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THE IMPACT OF CORPORATE GOVERNANCE ON THE FINANCIAL PERFORMANCE OF THE FIRM: AUSTRALIAN EVIDENCE

 

INTRODUCTION:

Corporate governance refers to the ways by which all the stakeholders of the firm such as shareholders, creditors, employees, customers, managers, suppliers and government have an impact over the management of a firm Shah, Butt, and Saeed (2011).The ways through which the stakeholders exerts influence over the management of the firm are called as mechanisms of corporate governance. These mechanisms are divided into two subheads which are internal and external mechanisms. Internal corporate governance mechanisms include board characteristics, managerial ownership etc. External mechanisms include government legislation, presence of equity stakes of financial institution in the corporation, industry guidelines etc. This study will examine the impact of internal mechanisms of corporate governance such as board characteristics (board independence, board size, family affiliation of directors and audit committee size) and managerial ownership on the financial performance of the firm.

According to Gallo (2005) independent board refers to the board which mainly consist of members that are not employed by the company, not owners of the company and also these members do not have family affiliation. So, we can say that board independence is the proportion of independent or non-executive directors on the board. Board size can be defined as the number of directors serving on the board. Family affiliated director means director who has family ties with the executives of the company. Audit committee size simply means the number of directors on an audit committee. The other mechanism of corporate governance i.e. managerial ownership is defined as the proportion or percentage of total shares possessed by the managers.

 

According to Code of corporate governance (2002) independent director refers to

“director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether

pecuniary or otherwise, with the listed company, its associated companies, directors,

executives or related parties”

The other mechanism that have been used in this study is board size. Most of the researcher stated that board size is the number of directors serving on the board or simply board size means number of board of directors. Strength of board of directors also be used as a definition of board size. 

 

The third board characteristic or mechanism of corporate governance is the family

affiliation of directors. Family affiliated director refers to a director who has family ties

with the executives of the company such as CEO’s Spouse, children, Cousins etc.

 

Last board characteristic or fourth mechanism of corporate governance that have been used in this study is the size of the audit committee. Like board size, audit committee size simply means the number of directors on an audit committee or how many directors are included in the audit committee.

As it is known that in order for board to discharge their duty there are three board

committees these includes audit, nomination and remuneration Higgs (2003) [43] and

Ticker (1994).

Responsibility of audit committee includes ensuring proper examination of books of

accounts that is the reason audit committee take part in selection of auditor, removal of

auditor and remuneration of auditors, what would be included in audit work, decide upon independence of the auditor, and how the disputes if any among executive management and auditor will be sought out, as well as audit committees approval of accounting policies in addition to that audit committee influence corporation’s way of financial reporting, disclosure levels, and how much they are following standard practice Amer, Ragab and Shehata (2014).

Several studies have been conducted in the context of developing and developed countries to determine the relationship between corporate governance mechanisms and firm performance, see for example Javed, Iqbal and Hasan (2006) and the other paper is of Rehmans and Mangla (2010) and also several studies have been conducted in developed countries on the impact of corporate governance mechanisms on the firm performance but the findings of these studies are inconclusive or among these studies consensus has not been developed for example Koerniadi and Tourani-Rad (2012) and Liu, Miletkov, Wei, and Yang(2014). 

The focus of this study will be to determine the impact of board characteristics and managerial ownership on the financial performance of the companies that are listed on Australian Stock Exchange.

 

 

1. Literature Review and Hypothesis Development:

Corporate Governance:

The impact of different mechanisms of corporate governance is studied by different

researchers in different countries and corporate governance is defined by many researchers, according to Shleifer and Vishny (1997) corporate governance are the ways with the help of which providers of finance make sure that they are receiving return on their investment. Good corporate governance is very important for the effective functioning of the organization such as a study conducted by Bhagat and Bolton (2008) concluded that if there are good corporate governance then the performance of the firm will improve and vice versa. Similarly, Dittmar and Smith (2007) research on corporate governance and the value of cash holdings reveals that poor corporate governance in a firm cause’s quick dissipation of cash in those ways that have significantly negative effect on operating performance of the firm.

Board Independence:

Mostly Boards are composed of executive and non-executive directors, executive directors are also called as management directors and they are employed by the organization where as non-executive directors are not employed by the organization and they also called as non-management director. Executive directors and non-Executive directors refers to dependent and independent directors respectively Shah et al., (2011)It can also be said that usually it is a practice of dividing directors into inside directors, affiliated directors and independent directors (see the definitions provided by Institutional Shareholder Services, 1998, p. 3.11; Council of Institutional Investors, 1991)

Board Size:

One of the mechanism of corporate governance is size of the board, board size impact on corporate financial performance is widely researched but the results are inconclusive that whether size of board is positively or negatively related to firm’s performance.

Family affiliation of CEO:

Family affiliation of director means that the director who has family ties with the

executives of the company such as CEO’s Spouse, children, Cousins etc. The study which argue that board that are controlled by family members performs better than the non-family controlled board is Tsai, Hung, Kuo and Kuo (2006) which is conducted in Taiwan Named as “CEO Tenure in Taiwanese Family and Nonfamily Firms: An Agency Theory Perspective” in which data is obtained from a sample that includes 304 companies that are listed in Taiwan in which firms that are not controlled by family are 241 whereas 63 firms were family controlled, findings reveal that CEO dismissed more in non-family controlled firms as compared to family controlled firms but when CEOs from the family poorly perform, their chances of termination is more as compared CEOs of non-family company or from outside family they also stated that “Directors of boards in family firms may mitigate rather than exacerbate agency problems”

Audit Committee Size:

In order for board to discharge their duty there are three board committees these includes audit, nomination and remuneration Higgs (2003).

 

The previous studies reveal that board independence, board size and audit committee size impact positively whereas family affiliation of directors and managerial ownership effect negatively the financial performance of financial and non-financial firms, see for example Shleifer and Vishny (1997) and Al-Matari, Al-Swidi, Fadzil, and Al-Matari (2012). On the basis of the above literature the following hypothesis are made.

H1: There is a positive impact of board independence on the financial performance of the company.

The basis of the hypothesis is Agency theory states that agent is likely to pursue interests that may hurt the principal when there is information asymmetry and in this situation if the corporation have independent board then that board will govern in such a manner that will cause decrease in misappropriation of shareholders by managers as well as by controlling shareholders.

H2: There is a positive impact of board size on the financial performance of Australian Companies listed on ASE.

According to resource dependency theory focus on the role directors of the company has in providing or safeguarding crucial resources to the corporation through their connections to the external environment. Therefore, the more the directors are serving the board the more they have connections and access of resources.

 

H3: There is a negative impact of family affiliation of directors on the financial performance of Australian Companies listed on ASE.

As if the directors do not have family affiliation means that they are independent or outsiders than we can say that board will be unable to solve agency problem. As according to agency theory agent is likely to pursue interests that may hurt the principal when there is information asymmetry and in this situation if the corporation have family affiliated directors then the board will be unable to solve agency problem.

H4: There is a positive impact of audit committee size on the financial performance of Australian Companies listed on ASE.

As this is necessary that the head of the audit committee is independent director, secondly in this different experts come which cause less chances of financial reporting mistakes.

H5: There is a negative impact of managerial ownership on the financial performance of Australian Companies listed on ASE.

According to transaction cost theory which states that managers are opportunists and arrange firms’ transactions to their interests. As per management entrenchment theory managers’ if given power than they will capitalize the resources of the firm in a way that will benefit them, even such use of the firms’ resources do not maximize the value of the firm Shleifer and Andrei (1989). In this situation if they are given ownership in the firm then they will misuse them on the basis of that negative impact of managerial ownership is expected.

a. Research Objectives:

The objective of the study is to examine the effect of board characteristics and managerial ownership on financial performance of firms listed on ASE. In addition this study will also examine the difference in the impact of board characteristics and managerial ownership on financial performance of financial and non-financial firms.

b. Significance of the study:

Studies conducted in the context of Pakistan are limited to the few sectors and studies from emerged markets are inconclusive .Therefore its significance is both practical and theoretical and it will contribute to the literature of corporate governance as well as finance.

2. Conclusion:

A study conducted by Suchard and Zein (2011) in the context of Australia named as corporate governance and alternative performance measures: evidence from Australian firms found no significant relation among the corporate governance mechanisms and financial performance of the companies. Therefore, this study will be conducted with an aim to enrich the literature on corporate governance as well as to empirically find the relationship among the two. Therefore, the following questions will be answered in the research.

The following are the research questions which are going to be answered through this

research:

• What is the effect of board independence on financial performance of companies listed on Australian Stock Exchange?

• What is the effect of board size on financial performance of companies listed on

ASE? 

• What is the effect of family affiliations of directors on financial performance of companies listed on ASE?

• What is the effect of audit committee size on financial performance of companies listed on ASE? 

• What is the effect of managerial ownership on financial performance of companies

listed on ASE?

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