from financial markets as well as they are more prone to investor due to their big size
and market reputation. Leverage is negatively impacting earnings management while
risk is creating incentive for managers to manage earnings, although both these
control variables are statistically insignificant.
4.2.6 Is Discretionary Earnings Management Opportunistic or Beneficial?
Literature has documented different motives of earnings management either income
increasing or income decreasing; however the empirical evidence on these motive is
not truly convincing (Beneish, 2001). The research on the role of DEM on firm value
is deficient in corporate finance literature. Empirical studies argued that earnings
management activities have a significantly negative impact on future value, earnings
growth and future cash flow which may be attributed to opportunistic earnings
management (Healy & Palepu, 1993; Sireger & Utama, 2008). Some others contended
that managers exercise earnings management behavior in order to enhance the
reported earnings due to which shareholders benefit from managed earnings (Guay et
al., 1996; Arya et al., 2003; Bowen et al. 2008). Due to the mixed evidence on
whether earnings management is beneficial or opportunistic, the impact of DEM has
been analyzed i.e. third research objective, and results are reported in Table 4.18.
There is no significant relationship found between DEM and accounting value
measures of ROA and ROE. Sireger and Utama (2008) claimed that if earnings
management is significantly increasing the firm value, it is named as
145
beneficial/efficient earnings management, otherwise; this is opportunistic. There is no
statistically significant association is found between DEM and accounting value of
firms. Moreover, long term value measure of EVA is actually declining with
increased DEM. These results confirm the notion that managers of Pakistani firms are
opportunistically managing the reported earnings. Chen et al. (2010) reported that
accrual based earnings management is negatively impacting the firm value for their
sample of study. These findings are also similar to those of Mizik and Jacobson
(2007) and Anjum et al. (2012) who discussed earnings management as the
opportunistic behavior of managers.
Table 4.18 also reports an interesting finding where Tobin’s q is positively related to
DEM. An upward increase in current period reported earnings is positively
influencing the perceptions of investors in capital markets and hence market value of
firm is increasing for firms who are managing their accounting earnings. Jiraporn et
al. (2008) concluded that firms with higher discretionary abnormal accruals have
greater market value. This positive relationship between DEM and Tobin’s q creates
an ambiguous and inconclusive deliberation about the opportunistic or beneficial
earnings management in Pakistani firms. In order to resolve this issue, the present
study further enhances the analysis and evaluates the impact of DEM on one-year and
two-year future value.
In Table 4.19, DEM is negatively impacting the one-year and two-year subsequent
value of the sample firms and these coefficients are statistically significant at high
level of significance. This confirms the belief that earnings management practiced in
Pakistani firms is purely opportunistic and not efficient or beneficial and not creating
value for investors. Corporate managers are not creating value in terms of accounting
profits as well as long term value rather damaging it. Although, investors assign
positive value to firms managing earnings, however; in long run the value outcomes
are negative even on market value measure of Tobin’s q. These results could be
strongly supported by earlier evidence provided by Toeh et al. (1998), Gunny (2005),
Bhojraj et al. (2009), Taylor and Xu (2010), Francis et al. (2011), Iqbal et al. (2011),
Tabassum et al. (2014, 2015).
146
Table 4.18: DEM and Current Firm Value
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0553 0.0675 0.1143 -0.0296 1.4137 -0.4371 24.9437 -0.0057
(23.58)*** (4.26)*** (18.91)*** (-0.63) (38.82)*** (-1.52) (20.03)*** (-0.11)
DEM 0.0124 -0.1116 0.0401 -0.2039 1.6859 -6.0172 -72.0164 -1.3665
(1.24) (-0.491) (0.339) (-0.42) (0.58) (-2.04)** (-7.22)*** (-2.50)**
Firm_Size 0.0070 0.0173 0.1400 -0.0016
(6.45)*** (5.35)*** (7.09)*** (-0.45)
LVRG -0.2070 -0.2082 -0.4652 0.0110
(-24.76)*** (-8.32)*** (-3.06)*** (0.39)
Risk 0.0004 0.0002 -0.0028 -0.0021
(0.45) (0.07) (-0.14) (-0.57)
F-Value 2.02** 153.49*** 2.45** 20.41*** 2.33** 13.46*** 52.10*** 691.04***
Adjusted R2 0.0120 0.2954 0.020 0.0506 0.019 0.0331 0.039 0.6548
RMSE 0.08127 0.0681 0.2094 0.2040 1.2615 1.2401 4.3191 2.5817 t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for DEM variable whereas model 2 includes control variables as well.
147
Table 4.19: DEM and Firm Subsequent Value
Variables One Year Subsequent Value Two Years Subsequent Value
ROA ROE Tobin’s q EVA ROA ROE Tobin’s q EVA
Constant 0.0992 0.0556 -0.2694 -4.2752 0.1019 0.0385 0.1384 0.0927 (5.32)*** (1.03) (-0.84) (-6.31)*** (4.12)*** (0.64) (0.40) (0.387) DEMt+1 -0.1705 -0.3485 -0.4463 -11.4202 (-5.31)*** (-3.74)*** (-1.97)** (-6.09)*** DEMt+2 -0.0957 -0.2289 -1.5095 -12.8560 (-2.56)** (-2.13)** (-2.45)** (-6.24)*** Firm_Size 0.0038 0.0083 0.1268 2.0759 0.0026 0.0078 0.0960 1.9819 (3.03)*** (2.30)** (5.87)*** (45.50)*** (1.60) (1.95)* (4.16)*** (4.26)*** LVRG -0.1736 -0.1141 -0.5067 -3.1268 -0.1569 -0.0899 -0.4711 -2.6375 (-17.84)*** (-4.05)*** (-3.03)*** (-8.85)*** (-13.85)*** (-2.79)*** (-2.55)** (-6.70)*** Risk 0.0001 0.0012 -0.0086 -0.1264 0.0001 0.0015 -0.0077 -0.1345 (0.03) (0.73) (-0.41) (-2.82)*** (0.88) (0.81) (-0.45) (-2.46)**
N 1243 1035
F-Value 86.45*** 8.82*** 10.36*** 560.24*** 50.22*** 5.17*** 10.22*** 579.27***
Adjusted R2 0.2151 0.0245 0.0291 0.6421 0.1593 0.0119 0.0259 0.6254 RMSE 0.0726 0.2105 1.2475 2.6359 0.0751 0.2163 1.2393 2.6431
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively
148
Table 4.20: Moderating Role of DEM in CG-Value Relationship
Variables ROA ROE Tobin’s q EVA
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 Model 1 Model 2
Constant 0.0115 0.0568 0.0204 -0.0431 -0.0236 -0.8227 16.6420 -3.9996 (0.90) (3.44)*** (0.62) (-0.87) (-0.12) (-2.77)*** (25.98)*** (-6.39)*** CGI 0.0029 0.0018 0.0063 0.0025 0.0979 0.0737 0.5667 0.0022 (3.48)*** (2.39)** (2.89)*** (1.06) (7.51)*** (5.18)*** (13.15)*** (0.08) DEM 1.3038 -0.4204 0.6903 0.1077 19.4084 25.7387 -138.4005 -55.4465 (1.32) (-0.50) (0.27) (0.04) (1.29) (1.69)* (-2.79)*** (-1.73)* CGI*DEM -0.0880 -0.0191 -0.0774 -0.0244 -1.1897 -1.4495 -4.7712 -3.9608 (-1.32) (-0.34) (-0.45) (-0.14) (-1.17) (-1.71)* (-1.41) (-7.83)*** Firm_Size 0.0057 0.0156 0.0887 2.0387 (4.85)*** (4.39)*** (4.14)*** (45.13)*** LVRG -0.2045 -0.2041 -0.3301 -3.2971 (-24.24)*** (-8.07)*** (-2.18)** (-10.31)*** Risk 0.0005 0.0003 -0.0011 0.0378 (0.53) (0.09) (-0.06) (0.91)
F-Value 6.84*** 103.64*** 4.06*** 13.85*** 25.46*** 16.00*** 82.65*** 461.92***
Adjusted R2 0.0119 0.2974 0.0063 0.0503 0.0480 0.0583 0.1441 0.6553 RMSE 0.08075 0.0681 0.2087 0.2040 1.2305 1.2239 4.0654 2.5801
t-values are in parentheses whereas *, **, and *** represent the level of significance at 10%, 5%, and 1%, respectively. Model 1 is only for CG related variable whereas model 2 includes control variables as well.
149
4.2.7 Moderating Role of DEM in CG-Value Relationship
Up till now, the present study has concluded that effective CG mechanism may
enhance firm short term and long term value. Moreover, there is no issue of
endogeneity in Pakistani firms and both of these variables of CG and firm value are
exogenously determined. Furthermore, if firm has efficient governance system of
good quality, it can mitigate the agency issue and refrain its managers to involve in
subjective manipulation of reported accounting earnings which may damage current
as well as subsequent value. However, there are some contrary results found in
establishing CG and DEM relationship which raise an important question that how
this DEM behavior of firms moderates the established relationship of CG and firm
value. In order to resolve this issue and to cater fourth research objective, a moderated
regression analysis has been conducted for CG and DEM with firm value. An
interaction variable of CGI and DEM has been introduced in the model for firms with
good governance and results have been reported in Table 4.20.
The results of Table 4.20 elaborates that there is significant positive association
between CG index and all four measures of firm value. Good governance enhances
the firm value both in long term and short term. This is consistent with many other
earlier studies. Moreover, DEM practices not only irrelevant to firms’ current value
but also damaging subsequent long term firm value which is also consistent with
many prior studies as well as our earlier results of Table 4.18 and 4.19. Importantly,
the interaction variable of CGI and DEM is negative for all the value measures;
however, it is statistically significant only for Tobin’s q which is market value and
EVA, a long term economic value measure. The DEM is negatively moderating the
relationship between CG and firm value. If the managers are involved in earnings
manipulation, the market and economic value will decline even for the firms with
good quality of CG. This is consistent with Kang and Kim (2011) who claimed to be
first study to capture the moderating role of earnings management between the
relationship of CG and firm value. Their study also confirms that earnings
management leads to lower the value of Korean firms and this discretionary behavior
of managers to manage reported earnings also moderates the relationship between CG
and market value of firms measured by Tobin’s q.
150
Chapter 5
CONCLUSION
151
During the last couple of decades, regulators, investors, policy makers and other
capital market participants have focused on the need for firms to have an effective
corporate governance mechanism in order to minimize misalignments of interests and
agency problem between shareholders and managers through active monitoring and
accountability system. Effective governance and control mitigate the opportunistic
behavior of mangers and can presumably make accounting earnings informationally
reliable for the stakeholders and hence, increases firm value. The present research
study attempts to investigate the role of corporate governance mechanisms in
increasing the firm value through effective monitoring of managerial behaviors and
decisions and reducing agency problem. The study used sample data of 208 Pakistani
firms for a period of 2004-2011 to examine the impact of different individual
mechanisms of CG as well as an integrated governance index (CGI) on the
accounting, market and economic value of firms. Moreover, the role of these CG
measures in mitigating the opportunistic behavior of manager towards managing
earnings is also investigated. Furthermore, an effort has been made to contribute to
existing empirical literature on CG by analyzing the role discretionary earnings
management in moderating the relationship between CG and firm value.
The findings of the current study revealed that effective CG contributes to enhanced
firm value in long as well as short run. Constitution of internal audit committees as an
effective internal audit system is essential for the progress of a firm. Large and
independent audit committees meeting more frequently not only mitigate information
asymmetry problem between insiders and external stakeholder by ensuring credibility
of accounting information but also exterminate the chances of misrepresentation of
accounting information and window dressing in the firm which in turn enhances
returns on firms’ assets as well as helps it to sustain long term value capital markets.
Moreover, the quality of external audit by a reputable chartered accountancy firm may
also be used as external monitoring system and serves the same purpose. However,
the role of independent audit committee in controlling the opportunistic behavior of
managers is rather found limited in the present study. The reason may be the lack of
real independence of audit committees as most of the non-executive directors of firms
are affiliated with the firm as directors on associated companies’ boards. This reduces
the level of real independence and audit committees are unable to control
opportunistic behavior of managers which they show while subjectively managing
152
and altering reported accounting earnings. The existing empirical literature on audit
structure has mainly focused on controlling earnings management activity in business,
however; fewer studies have focused on role of audit system in improving firm value
which is one of the main contributions of current study.
Similar to independent audit committees, board composition and structure is an
emerging technique to effectively monitor the managers as this is the highest decision
making body in the firm. Board size, board independence and CEO duality are
extensively used in existing literature as a measure of board structure. In addition to
these variables the present study used three variables namely CEO dominance, board
activity and board participation, which are rarely used in CG and firm value research.
The findings exhibited that, larger and independent boards, which are free from the
CEO duality, help in enhancing firm accounting, market and economic value.
Moreover, valuable participation of directors in the board makes sure that strategic
managerial affairs are thoroughly discussed in board meetings which results in
effective decision making and improved firm value. Furthermore, due to lack of real
independence of non-executive directors in the board, the opportunistic behavior of
the managers is also not mitigated.
The monetary incentives and compensation paid to the top executives of a firm is also
analyzed in the current research. Overall, compensation to CEO, executive directors,
and top key management personnel motivates them to work in the best interests of the
company which increases not only short term accounting value of firm but also long
term market and economic value of the firm. Managerial compensation aligns the
managerial interests to the shareholders’ interests and is helpful in reducing the
agency problem. Moreover, a well-defined compensation structure also alleviates the
problem of information asymmetry and limits the incentive of managers to manipulate
the level of reported earnings. In Pakistan, firms mostly pay cash and non-stock
compensation to their top executives, which are short term monetary compensation
plans. Therefore, there is no incentive for the managers to upsurge earnings because
they have no personal benefit in boosting the market value of firm. Furthermore, strict
surveillance by SECP and stock market regulators regarding share trading of insiders
(CEO, directors) also limit this incentive manage corporate earnings discretionally.
153
The ownership structure, another element of CG, is comprehensively discussed in
existing empirical literature. The present study has used five external and two internal
ownership variables to check the impact of ownership structure on firm value and
earnings management behavior. Family influence in the firm is very much positive on
accounting performance, a short term measure of firm value. However, market does
not perceive family involvement in the business as a good phenomenon and lower
value is assigned by investors to firm with higher family ownership. Moreover,
resource sharing by associated companies and technological and managerial
competencies imparted by foreign ownership give unrivaled value to the firms, as
found in the positive role of associated companies and foreign ownership in
increasing firm value. However, both of these investors need return on their invested
capital whether it is coming through the real value of firm or by manipulating the
short term accounting profits of firms indicating a positive role of both in earnings
management. In addition, concentration and block holding is also helpful in creating
and sustaining value through the control of managerial opportunism.
On the other hand, the inside ownership and the firm value has nonlinear U-shaped
nonlinear relationship. If the managers own the threshold level of 15-25% of firm
ownership, their interests can be converged to those of shareholders. The
entrenchment hypothesis is applicable for other than 15-25% inside ownership level
which may damage the firm value. Moreover, ownership concentration also has a
nonlinear effect on firm value; hence, moderate level of ownership concentration may
not enhance firm value. Similarly, the ownership stake by financial institutions does
not have a linear relationship with firm value. Only moderate level of financial
institution ownership may create value which is very much relevant to convergence of
interest hypothesis proposed by Pound (1988). Furthermore, active financial
institutions having nominee on board may align their strategic interests with inside
management and may damage firm’s long term economic value. However, short term
value is enhanced by active monitoring and participation of financial institutions. In
addition, the ownership by insiders and financial institution may limit the managerial
incentive for managing earnings. Insiders will not manipulate because it may decrease
the long term value of their own stocks and therefore the financial institutions will not
allow the managers do so due to their long term stake in organization.
154
Additionally, a composite measure of CG has been utilized to examine the effect of
quality of overall governance on firm value and earnings management. This
composite measure (CGI) is based upon variables from all four CG mechanisms and a
higher score of CGI depicts better quality of CG. Findings showed that quality of CG
is not only helpful in controlling the opportunistic behavior of managers by reducing
the level of judgmental manipulation of earnings, but also enhances the firm value in
all respect. Better the quality of CG, superior the firm value and lesser the DEM.
Moreover, this relationship between CG and firm value is exogenous and there is no
issue of endogeneity between firm value and CG.
Whether DEM is a beneficial or an opportunistic activity? The present study also
answers this question by evaluating the impact of DEM on current and future firm
value. The findings revealed that DEM activity is not irrelevant to current value but
also damage the long term value in future. It is leading the future value of (one and
two subsequent years) in a negative way and same has been found for all the value
measures of the study. Further, this value damaging behavior of DEM of corporate
managers negatively moderates the CG and firm value. Firms with earnings
manipulation weakens the impact of effectiveness of CG system and leads to lower
firm value. If the managers are involved in earnings manipulation, the market and
economic value will decline even for the firms with good CG mechanisms.
The present research also provides some practical guidelines and suggestions for
investors, policy makers / regulators and managers. For the corporate strategy
formulators, the present study highlights the need and significance of motivating their
executives to work in the best interests of stakeholders and not to get involved in
manipulative activities which may damage the long term value of the firm. In this
regards, managers must be conveyed that their activities are being monitored by
effective audit and board structure and they will be held accountable for their
managerial actions. Efficiency and effectiveness of board decisions can be improved
by increasing the participation of directors in board meetings. Moreover,
compensation committees must realize the importance of managerial compensation
and it should formulate appropriate compensation plans which not only refrains the
managers from being opportunistic but motivate them to indulge in value creating
activities for the firm. Increased inside ownership, up to a certain threshold, might
155
serve as a motivating factor and it will improve the long term firm value.
Furthermore, the firms and managers can get benefits from the presence of foreigners
on board and their managerial and other skills can be used to enhance the firm. Along
with this, presence of external block holder and shareholder activism of financial
institutions may put the managers under strict monitoring and control.
With respect to policy makers and regulators, the study also presents some practical
implications. SECP should consider the effectiveness of independent audit committee
and board independence as an important factor for the active implementation of CG in
Pakistan. The role of external auditor is of much importance in enhancing firm value
and reducing accounting misrepresentation activities in the firm. SECP should ensure
that firms must get their accounts audited from a reputable audit firm. Moreover,
SECP should instruct public limited companies to change their audit firms on regular
basis so that strategic alliance between managers and external auditor should be kept
at the minimum level. Currently, firms reappoint the same external auditors, or rotate
the engagement partner in same audit firm, after the contract expiration. Furthermore,
SECP should also focus on the real independence of the board of directors as
highlighted by the current research as one of the important issues of corporate
governance. Currently, SECP encourages the presence of at least one independent
unaffiliated director on the board of directors and firms also keep this to the minimum
requirement. Remaining non-executive directors are usually affiliated directors from
associated companies with the similar objectives as those of the firm which leads to
lack of real independence of board of directors and its sub-committees.
Existing and potential investor may also get benefit from the practical implications of
the current study. Investors should evaluate the CG structure before investing in these
firms. Role of audit committee, external audit quality, board participation rate,
managerial compensation, presence of external block holder, foreign ownership and
moderate level of inside and institutional ownership are the important factors for
investors which must be evaluated prior to making their investment. Audit and board
structure can monitor the activity of the managers in which investors are investing
whereas managerial compensation induces managers to work at their best for them.
Along with this, presence of external block holder in the firm may resolve the agency
issue between minority and controlling shareholders and moderate the level of inside
156
and institutional shareholding which may lead to the wealth maximization of
shareholders. Finally, role of family has been changed overtime in Pakistani business
environment and the present study found that family ownership not only mitigates the
opportunistic behavior of managers but also enhances the firms’ returns on
investment.
The study also has some implications for academic researchers and opens few new
research horizons for future research because of certain limitations. The study has
conducted a detailed analysis of corporate governance mechanism, discretionary
earnings management and firm value. However, this research is only limited to 208
firms for eight years research window. In future, more firms from various other
industrial sectors with longer time series data and application of advance econometric
techniques can be conducted to more generalize the results of current study. Due to
unavailability of the data, the present study has also omitted some other corporate
governance variables and perspectives which were difficult to obtain for sample firms
in case of Pakistan. In future, academic researchers can use these variables for future
research to have a more deep insight into corporate governance structure of Pakistan.
These alternative prospects may include pay for performance sensitivity, financial
expertise of directors, tenure and experience of board members, non-executive
directors’ participation rate, role of board committees, blockholders’ identity, along
with more control variables. With respect to future guidelines and extension, the
similar research on corporate governance can be conducted to have a cross-country
comparison of Pakistani alike economies, particularly south Asian countries. Finally,
future research on corporate governance can focus on the separate analysis of service
and manufacturing sector as well as separate analysis of mandatory and voluntary
corporate governance practices.
157
Chapter 6
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APPENDICES
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Appendix I: Variables Measurement
Variable Measurement
[Panel A: Value Measures]
ROA Return on Assets; measured by Earnings after interest and taxes/total assets
ROE Return on Equity; measured by Earnings after interest and taxes/total shareholders’ equity
Q Tobin’s Q; Market value of firm / book value of assets
EVA Economic Value added; Earrings after interest and taxes – Capital charge (capital charge = capital employed*WACC)
[Panel B: Audit Structure Measures]
AC Size Internal audit committee size measured by total number of audit committee members/total number of directors on the board
AC Ind Internal audit committee independence measured by ratio of non-executive directors in audit committee to total members of audit committee members
AC Activity Audit Committee activity measured by frequency of audit committee meetings in a financial year
EAQ External auditor quality is a dummy variable with the value of “1” if firm is being audited by Big 5 auditing firms and “0” otherwise
[Panel C: Board Structure Measures]
BoS Board Size measured as natural log of total members of board of directors
BoI Board Independence measured as; 1 x Outside Directors BoS Inside Directors
CEO Duality CEO duality; a dummy variable is 1 if CEO holds the position of chairman of the board as well; and zero otherwise
CEO Dom CEO dominance; a dummy variable equals to 1 if CEO is nominated on board committees/s and zero otherwise
B_Activity Board Activity; total number of board meetings in a financial year
B_Part Board participation rate; measured by total participation of board members in all meetings/total required attendance
[Panel D: Compensation Structure Measures] CEO_Comp Natural Log of (salary + bonus+ perquisites) of CEO Dir_Comp Natural Log of (salary + bonus+ perquisites) of Executive Directors
Exe_Comp Natural Log of (salary + bonus+ perquisites) of key management personal
[Panel E: Ownership Structure Measures]
Inside Inside Ownership measure by fraction of shares owned by all insiders as a ratio to total shares outstanding
Family Family ownership measured by no. of shares owned by family members / total shares outstanding
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Institutional Institutional ownership measured by fraction of shares held by financial institution to total shares outstanding
Institutional _ Activism
Dummy variable which takes a value of 1 if board of directors of ith company have a nominee director of financial institutions, and zero otherwise.
Foreign Fraction of shares held in the company by Foreigners
Block External Blockholders dummy equals to 1 of shareholding of the largest shareholder is greater than 10% and zero otherwise
Associated Co
Fraction of shares held in the company by related and associated companies including parent and subsidiary firms
Own_Conc Ownership concentration measured by Herfindahl Index sum of square of holdings of top 5 shareholders in the firm
CGI
CG Index is an integrated and composite measure of 28 CG provisions based upon audit, board, compensation and ownership structure of firm. The value of CGI ranges from 0-28 where a higher score indicates better quality of governance
[Panel F: Control Variables]
Firm_Size Natural log of book value of total assets LVRG Total Liabilities/Total Assets
Risk Systematic risk of a firm by notated as b coefficient in CAPM model estimated using daily stock prices of firms and stock index data of KSE.
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Appendix II: List of Companies
CoID Symbol Company Name Sector Year of Inc.
1 AGIL Agriautos Industries Limited Automobile 1981 2 ATBA Atlas Battery Limited Automobile 1966 3 ATLH Atlas Honda Limited Automobile 1962 4 BWHL Baluchistan Wheels Limited Automobile 1980 5 EXIDE Exide Pakistan Limited Automobile 1954 6 GTYR General Tyre and Rubber Company Ltd. Automobile 1963 7 GHNL Ghandara Nissan Limited Automobile 1981 8 HCAR Honda Atlas Cars (Pakistan) Limited Automobile 1992 9 INDU Indus Motor Company Limited Automobile 1989 10 PSMC Pak Suzuki Motor Co. Limited Automobile 1983 11 SAZEW Sazgar Engineering Works Limited Automobile 1991 12 ABL Allied Bank Limited Banks 1991 13 AKBL Askari Bank Limited Banks 1991 14 BAFL Bank Al-Falah Limited Banks 1992 15 BAHL Bank AL-Habib Limited Banks 1991 16 BIPL Bankislami Pakistan Banks 2004 17 FABL Faysal Bank Limited Banks 1994 18 HMB Habib Metropolitan Bank Limited Banks 1992 19 KASBB KASB Bank Limited Banks 1994 20 MCB MCB Bank Limited Banks 1947 21 MEBL Meezan Bank Limited Banks 1997 22 NIB NIB Bank Limited Banks 2003 23 SBL Samba Bank Limited Banks 2002 24 SILK SILKBANK Limited Banks 1994 25 SNBL Soneri Bank Limited Banks 1991 26 SCBPL Standard Chartered Bank Banks 1991 27 SMBL Summit Bank Limited Banks 2005 28 BOP The Bank of Punjab Banks 1994 29 BAPL Bawany Air Product Limited Chemicals 1978 30 BIFO Biafo Industries Limited Chemicals 1988 31 BUXL Buxly Paints Limited Chemicals 1948 32 DYNO Dynea Pakistan Limited Chemicals 1982 33 EPCL Engro Polymer and Chemicals Limited Chemicals 1997 34 FFBL Fauji Fertilizer Bin Qasim Limited Chemicals 1994 35 FFC Fauji Fertilizer Company Limited Chemicals 1978 36 GATI Gatron Industries Limited Chemicals 1980 37 ICI ICI Pakistan Limited Chemicals 1953 38 ICL Itehad Chemicals Limited Chemicals 1991 39 LINDE Linde Pakistan Limited Chemicals 1949 40 LGPL Linear Pak Gelatin Limited Chemicals 1983 41 LOTPTA Lotte Pakistan PTA Limited Chemicals 1991 42 PGCL Pak Gum and Chemicals Limited Chemicals 1982
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43 SARD Sardar Chemicals Limited Chemicals 1989 44 SHCI Shafi Chemicals Limited Chemicals 1994 45 SITC Sitara Chemical Industries Limited Chemicals 1981 46 WAHN Wah-Nobel Chemicals Limited Chemicals 1983 47 ACPL Attock Cement Pakistan Limited Construction 1981 48 BWCL Bestway Cement Limited Construction 1993 49 CHCC Cherate Cement Company Construction 1981 50 DADX Dadex Eternet Limited Construction 1959 51 DGKC DG Khan Cement Company Limited Construction 1978 52 FCCL Fauji Cement Company Limited Construction 1992 53 FLYNG Flying Cement Limited Construction 1992 54 GAMON Gammon Pak Limited Construction 1947 55 KCL Karam Ceramics Limited Construction 1979 56 KOHC Kohat Cement Limited Construction 1980 57 LUCK Lucky Cement Limited Construction 1993 58 MLCF Maple Leaf Cement Factory Limited Construction 1960 59 PIOC Pioneer Cement Limited Construction 1994 60 STCL Shabbir Tiles and Ceramics Limited Construction 1978 61 PAEL Pak Elektron Limited Electronics 1956 62 PCAL Pakistan Cables Limited Electronics 1953 63 PTEC Pakistan Telephone Cables Limited Electronics 1983 64 SIEM Siemens Pakistan Engineering Compay Electronics 1953 65 SING Singer Pakistan Limited Electronics 1877 66 AGTL Al-Ghazi Tractors Limited Engineering 1983 67 ATEL Atlas Engineering Limited Engineering 1951 68 BCL Bolan Casting Limited Engineering 1982 69 GHNI Ghandhara Ind. Limited Engineering 1963 70 HINO HinoPak Motors Limited Engineering 1986 71 HSPI Huffaz Seamless Pipe Industries Limited Engineering 1984 72 KSBP KSB Pumps Company Limited Engineering 1959 73 MTL Millat Tractors Limited Engineering 1964 74 PECO Pakistan Engineering Company Limited Engineering 1950 75 CSAP The Crescent Steel & Allied Limited Engineering 1987 76 ADAMS Adam Sugar Mills Limited Food Producers 1965 77 AABS Al Abbas Sugar Mills Limited Food Producers 1991 78 ALNRS Al-Noor Sugar Mills Limited Food Producers 1969 79 CHAS Chashma Sugar Mills Food Producers 1988 80 CLOV Clover Pakistan Limited Food Producers 1986 81 CSMD Crescent Sugar Mills and Distillery Ltd, Food Producers 1959 82 DAAG Data Agro limited Food Producers 1992 83 DWSM Dewan Sugar Limited Food Producers 1982 84 FRSM Faran Sugar Mills Limited Food Producers 1981 85 HABSM Habib Sugar Mills Limited Food Producers 1962 86 HAL Habib-ADM Limited Food Producers 1980 87 HWQS Haseeb Waqas Sugar Mills Limited Food Producers 1992 88 HUSS Hussein Sugar Mills Limited Food Producers 1968
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89 ISIL Ismail Industries Limited Food Producers 1989 90 JDWS JDW Sugar Mills Limited Food Producers 1990 91 KOHS Kohinoor Sugar Mills Limited Food Producers 1968 92 MRNS Mehran Sugar Mills Limited Food Producers 1965 93 MIRKS Mirpurkhas Sugar Mills Limited Food Producers 1964 94 MFFL Mitchells fruit Farms Food Producers 1933 95 MUREB Murree Brewery Company Limited Food Producers 1861 96 NATF National Foods Limited Food Producers 1970 97 NOPK Noon Pakistan Limited Food Producers 1966 98 NONS Noon Sugar Mills Limited Food Producers 1964 99 PAKT Pakistan Tobacco Company Limited Food Producers 1947
100 PMPK Philip Morris (Pakistan) Limited Food Producers 1969 101 RMPL Rafhan Maize Products Limited Food Producers 1952 102 SANSM Sanghar Sugar Mills Limited Food Producers 1986 103 SGMLPS Shakarganj Mills Limited Food Producers 1967 104 SHEZ Shezan International Limited Food Producers 1964 105 SASML Sindabadgar's Sugar Mills Limited Food Producers 1984 106 TSML Tandlianwala Sugar Mills Limited Food Producers 1988 107 TICL The Thal Industries Corporation Limited Food Producers 1953 108 GHGL Ghani Glass Mills Limited Gen. Ind. 1992 109 NETSOL Netsol Technologies Limited Gen. Ind. 1996 110 PACE Pace (Pak) Limited Gen. Ind. 1992 111 TRIPF Tri-Pack Films Limited Gen. Ind. 1993 112 AICL Adamjee Insurance Limited Insurance 1960 113 ASIC Asia Insurance Limited Insurance 1979 114 AGIC Askari General Insurance Limited Insurance 1995 115 CENI Century Insurance Limited Insurance 1985 116 CICL/CYAN Cyan Limited / Central Insurance Limited Insurance 1960 117 EFUG EFU General Insurance Limited Insurance 1932 118 HICL Habib Insurance Limited Insurance 1942 119 IGIIL International General Insurance (IGI) Ltd Insurance 1953 120 JGICL Jubilee General Insurance Company Ltd Insurance 1953 121 PIL PICIC Insurance Limited Insurance 2004 122 PINL Premier Insurance Limited Insurance 1952 123 RICL Reliance Insurance Limited Insurance 1981 124 SHNI Shaheen Insurance Limited Insurance 1995 125 SSIC Silver Star Insurance Limited Insurance 1984 126 CSIL The Crescent Star Insurance Company Insurance 1957 127 PKGI The Pakistan General Insurance Company Insurance 1947 128 UNIC The United Insurance Company of Pak. Insurance 1959 129 UVIC The Universal Insurance Insurance 1958 130 APL Attock Petroleum Limited Oil and Gas 1995 131 ATRL Attock Refinery Limited Oil and Gas 1978 132 BPL Burshane LPG (Pakistan) Limited Oil and Gas 1967 133 BYCO Byco Petroleum Limited Oil and Gas 1995 134 MARI Mari Petroleum Company Limited Oil and Gas 1984
199
135 NRL National Refinery Limited Oil and Gas 1963 136 OGDC Oil & Gas Development Company Ltd. Oil and Gas 1961 137 PPL Pak Petroleum Limited Oil and Gas 1950 138 POL Pakistan Oilfields Limited Oil and Gas 1950 139 PRL Pakistan Refinery Limited Oil and Gas 1960 140 PSO Pakistan State Oil Company Limited Oil and Gas 1974 141 SHEL Shell Pakistan Limited Oil and Gas 1969 142 CEPB Century Papers Limited Paper 1984 143 MERIT Merit Packaging Limited Paper 1980 144 PKGS Packages Limited Paper 1957 145 SEPL Security Paper Limited Paper 1965 146 AASM Al-Abid Silk Mills Limited Personal Goods 1968 147 ANL Azgard Nine Limited Personal Goods 1993 148 BNWM Bannu Woolen Mills Limited Personal Goods 1960 149 BATA Bata Pakistan Limited Personal Goods 1951 150 BHAT Bhanero Textile Mills Limited Personal Goods 1980 151 BTL Blessed Textiles Limited Personal Goods 1987 152 COLG Colgate Palmolive (Pakistan) Limited Personal Goods 1977 153 CRTM The Crescent Textile Mills Limited Personal Goods 1950 154 DKTM Dewan Khalid Tax Mills Limited Personal Goods 1978 155 DINT Din Textiles Mills Limited Personal Goods 1988 156 DMTX DM Textile Mills Limited Personal Goods 1958 157 FASM Faisal Spinning Mills Limited Personal Goods 1984 158 FZTM Fazal Textile Mills Limited Personal Goods 1963 159 FML Feroze 1888 Mills Limited Personal Goods 1972 160 GFIL Ghazi Fabrics Limited Personal Goods 1989 161 GRAYS Grays Of Cambridge (Pakistan) Limited Personal Goods 1964 162 GATM Gul Ahmad Textiles Limited Personal Goods 1953 163 HAEL Halla Enterprises Limited Personal Goods 1974 164 IBFL Ibrahim Fiber Limited Personal Goods 1987 165 IDYM Indus Dyeing Manufacturing Limited Personal Goods 1957 166 KML Kohinoor Mills Limited Personal Goods 1949 167 KTML Kohinoor Textile Mills Limited Personal Goods 1953 168 MEHT Mehmood Textile Mills Limited Personal Goods 1970 169 NATM Nadeem Textiles Mills Limited Personal Goods 1984 170 NCLNCP Nishat Chunian Limited Personal Goods 1990 171 NML Nishat Mills Limited Personal Goods 1951 172 PSYL Pakistan Synthetic Limited Personal Goods 1984 173 QUET Quetta Textile Mills Limited Personal Goods 1970 174 RAVT Ravi Textile Mills Limited Personal Goods 1987 175 RUPL Rupali Polyesters Limited Personal Goods 1980 176 SANE Salman Noman Enterprises Limited Personal Goods 1989 177 SNAI Sana Industries Limited Personal Goods 1988 178 SAPT Sapphire Fibers Limited Personal Goods 1979 179 SRVI Service Industries Limited Personal Goods 1957 180 STML Shams Textiles Mills Limited Personal Goods 1968
200
181 SURC Suraj Cotton Mills Limited Personal Goods 1984 182 TGL Tariq Glass Limited Personal Goods 1978 183 TATM Tata textile Mills Limited Personal Goods 1987 184 TREET Treet Corporation Limited Personal Goods 1977 185 WAZIR Wazir Ali Industries Limited Personal Goods 1953 186 ZTL Zephyr Textile Limited Personal Goods 1999 187 ZIL ZIL Limited Personal Goods 1954 188 ABOT Abbott Laboratories (Pakistan) Limited Pharma. 1948 189 FEROZ Ferozsons Laboratories Limited Pharma. 1954 190 GLAXO Glaxosmithkline (Pak) Limited Pharma. 2001 191 HINOON Highnoon Laboratories Limited Pharma. 1984 192 SEARL Searle Company Limited Pharma. 1965 193 WYETH Wyeth Pak Limited Pharma. 1949 194 SHFA Shifa International Hospitals Limited Pharma. 1987 195 HUBC Hub Power Company Limited Power 1991 196 KOHE Kohinoor Energy Limited Power 1994 197 KAPCO Kot Addu Power Limited Power 1996 198 SEL Sitara Energy Limited Power 1991 199 SEPCO Southern Electric Power Company Power 1994 200 SNGP Sui Northern Gas Limited Power 1963 201 SSGC Sui Southern Gas Company Limited Power 1954 202 PAKD Pak Datacom Limited Telecom 1992 203 PTCL Pakistan Telecom Company Limited Telecom 1995 204 TELE Telecard Limited Telecom 1992 205 WTL WorldCall Telecom Limited Telecom 1996 206 PIAA Pakistan International Airlines Corp. Transportation 1956 207 PNSC Pakistan National Shipping Corp. Transportation 1979 208 PICT Pakistan International Container Ltd. Transportation 2002
