Impact of Corporate Governance

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Impact of Corporate Governance Principles on Entity Financial
Performance: Evidence from South Africa
Submitted in partial fulfilment of a Master’s degree in
Accounting & Finance
Students name and ID:
Supervisors name:
Date:
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Table of Contents
1. INTRODUCTION …………………………………………………………………………………………………………..3
(a) Background……………………………………………………………………………………………………………..3
(b) Research Rationale……………………………………………………………………………………………………3
(c) The Purpose of the Research………………………………………………………………………………………4
(d) Research Question ……………………………………………………………………………………………………4
2. LITERATURE REVIEW …………………………………………………………………………………………………5
2.1 Review of Literature on Corporate Governance ……………………………………………………………5
2.2 Theoretical Stance…………………………………………………………………………………………………….6
3. METHODOLOGY AND METHODS………………………………………………………………………………..7
4. SIGNIFICANCE OF PROPOSED RESEARCH………………………………………………………………….9
5. PROVISIONAL WORK SCHEDULE……………………………………………………………………………..10
6. REFERENCES ……………………………………………………………………………………………………………..11
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1. INTRODUCTION
(a) Background
South Africa experienced socio-economic and political changes in the late 1980s’and early
1990s’ (Ntim, 2009) as the apartheid era came to an end through extensive negotiations. Part
of the economic changes that were being crafted included improving how entities are governed.
South Africa’s efforts at improving its corporate governance were also at the same time with
other developed countries in enhancing the efficacy of corporate governance around the world
(Rossouw, et al., 2002). The international response to develop legislation, regulations and/or
codes to guide corporate governance in different jurisdictions had been a direct response to
scandals that led to the failures at Enron, Parmalat, Tyco, Worldcom etc. These company
failures have been largely attributed to the breakdown in corporate governance within these
entities (Cadbury Committee, 1992, para 1.9; Jones and Pollitt, 2004).
As a response to all these scandals, South Africa through the Institute of Directors Southern
Africa set up a committee that was chaired by retired Judge Mervyn King (Ntim, 2009). The
committee issued its first report in 1994 which is the Code of Corporate Governance and
popularly referred to as King I report. Enhancements and improvements have been made to the
original report and reports issued/published in 2002, 2009 and 2016 which are referred to King
II, King III and King IV reports respectively. The Code of Corporate Governance is required
to be mandatorily implemented for all public entities and any listed entities on the
Johannesburg Stock Exchange (King Committee, 1994, 2002, 2009, 2016).
South Africa has recently experienced scandals of its own at the Public Investment Corporation
(PIC), VBS Mutual Bank, African Bank, and Steinhoff. This has called into question if the
corporate governance principles being followed are safeguarding the interests of owners of the
entities. Research about the board leadership, composition and the audit committees has been
in the spotlight as the scandals are supposed to be prevented by these governance principles in
place.
(b) Research Rationale
Corporate Governance has been a widely researched topic in the developed countries and has
built sufficient empirical evidence as to its impact on an entity’s performance from an
accounting perspective or entity valuation. However limited research has been performed for
emerging/developing countries such as South Africa) to determine the relationship that exists
between corporate governance principles and entity financial performance. Ntim (2009)’s
studies were based on King Committee (2002), which was published in 2002. Enhancements
have been performed on this King Committee (2002) (King II) report, in 2009 which is known
as King Committee (2009) (King III) and in 2016 which is known as King Committee (2016)
(King IV). No empirical research has been identified as been done since 2009 to determine the
relationship that the enhancements to the King III: Code of Corporate Governance to the entity
financial performance. This is also the period after the 2008 Global Financial Crisis.
Research/studies performed on corporate governance in Africa or emerging markets has been
mainly performed on a cross country sample (Klapper & Love, 2002; Coleman
2007 etc), which tends to lead to bias in the sample selection as the researchers focus on the
entity’s size and investor’s interest, and therefore the research has not looked on South Africa
exclusively and therefore are affected by the different cultures, business environment and
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economic set-up. This research will contribute to empirical evidence that has been obtained
from a sample of exclusively South African entities.
(c) The Purpose of the Research
The research/study being undertaken is meant to highlight the effect that corporate governance
principles has had since its introduction in 1994 on the financial performance of listed entities
that has been adopted in South Africa. The King Committee which first published the Code of
Corporate Governance in 1994 has constantly updated and reviewed the code so that there is
greater clarity on its principles as King II was published in 2002, King III was issued in 2009
and recently King IV was issued in 2016 (King Committee, 1994, 2002, 2009, 2016). Limited
empirical studies have been carried out to determine the relationship between corporate
governance and financial performance with regards to King II but no empirical studies have
been performed after King III was published. This therefore provides an opportunity for new
empirical studies on corporate governance that have been limited in Sub-Saharan Africa and
have not identified any data that has been collected post 2009 when King III was published.
This research will therefore provide new empirical evidence on the relationship between
corporate governance principles and entity financial performance from listed South African
entities. The financial performance will cover both the accounting ratios as well as firm
valuation.
(d) Research Question
The questions that this research will address is to determine the relationship that exists between
corporate governance principles and entity financial performance in South Africa. The specific
question being is, what is the relationship between Board Leadership, Board Composition,
Audit Committee and Financial Performance?
The main objective of this study is to determine relationship between the corporate governance
principles and financial performance in South Africa where the Code of Corporate Governance
by the King Committee has been adopted. The specific objectives are:
1. To determine the relationship between board leadership and financial performance?
2. To determine the relationship between board composition and financial performance?
3. To determine the relationship between audit committees and financial performance?
.
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2. LITERATURE REVIEW
2.1 Review of Literature on Corporate Governance
Corporate Governance has been a widely researched topic in the developed countries and has
built sufficient empirical evidence as to its impact on an entity’s performance from an
accounting perspective or entity valuation. However limited research has been performed for
emerging/developing countries such as South Africa) to determine the relationship that exists
between corporate governance and entity financial performance. Ntim (2009)’s studies were
based on King Committee (2002), which was published in 2002. Enhancements have been
performed on this King Committee (2002) (King II) report, in 2009 which is known as King
Committee (2009) (King III) and in 2016 which is known as King Committee (2016) (King
IV). Limited empirical research has been identified as been done since 2009 to determine the
relationship that the enhancements to the King III: Code of Corporate Governance to the entity
financial performance. This is also the period after the 2008 Global Financial Crisis.
(a) Board Leadership
Prior empirical research has shown mixed bag or results when it comes to the correlation of the
entity financial performance to board leadership, whether the board chairperson should be
independent to the CEO (e.g. Rechner & Dalton 1991; Dahya et al., 1996; Ho & Williams,
2003; Donaldson & Davis, 1991 etc).
Rechner and Dalton (1991)’s investigation on 141 large US corporations from 1978 to 1983
noted a positive relationship between a separate board chairperson and the entity’s financial
performance even though the study was criticised based on its sampling, used only accounting
measures. Dahya et al. (1996) using UK listed firms also identified a positive trend as that of
Rechner and Dalton (1991). Haniffa & Hudaib (2006) report that entities that separated the
two roles performed financially (ROA) better than those that vested the two roles in one
person.
However, Ho and Williams (2003) using a sample of 84 South African listed firms reported a
negative link between a firm’s physical and intellectual capital performance and role or CEO
duality. This was also confirmed by a group of researchers that were able to identify the same
negative correlation this supporting duality of the CEO and Chairperson’s roles (e.g.,
Donaldson & Davis, 1991; Boyd, 1995; Kiel & Nicholson, 2003 etc) The following
hypothesis will be tested:
H1: Board leadership relates positively to entity financial performance.
(b) Board Composition
A board with a majority of independent and non-executive directors is meant to composition
of help reduce the agency problem (Hermalin & Weisbach, 1991; Weisbach, 1988) A positive
relationship is therefore expected between an entity’s financial performance and the proportion
of independent/non-executive directors sitting on the board. Independent and non-executive
directors are more likely to challenge the CEO. It is perhaps in recognition of the role of
independent and non-executive directors that in South Africa that they must constitute the
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majority of the board (King Committee, 2009), in the UK a minimum of three outside directors
is required on the board; and in the US, the regulation requires that they constitute at least twothirds of the board (Bhagat and Black, 2001).
Empirical studies that have been performed to date have indicated conflicting results. Studies
by Weisbach (1988) and Gupta and Fields (2009) have produced evidence in support of a
positive role for outside directors on firm performance. Other studies have reported no evidence
of a significant relationship between entity financial performance and the proportion of outside
directors on the board (Bhagat and Black,1999, 2000; Hermalin and Weisbach, 1991; and
Yermack, 1996).
Ntim (2009) has stated that recent studies carried out in developing countries by El Mhendi
(2007) and Mangena & Tauringana (2008) report evidence, which is entirely consistent with
prior research that boards dominated by independent and non-executive directors perform
better for listed firms from developing countries , Tunisian and Zimbabwean respectively. The
following hypothesis will be tested:
H2: Board composition relates positively to entity financial performance.
(c) Audit Committee
Limited empirical studies have been performed on the relationship of Audit Committees with
that of the entity’s financial performance. Establishment of an audit committee is one of the
corporate governance principles that is meant to improve the financial management of an entity
and therefore its financial performance as well (Coleman, 2007). Markets react favourably to
earnings report after the establishment of Audit Committees (Wild, 1994). Coleman, 2007’s
result of the study on Audit Committees were mixed and could have been due cross-country
sampling (Ghana, Nigeria, South Africa) that were utilised which distorted the result due to
differences in business environment, culture etc. The following hypothesis will be tested:
The research question that has been formulated the research is going to test the following
directional hypothesis:
H3: Establishment of an audit committee relates positively to entity financial performance.
H4: Majority of audit committee are independent or non-executive directors relates positively
to entity financial performance.
2.2 Theoretical Stance
The Agency Theory (Berle & Means, 1932) and expounded by (Jensen & Meckling, 1976),
has been the dominant framework for corporate governance but is not the only theoretical
framework available. Studies have been performed which has used this framework on corporate
governance principles/structure and firm performance (Bhagat & Black, 2002; Heenetigala &
Armstrong, 2011, Klapper & Love, 2002). Jensen & Meckling, 1976 p 311, defined an agency
relationship as a “contract under which one or more persons (the principal(s)) engage another
person (the agent) to perform some service on their behalf which involves delegating some
decision-making authority to the agent”.
The agency theory highlights the responsibility of the principal and agent who are the
shareholders and management respectively. This has been further emphasised by Fama,(1980)
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who has assigned responsibilities based on the type of decisions assigned to the being, to the
role players in the corporate governance web, which is management decisions and control
decisions. The risk bearers who are the shareholders are responsible for making controls
decisions which involve monitoring and ratification of management decisions but also come
with responsibility of providing capital required for the operations.
Generally, the interests of the principal are prudent management of their firms, growth and
expansion of the firm and ultimately the profitability of their investment. However, this is not
always the case due to agency problems brought about by information asymmetry and moral
hazard challenges. To reduce these agency challenges, the Principals(shareholders) should
appoint the board of directors, composed of independent and non-independent board members
with a view of monitoring the activities of the management team (Jensen & Meckling, 1976;
Peters & Bagshaw, 2014). To deal with the identified agency challenges, agency costs are
incurred to ensure that the interests of the principal are aligned to the those of the agent (Jensen
& Meckling, 1976), and these include monitoring expenses, bonding fees and the residual loss.
The Agency theory has also had its fair amount of criticism due its assertion that managers will
not get the job done without outside monitoring. In contrast to this general view, managers are
motivated to serve the interests of their shareholders and be trusted with responsibility while
being accountable (Donaldson & Davis, 1991). Donaldson & Preston (1998) who are
proponents of the stakeholder theory have contended that it views company as an entity, where
diverse participants come together to attain desired results. Chitayat (1985 articulates that one
of the critical issues that influences organisational performance and shareholder returns is how
the organisation is structured to allow managers to take effective action.
3. METHODOLOGY AND METHODS
The research study is going to be performed on listed entities on the main bourse of the
Johannesburg Stock Exchange in South Africa. A random sample of 40 listed entities will be
selected over a period of 5 years from 2011 to 2015, so my sample population will be 200 units.
The Johannesburg Stock Exchange has the following industries; Oil & Gas, Basic Materials,
Industrials, Consumer Goods, Health Care, Consumer Services, Telecommunications,
Financials and Technology.
A longitudinal analysis of secondary data from the selected entities published annual reports
over a period of 5 years. The annual reports will be downloaded from the respective websites
or rest of the world filings of the Perfect Information Database in electronic format. Entities
listed on the Johannesburg Stock Exchange are required to comply to the Code of Corporate
Governance and therefore have to publish Annual and Integrated reports (King Committee,
1994, 2002, 2009, 2016) . These reports contain information and summary biographs on board
members as well as audit committee membership. Financial information will be collected from
DataStream to determine the accounting ratios and firm value.
The entities in our final sample should meet the following criteria; have the entity’s complete
5 years annual reports from 2011 to 2015 inclusive available and the requisite financial
information for those years must be available on DataStream. An Ordinary Least Squares
(OLS)regression analysis will be used on a presumed linear relationship and the independent
variables will be the Board Leadership, Board Composition, and Audit Committee. The
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dependent variable will be the financial performance indicators being the Return on Assets and
Tobin’s Q.
The information that is going to be used for this research is widely available and no ethical
approvals are required to use or obtain the information.
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4. SIGNIFICANCE OF PROPOSED RESEARCH
This research is going to be carried on a sample of South African listed companies from the
period of 2011 to 2015 and in my literature review identified the following:
1. South Africa was one of the first developing countries to introduce corporate
governance in 1994 (Aguilera & Cuervo-Cazurra, 2009), however empirical evidence
with regards to Corporate Governance in South Africa has been very limited. Limited
empirical evidence has been collected relating to the South African market post 2010
when was King III effective after publication in 2009 (King Committee, 2009)and post
the 2008 Global Financial Crisis which had huge impact on stock/share prices.
2. Most of the papers written with regards to Corporate Governance for emerging
countries in Africa have selected their samples across several African countries. The
extant literature suggests that corporate governance structures and systems vary
across different countries (Aguilera & Cuervo-Cazurra, 2009). This research will be
performed specifically on South Africa listed entities.
3. The Johannesburg Stock Exchange had a market capitalisation of US$892 Billion in
October 2018 (CEIC data website). Failure in corporate governance will have serious
implications that may reach beyond Africa due to South Africa being rated as
investment grade by rating agencies such as Moody’s, and Standards & Poors.
(a) Research Limitations
The identified limitations of this research are as follows:
1. The information that is to be used for this research will be extracted from annual
financial statements of the entities and which have been prepared taking into account
management estimates that may be subjective and the policies adopted by different
entities are not consistent which may cause distortions in the results e.g. Assets being
valued on a cost basis or revaluation basis. Also, the financial statements might have
been prepared using a differing financial reporting standard that may distort the results.
2. The research will be looking at entities that are listed on the Johannesburg Stock
Exchange and must not be generalised as a study that includes other emerging countries
in Africa or even entities listed Alternative Listed Market which does not require
compliance to the Code of Corporate Governance by the King Committee.
3. The research is not going to look at the total compliance with all the King III principles
and therefore will not able to determine the sensitivity of certain principles.
4. The research does not take into consideration that King’s Code of Corporate
Governance that permits non-complying entities to explain why they have not complied
with the principles and assess the reasonability.
(b) Direction of Future Research
1. More empirical evidence must be obtained from other emerging economies/countries
so as to determine the relationship that corporate governance principles has on entity
financial performance in South Africa and other emerging countries.
2. King III report which has an enhancement of the earlier issued reports was issued in
2009 and is applicable effective 31 March 2010 and limited research has been
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performed to confirm if entities are complying with its requirements which will also be
assessing the qualitative aspects of comply or explain.
5. PROVISIONAL WORK SCHEDULE
No.
Activity
Start Date
Days
End Date
1.
Introduction
06/05/19
9
14/05/19
2.
Overview of Corporate
Governance
15/05/19
7
21/05/19
3.
Literature Review
22/05/19
13
03/06/19
4
Research Methodology,
Design and Methods
04/06/19
9
12/06/19
5
Research Analysis and
Discussion of Results
Data Collection
13/06/19
20
02/07/19
Data Analysis
03/07/19
14
16 /07/19
Write Up
08/07/19
14
21/07/19
6
Conclusions and
Recommendations
22/07/19
15
31/07/19
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Coleman, K. A., 2007. Corporate Governance and Firm Performance in Africa: A Dynamic
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