Submitted in part fulfilment of the requirements for the degree of

Master of Science in Accounting and Finance

Corporate Governance and Accounting Quality

by

Basim Abdullah

Faculty of Arts and Social Sciences

University of Surrey

September 2016

Word count:11,374

© Basim Mohammad Abdullah

ii

Abstract

The core objective of this study is to examine how corporate governance mechanisms can

efficiently impact and improve the accounting quality within a firm. This research has been done

in light of existing literature on similar subjects regarding tools of corporate governance in

mitigating the agency cost to help enhance accounting quality. Along with the main research

element of accounting quality, this study also highlights the impact of corporate governance on

agency cost, that arise in cases where there is a separation of ownership and control.

Existing literature supports the theory that in general, corporate governance codes help improve

the financial reporting and accounting quality within a firm. For this research, a set of 92 out of

FTSE-350 UK stock exchange firms have been selected for empirical analysis, the number trimmed

down based on limited availability of required data and after taking out those belonging to the financial

sector. Time frame considered for the dataset is from year 2000 to 2011 and since the gathered data is

spread over multiple years, it creates the data in a Panel form on which Fixed Effects and Random Effects

Model are used for empirical testing. These models have been decided upon the outputs of Hausman

Tests.

After thorough research on relevant topics as well as existing published articles, hypotheses for

this study were created. Upon empirically examining the hypotheses, findings of this study

document that strong corporate governance attributes among the firms in the dataset will lead

to lower agency costs and improved accounting quality. In addition, the results of this study are

in line with previous researches. The results confirm that components of the board, board

compensation and ownership structure have an important influence on the firms accounting

quality and are positively related.

The contribution of this study to the existing literature is that four key elements of corporate

governance namely; independent directors, board structure, board compensation and ownership

structure have been examined together to understand the impact they have on accounting

quality. Previous studies have not had these four elements and their impact discussed together.

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iv

List of Figures

Figure 1 Graphical Analysis of Expense Ratio………………………………………………..36

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List of Tables

Table 1 Descriptive Statistics Analysis …………………………………………………….....26

Table 2 Independent Directors and Accounting Quality……………………………………...28

Table 3 Components of Board and Accounting Quality……………………………………....31

Table 4 Board Compensation Structure and Accounting Quality…………………………….33

Table 5 Board Ownership and Accounting Quality…...............................................................35

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Table of Contents

Title Page……………………………………………………………………………………….i

Abstract……………………………………………………………………………....………..ii

Declaration of Originality…………………………………………………………………...iii

List of Figures…………………………………………………………………………………iv

List of Tables…………………………………………………………………………………..v

Table of Contents……………………………………………………………………………..vi

Acknowledgements …………………………………………………………………………viii

Abbreviations…………………………………………………………………………………ix

Chapter 1. Introduction

1.1 Overview of Research……………………………………………………………...1

1.2 Research Question………………….………………………………………………2

1.3 Background and Objectives of Study………………………………………………2

1.4 Organization of the Study…………………………………………………………..4

Chapter 2. Literature Review

2.1 Accounting Quality…………………………………………………………………6

2.1.1 Accounting Quality and Corporate Governance……...……………………….8

2.1.2 Accounting Quality and Independent Directors……………………………….8

2.1.3 Accounting Quality and Board Structure……………………………………...9

2.1.4 Accounting Quality and Age, Education & Experience……………………….9

2.1.5 Accounting Quality and Gender & Ethnic Diversity………………………....10

2.1.6 Accounting Quality and CEO Duality………………………………………..11

2.1.7 Accounting Quality and Executive Compensation…………………………....11

2.1.8 Accounting Quality and Ownership Structure………………………………..11

2.2 Corporate Governance and Agency Cost………………………………………………….12

2.3 Independent Directors……………………………………………………………………..12

2.4 CEO Duality……………………………………………………………………………….13

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Chapter 3. Methodology

3.1 Hypotheses Development and Purpose of the Study…………………………...…14

3.2 Empirical Approach……………………………………………………………….16

3.2.1 Panel Data Analysis…………………………………………………………..16

3.2.2 Fixed and Random Effect……………………………………………...……...17

3.3 Sample Selection and Data Collection………………………………………….…17

3.4 Definition of Variables……………………………………………………………18

3.4.1 Dependent Variable…………………………………………………………..18

3.4.2 Independent Variables………………………………………………………..19

3.4.3 Control Variables…………………………………………………………….20

3.5 Regression Model…………………………………………………………………21

Chapter 4. Analysis of Model

4.1 Descriptive Statistics Analysis……………………………………………….……24

4.2 Empirical Analysis……………………………………………………..……...…..27

4.3 Graphical Analysis………………………………………………….……………..36

Chapter 5. Critical Analysis and Discussion

5.1 Discussion of the Results………………………………………………………….37

5.2 Implications of Research………………………………………………………….40

5.3 Conclusion………………………………………………………………………...41

5.4 Limitations………………………………………………………………………...42

5.5 Recommendations for Future Research…………………………………………...42

References………………………………………………………………………………….…43

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Acknowledgements

I would like to express my profound gratitude to my supervisor Dr Monomita Nandy for her

support and guidance throughout this study. She was always available for discussions and her

timely and regular feedback were instrumental in the successful completion of this research

project.

I would also like to thank my parents, family and friends who supported me during the course

of this program. This would not have been possible without any of them.

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Abbreviations

LEVE_R Leverage Ratio

SIZE_R Firm Size

TOBIN_R Tobin’s Q Ratio

NEDIR_RATIO Ratio of Independent Outside Directors

REC_2008 Pre-Recession (2008)

WAGE_EDIR Wage of Executive Directors

EQUITY_EDIR Share of Executive Directors in Equity

AGE_AVG_T_DIR Total Age of the Directors

EDU_AVG_T_DIR Total Education of the Directors Index

EXP_AVG_T_DIR Total Experience of Directors in Years

NAT_AVG_T_DIR Ethnic Diversity

MALE_AVG_T_DIR Gender Diversity

CEO_DUAL Dual Role of CEO and Chairman of the Board

BONUS_EDIR Remunerations of Executive Directors

EQUITY_T_DIR Equity Held by Total Number of Directors

FTSE Financial Times Stock Exchange

SPSS Statistical Package for Social Sciences

CEO Chief Executive Officer

UK United Kingdom

US United States of America

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CHAPTER 1

Introduction

1.1 Overview of Research

The aim of this study is to thoroughly understand the impact of corporate governance

mechanisms on accounting quality. Accounting quality refers to the true and fair view of the

firm’s financial reporting information. The board of directors have influence over the financial

reporting and can tamper the values to enhance the firm value, giving rise to agency problems.

There is strong evidence that corporate governance mechanisms are effective in mitigating

agency problems and improving accounting quality (Ang et al., 2000; Florackis 2008). It is

important to establish that agency problems arise when there is a separation of ownership and

control of a firm and not in cases where both are handled by the same party.

Corporate governance emphasizes on the importance of accounting quality and not to mislead

the shareholders. To do so, it recommends several corporate governance mechanisms to further

improve the accounting quality. Prior researches document strong corporate governance should

be adhered to in order to circumvent restatement of financial statements (Core et al., 1999;

Loomis, 1999; Palmrose & Scholz 2004). This study examines the recommendations of

corporate governance and their impact on the accounting quality.

With a rise in corporate scandals in the recent past, this study is aimed to support decision

making processes of to be investors and looks to provide a fresh analysis on existing researches.

Importantly, it comprises of the four key elements of corporate governance, namely, the impact

of independent directors, impact of board structure, executive compensation and ownership

structure on accounting quality within a single study.

On the other hand, different tools of corporate governance, including the number of independent

outside directors which is a major recommendation of Cadbury Code of Best Practice (1992),

components of the board of directors, executive compensation and ownership structure for the

UK listed firms has been empirically evidenced. It is important to identify the mechanisms of

2

corporate governance that enhance accounting quality as poor reporting may in turn affect the

financial and investment decisions within the firm. This leads to the research question.

1.2 Research Question

Can accounting quality in FTSE-350 firms be enhanced by adhering to corporate governance

mechanisms?

1.3 Background and Objectives of Study

During the era of Industrial Revolution in the mid 1800’s, a number of changes occurred in the

behavior of the corporate sector. This was also a phase when technological advancements took

place. Adoption of new technologies were on the up-rise as production processes started to be

less time consuming, eventually leading to an increased number of output. Since new

technologies are expensive to set up but play an important part in reducing costs of production

and adding to economies of scale, corporations were in severe need of additional finance for

investment in technology.

During this time, the required additional capital could either be fulfilled by loan or joint stocks.

It was here when people in the society inclined towards investing in corporations which worked

out well for both; the firm received its requirement for cash and the investors started getting

return on their investments.

In such a situation, investors become risk bearers as they are not involved in any managerial

roles since the management controlling assets of the firms is different to the people who have

invested. The motive behind separation of management and shareholders could be reasoned as

a gap of expertise and skills between both the parties. Thus, it became necessary to disclose all

relevant information to the shareholders about how their investments are being used as better

reporting quality was demanded by the shareholders. In presence of the thread of literature,

corporate governance has found to be useful for enhancing the accounting quality.

The structure in which legal, traditional and institutional factors that help the shareholders to

exercise their rights on managerial decision-makings is known as corporate governance

(Weimer and Pape, 1999). The definition of corporate governance can be as: a set of laws, rules

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and some other elements like independent outside directors, remuneration committee, separation

of CEO and chairman that help run a company and control its operations (Gillan and Starks,

2003). For improving accounting quality, different types of corporate governance tools can be

employed. Among all these different tools of the corporate governance, number of independent

outside directors is important. Independent directors are not the direct employees of the

company, instead they are elected members of the board and they have no relation with the firm

or with the person who is associated with the firm. Studies show a positive relation between

independent directors on board and the accounting quality of the firm (Bushman et al., 2004;

Mace, 1986).

Independent directors are important to avoid and if required, resolving agency problems as they

have strict accountability criterion and have the authority to decide fair compensation or

remuneration for executive directors, which means in effect they are helpful in mitigating

agency costs (Singh and Davidson, 2003).

An important tool of corporate governance is the executive compensation; which are the salaries

and remuneration to the executive directors and work as important indicators for mitigating

agency problems. With a sound compensation and salary structure, there is always a higher

probability of directors working in the best interest of the firm. There is evidence that fair

compensation to executive directors support in mitigating agency cost (Florackis, 2008).

A combination of experience, skill and education among the board can also significantly help

reduce accounting quality. While young minds can support with technological suggestions to

improve and maximise firms’ assets, experienced directors can take bold decisions for the

betterment of the firm. The experience of the board of directors may also allow them to compete

in the market and to deal with risky trends.

The dual role of CEO and chairman is most likely to negatively impact a firms’ performance

and accounting quality as with dual roles, CEO may influence the board of directors by voting

for their own vested interests through compensation which may influence the effectives of audit

committees. Another important mechanism is executive ownership in which some share of

equity is held with the executive as well as non-executive directors that helps for an improved

performance with the purpose of asset maximisation.

4

With technological advancements began the rise of inter country trade through multi-national

companies and started economic linkage of countries. This also meant that disturbance in

economic patterns of one country began to impact others, in the same way as the financial crises

in 2008 lead to the recession spread across the world.

This study looks at large publicly traded companies and how their financial reporting and

accounting quality can be strengthened with a look at corporate governance mechanisms. As

this research looks at large public companies of FTSE-350, there is a probability of finding

agency problems within them. Panel estimation techniques are used as part of the panel data,

along with methods of data analysis including Fixed and Random Effects Model for empirical

analysis.

1.4 Organisation of the Study

The first part of this study analyses the accounting quality and its related problems and discusses

the suggestive tools in mitigating the issue under prior literature. Second part of this study purely

investigates the previous literature and provides evidence for the theoretical model and also

helps in building the hypotheses. The third part of this study, investigates data sample, sources

of the data and effective tools for empirical analysis. The fourth section empirically extends the

support to assumed hypotheses and this is capped with the final section on conclusion of the

four segments.

Following the five chapters are references. Here is a description of each of the chapters.

Chapter 1 of this study starts with an overview of research, background and objectives of study.

It introduces the research question and describes the specific problem to be addressed.

Chapter 2 presents a review of existing literature and relevant research associated with the

question stated earlier. This is the core section of the study as it provides support in the

derivation of hypotheses.

Chapter 3 presents the methodology of the study. It is in this section where the hypotheses

assumed will be introduced along with variable operationalisation– identification, description

and the measurement criteria used. This section will also describe testing methods used for

empirical analysis of panel data. Additionally, number of firms selected in the sample and their

5

selection criteria known as sample design will be discussed along with the method used and

sources accessed to retrieve the required data. This chapter concludes by introducing the model

equations for study.

Chapter 4 provides with results obtained from regression analysis through SPSS software. The

output of results is then put together in a tabular form supported by the explanation of the

findings. The chapter ends with the results of hypotheses.

Chapter 5 Summary of this study along with a conclusion of the analysis are mentioned in this

chapter. A link between this research and the existing literature is also made. Towards the end,

limitations faced during the course of this study and recommendations for future research are

mentioned.

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CHAPTER 2

Literature Review

2.1 Accounting Quality

The accuracy with which the financial reports communicate the information about the firms’

operations to its investors, specifically about the company’s cash flows is known as financial

accounting quality (Biddle et al., 2009). Another study states that accounting quality is the

accrual accounting that aids the measurement of the underlying economic performance (Dechow

et al., 2010). Extreme significance has been put on the accuracy and the quality of the

information provided by the financial reporting statements as the decisions of prospective

investors, creditors, etc. are based on these. Literature provides with evidence that the

accounting quality is also connected with tax reporting enticements (Guenther and Young, 2000;

Haw et al., 2004). Another study revealed that accounting quality can be further enhanced by

eliminating substitute accounting methods which are less reflective of a firms’ performance, and

are used by managers to manage earnings (Barth et al., 2008).

However, some studies based on accounting quality reveal that it is essentially or primarily

determined by accounting standards (Ball et al., 2000; Leuz et al., 2003; Ball and Shivakumar,

2005; Burgstahler et al., 2006). A study based on US and Non-US firms reveal that firms in

compliance of US GAAP have higher accounting quality (Lang et al., 2006). Improved

accounting quality was noticed in firms applying IAS and adopting it compared to ones who did

not (Barth et al., 2008). The effects of adopting IFRS on accounting quality investigate sectors

other than the financial industry (Hung and Subramanyam, 2007; Barth et al., 2008; Christensen

et al., 2008). Interestingly, former studies show that results about the influence US GAAP and

the IFRS have on the quality of financial reports are mixed (Psaros and Trotman, 2004; Amir et

al., 1993; Van der Meulen et al., 2007; Ashbaugh and Olsson, 2002; Barth et al., 2008; Bartov

et al., 2005). There exists no comprehensive evidence about accrual models concerning the

quality of financial reporting (Healy and Wahlen, 1999).

7

Financial reporting quality and its relationship with the mechanisms of corporate governance

were highlighted by (Cohen et al., 2004). Several studies reveal that a company with poor

corporate governance mechanisms, such as internal controls, are more likely to have the quality

of their financial reporting decreased (Dechow et al., 1996; Beasley, 1996; Rezaee, 2003).

Having strong corporate governance enhances the probability of true and fair view or the faithful

representation of the financial reporting quality (Sloan, 2001; Holland, 1999). Prior literature

suggests that researchers have based their questions about corporate governance and its impact

on financial reporting quality on the Western agency theory (Firth et al., 2007). Sufficient

literature proves that institutional investors act as crucial monitoring agents and play an

important role in improving the quality of financial information being reported quality (Shleifer

and Vishny, 1997; Chung et al., 2002; including many others).

External auditors can also improve the quality of reporting by limiting earnings management

(Nelson et al., 2002). Investors consider financial reports as their initial source of independently

certified information (Sloan, 2001). Users of the financial statements rely on information

provided by the management and on auditors to certify its credibility (Chen et al., 2000; Chow

and Rice, 1982; Dopuch et al., 1986). Quality of reporting is positively associated with auditor

quality (Francis, 2004). If financial reports are not misleading, then they provide quality

financial reporting (Jonas and Blanchet, 2000). Quality of financial information improves with

independent directors on board who are free from any material stake in the company, apart from

remuneration they receive (Higgs Report, 2003). Studies about developed countries reveal a

positive relation between a board having higher percentage independent directors and the quality

of financial reporting (Beasley, 1996, Dechow et al., 1996; Peasnell et al., 2000; Klein, 1998;

Davidson et al., 2004). As independent directors are not involved in the day to day running of

an organization, their presence acts as an effective monitoring tool and hence provides with

better reporting quality (Peasnell et al., 2000). On the other hand, boards of companies with

higher number of outside directors are likely to suffer from monitoring of accounting quality,

which eventually leads to unusual abnormal accruals (Klein, 2002).

8

2.1.1 Accounting Quality and Corporate Governance

A link between corporate governance and the earnings quality was examined. Researchers

conclude that earnings quality significantly improves only in firms that observe supreme levels

of corporate governance (Jiang et al., 2008). In the wake of corporate scandals of Enron,

WorldCom, etc., it became very important to ensure highest levels of corporate governance are

being met to avoid restatements of earnings (Core et al., 1999; Loomis, 1999; Palmrose and

Scholz, 2004).

2.1.2 Accounting Quality and Independent Directors

Previous literature regarding corporate governance and the financial reporting quality has

mainly been focused on board characteristics, specifically board independence. Companies with

financial statement frauds have less independent directors on their board than the companies

with no fraud (Beasley, 1996). Earnings quality is also further improved with independent

directors (Firth et al., 2007). Having independent directors on board enriches the relevance and

the credibility of the financial information available to the intended users (Mace, 1986). A

research on firms in Greece suggest that more independent directors on board means higher

board independence, which enhances the quality of earnings reported further (Dimitropoulos

and Asteriou, 2010). Board of directors being independent mitigates earnings management

(Klein, 2002; Peasnell et al., 2000). Quality of financial reporting is improved with outside

directors on board (Bushman et al., 2004).

Many other studies emphasize the importance of having independent directors on board as they

influence the quality of financial reporting in a positive manner (Baysinger and Butler, 1985;

Daily and Dalton, 1993; Barnhart, 1994). A study based on the UK firms reveal that the quality

of information disclosed is enhanced with an independent board (Beekes et al., 2004). On the

other hand, other studies suggest that directors being independent are not sufficiently competent

to make a difference in the quality of reporting (Petra, 2007; Bradbury et al., 2006; Ahmed et

al., 2006). Researchers argue that there will be an adverse effect of having independent directors,

on the financial reporting quality (Jensen and Meckling, 1976; Bhagat and Bolton, 2008).

9

Furthermore, there are few other researches where no significant relationship was found

between the financial reporting quality and independent directors (Hermalin and Weisbach,

1991; Dalton, 1998).

2.1.3 Accounting Quality and Board Structure

Structuring of a board is crucial for the success of any organization, and is a key determinant of

the roles and duties of the board members (Deutsch, 2005; Minichilli et al., 2009). A board of

directors is formed which is comprised of insiders (the top management) and outsiders (to

monitor top management (Fama, 1980). Early studies document that having a small board size

is effective for communication with the management and hence improves the quality of financial

reporting (Jensen, 1993). The separate roles of the CEO and the chairman are considered to be

part of a board structure, which are in favour of the shareholders (Jensen, 1993; Goyal and Park,

2002; Brickley et al., 1997). Researchers argue that having independent directors as a part of

board structure steer the company away from accounting issues which may eventually lead to

the restatement of earnings (Agrawal and Chadha, 2005). Numerous empirical studies show

agency costs are reduced when the CEO and chairman roles are separated (Rechner and Dalton,

1991; Pi and Timme, 1993). Empirical investigation of higher number of outside directors as a

rise in the firm’s performance gives strength to the decision to have more outside directors on

board (Choi et al., 2007). Size of a board holds a significant importance, as size and

communication problems are positively related (Hermalin and Weisbach, 1991). Other

researchers also found a positive relationship between the two (Klein 1998; Pfeffer 1972). On

the other hand, prior literature suggests that the size of the board has a significant negative

relationship with the firms’ value (Eisenberg et al., 1998; Yermack, 1996).

2.1.4 Accounting Quality and Age, Education & Experience

A research reveals that the age of a CEO and the quality of financial reporting is positively

related (Huang et al., 2012). A study carried out to determine the relationship between the

financial expertise of directors and corporate governance show a positive relationship. This was

further strengthened by a researcher suggesting that there in an inverse relationship between the

10

directors with financial expertise and any irregularities in the financial reporting (Cunningham,

2007). Experienced board will help with their skills, expertise and knowledge in delivering

transparent and improved quality of financial information (Dahya et al., 1996). Another study

examining the relationship amongst board experience with regards to average age of the

directors and the timelines of financial reports provide a positive relationship (Abdelsalam and

Street, 2007). A study reveals that better education and highly qualified CFO’s have a positive

relation with the reporting quality (Aier et al., 2005; Van Ness et al., 2010).

2.1.5 Accounting Quality and Gender & Ethnic Diversity

Generally, it is known that gender of executives play a significantly important role shaping the

organization in many different corporate aspects, including the firm performance and the quality

of financial reporting (Lam et al., 2013; Low et al., 2015; Huang and Kisgen, 2013). The

different proxies used for earnings quality by the researchers do not exhibit any significant

variations in the earnings quality and the gender diversity in the top management (Ye et al.,

2010). A study suggests that gender is an important variable in analysing components of board

of directors (Goodstein et al., 1994). Few studies suggest that women are seen as more

independent decision makers and risk averse than men, and have less tolerance of unethical

behaviour. This ensures women are more effective in acting as a monitoring agent for the

shareholders and supervising the managers’ decision making. (Adams and Ferreira, 2009;

Srinidhi et al., 2011). There is a positive association between gender diversity and the quality of

financial reporting. Higher earnings quality is witnessed with boards having female directors

(Srinidhi et al., 2011). The association between the earnings quality and the presence of female

directors on the board is found to be positive (Krishman and Parsons, 2008). There is a positive

relation between the gender diversity in the top management and earnings quality (Labelle et

al., 2010). Other researchers find no relation between the two (Sun, Liu and Lau, 2011; Firoozi

et al., 2016). There was no significant relationship found between the earnings quality and the

gender diversity of the board of directors.

A study reveals that board being ethnically diverse will enhance exposure and experience among

the board, leading to better performance (Cox, 1991). However, ethnic diversity may lead to

11

grouping amongst the board, increasing conflicts within a company and poor overall

performance (Amason, 1996).

2.1.6 Accounting Quality and CEO Duality

A study carried out on the association of the quality of financial reporting and the CEO duality

reveals that there is a positive relationship between the two (Cannella and Lubatkin’s, 1993).

Firm with the roles of CEO and the chairman combined observe a poor quality of reporting

financial information (Byard et al., 2006; Dalton, 1991). Separating the two roles ensures that

financial reporting is more relevant (Beekes et al., 2004; Firth et al., 2007). Other researchers

did not find any evidence and conclude that there exists no significant relationship between CEO

duality and reporting quality (Ahmed et al., 2006; Petra 2007; Donaldson and Davis, 1991).

Merging of the two roles can have a positive association only under specific industry conditions,

otherwise it remains negative (Boyd, 1995).

2.1.7 Accounting Quality and Executive Compensation

Management rewarded with bonus and incentives increase the firms performance (Chen, 2003).

Improved performances include better financial reporting quality and lowered agency costs.

Literature suggests that whenever unfavourable behaviour of the firm’s performance and

uncertain attitude of management comes under observation, corporate governance instruments,

in specific executive compensation becomes imperative to maximize shareholder’s wealth

(Mehran, 1995). The compensation packages for executives are linked to maximising the firms

value and earnings management (Holthausen et al., 1995; Gaver et al., 1995). Another study

documents a positive relation between CEO compensation and accounting quality (Masulis and

Mobbs, 2016).

2.1.8 Accounting Quality and Ownership Structure

Managers have the tendency to weaken the faithfulness of the accounting numbers they disclose;

this suggests that there is a positive relationship between the managerial ownership and the

12

quality of accounting information (Warfield et al., 1995). A study documents that one of the

effects of ownership structure on earnings quality is the demand hypothesis. According to

demand hypothesis, shareholders put stronger demands for quality reporting on the management

(Givoly et al., 2010). Equity compensation is a corporate governance mechanism that helps to

ensure that interests of the outside directors and the shareholders are aligned. Firms observe

better and improved corporate governance when the outside directors are offered equity

compensation, which leads to a decrease in agency cost, simultaneously enhancing the overall

quality of financial reporting (Kim et al., 2014). Managers having higher share of ownership

supports the alignment of the incentives along with reducing agency problems (Jensen and

Meckling, 1976), therefore once agency problems are on the decline, a positive relationship

between the managerial ownership and the accounting quality is expected (Beekes et al., 2004).

However, there are some offsetting motives for the management to reduce the accounting

information quality. Managers tend to reduce the quality to gain advantage over competitors and

suppliers, etc., as the less information they know about the firm the better (Verrecchia, 1990;

Wagenhofer, 1990). Research about banks suggest that ownership structure of banks is likely to

affect a banks’ accounting quality (Leuz, 2006).

2.2 Corporate Governance and Agency Cost

Corporate governance refers to a set of rules, practices and guidelines that ensures a company fulfils its

objectives successfully (Gillan and Starks, 2003). Appointment of board of directors (agents) by

shareholders (principals) to work on their behalf is called agency relationship, and the costs that are

incurred to align the interests of the management and the shareholders are known as agency costs (Jensen,

1976). Companies with weaker governance mechanisms face high agency costs (Core et al., 1999). Due

to lack of corporate governance mechanisms, information asymmetry will rise between the shareholders

and the management (Florackis, 2008).

2.3 Independent Directors

Directors who are not associated with the management of a company, have any relation with the

senior employees or hold a substantial stake in the routine activities are known as independent

13

non-executive directors (Ravina and Sapienza, 2010). As there is a separation between

ownership and control, board of directors are appointed to monitor the top management (Fama,

1980). Independent directors, with their level of experience, bring in valuable expertise and

skills (Fama and Jensen, 1983). During the appointment of independent directors, it was greatly

emphasized to mention the current lack of independence (Higgs 2003; Tyson 2003). When an

individual holds the two top positions in an organization, they get unfettered power and hence

the independence of the director is severely compromised (Cadbury Committee Report, 1992).

The independence of directors is also impaired when they have close relationships with the

existing board (O'Sullivan and Wong, 1999). Independent directors are responsible for

monitoring, contributing in the management’s decision making and the overall enhancement of

the firms’ resources (Johnson, Daily and Ellstrand, 1996). Appointment news of new directors

who are independent emits a positive signal in the market (Rosenstein and Wyatt 1990).

2.4 CEO Duality

CEO duality refers to a situation when decision management and decision control are being

carried out by the same person (Fama and Jensen, 1983). This is one of the most vital areas in

corporate governance (Finkelstein and D’Aveni, 1994). Previous literature gives evidence that

CEO duality has an impact on earnings (Davidson et al., 2004; Conyon and Peck, 1998). It was

also seen that the dual role makes the CEO powerful along with weakening the board of directors

(Cannella and Lubatkin, 1993; Finkelstein and D’Aveni, 1994). The duality helps execute the

process of decision making in an efficient manner (Harris and Helfat, 1998). CEO duality

sometimes obstruct board to monitor management, thereby increasing agency cost (Fama and

Jensen, 1983; Jensen, 1976). When the two roles are merged, it eliminates independence from

the board of a company (Coombes and Wong, 2004). A positive market reaction was witnessed

in the UK firms when it was announced that CEO and chairman roles are to be carried out by

two different individuals (Dahya et al., 1996). Separating the two roles increases the cost

compared to the benefit a firm might receive (Brickley et at., 1997).

14

CHAPTER 3

Methodology

This section consists of the hypotheses created, along with their detailed explanation and the

approach employed to carry out the regressions. It will also include sample and data collection

methods, sources used to gather the required data and their reliability, followed by hypotheses

testing and discussion of the findings. Also included in this chapter are variables used

throughout the research, their discussion and the methods applied to measure them.

3.1 Hypotheses Development and Purpose of the Study

Due to recent corporate scandals, the deficiencies in the corporate governance system of a

company have been highlighted. Such deficiencies lead to, apart from poor firm performance,

agency conflicts between the shareholders and their management, eventually affecting the

accounting quality. Firms with higher accounting quality can efficiently reduce the agency costs

being faced, as it enhances transparency between the management and shareholders (Bharath et

al., 2008; Ball et al., 2008). In general, the literature complements that agency cost and

accounting quality have a negative relationship. To understand the impact of corporate

governance and the codes of best practice on accounting quality, the following hypotheses have

been derived.

Firms with low corporate governance observe an increase in agency conflicts between

shareholders and the management, ultimately resulting in poor accounting quality. However,

financial reporting quality is enhanced and agency conflicts are mitigated when the board of a

company is independent (Firth et al., 2007; Mace, 1986). Prior research reveals that even in

developing countries, having independent directors on boards will improve the quality of

financial reporting (Dimitropoulos and Asteriou, 2010). Since this study is on the UK-listed

15

firms and as the UK is a developed country, it is predicted that having independent directors as

part of the board will increase the accounting quality of the firm, and decrease agency costs.

Therefore, the first hypothesis is:

H1: Independent directors have a significantly positive impact on accounting quality

Board structure is an important element of corporate governance that steers the entire company.

A board structure is made up of several different components such as the age; experience;

education of the directors and gender and ethnic diversity. These components are incorporated

as variables in the hypothesis. Corporate governance recommends to incorporate each of these

components in an efficient manner in order to get the most out of the board, simultaneously

reducing agency cost and improving the overall firm efficiency, including accounting quality.

Diverse and higher educational background of the directors ensure that they have the skills of

finance, accounting and the legal system which improves firms’ performance (Adams and

Ferreira, 2007). These components of the board are expected to have a positive impact on

accounting quality, thereby reducing agency cost.

Hence, the second hypothesis is:

H2: Components of board structure have a significantly positive impact on accounting quality

Executive compensation relates to the salaries and bonuses directors are entitled to. Sound

compensation packages help directors keep themselves focused and work for the best interest

of the company (Florackis, 2008). Incentive contracts are beneficial and keep the top

management motivated to maximize shareholder wealth and minimize agency conflict (Murphy,

1999). Fair compensation packages are a part of corporate governance mechanisms, and help

improve accounting quality (Masulis and Mobbs, 2016).

Therefore, the third hypothesis is:

H3: Executive compensation structure has a significantly positive impact on accounting quality

16

Ownership structure of a company has high significance in terms of managing and governing it.

Dispersed ownership and management often leads to conflicts between the management and the

shareholders. Management allowed part ownership of the company will lead to better

performance and a reduction in agency cost as they own a share of the firm (Jensen and

Meckling, 1976). It will further improve governance within a company, including transparency

of information disclosed and accounting quality (Kim et al., 2014).

Thus, the fourth hypothesis is:

H4: Ownership structure has a significantly positive impact on accounting quality

3.2 Empirical Approach

This section of the study will discuss in detail why panel data was necessary and appropriate for

the selected dataset. It also includes the models employed for empirical analysis. The dataset to

be incorporated, sampling and data collection methods along with the relevant databases

accessed are mentioned. This chapter ends with presenting the model and equations created to

support the hypotheses and their regressions.

3.2.1 Panel Data Analysis

Since the data required for this study involves observation of firms over time, it makes the

dataset a Panel data. Panel data refers to the type of information or data gathered from various

firms over multiple periods. If the data type consists of cross sectional dimensions and time

series data, it qualifies to be panel data.

Cross-sectional dimension relates to data gathered at a single point in time. Whereas, time-series

means units of data acquired across a period of time. Time-series means data units being

collected over a period of certain time, whereas cross-sectional dimension means data for a

single point of time (Wooldridge, 2009).

Data which has a limited number of time series and higher number of cross sections is called

short panel data and used for empirical analysis.

A short panel data, which has less numbers of time series and more number of cross section, is

17

selected for the empirical analysis. The dataset consists of 12 time-series starting from 2000 and

ending at 2011 along 93 cross-sections. In general, 1093 number of observations are under

analysis. Our panel data is unbalanced panel data.

3.2.2 Fixed and Random Effect

There are several models that can be employed for empirical analysis of the selected dataset

such as Pooled Ordinary Least Squares (OLS), Fixed Effects Model and also Random Effects

Model. Panel data consists of diverse data over a number of periods, making it heterogeneous.

The two models that can now be considered are the Fixed Effects Model, Random Effects Model

or there is a probability of using both. In order to establish which of the above models are

suitable for this study, Hausman tests will be applied, as the data in use is an unbalanced panel

data. When comparing between Fixed Effects and Random Effects Model, based on the outputs

of Hausman test, if the p-value is < .05, it means Fixed Effects estimator is suitable. On the other

hand, if the output of Hausman test displays a p-value which is > .5, then the Random Effects

Model can be selected. Therefore, based on the output of Hausman tests applied, both models

will be incorporated.

3.3 Sample Selection and Data Collection

In this study, the dataset being considered consists of the UK publicly listed non-financial firms

only, from FTSE 350 Share Index Companies. FTSE- Financial Times Stock Exchange is a

stock exchange based in the UK, in which FTSE-350 consists of the top 350 UK firms ranked

according to their market capitalization. Publicly listed firms have a greater probability of the

availability and consistency of financial data. Time frame of the panel dataset is from 2000 to

2011.

Financial firms are not part of the dataset and have been eliminated as they have to face

obligations from different institutions such as from Financial Services Advisory (McKnight and

Weir, 2009).

Since the data required for the firms consists of two different areas; financial and corporate

governance, two different sets of sources were accessed. This further scaled-down the number

18

of firms from the sample due to lack of availability of data, either partially or completely. It is

risky to run the regressions with missing or incomplete data as it can provide invalid results

(Neter et al., 1993). After taking these factors into account, the final dataset consists of 92 firms

with 1093 observations. Data required for the above mentioned firms is collected from two

sources. A database called Datastream was accessed for financial data requirements, while

another database known as BoardEx was extensively browsed to gather corporate governance

data. These databases are trustworthy and have been providing credible and reliable data, which

is an extremely important element of data collection.

3.4 Definition of Variables

Having a clear concept and structure of the variables to be observed and measured is called

Operationalisation. The ability to do this operationalisation is a vital part of the research design

which can affect the final findings (Gill and Johnson, 1997). Based on the objective of research

as well as the developed hypotheses, there is past precedent of employing variables which are

the same as or similar to those used in previous studies to compare and contrast results.

A brief overview of the dependant and independent variables along with their definitions is

mentioned below.

3.4.1 Dependent Variable

The key variable of a study is its dependent variable. Researchers attempt to understand and

explain this variable as it is dependent on other independent variables (Jankowicz, 1999;

Schwab, 1999).

In this research, dependent variable being used throughout the analysis is accounting quality,

which reflects the Principle-Agent Conflict Cost, also known as the agency cost. Prior researches

reveal that there are two proxies of agency cost; first one is the asset turnover ratio, which

indicates how quickly an asset converts into sales to generate cash flow which then helps

mitigate the agency cost. Therefore, the asset turnover ratio can be used as an inverse proxy of

19

the accounting quality and asset turnover ratio is being taken as the ratio of the total sales to

total assets (Florackis, 2008; Singh and Davidson, 2003). Second proxy, which is incorporated

in this study, is the expense ratio, i.e. ratio between general expenses to total assets. Thus, the

ratio can be taken as the direct indicator of agency cost as the agency cost increase with an

increase in expense ratio (Ang et al., 2000; Florackis, 2008). Thus, both indicators will be used

as dependent variables in this study as the direct and indirect indicators of the agency cost.

3.4.2 Independent Variables

In a “cause-effect” relationship, the presumed cause is called the independent variable (Polit et

al., 2001; Vogt, 1993). An independent variable is assumed to have an influence on the

dependent variable being considered in the empirical analysis.

Independent Directors

The number of independent directors on the board helps in mitigating agency costs and

improving accounting quality (Singh and Davidson, 2003). It is taken as the ratio of number of

independent directors. For Hypothesis 1, recession is used as a dummy variable to incorporate

the pre-recession (2008) period.

Independent Variables for Board Structure

Different components make up a board structure of a company. The components being used in

this study to test what impact they have on accounting quality are: Age – represents the total age

of the directors; Education – levels of education of the directors on board; Experience - this

represents the total experience of the directors in years; Ethnicity - refers to the ethnic diversity

in the board; Gender - denotes gender diversity (ratio of male to female directors) and CEO

Duality - represents when there is no separation in the roles of CEO and the chairman of the

board (Fama and Jensen, 1983).

20

Independent Variables for Board Compensation

Among the compensation of the board, the two different indicators can be used are: Wages -

salary of the executive directors; and Bonus - compensation to the executive directors.

Independent Variables for Ownership Structure

Ownership structure consists of equity held with the executive directors, as well as equity held

with the total number of directors. These two indicators are included in the regression to examine

its impact on the direct indicators

3.4.3 Control Variables

Control variables are inserted in a regression prior to any other independent variable. The sole

reason to do so is to identify the explanatory power they have, irrespective of the independent

variables (Tabachnik and Fidell, 2001).

Following is a list of control variables that will be used in all Hypotheses.

Firm Size

Firm size is taken as the logarithm of total assets, which includes sum of current, fixed and

tangible assets (Florackis, 2008). There is a positive significant relation between firm size to

asset turnover or utilization ratio (Singh and Davidson, 2003).

Leverage

Leverage is how the companies survive through means of debt. It is measured as ratio of total

debts scaled to total assets at the end of the year. It is an important and an influential variable,

21

and leverage ratio is negatively significant with inverse indicators of agency cost (Florackis,

2008; Chae et al., 2009).

Tobin’s Q

Tobin’s Ratio is a measure of firm performance and calculated by change in returns on assets.

It is helpful in mitigating agency problems (Van Ness et al., 2010).

3.5 Regression Model

A short panel data which has less number of time-series and higher number of cross-section is

selected for the empirical analysis. The data consists of 12 time-series’ starting from 2000 and

ending at 2011 along with 92 cross-sections, as previously mentioned. In general, 1093

observations are under analysis. Panel data being used is an unbalanced panel data.

Before moving towards analysis stage of this research it is important to ensure the stationarity

of the variables. To do so, Levin, Lin and Chu Test and The Im, Persaran and Shin W-Stats tests

are applied beforehand which confirm the absence of unit root or presence of stationarity of

variables. When the absence of the unit root is confirmed at 5% level of significance, only then

can the series be dealt with a two-way effect of the cross-section and time-series (Asteriou,

2015).

Based on the dataset selected in this study, there are three models that may be employed to

provide empirical support to our hypotheses; Common Effects Model, Random Effects Model

and Fixed Effects Model. As heterogeneity problem can surface along the cross-sections since

they are not from the same sector, therefore there is a higher probability of not using Common

Effects Model. Mathematical representation of Common Effects Model is:

ϒit =άi + ß Xit + μit (1)

22

In equation (1) ϒ is the dependent variable which is a direct proxy of accounting quality. X is

independent variable; representing different corporate governance mechanisms. In case of

Common Effects Model, ά may differ across the different cross-sections. Therefore, ß varies

with cross-sections and Common Effect Model is unable to capture cross-sections’ varying

effect. F-test and Bruesch Pagan is used to decide a good model between Common Effects

Model and Random-Fixed Effects Model. Under the following hypothesis a model can be

employed:

H0: Common Effects Model is good to be employed

H1: Random-Fixed Model is good to be employed

Under null hypothesis, Random-Fixed Effect Models cannot be accepted which states absence

of heterogeneity along the cross-sections. However, in case of presence of heterogeneity along

the cross-sections, Random-Fixed Model is good to be employed. Between the Random Effects

and Fixed Effects Model, cross-sections effect may correlate with the regresses, if the

correlation exists between regresses and cross-sections effects then it’s more appropriate to

choose a Fixed Effects Model. In individual-fixed effects model, a dummy variable for each

cross section is generated representing the individual specific effect. Fixed Effects Model can

be mathematically represented as:

ϒit =άi + ß Xit + Fi + μit (2)

In equation (2) ϒ is the dependent variable that is a direct proxy of accounting quality. X consists

of independent variables that are different corporate governance tools. Fi is the representation

of dummy variables that are generated against all cross-sections to capture cross-sectional effect.

There are some disadvantages of Fixed Effects Model in which all the explanatory variables can

be avoided. Varying variables can hardly be included in this model therefore Random Effects

Model is always given preference because in this model cross-sections do not correlate with

regresses of the independent variables. The mathematical representation of the Random Effects

Model can be given as:

23

ϒit =άi + ß Xit + εi + μit (3)

In equation (3) ϒ is the dependent variable that is a direct proxy of accounting quality. X

represents independent variables that are different corporate governance tools. A component ε

that is the error term is added in the equation which states the error among cross-sections.

Hausman Test is used to choose the better model between the two, Fixed and Random Effect

Models:

H0: Random Effects Model is good to be employed

H1: Fixed Effects Model is good to be employed

If the Hausman Test presents with significant results, it that means null hypothesis cannot be

accepted, which depicts that Fixed Effects Model is recommended to be employed. In other

case, if the Hausman Test concludes with insignificant results, it means Fixed Effects Model is

not good to be employed therefore random effect model is good to be employed (Gujarati, 2011).

24

CHAPTER 4

Analysis of Findings

4.1 Descriptive Statistics Analysis

The basic statistics of the dependent, independent and control variables are explained below in

Table 1, showcasing 1093 number of observations for each panel variable.

The mean value of the expense ratio is 92%, whereas its lowest value is 3%; the maximum it

can rise up to 208% and the deviation from the mean value is 12%. The deviation of expense

ratio is very high. Since expense ratio is calculated as ratio of all operating expenses to total

sales, its value of 208% is quite high. Shareholders may object to such supreme levels of

expenses as it will negatively affect both, accounting quality and agency cost.

The average ratio of independent directors on the board is 59%. The lowest ratio is 17%,

suggesting firms in the selected dataset adhere to poor corporate governance mechanisms.

Cadbury Report (1992) recommends at least 3 independent directors to be on board at all times.

The maximum ratio of independent directors on the board is 89%.

The average age of the directors on the board is 55 years. This suggests that most of the directors

are closing in on their retirement age and may continue for the post-retirement benefits. This

may have a significant negative impact on the accounting quality. The youngest directors in the

selected firms are 24 years of age. Although the age is quite low for a director since age and

experience are positively related, young directors bring power and energy to the board with

innovative ideas. They quickly adapt to the changing environment as opposed to a slow

adaptation by the relatively older directors. On the other hand, age of most senior directors was

72 years on average. It is fair to deduce that majority of the directors have passed their retirement

age and may not be capable of taking decisions in the best interest of the company while being

25

aware of the new business requirements. Hence, it will have a severe impact on accounting

quality and agency cost. Deviation from the mean is close to 3 years and the panel is normally

distributed.

Ratio of male directors on the board has a mean of 94%. This represents that the board on an

average, has a very high percentage of male directors, which is not recommended by the

corporate governance reforms. Maximum and minimum ratio is 100% and 33% respectively.

Gender diversity is an important element for an overall success of a company for many reasons.

The results from Table 1 for ethnic diversity reveal that the mean for directors from different

ethnicities is 17%. The highest percentage of foreign directors is 75% while the lowest is nill.

This represents strong corporate governance mechanisms are in place among the firms in the

dataset. Higher percentage of foreign directors on board allows the directors to bring in changes

on how the company is controlled. Different cultures have varying methods to deal with

problems and situations and having a good mix of nationalities and ethnicities can only do well

for a company in a diverse board, eventually leading to a higher accounting quality, better

governance and importantly lower principal-agent conflicts.

26

Table 1: Descriptive Statistics Analysis

Mean Median Maximum Minimum Std. Dev. Observations

EXPEN_R 0.92 0.94 2.08 0.03 0.12 1093

NEDIR_RATIO 0.59 0.58 0.89 0.17 0.13 1093

REC_2008 0.69 1.00 1.00 0.00 0.46 1093

AGE_AVG_T_DIR 54.69 54.85 71.50 23.75 3.17 1093

EDU_AVG_T_DIR 1.76 1.75 3.60 0.10 0.60 1093

EXP_AVG_T_DIR 4.37 4.00 32.60 0.65 2.26 1093

MALE_AVG_T_DIR 93.59 100.00 100.00 33.35 8.63 1093

NAT_AVG_T_DIR 0.17 0.15 0.75 0.00 0.19 1093

CEO_DUAL 0.01 0.00 1.00 0.00 0.11 1093

WAGE_EDIR 57.39 52.00 450.00 0.00 36.97 1093

BONUS_EDIR 204.70 132.00 1747.00 0.00 231.68 1093

EQUITY_EDIR 668.34 281.00 41204.00 0.00 1740.75 1093

EQUITY_AVG_T_DIR 338.40 141.50 20602.00 0.00 875.68 1093

LEVE_R 0.24 0.22 1.23 0.00 0.18 1093

SIZE_R 6.22 6.19 8.28 3.97 0.69 1093

TOBIN_R 1.22 0.85 26.21 0.00 1.32 1093

27

4.2 Empirical Analysis

For the empirical investigation of the first hypothesis of this study, the impact of independent

directors on the accounting quality of a firm will be analysed. In Table 2, number of independent

outside directors is taken as the independent variable and to find its significance on accounting

quality, the dependent variable. For the 1st and 3rd models in Table 2, Hausman Test confirms

the appropriation of the Random Effects Model while for the 2nd model Fixed Effects Model

has been applied.

In Model 1, NEDIR_RATIO shows an insignificant impact on accounting quality. Although

having higher number of independent directors on board helps mitigate agency problems and

enhance the accounting and financial reporting quality (Bushman et al., 2004), there is an excess

number of directors on board than required, which can and is most cases, will populate the board

of a company and create problems and delays in the decision making process eventually leading

to an insignificant impact on accounting quality (Hermalin and Weisbach, 1991). The

coefficient of Model 1 is (-0.041) and (t-statistics = -1.460).

In Model 2, NEDIR_RATIO is observed with pre-recession (2008) period. The coefficient of the

REC_2008 period is -0.032 and (t-statistics = -1.075). Model 2 also suggests an insignificant

relation between the two.

In Model 3, when NEDIR_RATIO is multiplied with REC_2008, it reveals a positive significant

relation with accounting quality. Coefficient shows a value of 0.030 and (t-statistics = 2.825).

SIZE_R and performance are significant, but negatively related with accounting quality in

Models 1, 2 and 3 with the values of (-0.026, t-statistics = -2.590); (-0.027, t-statistics = -1.767);

(-0.023, t-statistics = -2.377) respectively.

28

Table 2: Independent Directors and Accounting Quality

Variable

Model 1 (Random) Model 2 (Fixed) Model 3 (Random)

Coefficient t-Statistics Coefficient t-Statistics Coefficient t-Statistics

C 1.111 18.369 1.104 11.234 1.061 16.928

LEVE_R 0.005 0.168 0.028 0.885 -0.003 -0.122

SIZE_R -0.026 -2.590* -0.027 -1.767** -0.023 -2.377*

TOBIN_R -0.005 -1.893** -0.006 -2.005* -0.006 -2.211*

NEDIR_RATIO -0.041 -1.460 -0.032 -1.075

REC_2008

0.014 1.977*

NEDIR_RATIO*REC_2008

0.030 2.825*

Notes: Dependent Variable is Accounting Quality that has been taken as the ratio of Total Sales to Total Assets. In independent variables; LEVE_R is the

Leverage Ratio representing Debt to Asset Ratio of the Firm; SIZE_R is Firm Size and is also control variable that is taken as logarithm of total assets;

TOBIN_R is Tobin’s Q Ratio indicating performance. NEDIR_RATIO is the ratio of number of independent directors on the board; REC_2008 is a dummy

variable capturing the pre-recession (2008) period.

* 5% level of Significance and ** 10% level of Significance

29

Table 3 tabulates the impact of components of board over the accounting quality. Directors’ age,

experience, education level, gender and ethnic diversity are being investigated for the direct

proxy of the accounting quality. In Table 3, Hausman test suggests significance of Random

Effects Model for all models except Model 5, where Fixed Effects Models’ appropriation is

being confirmed.

In Model 1, accounting quality is empirically investigated under the index of age of the total

members of the board of directors along with other control variables. The coefficient of

AGE_AVG_T_DIR is 0.002 and (t-statistics = 1.730). This suggests a positive significant

relation with accounting quality at 10% level of significance. An increase in the age of directors

by 0.2% will increase accounting quality by 1%.

Model 2 investigates the impact of EDU_AVG_T_DIR on accounting quality. The coefficient

shows a positive significant relation with the value of 0.016 and (t-statistics = 2.359) between

the education of directors and accounting quality. The accounting quality is expected to rise by

1% if the level of education of directors increases by 1.6%.

Model 3 of Table 3 analyses experience of the board and accounting quality. The results suggest

that there exists a positive significant relation between the two (coefficient of 0.004 and t-

statistics = 2.479). These values imply a growth in the accounting quality by 1%, when

EXP_AVG_T_DIR increases by 0.4%.

In Model 4 of Table 3, the coefficient of 0.042 and (t-statistics 1.822) suggests the relation

between NAT_AVG_T_DIR and accounting quality is positively significant. Regression results

reveal that when foreign directors on the board increase by 4.2%, it will lead to an increase in

accounting quality by 1%.

Gender diversity among the board of directors is investigated in Model 5 of Table 3 to examine

their impact on accounting quality. With a coefficient of 0.001 and (t-statistics of 3.589), it can

be seen that accounting quality will rise by 1% if MALE_AVG_T_DIR increase by 0.1%,

suggesting a positive significant relation between gender diversity and accounting quality.

30

Table 3 concludes with Model 6, suggesting CEO_DUAL and accounting quality have an

insignificant relation (coefficient of -0.014 and t-statistics = -.0561).

Control variable in all models are not changing their sign and significance. Leverage Ratio and

Equity Share of the directors are positively related with the firms’ accounting quality.

Meanwhile firm size, Tobin’s Q and independent outside directors’ ratio is negatively related

with firms accounting quality.

31

Table 3: Components of Board and Accounting Quality

Variable

Model 1 (Random) Model 2 (Random) Model 3 (Random) Model 4 (Random) Model 5 (Fixed) Model 6 (Random)

Coefficient t-stats 1 Coefficient t-stats 2 Coefficient t-stats 3 Coefficient t-stats 4 Coefficient t-stats 5 Coefficient t-stats 6

C 1.009 12.360 1.091 17.319 1.081 17.020 1.107 17.594 0.992 9.538 1.101 17.419

LEVE_R 0.005 0.182 0.006 0.209 0.009 0.343 0.006 0.205 0.033 1.068 0.003 0.124

SIZE_R -0.024 -2.308* -0.026 -2.463* -0.023 -2.227* -0.025 -2.398* -0.030 -1.975* -0.023 -2.209*

TOBIN_R -0.005 -1.993* -0.006 -2.147* -0.006 -2.075* -0.005 -1.962* -0.007 -2.367* -0.005 -1.983*

NEDIR_RATIO -0.028 -0.964 -0.035 -1.220 -0.030 -1.042 -0.034 -1.189 -0.026 -0.886 -0.034 -1.172

WAGE_EDIR 0.000 -1.828** 0.000 -1.991* 0.000 -1.569 0.000 -1.985 0.000 -0.997 0.000 -1.765**

EQUITY_EDIR 0.000 2.104* 0.000 1.978* 0.000 2.067* 0.000 1.980* 0.000 2.374* 0.000 2.111*

AGE_AVG_T_DIR 0.002 1.730**

EDU_AVG_T_DIR 0.016 2.359*

EXP_AVG_T_DIR 0.004 2.479*

NAT_AVG_T_DIR 0.042 1.822**

MALE_AVG_T_DIR 0.001 3.589*

CEO_DUAL -0.014 -0.561

Notes: Refer to Table 2. WAGE_EDIR is wage of the Executive Directors; EQUITY_EDIR explains the share of Executive Directors in the Equity; AGE_AVG_T_DIR represents total age of the

directors; EDU_AVG_T_DIR is the total education of the Directors Index; EXP_AVG_T_DIR is total experience of the directors in years; NAT_AVG_T_DIR is the ethnic diversity;

MALE_AVG_T_DIR is representing Gender Diversity; CEO_DUAL is dual role of CEO and as Chairman of the Board.

32

In Table 4, the objective is to further analyse the association between board compensation

structure and the accounting quality. Hausman Tests recommend the use of Random Effects

Model in both, Model 1 and Model 2 in Hypothesis 3.

Model 1 is the examination of the relationship between salaries of the executive directors and

the accounting quality. With coefficient of (.0002) and (t-statistics = 1.828), it can be seen that

the association between WAGE_EDIR and accounting quality is positively significant. A slight

increase in WAGE_EDIR (0.02%) will result in the accounting quality being improved by 1%.

Model 2 of Table 4 tests BONUS_EDIR with accounting quality. The coefficient is (0.000036)

and t-statistics value of (2.280), suggesting a positive significant relation between the two. This

means the accounting quality is expected to go up by 1% when BONUS_EDIR increases by

0.0036%. Control variable in both models are not changing their sign and significance. Average

Ages of Directors and Equity Share of the directors are positively related with accounting

quality. Firm size, performance and independent outside directors’ ratio is negatively related.

However, Leverage is positively related in Model 1 and negatively in Model 2.

33

Table 4: Board Compensation Structure and Accounting Quality

Variable

Model 1 (Random) Model 2 (Random)

Coefficient t-statistics Coefficient t-statistics

C 1.009 12.360 1.008 12.429

LEVE_R 0.005 0.182 -0.001 -0.025

SIZE_R -0.024 -2.308* -0.024 -2.309*

TOBIN_R -0.005 -1.993* -0.005 -1.938**

NEDIR_RATIO -0.028 -0.964 -0.029 -1.023

EQUITY_EDIR 0.000 2.104* 0.000 2.175*

AGE_AVG_T_DIR 0.002 1.730** 0.002 1.688**

WAGE_EDIR 0.0002 1.828**

BONUS_EDIR 0.000036 2.280*

Notes: Refer to Tables 2 and 3. BONUS_EDIR is the remunerations to the Executive Directors.

34

Table 5 provides empirical analysis of Ownership Structure and its relation with accounting

quality. Random Effects Model is suggested by Hausman Tests for both the Models.

Model 1 analyses EQUITY_EDIR and accounting quality. A positive significant relation is

observed and coefficient shows a value of (0.000004) and (t-statistics = 2.104). These values

suggest if EQUITY_EDIR rises very slightly by 0.0004%, it will eventually lead to an increase

in accounting quality by 1%.

Model 2 also reveals a positive significant relationship between EQUITY_T_DIR and

accounting quality with coefficient being (0.00001) and (t-statistics 2.173). Accounting quality

will observe an increase of 1% if the equity held by director’s increase by 0.001%. Control

variable in both models are not changing their sign and significance. Leverage Ratio and

Average Age of Directors are positively related with accounting quality, whereas firm size,

salaries of the executive directors, Tobin’s Q and independent outside directors’ ratio is

negatively related with the accounting quality (Florackis, 2008: Singh and Davidson, 2003).

35

Table 5: Board Ownership and Accounting Quality

Variable Model 1 (Random) Model 2 (Random)

Coefficient t-statistics Coefficient t-statistics

C 1.01 12.36 1.00892 12.359

LEVE_R 0.005 0.182 0.00500 0.183

SIZE_R -0.024 -2.307* -0.02415 -2.305*

TOBIN_R -0.005 -1.992* -0.00544 -1.991*

NEDIR_RATIO -0.029 -0.964 -0.02771 -0.961

AGE_AVG_T_DIR 0.0018 1.729** 0.00173 1.733**

WAGE_EDIR -0.0002 -1.828** -0.00021 -1.863**

EQUITY_EDIR 0.000004 2.104*

EQUITY_T_DIR

0.00001 2.173*

Notes: Refer Tables 2 and 3. EQUITY_T_DIR is the equity held with total number of directors.

36

4.3 Graphical Analysis

Figure 1 of the expense ratio clearly depicts the accounting quality during the period that is

under observation in this study. In the year 2000, the average expense ratio for 92 firms was

93% which started gradually increasing in the year’s post 2000, while in 2003 the average

agency cost reached its maximum level that is almost 99%. Post 2003, a gradual decrease in

trend is observed specially in the year 2004 and 2005. In 2006, the expense ratio once again rose

at a level of almost 93%. After that, in 2007 and 2008 which was the recession period, it

decreased to its lowest level that is less than 90% in 2007 and 91% in 2008. The expense ratio

remains between the 90% and 91% in post-recession period.

Figure 1 Graphical Analysis of Expense Ratio

37

CHAPTER 5

Critical Analysis and Discussion

5.1 Discussion of the Results

The objective of this study is to examine whether having strong corporate governance

mechanisms in the selected dataset of 93 from the FTSE-350 UK-listed firms can help mitigate

agency problems and increase the accounting quality of these firms. As previously discussed,

there are numerous corporate governance mechanisms that, if not adhered to at all or not with

spirit of the law but rather with the intention of letter of the law, can have adverse impacts on

the overall success of a company. Thus conflicts between the principal and agents will rise

leading to an increase in costs to resolve the conflicts, known as the agency cost. Also,

transparency and disclosure of information may be tampered with resulting in a poor accounting

quality for the shareholders and other prospective investors. Hypotheses were created based on

the mentioned factors in order to understand the extent to which corporate governance

mechanisms may be helpful.

When the ratio of independent directors was examined to understand their impact on accounting

quality, the regressions provid an insignificant relation between the two. These results are

consistent with prior researches (Hermalin and Weisbach, 1991; Dalton, 1998). This could be

due to several factors but mainly the independence of directors alone may not have an impact

on accounting quality, as reported by (Petra, 2007; Bradbury et al., 2006; Ahmed et al., 2006).

Furthermore, if there is not an equal number of independent directors and executive directors,

as suggested by corporate governance reforms, independent directors may not be able to execute

duties as they may feel intimidated. Executive directors, being involved on a daily basis, will

have power to influence the accounting quality.

38

With regards to the board composition and corporate governance attributes, there are several

different factors which are being considered in this research. Each of those factors affect the

accounting quality and agency costs of a firm. When examining a board and its characteristics

studies should incorporate education, demographic and gender diversity as variables (Goodstein

et al., 1994).

The effect of the age of the directors on the board and their experience is also simultaneously

examined. As directors age, with their years of experience they learn new skills and expertise

which are relevant for a financial success of the company and thus play a crucial role in overall

success. Dealing with the conflicts that arise between the management and the shareholders

during the course of a business are normal but to ensure that they don’t negatively impact a

firms’ performance is dependent on innovative and shrewd style of management. Senior

directors are seen to have a positive impact on the accounting quality of the firm they run thereby

supporting mitigation of agency costs. This research reveals a positive significant relation

between the age and experience of the directors and the accounting quality of the firm. These

findings are consistent with prior studies (Huang et al., 2012; Cunningham, 2007; Dahya et al.,

1996; Abdelsalam and Street, 2007) in which they had also assumed age as an important variable

for board composition.

It is imperative that directors are well qualified and capable of making critical decisions on time.

This also brings about a healthy competition within the board. They must possess the right

abilities and knowledge that help in improving the firms’ performance. This study documents a

positive impact between the educational level and backgrounds of the directors on board and

the accounting quality of the firm. This relation is consistent with previous studies. A research

reveals being highly qualified in financial areas will enhance transparency as the directors will

tend to disclose all information and improve the accounting quality further (Van Ness et al.,

2010).

Ethnic diversity in the board represents how demographically diverse board of directors is. Such

diversity adds value to the board as those from different backgrounds help bring in multiple

solutions to problems and also helps the firm better understand and cater to the changing needs

of the shareholders. This is also recommended by the corporate governance mechanisms.

Results from the regressions of this study suggest there is a positive relation between the ethnic

39

diversity and the accounting quality, which is a part of a firms’ performance. Previous researches

also document a positive relation with firm performance (Cox, 1991). Ethnic diversity has

previously been used as a variable for board composition (Amason, 1996; Marimuthu, 2008).

Board of directors should have a good mix of both male and female representatives. When

diversity is well managed, it produces great results, both financial and non-financial. Female

directors are seen to be more independent and professional compared to male directors, and

better understand the needs of their shareholders (Adams and Ferreira, 2009 and Srinidhi et al.,

2011). Model 5 of Table 3 shows that gender diversity and accounting quality are positively

related. Prior authors also conclude that financial reporting and accounting quality has been

improved with female directors present (Krishman and Parsons, 2008; Labelle et al., 2010).

CEO duality in this study refers to a situation when the roles of CEO and Chairman of the board

are merged. This is not recommended by corporate governance reforms and is not considered

as a conduct of best practice. Model 6 of Table 3 reports an insignificant relation between the

CEO duality and the reporting quality. This insignificant relation is consistent with several other

previous studies that found no relation between the two (Ahmed et al., 2006; Petra 2007;

Donaldson and Davis, 1991). The reason for an insignificant relation could be that as the UK is

a developed country and the firms follow codes of best practice, there were very few firms in

the data set with the two roles combines. According to Higgs (2003), only 10% of firms in the

UK have the roles combined.

Board compensation relates to the salaries, bonuses and other benefits executive directors are

entitled to as a part of their remuneration package. This must be decided by having independent

directors on the remuneration committee, as recommended by corporate governance. A

remuneration package must attract, motivate and retain the directors. One of the most important

means of aligning the interests of shareholders and the executive directors is the executive

compensation contract (Mehran, 1995). These contracts are often performance-based. Directors’

performance increases when they are well compensated. This study revealing a positively

significant relation between board compensation and accounting quality, is consistent with prior

researches (Chen, 2003; Holthausen et al., 1995; Gaver et al., 1995). These authors argue that

firm performance and accounting quality is enriched when there is an increase in directors’

compensation.

40

Equity ownership to executive directors means that the directors are being offered a share in the

company they manage. These are usually performance based stock options with a vesting period.

This can also be used as a corporate governance mechanism to align the interests of the directors

and the shareholders to ensure directors work in the best interest of the company. Once the

interests of the directors are also sorted, they will work much efficiently. The regression results

in Models 1 and 2 of Table 5 show a positive significant relation between share of equity

ownership of directors and the accounting quality. Directors are expected to outperform and

improve the overall firm performance. These results are consistent with previous findings, in

which the authors also find significant positive relationship between the two (Warfield et al.,

1995; Kim et al., 2014).

5.2 Implications of Research

It is important to note that the primary reason of shareholders to invest in a company is to get

returns and eventually increase their wealth. However, before they make this decision to invest,

shareholders will want to be assured that their investments will be looked after by industry

professionals who will do their best to secure the expected returns. Now it is the company’s

responsibility to have strict control mechanisms that ensure each shareholder’s wealth is taken

care of. A company’s reputation is a key determinant and corporate governance was introduced

to protect the rights of the shareholders. The findings of this research should help companies

that are not fully complying with the corporate governance recommendations to improve, as it

examines the key mechanisms that impact accounting quality positively. At the same time, this

study can aid investors in making the decision to go ahead with trusting a company with their

wealth. In specific, this research has investigated relation between corporate governance and

accounting quality in UK-listed firms with a strong focus on examining four major corporate

governance recommendations together in one research which, when complied with, will have a

positive impact on financial reporting quality. Prior studies have examined how these corporate

governance tools can help mitigate the principal-agent conflicts and improve the efficiency of

accounting quality (Jensen, 1976; Fama and Jensen, 1983; Core et al., 1999; Loomis, 1999;

Palmrose & Scholz 2004). Well-governed firms face less probability of restatement of earnings.

41

5.3 Conclusion

The aim of this study is to examine corporate governance mechanisms in the selected firms and

how influential these mechanisms are in reducing agency costs and improving the accounting

quality. Accounting quality is the truthfulness and the fair presentation of the firms’ financial

reporting information and transparent disclosure of information, therefore it is important to

neither under or overstatement figures which can negatively impact decision making.

This study looks at the data of 92 from FTSE-350 UK-listed firms have been used and the time-

frame is 12 years. Since these are large companies that are publically traded therefore probability

of agency conflicts do exist. Accounting quality in this study is taken as operating expenses

scaled by total assets. Fixed Effects and Random Effects Models are employed for the empirical

analysis.

While the first hypothesis was set to establish a positive impact of independent directors on the

accounting quality, the results however reveal an insignificant relation between the two. This

insignificant relation thus shows that independence of directors alone does not impact

accounting quality.

Moreover, the components that make up a board of directors examined in this study are age,

experience, education, gender and ethnic diversity, these have been empirically investigated.

All of the above mentioned components when examined exhibited a positive and significant

relation to accounting quality. However, another variable included for the same hypothesis was

the dual role of CEO. Results for this particular variable showed an insignificant relation

towards the accounting quality.

Indicators for executive compensation used in this research are wages and bonus entitlements

to the executive directors. Results reported from this study are positive and significantly related

to the accounting quality, suggesting the executive directors cater the firm in a much challenging

manner. Regression analysis confirms the prediction that those executive directors with their

compensations tied to performance related pay, work for the interest of their principals.

To investigate the relation between the ownership structure and accounting quality, equity held

by the executive directors and equity held by total board members were considered as an

independent variable. The results of this study follow the footsteps of other previous studies

42

documenting similar relation between the two. There exists a positive significant relation

between the ownership structure and the accounting quality.

5.4 Limitations

There were several limitations that surfaced during the course of this research. Corporate

governance is a difficult topic to comprehend and it becomes slightly more complicated if it is

used as an instrument to understand it’s the impact on accounting quality. Firstly, the study was

concentrated within the UK only in order to track the main tendency with 92 non-financial

organisations selected with a 12-year time frame and the total sample counted 1093

observations. Secondly, the data for the selected sample was not completely available.

Databases accessed did not provide the require data for all of the companies, hence the firms

were trimmed down to 92 from the FTSE-350 UK-listed (non-financial) firms. In addition,

cross-sectional research design had its own difficulty because the data within a firm changes

abruptly through years and this sample size is not a representation of the entire population.

5.5 Recommendations for Future Research

Upon completion of this research, a number of recommendations for future study are suggested.

To begin with, as this study is a cross-sectional research design with the limitations mentioned

above, it is recommended that future researchers consider a longitudinal study. Increasing the

number of years in the sample, incorporating more recent years, can also give a better

understanding on how efficiently the firms are adhering to corporate governance mechanisms.

Furthermore, consideration of including more independent variables in the hypotheses is

suggested as it will steer towards concrete and more accurate results.

43

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