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CASE STUDY 5.1

  • Read the Case Study: On the relation between corporate governance compliance and operating performance. Accounting & Business Research (Wolters Kluwer UK), 39(5), 497-513. Vander Bauwhede, H. (2009).
    (this case study is located in the EBSCO Host of the University of the Potomac Library)
  • Write a summary analysis and what is your opinion of the discussion? What is the high point that convinces you that Corporate governance compliance does make a difference in the operating performance.

Writing Requirements

  • 3–5 pages in length (excluding cover page, abstract, and reference list)
  • APA format, Use the APA template located in the Student Resource Center to complete the assignment.
  • Please use the Case Study Guide as a reference point for writing your case study.

CASE STUDY 6.1

  • Read the Case Study: (this case study is located in the EBSCO Host of the University of the Potomac Library) Busco, C., Frigo, M. L., Giovannoni, E., Riccaboni, A., & Scapens, R. W. (2005). Beyond compliance why integrated governance matters today. Strategic Finance, 87(2), 34-43.
  • Write a summary analysis and give you opinion on why integrated governance matters today.

Writing Requirements

  • 2-3 pages in length (excluding cover page, abstract, and reference list)
  • APA 6th edition, Use the APA template located in the Student Resource Center to complete the assignment.
  • Please use the Case Study Guide as a reference point for writing your case study.

CASE STUDY 7.1

  • Read the Article: Upcoming Compliance and Governance Events. (2014). Compliance Week, 11(126), 70-71
    (this Article is located in the EBSCO Host of the University of the Potomac Library)
  • Write a summary analysis and discuss the relevance of each of these events to the educational, ethical and opportunities provided for growth in compliance.

Writing Requirements

  • 2-3 pages in length (excluding cover page, abstract, and reference list)
  • APA 6th edition, Use the APA template located in the Student Resource Center to complete the assignment.
  • Please use the Case Study Guide as a reference point for writing your case study.

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497 Aecounting and Business Research. Vol. 39. No, 5, pp. 497-513, 2009 On the relatíon between corporate governance compliance and operating performance Heidi Vander Bauwhede Abstract — Better corporate perfonnance has been cited as one of the main benefits of adopting good corporate govemance structures within organisations. However, in contrast to theory, a prior European study (Bauer et al., 2004) reports evidence of a negative relationship between corporate govemance and corporate performance. This study re-examines this relationship, and reports evidence of a positive relationship between the extent of compliance with intemational best practices concerning board structure and functioning and operating perfonnance when operating perfonnance is measured by the retum on assets (ROA). This resuh is robust to controlling for the firms' compliance with best practices in other govemance areas, and holds for some other govemance dimensions, namely disclosure of corporate govemance and the range of takeover defences. Further tests indicate that greater compliance with intemational best practices conceming board stmcture and functioning is significantly associated with reporting less income from asset disposals and that studying a performance measure that includes this item obscures the inherently positive relationship between operating perfonnance and the extent of compliance with intemational best practices regarding board stmcture and functioning. The results provide some support for an oftencited motivation for the adoption of good govemance practices, and provide explicit evidence that the measure of operating perfonnance is cmcial in examining firm-level operating performance. Keywords: corporate govemance; operating performance 1. Introduction This paper examines the relationship between corporate govemance compliance and operating performance for a set of large listed European companies. My focus is on compliance with intemational best practice in corporate govemance. Following Jensen (1993) and prior govemance research, I hypothesise that greater compliance with intemational corporate govemance best practices and, more specifically, best practices conceming the structure and functioning of the board, is associated with better operating performance, ceteris paribus. I investigate the relationship between corporate govemance compliance and operating performance for a sample of European companies in 2000-2001, because, during that period, there remained considerable variation in corporate govemance practices (see Wójcik, 2006; Bauer et al, 2008), notwithstanding that there were pressures from, for example, institutional investors or cross-listings to comply with intemational corporate govemance best practices and that in some countries local codes were, de facto, mandatory."'^ The study focuses on operating performance, and not stock market performance, in order to investigate fiirther the result of a prior European study (Bauer et al., 2004) on the relation between compliance with best practices conceming corporate govemance and operating performance which seems to conflict with both theory as well as prior American results. More specifically, Bauer et al. (2004) report evidence of a negative relationship between ratings on the extent of compliance with intemational best practices and firm operating The author is at Maastricht University and at Ghent University. She also has an affiliation to Katholieke Universiteit Leuven. She gratefiilly acknowledges Ping-Sheng Koh, Kevin McMeeking, Piet Sercu, Konstantinos Stathopoulos, participants at the 2006 European Accounting Association Annual Conference (Dublin, Ireland), the editor and two anonymous reviewers for usefijl comments. She also thanks Deminor for providing the govemance data. The usual disclaimer applies. Correspondence should be addressed to Dr Heidi Vander Bauwhede, Maastricht University, Department of Accounting & Information Management, P.O. Box 616, Maastricht, 6200 MD, Netherlands. E-mail: H.VanderBauwhede@maastrichtuniversity.nl. This paper was accepted for publication in July 2009. ' I refer to a study commissioned by the European commission (Weil et al., 2002) and to the website of the European Corporate Govemance Institute (http://www.ecgi.org/codes/ all codes.php) for an overview of the corporate govemance codes in the European Union. Intemational govemance codes are, for example, those established by the Intemational Corporate Govemance Network (ICGN), and the Organisation for Economic Co-operation and Development (OECD). ^Some countries (such as the UK and Italy) required companies to disclose whether they complied with a (national) corporate govemance code under a 'comply or explain' approach. This approach requires firms to disclose whether (and to what extent) they comply with a particular corporate govemance code and, if they do not (fully) comply, to explain why they do not comply. 498 performance, whereas theory (Jensen, 1993), predicts a positive relationship^ and a prior American study (Larcker et al., 2005)findssome (albeit weak) evidence of a positive relationship. I primarily focus on board structure and functioning, and not on other dimensions of corporate governance (such as, for example, rights and duties of shareholders and range of takeover defences), because it is especially the structure and functioning of the board that can directly affect the operating efficiency and operating performance of a company. However, for completeness, I also perform and report the results of some additional analyses on the relation between other dimensions of corporate governance and firm operating performance. I use a sample of European listed companies for which a private rating agency issues a firm-level rating of the extent of compliance with international best practices conceming board structure and functioning. Results of univariate and multivariate tests indicate that the one-year ahead retum on assets (ROA) increases in the extent of compliance with intemational best practices conceming board structure and functioning. Tests show that the results are not affected by the potential endogeneity of the extent of govemance compliance. In addition, the results are robust to controlling for the firms' compliance with best practices in other govemance areas, such as rights and duties of shareholders and-range of takeover defences, and to controlling for country-level performance. Moreover, I also find a positive relation between the extent of compliance with recommendations in some other govemance dimensions, more specifically disclosure on corporate govemance and range of takeover defences, and firm operating performance. Further, additional analyses indicate that greater compliance with intemational best practices conceming board stmcture and fiinctioning is significantly associated with reporting less income from asset disposals and that studying a performance measure that includes the income fi^om asset disposals, such as the retum on equity (ROE) or net profit margin (NPM) used by Bauer et al. (2004), instead of a performance measure which is not impacted by the incomefi^omasset disposals, such as the retum on assets (ROA), obscures the inherently positive relationship between operating performance and the extent of compliance with ^ Bauer et al. (2004)findindications of a positive relationship between govemance ratings, and stock retums and firm value, respectively. ACCOUNTING AND BUSINESS RESEARCH intemational best practices regarding board structure and functioning. This study contributes to the literature on the relation between corporate govemance and corporate performance. A first contribution is that the study reports a positive relation between the extent of compliance with intemational best practices on various govemance dimensions (board stmcture and functioning, disclosure on corporate govemance) and the operating performance of European companies. A second contribution is that this study reports evidence which indicates that the unexpected negative relationship between corporate govemance compliance and operating performance as reported by Bauer et al. (2004)^* is due to poorlygovemed companies using the available discretion over the timing of asset sales to cover up their inherently lower operating performance. The key difference between this study and that of Bauer et al. (2004) is that the retum on assets is introduced as the preferred measure of operating performance because the income measure used in computing the retum on assets, i.e. operating income, is less influenced by discretionary items than the income measure used to compute the retum on equity or net profit margin, i.e. income before extraordinary items. The retum on equity and net profit margin are the performance measures used by Bauer et al. (2004). The remainder of the paper is organised as follows. The next section develops the main research hypothesis. Section 3 describes the sample and data. Section 4 presents the empirical model. Section 5 presents the empirical results. Section 6 concludes. 2. Hypothesis development The various corporate govemance codes that have been issued since the late 1990s oflen refer to better performance as one of the key benefits of adopting their corporate govemance recommendations. This performance can be understood as better market performance (i.e. higher stock retums or firm Examples of other studies that have examined the relation between govemance and perfomiance using samples from other countries (for example, the US, Australia, and various Asian and some (individual) European countries), and using and focusing on a variety of govemance attributes and performance measures, are: Larcker et al. (2006), Black et al. (2006), Brown and Caylor (2006a), Brown and Caylor (2006b), Dumev and Kim (2005), Larcker et al. (2005), Alves and Mendes (2004), Bebchuk et al. (2004), Klapper and Love (2004), Drobetz et al. (2004), Kiel and Nicholson (2003), Bhagat and Black (2002), Yermack (1996), and Klein (1998). Vol. 39, No. 5. 2009 value)^ or as better operating performance. The expected relationship between compliance with corporate govemance recommendations and operating performance is based on the argument that firms with a better govemance structure operate more efficiently which increases their operating performance (see, for example, Jensen, 1993). However, results of previous studies on the relation between govemance and operating performance are mixed. Larckeret al. (2005), for example, find some evidence of a positive relationship between an overall govemance metric (The Corporate Library Board Effectiveness Rating) and the one-year ahead ROA for a set of large listed American companies. By contrast, Bauer et al. (2004) find a negative relationship between an overall govemance score and operating performance for large European companies. As with any govemance study, a crucial element in examining the relationship between govemance and performance is how one defines and measures 'better govemance'. In this study, I use a rating, issued by a private rating agency (Deminor rating),^ that assesses the extent to which large listed European firms comply with intemational best practices conceming corporate govemance and, more specifically, the extent to which firms comply with intemational best practices conceming board structure and functioning.^ Higher compliance is implicitly assumed to be better govemance. However, this is not necessarily true. A first reason is that European companies may have adopted govemance mechanisms and practices that differ from the intemationally accepted best practices, but are better tailored to the specific context in which they operate. However, it is probably also true that ^ Examples of studies that have examined aspects of corporate govemance and market performance in an American setting are Yemack (1996), Bhagat and Black (2002), Gompers et al. (2003) and Bebchuk et al. (2004). Beiner et al. (2006), Alves and Mendes (2004), Drobetz et al. (2004) and Kiel and Nicholson (2003) are examples of govemance-market performance studies using samples of Swiss, Portuguese, German and Australian companies, respectively. * In Section 3,1 provide more detail on the rating. 'Most govemance studies use either a single indicator of govemance, or an 'arbitrary' index. Larcker et al. (2006) argue that measurement error in these govemance metrics may be partly responsible for the mixed results on the association between tiie typical measures of corporate govemance and accounting and economic outcomes. Nevertheless, I prefer to use the ratings issued by an independent rating agency as measures of govemance compliance since these are publicly available and easily accessible for market participants. The aim of the study is to see whether these publicly available measures of the extent of compliance with intemational best practices are related to fiiture operating performance and can as such signal future operating performance to market participants, who can, in tum, use this infonnation for decision making. 499 there is less need for govemanee practices tailored to local contexts for the largest companies in Europe, which operate globally instead of locally. Whether large listed European companies benefit fi-om compliance with intemational best practices, and then specifically in terms of higher operating performance, is ultimately an empirical question. Another reason why higher compliance is not necessarily better govemance is that the best practices identified by Deminor are not always unequivocally related to better govemance. For example, evidence on whether CEO duality is bad govemance and board diversity is good govemance, is mixed (see, for example, Sonnenfeld, 2004; Massa and Simonov, 2007).* In order to refine the analysis I focus on the dimension of corporate govemance which is particularly likely to directly infiuence operating efficiency and operating performance, i.e. the structure and functioning of the board of directors.^ As Jensen (1993: 862-863) puts it, 'The board, as the apex of the intemal control system, has the final responsibility for the functioning of the firm. Most importantly, it sets the rules of the game for the CEO. The job of the board is to hire, fire, and compensate the CEO, and to provide high-level counsel' and ' . . . the very purpose of the intemal control mechanism is to provide an early waming system to put the organisation back on track before difficulties reach a crisis stage.' Jensen (1993) then also attributes the weak corporate performance from the early 1990s to problems with the intemal control activity (Jensen, 1993: 352) in the 1980s, which, in tum, stemmed from problems with the board of directors (Jensen, 1993: 862). The major threat to a well-functioning board, and strong operating performance, is that the board is dominated by managers (especially in Anglo-Saxon countries) or majority shareholders (especially in continental European countries) who act in their ovra interest (instead of in the interest of all stakeholders), and cover up any underperformance by eamings management or manipulation to appease (minority) shareholders. Jensen (1993: 869) then also recognises that characteristics such as, for example, high-equity ownership by managers and board members, a small board, not many insiders on the board, and a CEO which is not the chairman of the board, are key elements of a wellfunctioning govemance system, which limits selfinterested behaviour by managers, uncovers bad performance in time and takes the necessary actions * I thank one of the anonymous reviewers for this observation. ' For completeness, I later expand the analyses to govemance dimensions other than board structure and fiinctioning. The results are reported in Section 5.4. 500 ACCOUNTING AND BUSINESS RESEARCH to 'put the organisation back on track' (Jensen, 1993: 863). These key elements of a well-functioning board mentioned by Jensen (1993) are all covered by the intemational best practices conceming board structure and functioning. Therefore, I expect that higher compliance with intemational best practices conceming board structure and functioning is related to better operating performance. Although greater compliance with intemational best practices conceming rights and duties of shareholders and range of takeover defences may increase the pressure by investors and the market for corporate control on companies to perform well, it is less straightforward that this greater compliance with intemational best practices conceming rights and duties of shareholders and range of takeover defences is per se related to better underlying operating performance, for in the absence of a wellfunctioning board, managers and majority shareholders could still act in their own self-interest, underperform, and cover up weak performance by eamings management or manipulation.'"''' This leads to the following hypothesis: HI: A company's operating performance increases in the extent of compliance with intemational best practices conceming board stmcture and functioning, ceteris paribus. institutional investors. The indicators can be divided into four categories: rights and duties of shareholders, range of takeover defences, disclosure on corporate govemance and board stmcture and functioning. Deminor Rating issues a rating of each one of the four categories. This study focuses on the rating regarding board stmcture and functioning. This rating covers indicators on the election of members of the company's bodies, composition of the board, functioning of the board, remuneration of the company's bodies and committees of the board. Ratings are assigned by senior analysts from the different European offices of Deminor after all the most recent publicly available information on a particular company (i.e. not only financial reports, but also articles of association, agendas, resolutions and minutes of ordinary and extra-ordinary general meetings, investor's handbooks and newsletters, intemet-sites and all other publicly available information) has been benchmarked against the best practice found in intemationally accepted standards. Those intemationally accepted standards are established by, for example, the Intemational Corporate Govemance Network (ICGN) and the Organisation for Economic Co-operation and Development (OECD). A rating is measured on a scale of 5 to 1, with 5 representing the best practice (Deminor Rating, 2001: 9-10). The sample studied in this paper consists of all 3. Sample and data companies from the FTSE Eurotop 300 for which This study uses ratings of compliance with inter- there is a Deminor rating of board structure and national best practices regarding board stmcture and functioning for the year 2000 and/ or 2001, as well functioning which are supplied by a private rating as complete infonnation on the other variables in agency, Deminor Rating. Deminor Rating (a sub- the model.'"* I exclude financial companies (FTSE sidiary of Deminor Intemational) releases, since industry sector code 80) because their financial March 2001, corporate govemance ratings on the stmcture is distinct from other companies and they companies of the FTSE Eurotop 300 index.'^''^ The are often subject to special mies and recommendaratings are based on over 300 corporate govemance tions. I delete observations with extreme observaindicators, which were identified after consulting tions (i.e. values outside the 5* and 95* percentile) for the ratios in the model, namely leverage and the '"De Angelo (1988), for example, reports that, during an three measures of operating performance (i.e. ROA, election campaign, managers exercise accounting discretion to ROE and NPM), for ratios easily take on extreme portray a favourable eamings picture to voters. values. The final sample exists of 201 firm-year As concems disclosure on corporate govemance, it is straightforward that mere disclosure per se cannot improve the observations (from 118 different companies). operating performance of a company. However, the level of Table 1, Panels A and B give a breakdown of the disclosure is highly positively correlated with the quality of the observations by industry sector and by country, structure and the fiinctioning of the board: companies with wellstructured and -functioning boards have no problem in disclosrespectively. ing this information, while companies with badly-structured and I obtain financial statement data from -functioning boards are less transparent about this. A positive association between high disclosure and good operating Worldscope. performance is then probably also due to a well-structured and well-functioning board than to the level of disclosure per se. '^On 25 May 2005, Deminor announced that it had sold its corporate govemance unit Deminor Rating to Institutional Shareholder Services (ISS). '^ Some other studies that have used Deminor data are Bauer et al. (2008), Bauer et al. (2006), Wójcik (2006), Wójcik et al. (2005), and Bauer et al. (2004). '''The item that is most frequently missing is the Deminor govemance rating. This rating is missing because not all FTSE Eurotop 300 firms are followed by Deminor. Vol. 39, No. 5. 2009 501 Table 1 Sample description Panel A: Breakdown of sample by industry* Number of firms % Number of firm-years % Industry code Industry description 4 7 11 13 15 21 24 25 26 31 34 41 43 44 47 48 49 52 53 54 58 59 63 67 72 73 78 93 97 Mining Oil & Gas Chemicals Construction & Building Materials Forestry & Paper Aerospace Diversified Industrials Electronic & Equipment Engineering and Machinery Automobiles Household Goods & Textiles Beverages Food Producers & Processors Health Personal Care & Household Products Pharmaceuticals Tobacco General Retailers Leisure, Entertainment & Hotels Media & Photography Support Services Transport Food & Dñig Retailers Telecommunication Services Electricity Gas Distribution Water Information Technology Hardware Software & Computer Services Total 1.69 5.08 7.63 5.08 0.85 2.54 2.54 5.93 5.93 6.78 3.39 1.69 3.39 0.85 1.69 3.39 1.69 5.93 1.69 7.63 2.54 0.85 3.39 5.08 6.78 1.69 0.85 1.69 1.69 2 6 9 6 1 3 3 7 7 8 4 2 4 1 2 4 2 7 2 9 3 1 4 6 8 2 1 2 2 118 100 3 10 15 11 2 5 4 12 12 16 8 4 7 1 3 8 4 11 3 15 5 1 8 8 14 4 1 3 3 201 1.49 4.98 7.46 5.47 1.00 2.49 1.99 5.97 5.97 7.96 3.98 1.99 3.48 0.50 1.49 3.98 1.99 5.48 1.49 7.46 2.49 0.50 3.98 3.98 6.97 1.99 0.50 1.49 1.49 100 * Following the FTSE Global Classification System. Panel B: Breakdown of sample by country"* Country Belgium France Italy The Netherlands Portugal Spain Switzerland Germany Denmark Norway Sweden Finland Ireland UK Total Number of firms % 3 25 6 8 1 7 7 12 2 1 8 1 1 36 tl8 2.54 21.19 5.08 6.78 0.85 5.93 5.93 10.17 1.69 0.85 6.78 0.85 0.85 30.51 100 Number of firm-years % 6 49 10 13 1 13 13 21 3 2 12 2 2 54 201 2.99 24.38 4.98 6.47 0.50 6.47 6.47 10.45 1.49 1.00 5.97 1.00 1.00 26.87 100 ** All but two countries in the sample (Switzerland and Norway) are member of the European Union. All other countries , but the UK, Denmark and Sweden are part of the Eurozone or EMU (i.e. Europe's European and Monetary Union). 502 ACCOUNTING AND BUSINESS RESEARCH 4. Research design and model specification I test the relationship between the extent of compliance with intemational best practices conceming corporate govemance, and more specifically board structure and functioning, and the operating performance of large listed European companies by estimating the following operating performance model: Performancei, = ßo + iS|CG.COMPi, i, + (1) where: Performanceit = ROA, where: ROA is one-year ahead retum on assets for firm i in year t; CGCOMPLit = a rating proxying for the extent of compliance with intemational best practices regarding board structure and functioning for firm i in year t; = leverage, as measured by the sum of short-term and long-term debt divided by total assets, for firm i in year t; = the natural logarithm of total assets for firm i in year t;'^''^ Y2001it = indicator variable which takes one if the observation is from 2001, and zero if the observation is from 2000; Xjt = a vector of industry dummies, i.e. indicator variables for the (twodigit) industry codes of the FTSE Global Classification system. I measure the dependent variable in the operating performance model, i.e. one-year ahead firm-level operating performance, by the one-year ahead ROA. I use the one-year ahead, instead of the contemporaneous, ROA to make sure that the govemance systems described by the ratings are in place and operational at the moment that I start measuring operating perfonnance. Consistent with prior studies (e.g. Larcker et al., 2006), ROA is measured as operating income divided by average total assets.'^ For comparison, I also perform '^ Total assets are measured in thousands of Euros. Values initially stated in a local currency are converted to Euros by using the exchange rate at the balance sheet date. I use the natural logarithm because I do not expect a linear relationship between operating performance and firm size. " T h e average is computed as the sum of the value at the beginning of the accounting period and the value at the end of the accounting period, divided by two. analyses in which I replace the one-year ahead ROA with the one-year ahead ROE and the one-year ahead NPM, because the ROE and the NPM were used as performance measures in the study by Bauer et al. (2004). The ROE is measured as eamings before extraordinary items dividend by the average book value of stockholders' equity, and net profit margin is the ratio of eamings before extraordinary items divided by sales (see, for example, Gompers et al., 2003). As argued by Core et al. (2006) and Barber and Lyon (1996), the ROA is clearly the preferred measure of operating performance because it is less affected by discretionary items than the ROE and the NPM. This implies that I expect a stronger relationship between the extent of compliance with intemational best practices conceming board stmcture and functioning and the one-year ahead ROA, than between the extent of compliance and the one-year ahead ROE or the oneyear ahead NPM. I will further refer to the three models as the ROA model, the ROE model and the NPM model. The test variable is a measure of the level of compliance with intemational best practices conceming corporate govemance, and more specifically best practices conceming board stmcture and fiinctioning (CG COMPL). CG COMPL is proxied by Deminor's rating of board stmcture and functioning. The rating takes a value from 1 to 5 with 5 indicating the highest compliance with intemational best practice. A positive sign on CG_COMPL indicates that greater compliance with best practices conceming board structure and fimctioning is related to better operating performance, and is consistent with the hypothesis. I further include in the regression leverage (LEV), computed as the sum of short-term and long-term debt over total assets, to control for the well-known impact of leverage on ROE, the natural logarithm of total assets (LNTA) as a measure of firm size, a year dummy (Y2001) to control for the impact of the general macro-economic context on individual firm performance, and a vector of industry dummies. 5. Descriptive statistics and results 5.1. Descriptive statistics Table 2, Panel A, presents descriptive statistics for the dependent and independent variables of the operating performance model. Table 2, Panel A, shows that the mean one-year ahead ROA is about 6.6% (median 6.4%). The mean one-year ahead ROE is higher, and about 7.3% (median 10.2%). The mean one-year ahead NPM amounts to 2.9% (median 3.7%). Mean and median leverage is about 28%. Vol. 39, No. 5. 2009 503 Table 2 Descriptive statistics and correlations^ Panel A: Descriptive statistics Variable ROA ROE NPM LEV LNTA Mean StdDev 201 0.0658 201 0.0729 201 0.0289 201 0.2773 201 16.5757 0.0482 0.1507 0.0769 0.1135 1.0492 Median Min. Q3 Max. -0.0352 0.0314 0.0635 0.0946 0.1966 -0.5838 0.0433 0.1019 0.1588 0.3015 -0.4580 0.0110 0.0365 0.0684 0.1626 0.0470 0.1868 0.2794 0.3642 0.4955 13.7591 15.8908 16.3970 17.2708 19.1507 Panel B: Pearson correlation coefficients ROA ROE NPM ROA 1.0000 ROE 0.5095 NPM 0.5224 0.8328 CG COMPL 0.1823 0.0271 0.0190 LEV -0.1993 -0.1724 -0.1640 LNTA -0.4028 -0.1337 -0.2297 CG COMPL LEV LNTA1 -0.0092 -0.0273 1.0000 0.2066 1.0000 * Variable definitions: ROA = one-year ahead return on assets for firm i in year t, and is measured as operating income divided by average total assets, ROE = one-year ahead retum on equity for firm i in year t, and is measured as eamings before extraordinary items divided by the average book value of stockholders' equity, NPM = one-year ahead net profit margin for firm i in year t, and is measured as eamings before extraordinary items divided by sales revenues LEV = ratio of short-term debt plus long-term debt over total assets for firm i in year t LNTA = natural logarithm of total assets for firm i in year t CG_COMPL = scorefi^om1 to 5 with higher scores indicating greater compliance of firm i in year t with intemational best practice conceming board stmcture and fiinctioning Table 2, Panel B, presents the Pearson correlation coefficients between the dependent and independent variables of the operating performance model. The dependent variables, one-year ahead ROA, one-year ahead ROE and one-year ahead NPM are all positively correlated with CG_CO]V[PL. However, only the correlation of ROA and C G C O M P L is significant. The highest absolute value of the correlations among the independent variables is 0.21, which indicates that the regression results are not affected by multicollinearity. 5.2. Regression results I estimate the performance model using ordinary least squares (OLS). A concem in testing the relation between the extent of compliance with intemational best practices conceming corporate govemance, and more specifically board stmcture and fiinctioning, and the operating performance of large listed European companies is that firms with good prospects may self-select into the group with stronger govemance stmctures, while firms with poor prospects may self-select into the group with weaker govemance stmctures. If this is indeed tme, the OLS parameter estimates are inconsistent. However, the results of a Hausman-like test for endogeneity as described in Gujarati (2003: 713) show that CG_COMPL is not endogenous with respect to any of the dependent variables (p on the fitted value of CG_COMPL > 0.10, two-sided). For the endogeneity test, I used the following first stage model (govemance compliance model), which is based on prior empirical disclosure and govemance studies (see, for example, Pincus et al., 1989 and Willekens et al, 2004): CG_COMPLi, = 70 + y,FFLOATi, + (2) 504 ACCOUNTING AND BUSINESS RESEARCH Table 3 fiirther shows that the one-year ahead ROA and one-year ahead NPM decrease in size (LNTA). In addition, the industry dummies (not reported) are significant predictors of all three performance measures.'^ where: FFLOATit= the free float of firm i in year t; ROA_Cit = the contemporaneous retum on assets for firm i in year t; Yit = a vector of country dummies, i.e. indicator variables for the country of domicile of thefirmsin the sample; Z^ = a vector of other exogenous variables from the operating performance model (i.e. second stage regression). The other variables are as defined in Equation (1). Re-performing the endogeneity tests (1) deleting the contemporaneous retum on assets in the first stage regression, or (2) replacing the contemporaneous retum on assets with the past retum on assets in the first stage regression confirm that CG_COMPL is not endogenous with respect to any of the dependent variables. This contrasts with results in Renders and Gaeremynck (2006), and is most likely due to differences in research design. More specifically, to be sure that the corporate govemance systems are in place and operational at the moment that I start measuring operating performance, I use one-year ahead operating perfomiance measures (instead of contemporaneous operating performance measures). As there are two years of data, there are repeated observations on some companies. Although observations are still independent across firms, they are no longer independent within firms. Therefore, the t-values are adjusted to control for within-company dependence by using clustered robust standard errors.'* Table 3 reports the results of the OLS regression analyses. Columns 3, 5, and 7 show the results of models that use the one-year ahead ROA, the oneyear ahead ROE and the one-year ahead NPM as the dependent variable, respectively. Table 3 shows that the performance models have explanatory power (adjusted R^ of 49.30%, 23.41% and 22.11%, respectively). The coefficient on CG_COMPL is positive and significant at the 1% level (one-sided) in the ROA model. The magnitude of the CG_COMPL coefficient (0.0054) suggests a difference of 2.16% in the realised one-year ahead ROA betweenfirmswith the lowest and the highest rating of CGCOMPL (i.e. 4*0.54%). This result supports the hypothesis that operating performance is higher for firms that comply to a greater extent with intemational best practices conceming board stmcture and functioning. Consistent with the argument that the one-year ahead ROA is the preferred measure of operating performance, the coefficient on CG_COMPL is not significant for the ROE and NPM models. Examining the difference in results between performance measures The results in Tables 3 and 4 report a significantly positive relationship between the extent of compliance with intemational best practices conceming board stmcture andfiinctioning(CG_COMPL) and performance for some performance measures (i.e. the one-year ahead ROA, the one-year ahead retum on cash-adjusted assets and the one-year ahead ROS, all measures which use operating income in the numerator), but not for other performance measures (i.e. the one-year ahead ROE) and one-year ahead NPM, two measures which use income before exfraordinary items in the numerator). Especially the difference in results when using the ROS and the NPM is striking, since the only difference between these two measures is the numerator. (The ROS uses operating income '^ The results are qualitatively similar when not adjusting for within company dependence. " Deleting the industry dummies from industries with only one observation (i.e. health, transport, and water) or all industry dummies does not change the results on the test variable. 5.3. Additional analyses Other measures of operating performance To confirm the evidence from the ROA model on the positive and significant relation between the extent of compliance with intemational best practices conceming board stmcture and fiinctioning and operating performance, I replace the one-year ahead ROA in the operating performance model with two altemative measures of operating performance, i.e. the one-year ahead retum on cashadjusted assets and the one-year ahead retum on sales (ROS) (see Barber and Lyon, 1996). The retum on cash-adjusted assets is measured by dividing operating income by the average cashadjusted assets, i.e. total assets minus cash and cash equivalents. The ROS is operating income divided by sales. Table 4 reports the results of the operating performance regressions when using these altemative operating performance measures. Table 4 also reports the results of the regression when using the one-year ahead ROA as the dependent variable for comparison. Table 4 shows that the results on the test variable (CG COMPL) when using the alternative operating performance measures are qualitatively similar to the result when using the one-year ahead ROA. 505 Vol. 39, No. 5. 2009 Table 3 Regression results ROE ROA Variable Pred. sign Coef. estimate (t-statistic) Pred. sign Coef. estimate Pred. sign Coef. estimate (t-statistic) (t-statistic) Industry dummies 0.4252*** (7.14) 0.0054*** (2.38) -0.0291 (-0.90) -0.0197*** (-5.33) -0.0060* (-1.82) Included 0.4511* (1.70) -0.0034 (-0.39) -0.1930 (-1.32) -0.0144 (-0.88) -0.0258 (-1.59) Included Adj. R-squared N Evidence of endogeneity 49.30% 201 No 23.41% 201 No Intercept CG COMPL + LEV 9 LNTA Y2001 NPM ? + 9 9 ? ? 0.4142*** (2.87) -0.0023 (-0.61) -0.0702 (-1.2) -0.0179** (-2.04) -0.0106 (-1.10) Included 22.11% 201 No " This table reports the results of the OLS estimation of the following regression model: model: Perfotroanceu = ßo+ ^iCG_COMPL¡, -I- ftLEVj, + [TAj,-1-/Î4 72001 ¡, + ß5¡^it + Si, Where: PerfonTiance;, = ROA, ROE or NPM. ROA = one-year ahead retum on assets for firm i in year t, and is measured as operating income divided by average total assets; ROE = one-year ahead retum on equity for firm i in year t, and is measured as eamings before extraordinary items divided by the average book value of stockholders' equity; NPM = one-year ahead net profit margin for firm i in year t, and is measured as eamings before extraordinary items divided by sales revenues; CG_COMPL¡, = score fi-om 1 to 5 with higher scores indicating greater compliance of firm i in year t with intemational best practice conceming board stmcture and fiinctioning; LEV¡, = ratio of short-term debt plus long-term debt over total assets for firm i in year t; LNTAj, = natural logarithm of total assets for firm i in year t; Y2001 ¡t = year dummy, =1 when an observation is fi'om 2001, zero otherwise; X¡t = a vector of industry dummies based on the FTSE Global Classification System two-digit code for the industry sector. *,** and *** denote statistical significance at the 10%, 5% and 1% level respectively and is based on a onetailed test if the sign of the coefficient is in the predicted direction, and is based on a two-tailed test otherwise. T-values are adjusted for within-company dependence by using clustered robust standard errors. Results on the two-digit industry dummies are not reported for parsimony. whereas the NPM uses eamings before extraordinary items in the numerator. Both measures have sales revenues in the denominator.) This suggests that something that causes the difference between operating income and eamings before extraordinary items can explain why there is a significant relationship between performance and the extent of compliance with intemational best practices conceming board structure and functioning when using some performance measures, but not when using other performance measures. Some of the difference between operating income and eamings before extraordinary items is in interest payment and taxes. Moreover, given the Worldscope data definitions of operating income and eamings before extraordinary items, some of the difference between the two income measures stems fi'om allocations to and/or fi-om reserves, irom minority interests, from equity in eamings,^*^ and from other non-operating income and expenses. These other non-operating income and expenses include items such as: nonoperating interest income, non-operating dividend income, and the gain/ loss on disposal of assets, i.e. the income from asset disposals. To further explore what causes the difference in the relationship between corporate govemance ^^ This represents the 'pretax portion of the eamings or losses of a subsidiary whose financial accounts are not consolidated with the controlling company's accounts' (see Thomson Financial, 2003). 506 ACCOUNTING AND BUSINESS RESEARCH Table 4 Regression results using alternative operating performance measures" Retum on cash-adj. assets ROA Variable Return on sales Pred. sign Coef. estimate Pred. sign Coef. estimate Pred. sign Coef. estimate (t-statistic) (t-statistic) (t-statistic) Intercept 0.4252*** (7.14) 0.0054*** (2.38) -0.0291 (-0.90) 0.4722*** (7.11) 0.0050** (2.02) -0.0399 (-1.15) 0.4829*** (4.55) 0.0062** (2.09) 0.0901* (1.93) Industry dummies -0.0197*** (-5.33) -0.0060* (-1.82) Included 0.0220*** (-5.42) -0.0056 (-1.57) Included -0.0212*** (-3.57) -0.0048 (-1.09) Included Adj. R-squared N 49.30% 201 50.05% 201 47.90% 201 CG_COMPL + LEV 9 LNTA Y2001 + 9 This table reports the results of the OLS estimation of the following regression model: Performancei, = i^o + ;9iCG_C0MPLi, + + + Where: Performance;, = ROA, Retum on cash-adjusted assets or Retum on sales. ROA = one-year ahead retum on assets forfirmi in year t, and is measured as operating income divided by average total assets; Retum on cash-adjusted assets = one-year ahead retum on cash-adjusted assets for firm i in year t, and is measured as operating income divided by average (total assets minus cash and cash equivalents); Retum on sales = one-year ahead retum on sales for firm i in year t, and is measured as operating income divided by sales revenues; CGCOMPLit = score from 1 to 5 with higher scores indicating greater compliance offirmi in year t with intemational best practice conceming board structure and functioning; LEVi, = ratio of shortterm debt plus long-term debt over total assets forfirmi in year t; LNTAj, = natural logarithm of total assets for firm i in year t; Y2001i, = year dummy, =1 when an observation isfi-om2001, zero otherwise; X;, = a vector of industry dummies based on the FTSE Global Classification System two-digit code for the industry sector. *,** and *** denote statistical significance at the 10%, 5% and 1% level respectively and is based on a onetailed test if the sign of the coefficient is in the predicted direction, and is based on a two-tailed test otherwise. T-values are adjusted for within-company dependence by using clustered robust standard errors. Results on the two-digit industry dummies are not reported for parsimony. compliance (CG_COMPL) and performance when using the NPM instead of the ROS as the measure of performance, I compute the pairwise correlations between each one of the identified items which make up the difference between operating income and eamings before extraordinary income (scaled by sales) and the measure of corporate govemance compliance (CGCOMPL).^' I fiirther adjust operating income for each one of the items at a time and regress each one of the new income measures (scaled by sales) on the measure of corporate govemance compliance (CGCOMPL) and the control variables, i.e. I replace the dependent variable in the performance model with a new performance meastire. The results of these detailed analyses show that income fi-om asset disposals^^ (scaled by sales) is significantly negatively related to the extent of corporate govemance compliance (CGCOMPL) (correlation coefficient = -0.1869, p-value < 0.01), ^' As the performance measures used in the primary analyses, these items and the newly computed perfonnance measures are on a one-year ahead basis. •^•^ The sample companies report a gain on disposal of assets in 64% of thefirm-years,a loss on disposal of assets in 22% of the firm-years, and neither a gain nor a loss on disposal of assets in 14% of the firm-years. Vol. 39, No. 5. 2009 and that, once operating income is adjusted for the income from asset disposals and this measure scaled by sales is used as the measure of performance (i.e. the 'new ROS'), the significant relationship between performance and corporate govemance compliance (CG_COMPL), established when using the original ROS as the measure of performance, disappears. The coefficient is 0.0025, p-value > 0.10, one-sided, when using the new ROS, compared to a coefficient = 0.0062, p-value < 0.05, onesided, when using the original ROS (see Table 4). Moreover, although some other items which make up the difference between operating income and eamings before extraordinary items are also negatively related to corporate govemance compliance, none of the adjustments to operating income for these items makes the relationship between performance and the corporate govemance compliance insignificant like the adjustment for the income from asset disposals does. Taken together, the results of the additional analyses suggest that the income from asset disposals plays a major role in the disappearance of the significant relationship between performance and corporate govemance compliance, once the NPM is used instead of the ROS as the measure of performance. Management has some discretion over the timing of asset sales and previous studies (Herrmann et al., 2003; Bartov, 1993) have shown that the timing of assets sales is used as an instrument to manage eamings. More specifically Bartov (1993) finds that companies use the timing of asset sales to smooth income, i.e. report a higher (lower) income from asset sales in years in which (pre-managed) income is lower (higher) compared to the previous year. Further analyses^^ indicate that this study's sample companies present similar behaviour. Moreover, the extent of corporate govemance compliance (CG_COMPL) is significantly negatively correlated with the occurrence of a lower (pre-managed) income compared to the previous year (correlation coefficient = -0.2076, p-value 0.15, one-sided, when using the new ROA, compared to a coefficient = 0.0054, p-value
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Running Head: CORPORATE GOVERNANCE COMPLIANCE

Corporate Governance Compliance
Name
Institution

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CORPORATE GOVERNANCE COMPLIANCE

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Corporate Governance Compliance
The scope of the paper is limited to exploring the relationship between the operating
performance of large European corporate entities and its compliance. The author’s hypothesis on
this subject matter is that all factors remaining constant, the performance of an entity is influenced
by the compliance of the organization to the recommended best practices. The sample of
companies selected for this analysis is picked from a limited timeframe, 2000-2001. The rationale
for this timespan is that during that period there was considerable variation in the governance
practices.
Besides, corporate entities faced considerable pressure from other oversight institutions to
comply with the recommended industry best practices. It is important to point out here that the
performance of the stock market is not considered in this case, rather consideration is only made
for corporate performance. The study is partly necessitated by the need to evaluate the accuracy of
an earlier study depicting the presence of negative correlation between corporate governance and
the level of compliance. A second motive of the study is to clarify the conflict between theory and
the findings of a previous research.
Theoretically, there should be a positive correlation between compliance and corporate
performance. To reaffirm this theoretical inclination, a previous study in the United States
confirms the presence of a positive correlation between corporate performance and the level of
compliance with the industry best practices. To narrow down the assessment, the author uses board
structure functions as a metric to measure of corporate governance. The rationale for using this
metric is that these are the two principal dimensions of corporate governance that have the highest
direct impact on the ...


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