theoretical foundation of diversification decisions: - virtus

Corporate Ownership & Control / Volume 13, Issue 1, Autumn 2015

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OWNERSHIP & CONTROL

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4

EDITORIAL

Dear readers!

The recent issue of the journal Corporate Ownership and Control pays attention to issues of corporate

social responsibility, risks management, audit issues, corporate codes etc. More detailed issues are

given below.

Sujani Thrikawala, Stuart Locke, Krishna Reddy examine the impact of corporate governance

practices of microfinance institutions (MFIs) on outreach to the poor people in Sri Lanka by using

three outreach variables. Ziad Mohammad. Zurigat, Nadia Jawdat aim at testing the partial adjustment

model of cash holdings to investigate whether Jordanian industrial firms have a target cash holdings

and how fast they move toward that target when any target deviation exists. The results of the research

of Turki Al-Sabah signify a negative relationship between the firm’s financial leverage and dividend

payout ratio. Samer Khalil, Assem Safieddine examines governance-related issues within Middle East

family businesses. They construct a governance index and use a probit model to examine whether

family-related variables can explain the level of corporate governance.

Graziella Sicoli, Paolo Tenuta analyse the concept of going concern on the one hand, through a case

study of three companies which have recently come under observation of the CONSOB and have been

inserted in the so-called “black list” and, on the other, the consequences that the removal of the

presumption of continuity can have on the kind of assessment the auditors make. Rajni Mala, Parmod

Chand examine whether the accuracy of judgments made by accountants varies as a consequence of

their level of confidence, and whether their confidence in exercising judgments could be enhanced by

greater familiarity with IFRS. Sutaryo Sutaryo, Yediel Lase

investigate the effects of auditor

characteristics on local governments’ audit delay by studying 127 Indonesian local governments.

Agung Nur Probohudono, Eko Arief Sudaryono, Nurmadi Harsa Sumarta, Yonatan Ardilas examine

the impact of ownership, corporate governance and mandatory tax disclosure on voluntary financial

disclosure in Indonesia using 102 Indonesian listed companies in the period of 2009 to 2012.

Hayat M. Awan, M. Ishaq Bhatti, Zahid Razaq investigate the financial management performance

involved in increasing the firms’ profitability. Reem Khamis, Wajeeh Al-Ali, Allam Hamdan examine

the relation between ownership structure and corporate performance; the sample of the study included

42 out of 48 companies (resembling 87.5% of the population) of all sectors in Bahrain Stock Exchange

in five years from 2007-2011. Mahlomola Khumalo, Andries Masenge investigate the relationship

between CEO remuneration and firm performance. Roderick Bugador views the network of control in

a corporate business group as its source of competitive advantages.

We hope that you will enjoy reading the journal and in future we will receive new papers, outlining

the most important issues and best practices of corporate governance!


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CORPORATE OWNERSHIP & CONTROL VOLUME 13, ISSUE 1, AUTUMN 2015

CONTENTS

EDITORIAL 4

ACADEMIC NVESTIGATIONS & CONCEPTS AN EMPIRICAL ANALYSIS OF CORPORATE GOVERNANCE IMPACT ON OUTREACH OF MICROFINANCE INSTITUTIONS (MFIS) 8 Sujani Thrikawala, Stuart Locke, Krishna Reddy This study examines the impact of corporate governance practices of microfinance institutions on outreach to the poor people in Sri Lanka. The findings of this study revealed several significant relationships: Breadth of outreach in Sri Lankan MFIs improve when they have a female chair on the board but decreases when they have more female directors and client representation on the board, and female borrowers get more loans when the firm has women representation and international/donor directors on the board, but less loans if they have a female chair. TESTING THE PARTIAL ADJUSTMENT MODEL OF OPTIMAL CASH HOLDING: EVIDENCE FROM AMMAN STOCK EXCHANGE 15 Ziad Mohammad. Zurigat, Nadia Jawdat This study aims at testing the partial adjustment model of cash holdings to investigate whether Jordanian industrial firms have a target cash holdings and how fast they move toward that target when any target deviation exists. The study uses the estimated fitted values from the conventional cash equation as a proxy for the target cash holding. The study provides evidence suggesting that cash flows, net working capital, leverage and firm size significantly affect the cash holdings of Jordanian firms. THE EFFECT OF THE FIRM’S AGE AND FINANCIAL LEVERAGE ON ITS DIVIDEND POLICY – EVIDENCE FROM KUWAIT STOCK EXCHANGE MARKET (KSE) 24 Turki Al-Sabah In this research, the effect of the firms’ financial leverage and age on their dividend policy has been explored. Two hypotheses were formulated, where the first focused on examining the effect of the firms’ financial leverage and the second concentrated on investigating the effect of the firms’ age on their dividend policy. The hypotheses were tested using ordinary least square and fixed-effect panel regression. The results signify a negative relationship between the firm’s financial leverage and dividend payout ratio. CORPORATE GOVERNANCE IN MIDDLE EAST FAMILY BUSINESSES 32 Samer Khalil, Assem Safieddine This study examines governance-related issues within Middle East family businesses. The absence of proper external monitoring mechanisms – governmental or other – to protect shareholder rights, and


6

the absence of any pre-existing literature on the Middle East market provides the motivation to evaluate the corporate governance practices of Middle East family businesses. Authors construct a governance index and use a probit model to examine whether family-related variables can explain the level of corporate governance. It is found that the majority of boards had a prevalence of family members and a low proportion of independent directors.

AUDIT, ACCOUNTING & REPORTING THE IMPACT OF THE “GOING CONCERN” ON AUDITORS’ JUDGEMENT. ANALYSIS OF THE ITALIAN CONTEXT FROM AN INTERNATIONAL PERSPECTIVE 44 Graziella Sicoli, Paolo Tenuta The present work aims to analyse the concept of going concern on the one hand, through a case study of three companies which have recently come under observation of the CONSOB and have been inserted in the so-called “black list” and, on the other, the consequences that the removal of the presumption of continuity can have on the kind of assessment the auditors make. The aim of the present work is twofold: the first part analyses the principle of going concern from a business and economic perspective. Once this has been completed, the work will go on to offer an overview of the dynamics that can bring a company to a crisis point, and how these affect the judgments expressed by the auditors. CONFIDENCE OF ACCOUNTANTS IN APPLYING INTERNATIONAL FINANCIAL REPORTING STANDARDS 56 Rajni Mala, Parmod Chand Research on how accountants could increase their confidence in interpreting and applying IFRS is lacking. This study examines whether the accuracy of judgments made by accountants varies as a consequence of their level of confidence, and whether their confidence in exercising judgments could be enhanced by greater familiarity with IFRS. The results of the study support that accountants who are more confident make judgments that better reflect the economic substance of a transaction than accountants who are less confident. The results further indicate that familiarity with IFRS enhances the confidence of accountants and the most accurate judgments are made by those accountants who are not only familiar with IFRS but also have confidence in their judgments. AUDITORS CHARACTERISTICS AND AUDIT DELAY: EVIDENCE FROM INDONESIAN REGIONAL GOVERNMENTS 66 Sutaryo Sutaryo, Yediel Lase

Overdue financial statements reporting, more specifically audit delay, can cause losses in its capacity in decision making. We investigate the effects of auditor characteristics on local governments’ audit delay. We find that auditor professional proficiency and auditor educational background have significant effect on the audit delay of local government financial statements. Our results also indicate the intersection of some auditor characteristics in affecting audit delay. Our findings mainly suggest that the auditor professional proficiency should be improved to shrink audit delay. OWNERSHIP, CORPORATE GOVERNANCE AND MANDATORY TAX DISCLOSURE INFLUENCING VOLUNTARY FINANCIAL DISCLOSURE IN INDONESIA 74 Agung Nur Probohudono, Eko Arief Sudaryono, Nurmadi Harsa Sumarta, Yonatan Ardilas This study examines the impact of ownership, corporate governance and mandatory tax disclosure on voluntary financial disclosure in Indonesia. The results show that proportion of independent director, managerial ownership, institutional ownership, foreign ownership and mandatory tax disclosure are assosiated with voluntary financial disclosure. Analysis reveals a moderate level of 59,90% score of disclosure in the period of 2009 to 2012 in Indonesian listed companies.


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CORPORATE GOVERNANCE & PERFORMANCE FINANCIAL MANAGEMENT: THE IMPACT OF PERFORMANCE INDICATORS ON THE ORGANIZATIONAL PROFITABILITY 84 Hayat M. Awan, M. Ishaq Bhatti, Zahid Razaq This paper investigates the financial management performance involved in increasing the firms’ profitability. Stratified random sampling technique was used to select a sample of 200 manufacturing firms with process performance management system (PPMS) criteria to check the impact of performance indicators on the overall business performance index using ROE, ROA. The results of AHP analysis show that the “Supportive Culture” and “PPMS facilitate the competitive advantage” are the major facilitators for those organizations who have implemented the PPMS whereas firms without implementation of PPMS have major inhibitors as “ Non supportive culture” and ”Have another Performance System”. THE RELATIONS BETWEEN OWNERSHIP STRUCTURE AND CORPORATE PERFORMANCE: EVIDENCE FROM BAHRAIN STOCK EXCHANGE 97 Reem Khamis, Wajeeh Al-Ali, Allam Hamdan In this article we examine the relation between ownership structure and corporate performance; the sample of the study included 42 out of 48 companies of all sectors in Bahrain Stock Exchange in five years from 2007-2011. Several dimensions of ownership structure were studied and two different measurements of performance were used to capture the different results from using each one of them and to assess the relevance of each measurement to performance and to justify the conflicting results found by previous studies. Another objective of this study was to explore the patterns of ownership structure found in Bahraini market. EXAMINING THE RELATIONSHIP BETWEEN CEO REMUNERATION AND PERFORMANCE OF MAJOR COMMERCIAL BANKS IN SOUTH AFRICA 115 Mahlomola Khumalo, Andries Masenge The relationship between CEO remuneration and firm performance continues to receive much attention. Although the focus of most of the studies is across sectors, attention is increasingly being directed towards the banking industry. At the same time, controversy around what is deemed excessive remuneration of CEOs in the light of not so impressive firm performance across sectors continues. The 2008 global financial crisis and subsequent problems in the banking industry have increased interest in the dynamics of CEO remuneration and bank performance. This study, which examines the relationship between CEO remuneration and bank performance in South Africa, aims to bring a new perspective to the on-going research and debate. THE EFFECTS OF BUSINESS GROUP CONTROL ADVANTAGES AND AFFILIATE LEVEL ADVANTAGES ON AFFILIATE PERFORMANCE 125 Roderick Bugador This study views the network of control in a corporate business group as its source of competitive advantages. These control advantages are distributed among the business group affiliates and eventually influence their performance. This paper examines this by providing a reconceptualization of both the nature of business group and affiliate level advantages using the data of the top 20 Philippine corporate groups. The study found out that the group level control advantage affects the affiliate performance more than their individual level advantages. This result confirms the capability of business groups to influence and control their group internal market. This also implies that the business group affiliates have not yet developed significant capabilities which are independent to that of their business group. SUBSCRIPTION DETAILS 136


8

ACADEMIC INVESTIGATIONS

& CONCEPTS

SECTION 1

AN EMPIRICAL ANALYSIS OF CORPORATE GOVERNANCE IMPACT ON OUTREACH OF MICROFINANCE

INSTITUTIONS (MFIS)

Sujani Thrikawala*, Stuart Locke**, Krishna Reddy**

Abstract This study examines the impact of corporate governance practices of microfinance institutions (MFIs) on outreach to the poor people in Sri Lanka by using three outreach variables: Breadth of outreach, percentage of women borrowers and depth of outreach. Data for 54 MFIs are analysed using regression analysis of unbalanced panel data from 2007 to 2012. The findings of this study revealed several significant relationships: Breadth of outreach in Sri Lankan MFIs improve when they have a female chair on the board but decreases when they have more female directors and client representation on the board, and female borrowers get more loans when the firm has women representation and international/donor directors on the board, but less loans if they have a female chair. This study provides a direction for future researchers to explore more, and recommend good corporate governance practices for MFIs to reach more poor clients. Keywords: Microfinance Institutions (MFIs), Corporate Governance, Outreach, Sri Lanka, Panel Data *Corresponding author. Department of Finance, Waikato management School, University of Waikato, Private Bag 3105, Hamilton 3240, New Zealand Tel: +647 838 8182 **Department of Finance, Waikato Management School, University of Waikato

1 Introduction

Microfinance institutions (MFIs) emerge as an

important provider of microcredit to under-served

people and an instrument to combat extreme poverty

in developing nations (Hermes & Lensink 2007).

Widespread public enthusiasm for microcredit has

generated a dramatic increase in the number of MFIs

operating in developing countries. It is estimated that

in 2007 there was a total of around 10,000 MFIs in the

world (Ming-Yee 2007), serving over 113 million

clients. Due to the high profits and public perception

of social responsible investment, this sector has grown

commercially and now concerns itself only with

profitability. Unlike other firms, MFI performance

encompasses both financial profitability and outreach.

However, many MFIs are now drifting from their

original mission of alleviating poverty. Accordingly,

among policy makers there is a hefty debate on the

compatibility or trade-off between financial

sustainability and outreach of microfinance sector

(Hermes et al. 2011). Muhammad Yunus, the

foremost pioneer of the microfinance movement, also

expressed the opinion that MFIs must protect the poor

from loan sharks and not give rise to their own breed

of loan sharks. As a result, extant studies have

identified that good corporate governance practices

can improve the MFIs’ outreach to poor people

because sound corporate governance practices can

help MFIs to operate effectively and efficiently.

However, currently available measurements of MFIs

indicate an overriding concern with the profitability of


9

MFI activities and less with outreach. Therefore, it is

important to identify which corporate governance

practices are helping MFIs to reach more clients.

The motivation to examine the impact of

corporate governance on outreach of MFIs in Sri

Lanka is based on the following: First Sri Lanka has

been recovering after 30 years of war and terrorism

and enjoying peace and harmony for about four years

since the war. It is imperative to boost the economic

development of such a suffered country. As a result,

enhancement of microfinance activities became one of

the major economic development goals in Sri Lanka

(Central Bank of Sri Lanka 2012). However, there is

lack of formal governance guidelines for Sri Lankan

MFIs to improve their service in a broader context

(Modoran & Grashof 2009), particularly code of best

practice on corporate governance is not mandatory for

MFIs in Sri Lanka. Therefore, the findings of this

study will contribute to the existing literature relating

to corporate governance practices in MFIs in the Sri

Lankan context and boost the economic development

of a recovering country. From a policy perspective,

Kumar and Zattoni (2013, p. 199) stated that “firm-

level corporate governance performance affects the

development of national governance institutions”.

The remainder of this paper is structured as

follows: Section 2 provides a brief review of the

literature relating to corporate governance. Data

collection and research methods used are described in

section 3. Section 4 discusses the empirical research

results. Finally, the paper concludes with implications

of the study.

2 Literature review

Only a handful of studies have been done to test the

impact of corporate governance on outreach of MFIs.

The empirical analysis of good corporate governance

practices in relation to MFIs is still at an immature

stage and it is important to conduct more studies in

this field to enhance MFIs’ development (Hartarska

2005; Cull et al. 2007; Hartarska & Nadolnyak 2007;

Bassem 2009; Hartarska 2009; Mersland 2009;

Mersland & Strøm 2009). However, there is plenty of

empirical evidence in the financial literature that

supports the view that good corporate governance

enhances the performance of a firm. The same

rationale recommends that good governance practices

of MFIs would enhance their performance and reduce

risk. Therefore, it is important to examine the

empirical evidence of corporate governance

mechanisms in for-profit firms that improve firm

performance.

Previous studies undertaken by different scholars

have recognised certain aspects, such as board

composition and characteristics, and their impact on

firm performance (Lorsch & MacIver 1989; Daily &

Dalton 1997; Muth & Donaldson 1998; Bhagat &

Black 1999; Kula 2005; Roberts et al. 2005). They

revealed many factors to measure the corporate

governance practices of a firm, such as board size,

proportion of non-executive directors, stakeholder

representation on board, gender diversity,

CEO/chairman duality, education qualifications of

board members and number of board meetings

(Lorsch & MacIver 1989; Daily & Dalton 1997;

Bhagat & Black 1999; Roberts et al. 2005; Huse &

Solberg 2006; Kyereboah-Coleman & Biekpe 2006;

Solomon 2007).

However, the researchers that have tested the

relationship between corporate governance practices

and firm performance in the for-profit companies have

reported inconclusive evidence (Bhagat & Black

1999; Weir et al. 2002; Bathula 2008). Some have

reported evidence of a positive relationship between

corporate governance and firm performance (Gompers

et al. 2003; Kyereboah-Coleman & Biekpe 2006),

while others have reported evidence of a negative

relationship between governance and performance

(Hambrick et al. 1996; Sheridan & Milgate 2005;

Rose 2007). In addition, some studies found no

evidence to support the link between corporate

governance and firm performance (Baliga et al. 1996;

Dalton et al. 1998; Abdullah 2004), whereas Dalton

et al. (1998) and Weir et al. (2002) reported that there

is little evidence to support the view that board

characteristics have an impact on firm performance.

The appropriate corporate governance practices

have been a matter of continuing debate and

researches give mixed results. Inconsistent findings of

prior studies and lack of empirical results for the

microfinance industry have led to unclear ideas about

corporate governance influence on firm performance.

However, based on the indication given by many

empirical studies in developed and developing

countries around the world, it is important to further

explore the impact of corporate governance on

outreach of MFIs, as it leads to better service to the

poor people in these countries. Therefore, this study

argues that MFI boards need to have a high standard

of governance practices to deliver better outreach to

the poor.

3 Research methodology

Sample and sample period were constrained by the

data availability, accessibility and validity. Therefore,

our panel was comprised of 300 firm-year

observations over the period of 2007 to 2012. This

study collected data from the MFIs that are registered

with MIX market and Lanka Microfinance

Practitioners' Association (LMFPA), the Sri Lankan

microfinance network. Recent studies (Bassem 2009;

Cull et al. 2011; Lin & Ahlin 2011; Shahzad et al.

2012) have used MIX market database for their

empirical studies as MIX collects its data mainly

through the contracted consultants and the country

level networks that are based in each country

(Lafourcade et al. 2006). The director information has

been collected from the individual institutions by

going through their websites and by individually

contacting them.


10

Table 1. Dependent and independent variable definitions

Variables Acronym Definition

Dependent Variable

Breadth of outreach Breadth The natural logarithm of the number of active borrowers

in the MFI

Percentage of female borrowers FemBorr The ratio of female borrowers to total number of active

borrowers

Depth of outreach Depth

The natural logarithm of average loan balance per

borrower/adjusted gross national income (GNI) per

capita

Independent Variables

Percentage of female directors FemDir The ratio of female directors to total number of

directors on the board

Female CEO FemCEO Dummy variable that takes a value of 1 if the CEO of

the firm in a female

Female chairperson FemChair Dummy variable that takes a value of 1 if the

chairperson of the firm in a female

Duality Duality Dummy variable that takes a value of 1 if the firm’s

CEO and chairperson are same

Board of directors who represent

international/donors agencies of the

firm

IntdorDir

Dummy explanatory variable that takes a value of 1 if

the firm has at least one international/donor agency

representative on board.

Board of directors who represent

clients of the firm Clientdir

Dummy variable that takes a value of 1 if the firm has at

least one director representing clients of the firm.

Independent directors on board IndDir Dummy variable that takes a value of 1 if the firm has at

least one independent director on board.

Board size Bsize The natural logarithm of the total number of directors

on the board

Internal auditor IntAudit Dummy variable that takes a value of 1 if the firm has

an internal auditor reporting to the board

Control Variables

Regulated by banking authority Regbank Dummy variable that takes a value of 1 if the firm

regulated by banking authority in the country

Firm Age Fage The natural logarithm of the number of years from the

date of establishment

Firm size Fsize The natural logarithm of the firm’s total assets

Leverage Lev The ratio of the firm's total debt to its total assets

Year dummy variables year Six year dummies for each of the years from 2007 to

2012

Organisation type dummy variables otype

Dummy variables for each of the organisation type:

NGO, Company, NBFI, Specialised Licenced Bank,

Cooperatives and Credit Unions

Table 1 depicts the definitions of dependent and

independent variables in the study. Breadth of

outreach is measured by the number of clients that

MFIs has provided loans to, or the number of

borrowers over a specific period of time who currently

have an outstanding loan balance with the MFI

(Microfinance Consensus Guidelines 2003; Quayes

2012). Since the inception of the Grameen bank

concept, outreach to women has been a priority

because compared with men, women face greater

problems in accessing loans. According to Quayes

(2012), outreach to female borrowers (FemBorr) is

measured by the number of women borrowers as a

fraction of the total number of borrowers. With the

development of the microfinance sector, Depth of

outreach has become an important measure that

concerns with the overall social outreach of the

microfinance sector. It measures the access of credit

disbursement to poor people; that is, poorer borrowers

will lead to greater depth of outreach (Quayes 2012).

In other words, it indicates how well MFIs have

reached the very poor clients, and focuses on poverty

lending. It can be measured by comparing the loan

size to the Gross National Income (GNI) per capita of

a country.

Percentage of female directors on the board,

female CEO, female chairperson, duality,

international/ donor representation on boards, client

representation on boards, outside/independent

directors on board, board size and internal auditor are


11

employed as the proxies for corporate governance

variables. Regulated by central bank of Sri Lanka,

firm age, firm size, leverage, year dummy variables

and organisation type dummy variables are treated as

control variables in line with previous studies

(Hartarska 2005; Kyereboah-Coleman 2006;

Hartarska & Nadolnyak 2007; Kyereboah-Coleman &

Osei 2008; Reddy et al. 2008; Bassem 2009;

Hartarska 2009; Hartarska & Mersland 2009;

Mersland & Strøm 2009; Mersland et al. 2011;

Galema et al. 2012; Hewa-Wellalage et al. 2012;

Strøm et al. 2014).

This study employed different statistical methods

to analyse panel data. Under univariate analysis,

descriptive statistics including mean, standard

deviation, minimum and maximum values were

computed to identify the overall behaviour of the data.

In particular, the data was normally distributed so that

parametric form of statistical modeling could be

employed. Pearson’s correlation matrix and variance

inflation factor (VIF) were used to determine whether

there were multicollinearity issues in our dataset. The

strength of correlation between dependent variables

and explanatory variables suggests that independent

variables should be included in our regression. Our

results show that the correlation coefficients among

the regressors are below the threshold of 0.80

suggested by Gujarati and Porter (2009). Even though

the multicollinearity is not a serious problem, VIF was

used to do a further test for multicollinearity.

According to Myers (1990), VIF value of 10 or above

is a good indicator that multicollinearity is present

among independent variables and therefore, is a cause

for concern. The results of this study indicate that all

the independent variables had VIF values of less than

3. Therefore, the above evidence leads us to conclude

that there is no multicollinearity issue in our

estimations, as all the values are well below the

thresholds.

Under inferential statistics, we have used a

multiple linear regression model to estimate the

unknown parameters of corporate governance and

outreach of MFIs in Sri Lanka. The two methods,

fixed-effect and random-effect, were used to diagnose

the unobserved factors in the panel regression model.

The main difference between these two methods lies

with the treatment of the dummy variables. Both

fixed-effect and random-effect have their own strength

and weakness. According to Greene (2012), in both

models the explanatory variables tend to be

uncorrelated to the observed firm heterogeneity term

ui and suggest using the Hausman test to choose

between fixed-effect and random-effect model

(Hausman 1978). The test examines whether the

individual effects are uncorrelated with other

regressors in the model. The null hypothesis of the

Hausman test assumes that individual effects are

random, therefore estimators for both models should

be consistent (Cameron & Trivedi 2010, p. 266). The

Hausman test result suggests that it is important to

employ a fixed effect model for Depth variable, due to

the rejection of the null hypotheses where p-values are

significantly lower than the 0.05 level but employed a

random effect model for Breadth and FemBorr

variables due to the acceptance of the null hypotheses.

4 Discussion of empirical findings

Table 2 provides descriptive statistics for major

variables in the study. Due to the huge dispersion in

the number of active clients in the sample, this study

used natural logarithm transformation to condense the

dispersion, as a result the mean and the median values

are 8.16, 7.70 respectively. In Sri Lanka, the average

number of female borrowers represents 81% of the

total number of credit clients. The median value of

88% indicates that fifty percent of the MFIs have less

than 12% of male clients. Average depth of outreach

in Sri Lankan MFIs is Rs.0.14 where the median is

Rs.0.10. This is a relatively weak value when

compared with other studies, and these lower values

indicate that the poor borrowers are very well served

in Sri Lanka, because a higher value would mean that

fewer poor clients are being served (Hartarska 2005;

Bassem 2009). The percentage of women directors on

the board is approximately 43%, which is higher than

the value obtained by Hewa-Wellalage et al. (2012)

for listed companies in Sri Lanka (7.4%). MFIs with

female CEOs are 34% in Sri Lanka, while on the other

hand, 66% of the MFIs have male counterparts as their

CEOs. Findings of this study show that in Sri Lanka,

40% of MFIs have female chairpersons which is a

fairly high figure when compared with a global study.

Out of the total MFIs in the sample, 26% of them have

a CEO who is doubling the role as chairperson of the

board, and this value is relatively high when compared

with the global sample (12%-15%) but low with

Ghana (50%). Sri Lankan MFI boards have around

7.4% of directors who represent international/donor

directors which is a very insignificant representation

when compared with literature (Mersland & Strøm

2009; Galema et al. 2012). As found by Hartarska

(2005) and Mersland and Strøm (2009), Sri Lankan

MFIs also have very small numbers of directors (7%)

on their boards who represent the clients. Around 67%

of the board members in Sri Lankan MFIs are

independent directors. The number of board members

in Sri Lankan MFIs is around 9. On average, 31% of

MFIs have an internal auditor reporting to the board.

Table 3 illustrates the empirical results of

multivariate analysis of outreach variables in this

study. The study comments on the regression result as

a whole by controlling the unobserved heterogeneity

in the panel model. Even though most of the expected

signs of the coefficients are generated from the

regression, only very few of them are significant for

Sri Lankan MFIs. However, interesting results appear

in both of these significant and non-significant

regression results.


12

Table 2. Descriptive statistics

Variables Mean Median Std. Dev. Min Max

Outreach Variables

Breadth of outreach [LN(Active Borrower)] 8.16 7.70 2.03 3.22 13.7

Female borrowers on active borrowers (%) 0.81 0.88 0.19 0.30 1

Depth of outreach (Average loan balance per

borrower/GNI per capita) 0.14 0.10 0.13 0 0.89

Explanatory Variables

Female directors on board (%) 0.43 0.33 0.33 0 1

Female CEO 0.34 0 0.47 0 1

Female chairman 0.4 0 0.49 0 1

Duality 0.26 0 0.44 0 1

International/donor directors on board (%) 0.074 0 0.21 0 1

Directors representing clients (%) 0.071 0 0.16 0 0.8

Independent directors on board (%) 0.67 0.71 0.22 0 1

Board size (No. of board members) 8.47 8 4.44 1 30

Internal auditor reporting to board 0.31 0 0.46 0 1

Control Variables

Regulated by banking authority 0.13 0 0.34 0 1

Firm age 12.8 12 8.05 1 41

Firm size [LN(Total assets)] 18.1 17.7 2.41 12.7 25

Leverage 0.69 0.77 0.25 0 1.1

Female directors on the board are significantly

negatively correlated only with breadth of outreach and positively correlated with percentage of female borrowers in total active borrows in Sri Lankan MFIs. The findings of this study indicate that the number of female directors on boards is highly concentrated on gender inequality in the country, and they promote microfinance loans to more female clients. This result is vice versa for female chairperson on board. The female chairperson on board is significantly positively correlated to breadth of outreach but negatively correlated with female borrowers from MFIs in Sri Lanka. Even though they are female leaders they highly concentrate on increasing the number of active borrowers overall, rather than increasing the number of women borrowers only.

The international/donor directors have a significant positive correlation with female borrowers which shows that directors who represent international/donor agencies are highly concerned about providing microcredit to women in Sri Lanka. However, our results show that directors who represent clients are statistically significantly negatively associated with the number of active clients (breadth) in MFIs in Sri Lanka. Interestingly, depth of outreach does not have any significant relationship with corporate governance variables in this study. 5 Conclusion Based on the indication given by many empirical studies in developed and developing countries around the world, it is important to further explore the impact of corporate governance on outreach of MFIs as it enhances the financial services to the poor people in these countries. Inconsistent findings of prior studies

and lack of empirical results for the microfinance industry have led to unclear ideas about corporate governance influence on outreach. Therefore, this study expands the understanding of the corporate governance practices in MFIs and its impact on outreach for poor in Sri Lanka. This study has employed Sri Lankan data, to investigate the relationship between established internal corporate governance practices as independent variables and outreach as dependent variable for MFIs for the period 2007 to 2012.

Our results are robust with respect to controls for legal status, firm age, firm size, leverage and organisation type. However, our findings are mixed depending on the depended variables that we have examined. In spite of the mixed results, a number of interesting results have emerged from the study. The results of this study are appropriate for both individual MFIs and policy makers in the country, as they indicate that firms can perform better when they comply with good corporate governance practices, and invisible hands in the industry can direct MFIs to improve their corporate governance. The microfinance sector needs to be more effective if it wants to become the miracle cure for poverty and economic development. Now the sector is attempting to reinvent itself. This study points to the need for further empirical research into MFIs using more outreach measures to strengthen the speculations found in this study.

This study has a number of limitations that may pave the way for the further research. Since our focused was on only one country, further research could be undertaken by using more corporate governance variables and/or more countries to check the relationship between corporate governance and


13

outreach of MFIs. In addition, this study has considered only the fixed-effects and random-effects models to examine the relationship. Thus, further analysis can be done with a large dataset by

considering the endogeneity of the variable which is another aspect of the research that could be lead to the better understand of the industry and strengthen the speculations found in this study.

Table 3. Fixed-effect and random-effects regression results

Variables

Breadth FemBorr Depth

Random Effect Model Random Effect Model Fixed Effect Model

b/p t b/p t b/p t

FemDir -0.376* [-1.800] 0.086** [2.094] 0.043 [1.383]

(0.072) (0.036) (0.172)

FemCEO -0.003 [-0.028] 0.010 [0.495] 0.015 [1.211]

(0.977) (0.621) (0.231)

FemChair 0.253*** [2.813] -0.032* [-1.795] -0.010 [-0.777]

(0.005) (0.073) (0.441)

Duality 0.034 [0.352] -0.026 [-1.363] -0.022 [-1.647]

(0.725) (0.173) (0.106)

IntdorDir -0.009 [-0.093] 0.047** [2.394] -0.006 [-0.600]

(0.926) (0.017) (0.551)

ClientDir -0.201* [-1.886] 0.034 [1.643] 0.021 [1.374]

(0.059) (0.100) (0.175)

IndDir -0.052 [-0.191] -0.028 [-0.524] 0.013 [0.347]

(0.848) (0.601) (0.730)

Bsize -0.099 [-0.874] -0.007 [-0.292] 0.003 [0.234]

(0.382) (0.770) (0.816)

IntAudit -0.051 [-0.581] 0.023 [1.302] 0.006 [0.701]

(0.562) (0.193) (0.487)

Regbank -0.201 [-0.287] -0.018 [-0.121]

(0.774) (0.903)

Fage -0.001 [-0.100] 0.005* [1.719] -0.013*** [-4.189]

(0.921) (0.086) (0.000)

Fsize 0.802*** [15.980] 0.024** [2.321] 0.015 [1.065]

(0.000) (0.020) (0.292)

Lev 0.237 [1.179] 0.037 [0.930] -0.022 [-1.012]

(0.238) (0.352) (0.316)

Constant -6.062*** [-7.281] 0.306* [1.786] -0.000 [-0.002]

(0.000) (0.074) (0.998)

Note: Asterisks indicate significance at 10% (*), 5% (**), and 1% (***). Variables are defined in Table 1. Number of clusters are 54. Year dummy 2007 and Organisation Type dummy NGO are treated as the benchmark categories to avoid dummy variable trap

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15

TESTING THE PARTIAL ADJUSTMENT MODEL OF OPTIMAL CASH HOLDING: EVIDENCE FROM AMMAN

STOCK EXCHANGE

Ziad Mohammad. Zurigat*, Nadia Jawdat**

Abstract This study aims at testing the partial adjustment model of cash holdings to investigate whether Jordanian industrial firms have a target cash holdings and how fast they move toward that target when any target deviation exists. A sample of 57 industrial firms listed in the Amman Stock Exchange (ASE) over the period 2001-2013 is used. The study uses the estimated fitted values from the conventional cash equation as a proxy for the target cash holding. Using pooled and panel data analysis, the study provides evidence suggesting that cash flows, net working capital, leverage and firm size significantly affect the cash holdings of Jordanian firms. Moreover, it reveals that Jordanian industrial firms have a target cash level and make a target reversion whenever needed. However, Jordanian industrial firms adjust their actual cash holdings to its target level too slowly. Keywords: Cash Holdings, Trade-off Theory, Pecking Order Theory, Agency Theory of Free Cash Flow, Partial Adjustment Model *Department of Banking and Finance, Yarmouk University **Department of Islamic economy, Yarmouk University

1 Introduction The perfection assumption of capital market suggests

that firms should not show any preferences of internal

over external financing. Both internal and external

financing are perfectly substitute for each other.

Consequently, there is no need for holding cash to

meet any shortage in external financing as long as

external funds can be raised at any time needed. On

the other hand, when frictions exist, capital markets

are no longer perfect. This may restrict the firm's

ability to generate funds externally. Hence, external

and internal financing are not perfect substitutes for

each other. Consequently the need for holding cash

increases in order to avoid under investment problem

that might arise because of the presence of agency and

bankruptcy costs of using external financing (Jensen

& Meckling 1976). Consistent with this argument,

Acharya et al. (2005) argue that, in the presence of

financing frictions, cash plays a separate role and

should therefore be managed and studied in its own

right. The main problem in developing countries in

general is the lack of sources of funds and the reliance

on internal financing to take the advantages of

investment opportunities. In Jordan, the capital market

has been described as imperfect, less developed and

all frictions are relevant and may affect the firm's

investment, financing and dividend policy decisions.

This, along with the fact that banks credit policy is

largely affected by the uncertainty condition in the

world and the region. Such conditions make Jordanian

firms show a preference of internal over external

financing and increase the need for holding cash.

The most relevant theoretical models that can

explain determinants of the cash holding level are the

trade-off theory, the pecking order theory and the

agency theory. According to the trade off theory, firms

trade off the costs and benefits of cash holdings to

maximize the value, implying that the presence of

cash holding costs may outweigh its benefits.1 This

suggests that there is some threshold level of cash

holdings under which the firm’s value is maximized.

This threshold of cash is generally called the optimal

(target) level of cash holdings. Hence, the observed

cash holding is not always the optimal level which

increases the necessity of target adjustment when

deviation from that target exists.

With respect of pecking order theory, issuing

new equity is very costly for firms because of

information asymmetries. Therefore, firms finance

their new investment opportunities primarily with

internal funds, then with debt and finally with equities

as the last resort. Extending the pecking order theory

of Myers & Majluf (1984) and Myers (1984) to

explain what determine cash holdings leads to the

conclusion that there is no optimal cash level but cash

is used as a buffer between retained earnings and

1 The benefits of holding cash are the reduction of transaction

cost for precautionary needs and the cash allowance for speculation, while, the costs are the opportunity cost and liquidity premium.


16

investment needs, implying that cash level would just

be the result of financing and investment decisions.

Few studies provide evidence supporting the

prediction of pecking order theory such as Kalcheva &

Lins (2003) who conclude that cash is positively

related to the growth opportunities of the company, its

size and cash flow. Whilst, negatively related to the

level of debt and capital expenditures.

The agency theory of Jensen & Meckling (1976)

provides another explanation as to why firms hold

cash. It states that managers hold cash and other liquid

assets in order to minimize the cost of external

finance. Dittmar et al. (2003) find evidence suggesting

that firms hold more cash in countries with greater

agency problems. Dittmar & Mahrt-Smith (2007) and

Pinkowitz et al. (2006) find that cash is worth less,

when agency problems between insiders and outside

shareholders are greater.

According to Alles et al. (2012), tradeoff model,

pecking order theory and agency theory of free cash

flow complement each other and work together to

explain the existence of target cash level. Although a

cash holding is considered as one of the most

important topics of corporate finance, there are few

studies that focus on the partial adjustment of

corporate cash holding. Most of the studies focused on

investigating the determinants of firms' cash level,

mainly of large public and private firms in developed

economies (i.e. Ozkan & Ozkan, 2004 and Alles et al.,

2012) with less attention is paid to this topic in less

developed countries including Jordan.

In Jordan, where the capital market is imperfect,

market frictions such as information asymmetry

agency and bankruptcy costs are applicable and

influence a firm's investment and financial decisions

and thereby its value. Moreover, it is a thin and a

small market, making the cost of raising external

funds in primary market relatively high which

increases the reliance on internally generated funds.

However, information asymmetries and agency costs

restrict the firms’ ability not only to raise funds

externally, but also to raise funds internally,

supporting the information content of dividend

payment ( see, Baskin, 1989). This makes cash

management decisions too important for Jordanian

listed companies in Amman Stock Exchange(ASE).

Therefore, this study tries to investigate whether

Jordanian industrial companies have target cash

holdings and how fast do they move towards that

target if any deviations exist by testing the partial

adjustment model of cash holding using a sample of

57 Jordanian Industrial firms listed in the ASE over

the period of (2001- 2013). For this purpose, the

current study uses fitted values estimated by using the

conventional cash equation as a proxy for target cash

holdings level.

This paper is organized as follows. Section 2

presents theoretical framework and a related literature

review. Section 3 discusses the research methodology.

Section 4 presents the estimation results with some

conclusions and recommendations.

2 Theoretical framework and literature review

The theoretical background of cash holdings refers to

Modigliani & Miller (1958) who stated that, under the

perfection assumption of capital market, holding large

amounts of cash is irrelevant because all companies

can borrow and lend at the same rate and can easily

finance their profitable investment projects at

negligible transaction costs. The absence of market

frictions such as transaction, bankruptcy, agency and

information costs makes firms show no preferences of

internal financing over external financing. Hence, the

firm's decision to hold cash is not related to, or

affected by other financial decisions.

However, when transaction costs, agency costs

and information asymmetries are considered, firms'

investment decisions become highly sensitive to the

cash holdings. This suggests that the firm's decision to

hold cash is largely affected by capital market

frictions. More precisely, it is largely affected by the

costs and benefits of cash holding when firms are

restricted to raise funds externally, implying that there

is an optimal cash level that balances costs and

benefits and thus maximizes the firm's value (Garcia-

Teruel & Martinez-Solano, 2008). Moreover,

empirical evidence shows that any deviations from the

optimal level reduce firm value. This implies that

firms can increase their market value merely by being

around the optimal level of cash, which seems

consistent according to the trade-off between benefits

and cost of cash holdings.

In the absence of adjustment cost and the costs of

liquidating assets, firms would always have and

maintain their target cash ratio by changing its

existing ratio to equal its target cash ratio. On the

other word, each firm’s observed cash ratio should be

its optimal ratio. However, the presence of adjustment

costs may restrict the firm’s ability to back

immediately to its target level. Thus, when the

observed level of cash deviates from its optimal level,

firms will gradually adjust that level to the optimal

level in a process referred to as the partial adjustment

process (Jalilvand & Harris, 1984; Taggart, 1977).

The partial adjustment mechanism allows for firms’

observed cash ratio not always to be equal to their

optimal level. Hence, the dynamic trade-off theories,

not the static trade-off theory, will be able to capture

the dynamic change in firms cash holdings. Dynamic

behavior exists because the presence of market

frictions may limit the firm's ability to manage their

cash level, causing them to deviate from optimal

levels and consequently increasing the need for target

reversion to maximize value (Kim et al., 2011).

Moreover, it may not be appropriate for firms to

immediately adjust their target deviations when the

cost of moving toward target level is higher than that


17

of being away from the target (Alles et al., 2012). This

suggests that firms will make target-reversion when

the benefit of moving toward the target level is higher

than the cost of being away from the target. In

addition, Bruinshoofd (2009) found that firms increase

their level of cash holdings from an insufficient level

to a target level more rapidly than they decrease their

level from an excessive level to a target level.

Therefore, firms are very concerned about the speed

by which they move toward their target cash levels

because of high adjustment costs. Few studies

recognize and incorporate the dynamic nature of cash

holdings.

Therefore another trend of research appears to

examine the existence of partial adjustment model of

cash holding. Whether adjustment frictions, such as

those that affect capital structure decisions, influence

cash holding decisions is an important research

question because of their consequences on the

shareholder wealth which associated with deviating

from optimal levels of liquid assets, especially for

financially constrained firms (Denis & Sibilkov,

2010).

Bruinshoofd and Kool (2004) collect data from

Dutch firms and investigate the existence of long-run

liquidity targets. Depending on the empirical

methodology, they document that the rates of annual

target convergence range from 20 percent to over 60

percent which supports the dynamic nature of the

cash-holding decision, which is characterized by a

trade-off between the costs of deviation from the

target and the costs of adjustment. Slow adjustment

process is attributed to adjustment cost and therefore a

firm’s actual cash level is not necessarily identical to

the desired cash holding level.

Ozkan and Ozkan (2004) estimate a partial

adjustment model of cash holdings for a sample of

U.K. firms and find that a dynamic model of cash

holding behavior is better suited than the static models

employed in the extant literature. They find that the

estimated target-adjustment coefficient has a positive

value of 0.54, implying that UK companies adjust

their target deviation too quickly and supporting the

view that firms always adjust towards a target cash

ratio. Drobetz and Grüninger (2006) analyze Swiss

firms’ speed of adjustment towards an endogenous

target cash ratio, using dynamic panel estimation.

They find that the speed of target adjustment of Swiss

firms is between 0.35 and 0.5, indicating that Swiss

firms adjust their liquidity holdings more slowly

towards an endogenous target cash ratio than firms in

other countries. They suspect that the most reasonable

explanations are based on the strong influence of

banks in Switzerland and/or the unfavorable economic

conditions during the sample period that entail low

costs of deviation from the target.

Guney et al.(2006) investigate corporate cash

holding behavior in Japan, France, Germany, and the

UK using data for 3,989 companies over the period

1983-2000. Their findings reveal that the dynamic

cash holding analysis indicates that firms tend to

adjust their cash levels towards a target cash structure.

The speed of adjustment of cash holdings for France,

Germany and Japan is found to be similar (adjustment

coefficient is approximately 0.5),while firms in the

UK seem to adjust to the target cash level more

quickly. This possibly, may suggest that when

adjustment costs are higher, resulting in lower speeds

of adjustment. According to their study, the lower

speed of adjustment for Japan and Germany can be

explained by the fact that German firms and Japanese

firms have close ties with their banks and depend on

them for external financing. It is feasible for them to

adjust slowly towards their target level without

incurring a high level of agency cost. Overall, the

results lend strong support to the dynamic nature of

the cash holding decision of firms. Firms tend to

trade-off between costs of speedy adjustment and

costs of delay in achieving the target cash structure.

Empirical studies also indicate that the speed of

adjustment towards target levels varied among

different samples with different firm characteristics

and at different cash positions. For example, using a

dynamic adjustment model to analyze the cash-

holding behavior of small and medium-sized firms

(SMEs) in Spain, Garcia-Teruel and Martinez-Solano

(2008) find that SMEs aim to achieve a target level of

cash holdings and that they adjust their actual level

towards the target level more rapidly than large firms

do in developed countries.

Another related study by Jiang and Lie (2010)

estimates that firms close about 36% of the gap

between actual and target cash ratios each year. They

further document that across all sample firms, the

adjustment speed is slower if the cash level is above

the target than if it is below. They interpret this as

evidence that self-interested managers are reluctant to

disburse excess cash, and will allow cash levels to

remain high unless they are subject to external

pressure and this is consistent with the argument of

Opler et al. (1999).

Using a sample of U.S. manufacturing firms,

Venkiteshwaran (2011) estimates a dynamic model

that allows firms to adjust their cash holding levels

over time and find evidence consistent with trade-off

type behavior in cash holding levels. He finds a very

strong mean reversion in cash holding levels to

optimal levels and that any deviations from optimal

cash levels are rapidly corrected, typically within two

years for the average firm in the sample. He also finds

that this adjustment rate is faster for small, financially

constrained firms than for larger firm consistent with

the expectation that constrained firms may find it

more costly to operate at sub-optimal levels of cash.

Further, he finds that firms with excess cash are

slower to return to optimal levels than firms that have

cash deficiencies. His findings are similar to those

reported in Ozkan and Ozkan (2004) for a sample of

U.K. firms, but inconsistent with the finding reported

by Dittmar and Duchin(2011) for U.S. firms who


18

report a slower adjustment rates for a broader sample

of firms; firms need three to six years to correct any

deviations from optimal levels. They also find that, on

average, cash deficient firms are slower to adjust to

optimal levels compared to firms with surpluses and

attribute this finding to asymmetric adjustment costs

associated with building versus spending cash

reserves.


The study uses pooled and panel data analysis which

is usually estimated by either fixed effect or random

effects technique.

As the current study aims at investigating the

target adjustment path of Jordanian firms, the

conventional cash equation is used to estimate the

target cash holding. This is because the target cash

holding itself is unobservable. Previous studies have

analyzed determinants of cash holdings assuming

implicitly the existence of optimal cash holding (Opler

et al., 1999; Kim et al., 1998).In addition, Opler et

al.(1999) estimate the optimal cash holding as a

moving average of past cash holding levels.

Consistent with the majority of previous studies

(e.g. Opler et al., 1999, Dittmar et al., 2003, Kalcheva

& Lins, 2003, Ferreira & Vilela, 2004 and Bates et al.,

2009) which have identified a set of firm specific

characteristics that influence the target level of cash

holdings of firms, the current study uses firm specific

characteristics as predictors for target cash holdings of

listed Jordanian firms.

It is worth noting that the selection of

explanatory variables in the current study is based on

alternative theories that might be responsible for the

corporate cash holdings and can be found in the

literature. However, the choice is sometimes limited,

due to lack of relevant data. Following Opler et al.,

(1999) and Bates et al., (2009) in the selection of

independent variables, the following variables are

selected; firm size, growth opportunity (the market to

book ratio), cash flow, net working capital, capital

expenditure, leverage ratio and profitability.

The current study employs the following static

model to investigate the determinants of optimal cash

holding of listed Jordanian industrial firms in the

Amman Stock Exchange. In this model, the observed

cash holding is modeled as a function of the various

firm-specific factors has been discussed above.

ititit

itititititit

CExpCflow

LevprofNWCFSizGrthCash

1716

15141312110 (1)

Where Cash: is the dependent variable and measured by the ratio of cash and cash equivalent to total assets (e.g.

Kim et al., 1998; Opler et al., 1999; Ozkan and Ozkan, 2004; Bruinshoofd and Kool, 2004).

Grth is the Growth opportunity and measured by market to book ratio.

FSiz is the Firm size, and measured by the natural logarithm of total assets.

NWC is Net working capital and measured by current assets minus current liabilities minus cash.

Prof is the firm's profitability and measured as the ratio of earnings before interest and tax (EBIT)

divided by total assets.

Lev is the leverage ratio and measured by the ratio of total liabilities to total assets.

Cflow is the cash flows. Operating cash flows are calculated by EBIT+ Depreciation- Taxes.

CExp is the firm's capital expenditure is measured as the yearly change in fixed assets added to

depreciation.

ε is the error term which represents all random variables that are not included in the model.

3.1 Target adjustment model of cash holding

To investigate whether Jordanian listed industrial

firms have targeted cash ratio and move gradually

toward their target ratio when any deviations exist, the

static-partial adjustment models are adopted. Prior

studies have used several methods to estimate the

adjustment speed for cash levels. This study will

follow the theoretical framework developed by Opler

et al. (1999), who argue that firms' optimal cash

holdings are determined by the tradeoff between the

marginal costs and benefits of holding liquid assets.

They emphasize the persistence of cash holdings and

the existence of implicit target cash levels. They test

the validity of the static trade-off theory, using a

partial adjustment model to provide evidence for the

presence of target level of cash holdings. The

underlying assumption of this model is that, firms

optimally balance the costs and benefits of cash

holdings to maintain their target level of cash reserves.

Moreover, firms may not be always in equilibrium at

their target level of cash holdings. A delay in target

adjustment exists because of its adjustment costs

(Nicolusc, 2005). The presence of adjustment costs

may restrict the firms’ ability to make target reversion

immediately, suggesting the occurrence of partial

adjustment toward the target level (Opler et al., 1999;

Kim et al., 1998).

Hence, the firms’ observed cash ratio will be at

their target level only if no adjustment costs exist.

The speed of target adjustment, when target reversion

exists, depends on the adjustment cost as well as on

the cost of being away from the target level (the


19

benefits of moving back towards the target level). In

reality firms may not completely close the gap

between their actual and target levels of cash holdings

because it may not be effective to do due to the

existence of market friction (Alles et al., 2012). More

precisely, firms may keep the gap between their

observed cash holding and target level if the cost of

being away from the target is lower than that of

moving toward the target and vice versa (Dittmar &

Duchin, 2011).

Following Ozkan & Ozkan (2004) and Garcia-

Teruel & Martinez-Solano (2008), the partial

adjustment model of cash holding can be formalized

as follows:

11

itititit CBCBCBCB (2)

Where, *

ititandCBCB denote the actual cash

holding and the target cash holdings for firm i at time

t. 1 itit CBCB is the difference between a firm's

actual or observed cash holdings between year t and

year t-1. The expression 1

*

itit CBCB is the

deviation of a firm’s cash holdings from its target

level of cash holdings indicating that the target

adjustment is required to reach the optimal level.

Finally, estimating dynamic panel data model of

cash holdings taking into account the dynamic nature

of cash level, will help to analyze the speed of

adjustment of Jordanian firms towards an endogenous

target cash ratio. Unlike the static model that

implicitly assumes that firms can instantaneously

adjust their cash holdings toward the target levels, the

dynamic model recognizes that an adjustment process

may take place and there are some lags for firms to

adjust their cash holdings to their target levels (Gao et

al., 2012). By extending the static model, the study

estimates the speed of adjustment towards an

endogenous target cash ratio in a dynamic panel

model.

For the purpose of target adjustment estimation,

model 2 will be re-formalized as follows:

ititit TRDCBCB 10 (3)

Where itCB is 1 itit CBCB , itTRDCB

is 1

*

itit CBCB and used to measure how far the

actual cash ratio deviates from the target cash ratio.

it is the error term and assumed to be independently

distributed with zero mean.

In this study, 1 is used to capture a firm’s

ability to adjust to its target cash holdings, 1 should

be statistically significant and between zero and one,

not zero nor one (0 < < 1) implying that the

movement toward the target is not a costless process.

At one extreme, when 1 = 1, the model implies that

firms can immediately adjust to their target levels.

Such immediate adjustment is possible only in

frictionless perfect capital markets that impose no

adjustment costs. At the other extreme, when 1 = 0,

the model implies that adjustment costs are so large

that firms cannot adjust their actual level of cash

reserves (Alles et al.,2012).

In general, this class of model is used to describe

the adjustment process toward target levels of

corporate cash holdings taking in to account that the

deviations from target cash ratio are not necessarily

offset quickly. This implies that value-maximizing

firms will gradually adjust their actual cash holding

toward their target level (Garcia-Teruel & Martinez-

Solano, 2008). The reason for this is that cash holding

decisions may be affected by the existence of market

imperfections such as information asymmetry, agency

conflicts or the existence of transaction costs incurred

by accessing the capital markets (Garcia-Teruel &

Martinez-Solano, 2008).

It worth's noting that the conventional cash

equation will be used to estimate the target cash

holdings level that will be used to calculate the target

deviation and then estimating the target adjustment

rate. The following section presents the estimation

results of partial adjustment model.

4 Regression results

This section consists of two sub-sections. The first one

presents the estimation results of conventional cash

holding equation; the equation that has been used in

the current study to estimate the fitted values of cash

holdings as a proxy for the target cash level. The

second one presents the estimation results of partial

adjustment model.

4.1 Estimation results of conventional cash equation

The result presented in table (4-1) suggests that the

fixed effect model is found to be the best specification

of the study's data set. The significant Lagrange

Multiplier (LM) test implies that the panel data

analysis is better than pooled OLS analysis,

suggesting the presence of firm and time specific

effect, and hence, OLS regression will not be efficient

to estimate study empirical model. The Ch2 value of

LM test is estimated to be 138.09 with p-value of

0.000. However, Hausman test suggests that the fixed

effects regressors will be better than random effect

regressors to greater efficient estimation results. This

finding is confirmed by the insignificant value of

Hausman CH2. It is found to be 18.5 with a p-value of

0.000. Moreover, the results of diagnostic tests for

Multicolinearity and Heteroskedasticity indicate that

the empirical models have no Multicolinearity and

Heteroskedasticity problems. The results of VIF show

that the mean value of VIF for all variables included


20

in the model is 1.20, since the VIF for all variables are

ranged between (1.07 – 1.25) which indicates that the

model may not suffer from Multicolinearity problem.

With respect to the Heteroskedasticity problem,

Breusch-Pagan test is found to be statistically

insignificant, implying that the variance of residuals is

homogeneous, and hence no Heteroskedasticity

problem exists for the sample of the study.

The results presented in Table 1 show the

determinants of optimal cash holdings in Jordan. They

are generally similar to those documented in the

empirical studies in both developed countries and

other developing countries. Table 1 reveals the

estimation results of model (1). Discussion will be

restricted to the model which has been found the best

specification for the current data set.

- There is a significant positive relationship at

1% between a firm's cash holdings and cash flow

(Cflow). This result is in line with the findings of

Ferreira and Vilela (2004), Afza and Adnan (2007)

and Alam et al. (2011) who found a positive

relationship between cash flow and cash holdings.

This supports the idea that, in the presence of

information asymmetries, firms prefer to finance their

new investment opportunities with internally

generated resources (Garcia & Solano, 2008).

Table 1. The estimation results of study's models

REM FEM Variable

0.0276 0.0251 Cflow

(0.000) (0.002)

0.02443 0.0249 CExp

(0.439) (0.438)

-0.0426 -0.0529 Lev

(0.000) (0.000)

-0.1667 -0.2661 NWC

(0.006) (0.000)

0.0012 -0.03766 Fsize

(0.917) (0.086)

0.0200 0.01754 Grth

(0.194) (0.288)

0.00902 0.0071 PRO

(0.035) (0.114)

0.5709 1.259 Cons

(0.004) (0.001)

72.91 10.29 F test

(0.000) (0.000)

20.41% 22.17% R*2

Chi2 statistic =18.5

Prob(Chi2) = 0.000 Hausman test/Chi2

chi2(1) =138.09 LM test

Prob > chi2 0.000

2.51 Hottest

0.1128

- With respect to the effect of leverage (LEV) on

cash holdings, there is a significant negative

relationship at 1% between cash holding and the

leverage. The results may indicate that the leveraged

firms have lower cash holdings. This is in accordance

with the findings of Ferreira &Vilela (2004) that cash

and leverage are negatively related. The negative

coefficient supports the pecking order theory

according to Drobets & Gruninger (2006).

- There is significant negative relationship at 1%

between cash holding and net working capital. This

result is in line with Alam et al. (2011) who found a

negative relationship between net working capital and

cash holdings. Afza & Adnan (2007) and Megginson

& Wei (2010) also support that cash holdings are

negatively related to net working capital.

- There is significant negative relationship at

10% between cash holding and firm size. This is

consistent with Nguyen (2005), Saddour (2006), and

Drobetz and Grininger (2007) who found a negative

relationship between firm size and cash holdings

- Capital expenditure and profitability are also

positively correlated with cash level but not

significant. This result is in contrast to previous

empirical studies (e.g; Ferreira and Vilela, 2004;

Ozkan & Ozkan, 2004; Opler et al., 1999; Kim et al.,

1998). Also, growth opportunities (as measured by

market to book ratio) are found to be insignificant as

cash holding determinants in Jordan in both panel

regression models.

It worth's noting that the conventional cash

equation will be used to estimate the target cash

holdings level that will be used to calculate the target


21

deviation and then estimating the target adjustment

rate. The following section presents the estimation

results of partial adjustment model.

4.2 The estimation results of partial adjustment model

To investigate whether Jordanian industrial firms have

target cash holdings and how fast they move toward

that target, the study extends the static cash holding

model and formulates a partial (dynamic) adjustment

model. In a frictionless world, firms would always

maintain their target cash level. However, market

imperfections such as transaction costs may prevent

firms from immediate adjustment to their target level

of cash holding. Hence, the partial adjustment model

will be better than the static cash holding model to

capture the dynamic pattern of firms' cash holdings

behavior.

The estimation results of this model are

presented in table 2. As signified by the significant

Lagrange Multiplier (LM) and insignificant Hausman

tests, the model with fixed effects is the preferred

specification. Hence, discussion will be restricted to

results obtained by fixed effects regressors.

Table 2. The estimation results of partial adjustment model

Variables itCB

Pooled data FEM REM

Intercept -6.58

(-17.62)

(0.000)

-6.95

(-18.95)

(0.000)

-6.913

(-16.98)

(0.000)

itTRDCB 0.239

(3.48)

(0.001)

0.172

(2.53)

(0.012)

0.189

(2.88)

(0.004)

R2 0. 259 0. 159 0. 159

F-statistic 12.13

(0.0005)

6.39

(0.012)

8.27

(0.004)

Observations(n) 458 458 458

Hausman test Chi2 statistic = 0.81 Prob(Chi

2) = 0.3675

LM test chi2(1)= 87.62 Prob > chi

2 = 0.000

As can be seen, the estimation results of model

(3) suggest that industrial Jordanian firms are

dynamically adjusting their cash holdings towards

target levels. More precisely, they have a target cash

ratio and move gradually toward that target if any

deviation exists. This finding is confirmed by the

statistically significant of the itTRDCB variable.

However, the results indicate that Jordanian firms

adjust their actual cash level slower than do firms in

other countries. The estimated coefficient on the

itTRDCB variable is found to be, on average, 0.172,

implying that Jordanian industrial firms need 3.7 years

to adjust half of the deviation of their actual cash

ratios, and 7.2 years to correct totally target deviation.

As the estimated coefficient on the itTRDCB

variable measures the speed rate of target adjustment,

the speed of target adjustment of Jordanian industrial

firms is lower than that of other developed countries.

For Swiss non-financial firms, Drobetz& Grüninger(

2006) report an adjustment speed rate ranged between

0.35 and 0.50. Ozkan and Ozkan (2004) report 0.6

adjustment rates for U.K firms. Using sample data

from U.K., Japan, France, and Germany markets,

Guney et al. (2003) reports adjustment speed rates of

0.59, 0.57, 0.60, and 0.56 for French, German, UK,

and Japanese firms, respectively. Couderc (2005)

provides evidence suggesting that adjustment rates

differ across countries. The estimated adjustment rates

are higher for the U.S. and Canada (over 0.6) than for

Germany and France (roughly 0.5) (Drobetz &

Grüninger, 2006).

One explanation to the low adjustment speed of

Jordanian firms is the presence of adjustment cost. As

transaction costs are inversely proportional to the

adjustment coefficient, the lower the value of this

coefficient, the higher the transaction costs and then

the slower the movement toward the target level. For

some firms under certain circumstances, the

adjustment costs may be so high, that it is not cost

effective for them to make any further adjustments,

especially when the deviation is close to the target

levels (Alles et al., 2012) .The presence of market

frictions in Jordan creates many financial constraints

to which the Jordanian firms could generally respond.

As Jordanian firms have relatively large transaction

costs indicating that these costs are much higher than

those of staying away from the target which may

prevent firms or even make them reluctant from

making quick adjustments due to the higher

transaction costs involved, which may affect the

overall average adjustment speed. The role of

adjustment costs has been emphasized in the context

of other financial policies, such as capital structure


22

and investment but has not received attention in the

cash literature (Dittmer & Duhin, 2011).

Another explanation for the delay in adjustment

process is the access to bank credit. According to

Zeitun et al. (2007), Jordan is a bank-based system

and the cost of borrowing is quite high, which makes

retained earnings an important source of funds. Thus,

a limited source of funding that is available for

Jordanian firms would have an impact on their cash

adjustment ability, and this means that the

mechanisms for Jordanian firms to make their cash

adjustments are limited. These findings are consistent

with the finding of Dittmer and Duhin (2011) that

firms with access to bank credit have significantly

higher speed of adjustment of cash. These results are

supportive of the “trade-off theory” of cash holdings,

under which firms have an optimal cash level, as

opposed to the "financial hierarchy hypothesis" of

cash holdings.

5 Conclusion and recommendations

The aim of this study is to investigate the speed by

which a sample of Jordanian industrial firms adjust

cash ratios toward their target levels, using a dynamic

adjustment model. A panel data for a sample of 57

Jordanian firms over the 2001-2010 is used and

estimated using fixed and random effects model. The

findings of this study suggest that Jordanian industrial

companies retain an average 6.5% of their assets in the

form of cash. This implies that Jordanian firms keep

their cash holdings low for the purpose of reducing the

agency costs of holding cash. Furthermore, Cash flow,

net working capital, leverage and firm size

significantly influence the cash holdings of Jordanian

firms with no impact of growth opportunities,

profitability and capital expenditures. The negative

impact of leverage on cash holdings suggests that

Industrial Jordanian firms can use borrowing as a

substitute for holding high levels of cash and

marketable securities. This explains how severe the

agency problem in Jordanian industrial firms is as

listed in ASE.

The study also reveals that Jordanian industrial

firms identify a target level for their cash holdings and

their decisions are taken in the aim of achieving this

objective. However, target adjustment occurs too

slowly, indicating that Jordanian firms have a large

transaction, asymmetric information and agency costs,

increasing the cost of moving toward the target ratio

and consequently, reducing the impetus of these firms

to back quickly to their target.

In the light of above conclusions, the study

recommends that Jordanian firms should increase their

cash holdings in an attempt to lower the probability of

financial distress and bankruptcy because the

insufficient balance of cash holdings may force firms

to give up some of the profitable investment

opportunities. Moreover, it recommends that the

policy makers in Jordan should develop the capital

market, increase its efficiency, competition and

transparency to increase the firm's ability to generate

funds externally.

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24

THE EFFECT OF THE FIRM’S AGE AND FINANCIAL LEVERAGE ON ITS DIVIDEND POLICY – EVIDENCE FROM

KUWAIT STOCK EXCHANGE MARKET (KSE)

Turki Al-Sabah*

Abstract Identifying the major determinants of companies’ dividend policy has been the pith of various researchers and industry practitioners as well. In this research, the effect of the firms’ financial leverage and age on their dividend policy has been explored. Two hypotheses were formulated, where the first focused on examining the effect of the firms’ financial leverage and the second concentrated on investigating the effect of the firms’ age on their dividend policy. The sample assimilated in this study comprises of 38 Kuwait Stock Exchange listed companies from different industries. The period of investigation was five years, from 2009 to 2013. The hypotheses were tested using ordinary least square and fixed-effect panel regression. The results signify a negative relationship between the firm’s financial leverage and dividend payout ratio. Moreover, the results indicate a negative relationship between the firm’s age and dividend payout ratio. Keywords: Financial Leverage, Dividend Policy, Stock Exchange Market

*B.S. Finance & Financial Institutions-Kuwait University, College of Business Administration

1 Introduction

The monitoring of companies dividend policy is

requisite and integral for many investors and industrial

practitioners. Dividends distributed in the form of cash

to shareholders serves as a gauge of the financial

soundness, strength, and future prospects of

companies. Dividends are used to calculate a wide

range of ratios (e.g. dividend yield, dividend coverage

ratio, firm value via the dividend discount model) that

are essential for the valuation of companies.

Furthermore, there are investors who are dividend

seekers and who target companies with high cash

dividend payout ratios. In that perspective, these

investors are analogous to John D. Rockefeller who

quoted: “The only thing that gives me pleasure is to

see my dividend coming in”.

Due to the importance of companies’ dividend

policies to investors and practitioners, numerous

researchers focused on determining the dominant

factors that affected such policies and sought to

explain it in a quantifiable relationship.

2 Literature review

When companies generate profits, management must

decide whether to distribute these profits in the form

of dividends or else reinvest these funds in the form of

retained earnings within the company. Dividends are

categorized into two main classes: 1) Cash Dividend

2) Stock Dividend. Usually, it is more common for

companies to distribute dividends in the form of cash

as opposed to stocks, however stock market

characteristics and investor behavior vary substantially

with regards to different countries, opting many

companies to allocate stock dividends in certain

circumstances. Moreover, regulations in certain

countries can delimit the company’s dividend policies

and restrain their flexibilities.

Financial leverage refers to the total amount of

debt expressed as a percentage of total assets for a

specific company (debt ratio). Financial leverage

includes all fixed-income securities and preferred

stock included in the company’s capital structure. The

impetus behind the use of financial leverage is

inherent from the tax shield offered by several

governments, including the United States.

Furthermore, raising external debt adds economical

value to a company that earns higher returns on the

assets acquired by debt than the cost of debt itself.

Nevertheless, financial leverage has its negative

implications, which was salient during the financial

crisis in 2008, where many financial companies

collapsed due mainly to exorbitantly leveraged capital

structures (e.g. Lehmann Brothers). On the other hand,

Modigliani and Miller (1958) published the Nobel

Prize winning paper regarding the optimal capital

structure and theory of investment, where they

claimed that financial leverage has no effect on the

firms’ value in the absence of corporate income taxes

and distress costs (i.e. ex ante (related to increased

borrowing) and ex post costs (related to filing for

bankruptcy)).


25

All living organisms have a finite age, where

they go through various stages in their lives and

eventually end at some point in time. The life cycle

theory (Adizes, 1989) claims that firms experience

commensurate life cycles as living organisms on the

premise that they initiate, stabilize, and ultimately

perish. Copious researchers have concluded that the

firms operating and financial activities, including the

payout of dividends, are affected by the company’s

stage in its life cycle (Anthony and Ramesh, 1992).

The four stages of a firms life cycle are as follows: 1)

Introduction 2) Growth 3) Maturity 4) Decline.

Research regarding the determinants of dividend

policies traces back to the 1950’s, when Lintner

(1956) surveyed several chief executive officers

(CEO’s) and chief financial officers (CFO’s). Lintner

proposed several factors affecting firms’ dividend

policy including the corporation’s ownership

structure, investing expenditures, size, and proclivity

to employ external debt. Nonetheless, Lintner’s

dividend policy model was based on two main

parameters: 1) target payout level 2) the time it takes

for current dividends to adjust to the target. During his

research on determinants of dividend policy, Lintner

observed that managers tend to establish long-term

dividend to earning targets based on the total amount

of projected positive net present value (NPV) of

available projects. Further, he concluded that firms

would not alter the dividend policy, unless managers

are confident of sustaining earnings at a specific level.

Fama and Babiak (1968) further extended Lintner’s

model. Al-Kuwari (2007) researched the main

determinants of dividend policies for firms listed in

the Gulf Cooperation Council (GCC) stock exchange

markets. She tested several variables including

financial leverage, where she found a negative

relationship between a firm’s debt and it’s dividend

payout ratio. Nevertheless, she concludes that the

effect of leverage on dividend payout is not as

profound as other research cases suggest. Hafeez and

Attiya (2008) applied Lintner’s model along with its

extension in order to determine the main factors

affecting dividend policies for non-financial firms in

Pakistan’s stock exchange market. Their sample

included 320 listed non-financial firms from the

period 2001 to 2006. They tested several variables

including the company’s earnings, ownership

structure, liquidity, and market capitalization. More

importantly, they concluded that financial leverage has

negative impact on dividend policy. Thus, their

research suggests that highly leveraged firms listed in

Pakistan’s stock exchange market are more loath to

payout dividends. Furthermore, Talat and Hammad

(2010) analyzed 100 companies listed in Pakistan’s

stock exchange market. Although they also concluded

that financial leverage is negatively related to dividend

payout, however based on their sensitivity analysis,

they suggested that leverage is not a major factor in

determining the firm’s dividend level for companies

incorporated in the sample study. Azhagaiah and

Veeramuthu (2010) examined 73 stock exchange

listed companies across different sectors in India.

Their research manifested that the dividend payout

ratio for small-sized, medium-sized, and large-sized

companies is dependent on the level of debt reflected

in the capital structure. Wang et al. (2011) assessed

the main determinants of dividend policy and the

application of the life-cycle theory with regards to

Taiwanese companies. Their sample included various

listed companies in Taiwan’s stock exchange market,

from the period 1992 to 2007. Their results were

coherent with the life-cycle theory, where they found

out that younger firms with high growth trajectories

and limited profitability have a higher propensity to

distribute stock dividends as opposed to cash

dividends, whereas older firms with lower growth

potential and high profitability prefer to dispense cash

dividends as opposed to stock dividends. Ihejirika and

Nwakanma (2012) compiled a similar study on 62

stock exchange listed companies in Nigeria from the

period 2000 to 2008. Their results indicated that firms’

dividend payout ratio is affected mainly by the return

on equity (ROE), life-cycle stage, and size.

Surprisingly, their results suggested a negative

relationship between the firms’ life cycle stage and the

dividend payout ratio, demonstrating that younger

aged Nigerian firms have a higher predilection to pay

dividends than older firms, which is inconsistent with

Deangelo et al. (2006) study findings. Maladjian and

El Khoury (2014) conducted a study on several

Lebanese banks listed in the stock exchange market

from 2005 to 2011 to find out the main determinants

of dividend policies for banks in Lebanon. Similarly to

some previous studies, the results signified that

financial leverage is not a major variable affecting

dividend payout, however it was surprising that there

was a positive relationship between debt and dividend

policy. Lastly, Tamimi et al. (2014) evaluated the

effect of financial leverage and age on the dividend

policy of listed manufacturing companies in Tehran

stock exchange from 2005 to 2011. Their results

suggest a negative relationship between leverage and

dividend policy, while in the mean time indicate a

positive relationship between the firm’s age and it’s

dividend policy.

3 Objective of the study

The goal of this paper is to assess whether the firm’s

age and financial leverage have a significant effect on

its dividend payout ratio with regards to companies

listed in the Kuwaiti Stock Exchange (KSE).

Moreover, the study aims to quantify the magnitude of

the effect of financial leverage and age of the firm on

its dividend policy, if such relationship exists.

4 Hypotheses development

Consistent with the goals of this research paper, the

primary objective is to investigate the following


26

research hypothesis, which are related to the impact of

different firm specific variables on the company’s

dividend payout ratio after controlling the effect of

sales growth, earning per share and size of the

company. In particular, we will test:

H01: A firm’s financial leverage has no effect on

its dividend payout ratio.

Ha1: A firm’s financial leverage has a significant

effect on its dividend payout ratio.

H02: A firm’s age has no effect on its dividend

payout ratio.

Ha2: A firm’s age has a significant effect on its

dividend payout ratio.

5 Methodology 5.1 Sources of data

The empirical study is exclusively based on secondary

data obtained mainly from several related articles and

the Kuwait Stock Exchange (KSE) website. The data

garnered includes historical dividend payout ratio,

financial leverage, age, and earning per share (EPS) of

listed firms in KSE during the period of study.

5.2 Sample selection

The sample incorporated in this study comprises 38

disparate listed firms in KSE, analyzed across a period

of 5 years, from 2009 to 2013. In order to enhance the

accuracy of this study, all of the 38 listed companies

involved in the sample disbursed cash dividends each

year during the period of investigation. Furthermore,

the companies encompassed in the sample represent

different industries, in an attempt to assimilate a

multifarious sample that would represent the KSE

accurately (Table 1).

Table 1. Sample representation of KSE companies among industries

Type of Industry Number of Companies

Oil & Gas 1

Basic Materials 2

Industrial 12

Consumer Goods 3

Consumer Services 2

Telecommunications 2

Banks 4

Insurance 4

Real Estate 2

Financial Services 4

Technology 2

5.3 Research method

The conducted research represents a type of empirical

study applied to extrapolate the causal relationship

between the variables under observation. The study

will be conducted through the application of

econometrics, mainly correlation analysis and multiple

linear regression models. In order to estimate the

effects of the independent variables, company size and

financial leverage, on dividend payout ratio, we

perform the ordinary least square model. Next, we

look at the variance explained by the ordinary least

square model and decide whether the panel data

methodology or the variable effect models will be

more appropriate to test the proposed model. Further,

in order to decide between random and fixed effect

model, we have used Hausman test of correlated

random effects. The suppositions proposed by the

study will be tested using eviews statistical software.

5.4 Terminology of variables

5.4.1 Dependent variable

The dividend payout ratio considered in the study

takes into account only dividends disbursed in the

form of cash and disregards stock dividends. The cash

dividend payout ratio is calculated by dividing the

annual cash dividend per stock by its par value.

5.4.2 Independent variables

a. The age of the companies, which is found by

subtracting the current time period from the

company’s date of establishment.

b. The financial leverage of the company, which

is indicated by the percentage of total debt to total

assets, i.e. the debt ratio.

5.4.3 Control variables

In order to obtain a more accurate measure of the

relationship between the dependent and independent

variables, the following control variables have been

incorporated in the study:

a. The annual growth in sales (revenues), which

is calculated as follows:


27

b. The earning per share (EPS), which serves as

a gauge of a firm’s profitability and quantifies the

portion of a firm’s profit that is allocated to each share

of common stock. It is derived as follows:

c. The size of the company, which is found by

taking the log of the total assets at the end of each

financial year (DeAngelo, 1981).

Furthermore, the selection of the control

variables stated above is based on the fact that many

researchers applied the same control variables in

conducting analogous studies and achieved successful

results. Moreover, sales growth will be represented in

percentage terms, earning per share and company size

will equate to a minimal quantity. Therefore, the input

data of the control variables will maintain consistency

with the data of the dependent/independent variables,

which is represented by percentages and minimal

quantities, and which will aid in fostering reliable

results.

5.5 Model construction

In order to test the research hypotheses, the research

model has been constructed as follows:

DP=β0 +β1(LEVERAGE)+β2(AGE)+β3(SALES

GROWTH)+β4(EPS)+β5(SIZE)+ε

Where DP: Dividend Payout Ratio

LEVERAGE: Financial Leverage of Companies

(debt)

AGE: Companies Age

SALES GROWTH: Annual Growth In

Revenues

EPS: Earning Per Share

SIZE: Company Size

ε: Error Term

6 Data analysis results 6.1 Descriptive statistics

The analysis results in Table 2 summarize the

descriptive statistics of the data used in this research

study. The analysis results show the descriptive

summary of each variable; particularly it calculates

minimum, maximum, mean, median, standard

deviation, skewness, kurtosis, as well as the Jarque-

Bera test of normality. The analysis results in Table 2

indicate that most of the variables are symmetrical. As

we observed that all the variables are positively

skewed. However, the skewness values of some

variables such as- financial leverage, sales growth,

size and age of the companies are less than 3 (in

absolute value), so we can conclude that these

variables are nearly normally distributed. Nonetheless,

skewness value of the dividend payout ratio and

earning per share of the companies is greater than 3,

which manifests that these two variables are

asymmetrical. Similarly, the kurtosis values of all the

variables are summarized in Table 2. It is observed

that three series dividend payout, earning per share,

and sales growth have high kurtosis values, whereas

the other series have low kurtosis values. Thus, we can

conclude that dividend payout, earning per share, and

sales growth deviate slightly for a normal distribution.

Lastly, we confirm the normality of each variable

using the Jarque-Bera statistics and the corresponding

p-values. The Jarque-Bera test statistics indicate that

firm specific variables used in the study deviate

slightly from the normal distribution. However, from

the central limit theorem we can assume the variables

to be normally distributed if the sample size is

increased. Though, in the present study there is a

constraint on the sample size because of limited

availability of yearly data for each company.


Variables DP Leverage EPS SALES GROWTH SIZE AGE

N 190.00 190.00 190.00 190.00 190.00 190.00

Mean 0.31 0.44 0.05 0.03 8.23 30.11

Median 0.25 0.41 0.03 0.01 8.16 31.00

Maximum 2.00 0.91 0.72 0.60 10.27 61.00

Minimum 0.05 0.03 -0.03 -0.39 6.59 9.00

Std. Dev. 0.30 0.24 0.06 0.18 0.89 14.01

Skewness 3.01 0.37 3.20 0.45 0.45 0.22

Kurtosis 3.52 2.12 2.87 3.88 2.57 2.07

Jarque-Bera 15.45 10.48 12.93 12.66 7.93 8.36

Probability 0.00 0.01 0.00 0.00 0.02 0.02


28

6.2 Correlation matrix between the dependent and explanatory variables

In this research we have used simple correlation

matrix to examine multi co-linearity between the

explanatory variables. The analysis results indicate

that there is no significant violation to the multi co-

linearity assumption. Thus, we conclude that there are

no firm specific variables that are highly correlated

(>0.50) and there exists no multi co-linearity among

these variables.

Table 3. The pairwise- correlation matrix for dependent variable (DP) and explanatory variables

Variables DP Leverage EPS SALES GROWTH SIZE AGE

DP 1.00

Leverage -0.17 1.00

EPS 0.45 -0.05 1.00

SALES GROWTH 0.05 -0.09 0.17 1.00

SIZE 0.14 0.49 0.17 -0.14 1.00

AGE 0.05 0.36 0.00 0.01 0.39 1.00

6.3 Regression analysis (OLS model)

In order to confirm the normality of the residual terms

we generate the residual histogram plot (Figure 1) and

the normal quantile plot (Figure 2). It can be observed

that residual error terms deviate slightly from the

normal distribution. However, we can assume that the

residual error terms are nearly normally distributed

and proceed with further analysis. In addition, we can

observe that the VIF values are less than 4, indicating

that multi-collinearity is not an issue in the dataset.

This further confirms the findings from the correlation

analysis about the multi-collinearity.

The results from the ordinary least square model

are summarized in Table 4. The dependent variable is

dividend payout ratio and with the computed F-value

of 14.9421 (p<0.05) for OLS regression, we reject the

null hypothesis that all coefficients are simultaneously

zero and accept that the regression is significant

overall.

Table 4. Parameter estimates of ordinary least square regression model

Variable Coefficient Std. Error t-Statistic Prob. VIF Tolerance

C -0.5079 0.2174 -2.3358 0.0206

AGE 0.0014 0.0014 0.9789 0.3289 1.2048 0.8300

DEBTRATIO -0.5140 0.1137 -4.5193 0.0000 2.1185 0.4720

GROWTH -0.0011 0.1061 -0.0103 0.9918 1.0727 0.9322

EPS 1.7636 0.3139 5.6183 0.0000 1.1469 0.8719

SIZE 0.1122 0.0315 3.5658 0.0005 2.3080 0.4333

R-squared 0.2888

Adjusted R-squared 0.2695

F-statistic 14.9421

0.0000

Durbin-Watson stat 1.0667

Further, it is observed that the adj. R-square

value is 0.2695, which indicates that only 26.95% of

the variability in the dividend payout ratio is explained

by the OLS model. Moreover, the Durbin Watson

statistic value in our output of ordinary least square

model is 1.0667 and this confirms that residuals are

serially correlated. Thus, we conclude that the OLS

model does not fully explain the variation in the

dependent variable, dividend payout ratio. Next, we

look at the variable effects model to determine a better

fitting model. In order to choose between the two

variable effect models (random effect model v/s fixed

effect model), we perform the Hausman test for

correlated variable effect.

6.4 Hausman test for correlated random effects

In order to specify the type of panel regression

analysis (random-effects/fixed-effects), we have used

Hausman test (1978). Hausman test is used in the

study to confirm whether there exists any random

effect in the dataset. The null hypothesis in Hausman’s

test states that the random effect model is appropriate.

On the contrary, the alternative hypothesis states that

the fixed effect model is appropriate.

The analysis results for Hausman’s test are

summarized in Table 5. The analysis results indicate

that the corresponding effect is statistically significant.

Thus, we reject the null hypothesis and conclude that

the fixed effect model is appropriate.


29

Figure 1. Histogram plot of residuals

Figure 2. Normal P-P plot of standardized residuals

Table 5. Hausman’s test for correlated random effects

Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-Section random 53.02 5 0.000

6.5 Panel regression analysis (fixed effect model)

The analysis results of fixed effect panel regression

are reported in Table 6. The dependent variable is the

dividend payout ratio. As shown in Table 6, the adj.

R-squared value (0.6627) suggests that the model

serves its purpose in determining the impact of firm

specific variables on dividend payout ratio. In other

words, 66.27% of the variability in the Dividend

Payout ratio can be explained by the financial

leverage, earning per share, sales growth, size and age

of the company. The Durbin Watson statistic value in

our output of fixed effect model is 1.902 and this

result confirms that residuals are serially correlated.

Further, according to the computed F-value of 9.8407

(p<0.05) for the panel data regression, we reject the

null hypothesis that all coefficients are simultaneously

zero and accept that the regression is significant

overall.


30

The estimates of the fixed-effect regression

coefficients in Table 6 manifest that variables sales

growth and earning per share do not have any impact

on Dividend payout ratio. Further, we observe that the

financial leverage has a significant and negative

relationship with dividend payout ratio, which is

consistent with the majority of previous studies. This

result implies that companies with higher financial

leverage ratios tend to disburse fewer dividends as

compared to companies with lower financial leverage

ratios. Similarly, we observe that a firm’s age has a

significant and negative relationship with dividend

payout ratio, which is inconsistent with the life-cycle

theory. This result suggests that older companies tend

to pay fewer dividends as compared to new

companies. The coefficient of age indicates that a unit

increases in age of the company decreases the

company’s dividend payout ratio by (-0.0357) units

and the coefficient of leverage ratio indicates that a

unit increase in company’s leverage ratio decreases

company’s dividend payout by (-1.6561) units.

Lastly, it is observed that one of the control

variables i.e. the firm size has a significant and

positive relationship with dividend payout ratio. The

coefficient of size indicates that a unit increases in

total assets increases the dividend payout by 1.7753

units. This indicates that larger firms tend to disburse

more dividends to their shareholders compared to

smaller firms.

In summary of the regression results, the

variables age, size and leverage ratio of the company

seem to affect its dividend payout ratio. On the other

hand earning per share and sales growth of the

company do not appear to have a significant effect on

its dividend payout ratio.

Table 6. Regression analysis results from fixed-effect panel regression

Variable Coefficient Std. Error t-Statistic Prob.

C -12.4599 2.2296 -5.5885 0.0000

Financial Leverage -1.6561 0.3433 -4.8240 0.0000

Firm’s Age -0.0357 0.0109 -3.2765 0.0013

Sales Growth -0.0247 0.0790 -0.3128 0.7548

Earnings Per Share -0.4123 0.3197 -1.2896 0.1992

Firm Size 1.7753 0.2966 5.9861 0.0000

R-squared 0.7376

Adjusted R-squared 0.6627

F-statistic 9.8407

0.0000

Durbin-Watson stat 1.9020

7 Conclusion

The primary objective of the study was to examine the

effect of the companies’ age and financial leverage on

their dividend cash payout ratio. The study was based

on testing two hypotheses. The first hypothesis

focused on investigating the effect of the companies’

financial leverage on their dividend policy. On the

other hand, the second hypothesis focused on

examining the effect of the companies’ age on their

dividend policy. The sample assimilated in the study

includes 38 Kuwait Stock Exchange listed companies

from different industries. The period of study was 5

years, from 2009 to 2013. The data was initially tested

using ordinary least square regression, where the

results indicated that the regression is significant

overall. Nevertheless, the OLS model was not

sufficient to explain the variation in the dependent

variable (dividend payout ratio). Subsequently, the

Hausman test was applied, where it turned out that the

fixed effect model is appropriate. The results of the

fixed effect panel are more accurate, where 66% of the

variation in the companies’ dividend payout ratio is

explained by changes in their respective age and

financial leverage.

The panel data analysis results in Table 7

indicate that age and the financial leverage ratio

significantly affect the dividend payout ratio of

companies listed in Kuwait Stock Exchange (KSE).

Thus, we reject null hypothesis 1 and null hypothesis

2, and conclude that there is a significant impact of

firm’s age and firm’s financial leverage on a firm’s

dividend payout ratio. The results of hypothesis

testing are summarized in Table 7 and overall we can

conclude:

Ha1: There is a significant and negative

relationship between financial leverage of the

company and the dividend payout ratio.

Ha2: There is a significant and negative

relationship between age of the company and the

dividend payout ratio.

Table 7. Summary of the hypothesis testing

Variable Conclusion Remark

Hypothesis 1 Null Hypothesis Rejected Significant effect of leverage ratio of company

Hypothesis 2 Null Hypothesis Rejected Significant effect of Age of company


31

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32

CORPORATE GOVERNANCE IN MIDDLE EAST FAMILY BUSINESSES

Samer Khalil*, Assem Safieddine**

Abstract

This study examines governance-related issues within Middle East family businesses. The absence of proper external monitoring mechanisms – governmental or other – to protect shareholder rights, and the absence of any pre-existing literature on the Middle East market provides the motivation to evaluate the corporate governance practices of Middle East family businesses. Using a sample of 124 family businesses, we construct a governance index and use a probit model to examine whether family-related variables can explain the level of corporate governance. It is found that the majority of boards had a prevalence of family members and a low proportion of independent directors. Family businesses, still being run by the first generation, have a limited number of independent members on their boards and tend to adopt poorer governance practices than other firms where the third or fourth generations are involved. Instituting a family council has a positive governance impact, however, much work is needed, especially that it seems to lack clear vision as it is rendering the involvement of new generations ineffective. Keywords: Corporate Governance, Governance Score, Family Business, Middle East *Olayan School of Business, American University of Beirut, Bliss Street, P. O. Box 11-0236, Beirut, Lebanon Tel: +961 11350000 x 3769 **Corresponding author. The School of Business, American University of Beirut, Bliss Street, Beirut, Lebanon, P.O. Box: 11-0236 Tel: 961-1-350000 x 3949 Fax: 961-1-750214

1 Introduction

Corporate governance has been a subject for academic

research over the past decades (Adams, Hermalin, &

Weisbach, 2010; Gillan, 2006). Using data pertaining

to large, publicly traded firms, existing research

primarily investigates governance practices and their

implications on corporate policies, decision-making,

and performance in the Americas, Europe, East Asia,

and Latin America (Agrawal and Knoeber, 2012;

Kaplan, 2012; Carney, 2010; Claessens, Djankov, &

Lang, 2000). The existing literature, however, falls

short from documenting corporate governance

practices for family businesses operating in emerging

markets having stark differences in economic

environments, capital markets’ depth and breadth,

governance bodies and authorities, ownership

structure, financial markets participants, in addition to

cultural dissimilarities and differences in the ways of

doing business (Center For International Private

Enterprise (CIPE) 2011; PriceWaterhouseCoopers

(PWC) 2013).

We attempt to fill the void in the literature by

investigating the governance practices of privately-

held enterprises operating in the Middle East and

examining issues family businesses deal with in terms

of governance structures. Is there a link between

increased generational participation in the corporate

decision-making and corporate governance

enhancements? Does the presence of independent

directors on the Board of Directors (BOD) have an

effect on the corporate governance? Does the

governance of family businesses improve with the

presence of a family council? What are the effects of

the Chairman/CEO duality on the governance of the

family business?

The focus on family businesses in the Middle

East stems from various reasons. First, the Middle

East region is striving to improve governance

standards with significant achievements in a relatively

short period of time (Koldertsova, 2010; Nadal, 2013).

The past few years witnessed the establishment of at

least four new institutes of corporate governance or

institutes of directors that provide corporate

governance information, training, and guidance for

companies to improve their practices. Codes for

national corporate governance rules have also been

issued by most Middle Eastern countries (14 out of the

17 countries) over the past ten years. The Egyptian

Institute of Directors also introduced a governance

code targeted specifically at state-owned entities. The

Jordanian, Palestinian and Emirati regulators

introduced codes for banks, while the Lebanese,

Yemeni and Egyptian Central Banks are currently


33

working on developing guidelines on corporate

governance of banks. Moreover, the Lebanese

Transparency Association introduced specialized

guidelines for family-owned enterprises.

Second, family businesses play a key economic

role in their local and regional markets (PWC 2013)2.

They play a critical role in their respective sectors and

account for a large fraction of employment in various

economic sectors including retail, automotive,

construction, import/export, shipping, insurance,

agriculture, financial services, real estate and

manufacturing. Ninety percent of companies are

family-owned businesses, contributing up to 80% to

GDP as well as capturing 70% of the total

employment market. A large percentage of firms start

their operations as small trading entities that grow into

large, diversified conglomerates over two or three

generations by capitalizing on dominant positions

within their own markets, robust trading networks

within individual markets, and strong relationships

with banks. Until the recent financial crisis, the latter

has made access to finance far easier than it is for

family businesses elsewhere in the world.

Third, a relatively large number of family

businesses in the Middle East are first - or second-

generation businesses that were originally established

50 or 60 years ago and that currently face a transition

to the next generation in the next 5-10 years (PWC

2013; CIPE 2013). In Western countries, a large

number of family businesses have moved to the

ownership of the third and fourth generation. In the

MENA region however, the majority of family firms

are still under the second generation ownership with

only around 20% starting to have involvement from

members of the third generation. Succession planning

can be a sensitive topic since the founder or the

patriarch of the family may not feel completely secure

about training a successor and ceding his/her own

position to an heir. This process may also be intricate

due to family members’ hesitance to relinquish control

to outside managers - even in the absence of qualified

family members - especially that putting a succession

plan in place would require a management team

capable of growing the business independently of the

shareholders as well as having highly qualified board

members. Finally, succession planning, especially in

the MENA region, may be further complicated by a

strong cultural tradition of respect for older

generations which affects the manner in which a

change in management and control is handled.

In order to further evaluate the 124 family

businesses across the Middle East, we obtain results

using a 20-factor governance score developed along

the lines of Gompers, Ishii & Metrick (2003) and

Brown and Caylor (2006). We document the

following: First, corporate governance is still a topic

that is significantly under-studied and misunderstood

2 In the Gulf region, 80% of gross domestic product (GDP)

outside the oil sector is generated by family businesses (PWC 2013)

given that one-third of the respondents reported that

they were not well-enough informed about corporate

governance. Second, having an effective and well-

structured family council can enhance corporate

governance since it represents a forum for

communicating and voicing concerns and constitutes a

venue for identifying the way of dealing with family

and business issues.

Findings also show that, at the onset of family

firms, chairman/CEO duality is prevalent across

sample firms (close to 85 percent of the sample), and

board structures significantly contest best governance

practices. The majority of the firms in our sample had

a prevalence of family members on board and a

significantly low proportion of independent directors.

Interestingly, sample firms still being run by the

founding member or the first generation, have a

limited number of independent members on their

board and tend to adopt fewer governance practices

than other firms where the third or fourth generations

are involved.

Results further show that succession planning,

one of the key challenges in family firms and one of

the key pillars in sound governance practices, are

substantially ignored within our sample, whereby few

of the family businesses have any succession planning

arrangements in place; even those businesses with

established family councils report that family

succession is not an area of focus on their agenda.

While 51% of the firms in the sample with a family

council are dealing with succession planning, 10%

with no family council do have a succession plan.

Finally, findings reveal that family firms adapting and

abiding by corporate governance practices are less

likely to have family members with higher

compensation than the market salary.

The paper is structured as follows: following this

introduction, we present in a second section the

theoretical framework for the governance score and

develop the hypotheses. The third section describes our

sample and methodology, which includes a discussion

of the data collection process as well as the calculation

of the governance score, ME-Gov. A presentation of

our results follows in the fourth section to conclude

with a discussion of the findings and their practical

and research implications.

2 Theoretical perspectives and hypothesis

There is scant empirical evidence that investigates

corporate governance practices and their implications

in the Middle East. For instance, Hussainey and Aljifri

(2012) examine the degree to which internal and

external corporate governance mechanisms affect

UAE firms’ capital structure. Chahine and Safieddine

(2011) examine the effect of board size and its

composition on banks’ performance. Their findings

document that bank performance is positively related

to board size. Hussain and Mallin (2007) analyze the

state of corporate governance in Bahrain and find that


34

companies have boards dominated by non-executive

directors and that there is a separation of the Chair and

CEO position. El Sayyed (2007) examines the extent

to which corporate leadership structure affects

Egyptian publicly listed firms. Results indicate that

CEO duality has no impact on corporate performance.

Family firms have a number of characteristics

that distinguish them from typical listed firms. Amit

and Villalonga (2004) find that family and non-family

firms differ significantly in age, growth, performance,

and corporate governance and control. Daily and

Dollinger (1992) find that the principal common

characteristic among the majority of family firms is

that the main owner (family) is usually involved in the

key-decision-making of the firm. Similarly, Ali, Chen,

& Radhakrishnan (2007) report that in the U.S.,

families own 18% of their firms voting rights, hold top

executive and board director positions in respectively

63% and 99% of their firms.

In order to examine the issues related to the BOD

structure and role, family continuity and succession

planning, we develop four hypotheses and base our

findings on a sample of 124 firms. Anderson and

Reeb (2003), using a sample of S&P 500 firms, find

that boards in family firms contain significantly fewer

independent directors, and more inside directors than

boards in non-family firms. Lorsch and Maclver

(1989) indicate that objective evaluation and

monitoring of firm activity is one of the most critical

functions of independent directors. Byrd and Hickman

(1992) observe that independent directors are

responsible for protection and promotion of minority

shareholders’ interests.

Hypothesis I: Presence of independent directors

on the BOD has a significant influence on the firm’s

corporate governance.

Succession planning and family continuity is a

critical concern for family members, practitioners, and

family firm researchers. Prior studies have put forth

that continuity of businesses from one generation to

the next depends in significant part on succession

planning. Gersick, Davis, Hampton and Landsberg

(1997) indicate that proper succession planning is

critical to take the business from one generation to the

next. Beckard and Dyer (1983) find that only 30

percent of family businesses survive the transition to

second generation and only 10 percent go on to a third

generation. Statistics show that family businesses face

continuity issues in the transition process from one

generation to the next with 80% of firms not surviving

the third generation. Morck, Strangeland, &Yeung

(2000) report that heir-controlled firms exhibit lower

levels of industry-adjusted performance and technical

innovation, and conclude that inherited control is a

strong impediment to organizational growth.

In addition to succession planning, the presence,

or lack thereof, of a family charter and council may

serve as a good indicator of the strength of a family

business’s governance structure.

Hypothesis II: The presence of an effective

family council or assembly, taking into account family

continuity and succession planning, results in a better

governance at the business level.

Bartholomeusz and Tanewski (2006) find that it

is substantially more common for the Chairman of the

Board and CEO to hold the same position in family

firms compared to non-family ones.

Hillier and McColgan (2004) sample UK firms

and note that stock prices react favorably when

companies announce the departure of a family CEO,

but only when these directors are replaced by a non-

family successor. Shleifer and Vishny (1997), show

that CEO duality is linked with ineffective governance.

Family firms are more likely to have CEO

duality since such structure provides the family with

the opportunity of getting benefits that are not shared

with the minority shareholders. However, According

to Lam and Lee (2007), CEO duality has a negative

impact on family-owned businesses. Thus, segregation

of CEO and chairman duties is more appropriate for

family firms.

Hypothesis III: Having the Chairman of the

Board act as the CEO of the firm results in weaker

governance for the business.

Gompers et al. (2003) constructed a governance

index to proxy for the level of shareholder rights. GIM

classify 24 governance factors into five groups: tactics

for delaying hostile takeover, voting rights,

director/officer protection, other takeover defenses,

and state laws. They found that firms with stronger

shareholder rights had higher firm value, higher

profits, higher sales growth, lower capital expenditures,

and made fewer corporate acquisitions.

Brown and Caylor (2006) also created a measure

of corporate governance, Gov-Score, which constitutes

a measure of 51 factors encompassing eight corporate

governance categories: audit, BOD, charter/bylaws,

director evaluation, executive and director

compensation,

ownership, progressive practices, and state of

incorporation. They note that better-governed firms

are relatively more profitable, more valuable, and pay

out more cash to their shareholders.

Hypothesis IV: The higher the ME-GOV, the

more likely family members are to be compensated in

line with the market.

2.1.Estimating corporate governance quantitatively: the governance score

We derive the ME-GOV using the following twenty

parameters.

2.1.1 Presence of well-defined written strategy

Firms having a well-defined and written strategy are

scored 1, otherwise 0. A well-defined strategy helps in

shaping the corporation performance and the way the

strategy is being implemented.


35

2.1.2 BOD written and documented charter Firms having a written and documented charter specifying the BOD’s composition and responsibilities are assigned a score of 1, otherwise 0.

2.1.3 Financial expertise of board members Firms having at least one board member with expertise in financial matters are scored 1, otherwise 0. Ismail and Kamarudin (2012) examine whether the presence of financial experts reduces the perceived inherent risk of auditors. Results show that financial experts on the audit committee reduce the auditors' perception of the risk inherent in family firms.

2.1.4 Audit and accounting expertise of board

members Firms with an audit and accounting expert sitting on their board are assigned a score of 1, otherwise 0. Felo, Krishnamurthy, and Solieri (2003) found that the percentage of audit committee members having expertise in accounting is positively related to financial reporting quality.

2.1.5 Human resources expertise of board members A score of 1 is allocated for firms with at least one Human Resources expert sitting on the board, otherwise 0. Huselid, Jackson & Schuler (1997) found positive relationships between HR management effectiveness and productivity, cash flow, and market value.

2.1.6 Industry expertise of board members Firms with at least one board member being an industry expert are assigned a score of 1, otherwise 0. Faleye, Hoitash and Hoitash (2013) that board industry expertise is robustly associated with an increase in firm value since their presence has a positive effect on innovation.

2.1.7 Strategy expertise of board members

Firms having at least one member with expertise in strategy are given a score of 1, otherwise 0. The presence of a strategy expert on the board is very important in enhancing the ability of the latter in overseeing corporate strategy development and implementation which is considered to be one of the most important duties of the board.

2.1.8 Representation of non-family minority

shareholders on the board

Firms having at least one non-family minority shareholder on the board are scored 1, otherwise 0. Many studies show a positive relationship between the fraction of minorities on the board and firm value.

2.1.9 Establishment of Audit Committee

Firms having an Audit Committee are scored 1, otherwise 0. In his findings, Swamy (2012) shows a positive relationship between audit committee and performance.

2.1.10 Establishment of Nomination committee

Firms with an established Nomination Committee are scored 1, otherwise 0. Vafeas (1999) examines the association between the employment and composition of nominating committees with board and ownership characteristics. The results of the study are consistent with nominating committees substituting inside ownership in controlling management, mostly improving board quality, and being staffed with independent, experienced, and knowledgeable members.

2.1.11 Establishment of Remuneration Committee

Firms having Remuneration Committee are scored 1, otherwise 0. Câmara (2012) found that the presence of a remuneration committee promotes the rigor and transparency of the remuneration setting process.

2.1.12 Establishment of Risk Committee

Firms with an established Risk Committee are scored 1, otherwise 0. Tonello (2012) suggests that risk committee of the board is not a one-size fits-all solution, and it may be a better fit for companies with special circumstances. Organizations with complex market, credit, liquidity, commodity pricing, regulatory and other risks that require special attention may find a risk committee useful.

2.1.13 Establishment of Human Resources

Committee

Firms having a Human Resources Committee are scored 1, otherwise 0. Huselid (1995) indicates that Human Resource management practices have an economically and statistically significant impact on a firm’s turnover and productivity as well as on short and long term measures of corporate financial performance.

2.1.14 Establishment of Governance Committee

Firms having an established Governance Committee are scored 1, otherwise 0.

2.1.15 Presence of CEO/Chairman Duality

Firms with CEO duality are scored 0, otherwise 1. Klai and Omri (2011) emphasize the need of separating the positions of CEO and Board chairman in order to guarantee the board independence and improve the firm transparency, thus avoiding conflict of interest.


36

2.1.16 Appointment of Big 4 external auditor

Firms assigning big 4 external auditors are scored 1 otherwise 0. Allocating well-experienced and professional auditors helps in improving accountability and transparency in corporate governance.

2.1.17 Establishment of internal audit department

Companies having an internal audit department are scored 1, otherwise 0. Lasher (2010) examines the role of the internal audit function. Results show that an internal audit function of high-quality can provide greater monitoring and therefore greater transparency to any potential bias in management’s decision making focused upon the proportion of nonfamily management in the firm.

2.1.18 Presence of corporate governance code Firms documenting and adopting a corporate governance code are scored 1, otherwise 0. Becht, Bolton and Röell (2002) show that corporate governance’s main concern is the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders.

2.1.19 Qualified audit opinion Firms having a qualified audit opinion are scored 0 otherwise 1. A qualified audit opinion indicates that the information provided is limited in scope and that the company is not following the appropriate accounting principles. Yeganeh, Dadashi and Akbari (2010) indicate that there is a significant relationship between businesses with a moderate or weak governance rate and the representation of qualified auditors’ opinion.

2.1.20 Presence of independent board members Firms having at least one independent board member are assigned a score of 1, otherwise 0. Klai and Omri (2011) found that independent directors in the board allow disclosing information of good quality and helps improve earnings quality.

3 Sample and methodology 3.1 Sample In order to examine the governance structures of Middle East companies, data is collected through a survey sent to 500 firms. The sampled companies were selected based on two criteria. The first criterion is related to the country of incorporation. We restrict the sample to businesses incorporated in the Gulf Cooperation Council (GCC) countries, as they tend to have similar business laws, family structures and cultural values. The second criterion on which companies were selected relates to size. We sent the questionnaire to the top 500 family companies in terms of employees (or revenues when available).

Appendix 1 presents the questionnaire sent to the 500 companies. The questionnaire is made up of 80 questions, divided into the following categories: general information, shareholding, the family business, corporate governance, family governance, and the nature of the relation between the family and the business. Several measures were used to analyze the data, including ownership, generational state, and other corporate governance characteristics. Appendix 2 provides detailed explanations on each section of the questionnaire. The final sample comprises 124 companies with dully completed questionnaires from different countries and operating within different industries and service lines.

Table 1 provides descriptive statistics on the industries to which the sample firms belong. The different industries and service lines are consistent with the type and structure of family businesses, which tend to be diverse and unfocused in the Middle East.

Table 1. Breakdown of Sample by Industry

# of firms Percentage (%)

Retail 32 26%

Engineering & Construction 21 17%

Real Estate 16 13%

Manufacturing 20 16%

Services 17 14%

FMCG 10 8%

Healthcare 8 6%

Total 124 100%

The 124 family businesses in the sample are from

7 different industries, with the majority of companies from the retail industry (32 companies), construction/engineering (21 companies), manufacturing (20 companies), services (17

companies) and real estate (16 companies). A financial analysis of the sample is consistent with our earlier observations of scale and complexity of operations, as average annual sales for the 124 sampled companies are USD 2 billion. Table 2 shows


37

details of financial data for the sample studied. With respect to employees, the average number is 1,450,

offering further evidence of the complexity and scale of operations for these family businesses.

Table 2. Descriptive Statistics on Financial Data (Mean & Median values in Millions USD)

Mean Median

Total Assets 408 300

Current Assets 101 20

Current Liabilities 51 20

Receivables 34 30

Sales (annual) 331 200

3.2.Methodology The empirical models employed try to capture the hypothesis on how family variables can influence the corporate governance quality and stage of development in family firms.

3.2.1 Empirical model 1 y = β1+β2 F1 + β3 F2 + β4 FCA + β5 Age + β6 Log TA +

β7 Gen1

3.2.2 Empirical Model 2

y = β1+β2 F1 + β3 F2 + β4 FCA + β5 Age + β6 Log TA + β7 Gen1 + β8 Gen2

3.2.3 Empirical Model 3 y = β1+β2 F1 + β3 F2 + β4 FCA + β5 Age + β6 Log TA +

β7 Gen1 + β8 Gen3

Where Y: corporate governance score being the dependent variable, a quality variable: the higher the score the better the governance at the business level F1: Family members’ compensation relative to the market. F2: Family members’ compensation relative to non-family members. FCA: Presence of family council or assembly. Age: Firm Age. Log TA: Logarithm of the firm’s total assets (reflecting the firm’ size). Gen1: involvement of family’s first generation in the business. Gen2: involvement of family’s second generation in the business. Gen3: involvement of family’s third generation in the business.

The three regression models are performed over

the same sample consisting of 124 family firms from different countries in the Middle East, operating in various industries. These models were used to capture the effect of the involvement of the family’s first, second and third generations in the business on the firm’s corporate governance practices and quality. The first model accounts for the participation of the first generation in the business, the second model considers

the participation of both first and second generations while the third model accounts for the involvement of the first and third generations. 4 Results Our first hypothesis concerning the presence of independent directors is strongly supported. Our results show a high correlation between independent board members and other significant variables. For example, 80% of firms with independent directors had non-family minority shareholders on BOD, 79% had corporate governance code, 69% had financial experts on the BOD as well as an internal audit department, 61% showed non-CEO duality, and 59% had industry expert on BOD.

As for the second hypothesis concerning family council, empirical results do not seem to support it. While 51% of the firms in the sample with a family council are dealing with succession planning, 10% with no family council do have a succession plan. 57% of firms with above median Gov-Score have established a family council, yet do not seem more likely to have independent directors or corporate governance codes.

Regarding the third hypothesis, our results highly support it. Family firms where the Chairman of the Board is not the CEO, seem to have better governance than the ones with CEO duality. 85% of the firms with non-CEO duality had audit experts on the BOD, 76% followed a good corporate governance code, 64% of the firms had a strategy expert on the BOD as well as a non-family minority shareholder, and 56% had a financial expert.

Regarding the fourth hypothesis related to the ME-GOV score, it is seen that whenever the governance score for the family firm is high, chances for the family member to have a greater pay than non-family member is low.

4.1 Correlation matrix We built a correlation matrix among the 20 governance variables that were used to derive the firm’s corporate governance quality score, in order to identify the components having the strongest direct influence on the corporate governance structure in family firms. Based on the correlation matrix in Table 3, the following relationships were identified.


38

Table 3. Correlation matrix

Fin

ancial

Exp

ert on

BO

D

Strateg

y

Exp

ert on B

OD

Au

dit

Expert

On

BO

D

Industry

Ex

pert o

n

BO

D

Non-F

amily

Min

ority

Shareh

old

ers on

BO

D

Au

dit C

om

mittee

Govern

ance

Com

mittee

Nom

inatio

n

Com

mittee

Rem

uneratio

n

Co

mm

ittee

Risk

Com

mittee

Co

rpo

rate

Govern

ance

Cod

e

No

n-C

EO

Duality

Big

4 E

xtern

al

Audito

rs

Intern

al Au

dit

Dep

artmen

t

Unqualified

Audit

Op

inio

n

Indep

enden

t

Board

Mem

bers

Fam

ily C

oun

cil/

Assem

bly

Well-D

efined

and

Written

Strateg

y

Do

cum

ented

charter

layin

g d

ow

n th

e

BO

D co

mpositio

n

and resp

onsib

ilities

Financial Expert on BOD 1.00

Strategy Expert on BOD 0.29 1.00

Audit Expert on BOD 0.52 0.49 1.00

Industry Expert on BOD 0.64 0.43 0.52 1.00

Non-Family Minority

Shareholders on BOD 0.68 0.45 0.41 0.68 1.00

Audit Committee 0.30 -0.23 -0.16 0.38 0.56 1.00

Governance Committee 0.45 -0.32 -0.16 0.35 0.52 0.89 1.00

Nomination Committee 0.06 0.11 0.09 0.05 0.07 0.07 0.13 1.00

Remuneration Committee 0.41 -0.41 0.01 0.38 0.38 0.82 0.89 -0.07 1.00

Risk Committee 0.06 -0.08 0.29 0.15 0.09 0.08 0.11 -0.03 0.40 1.00

Corporate Governance Code 0.73 0.41 0.57 0.57 0.84 0.32 0.44 0.08 0.32 -0.04 1.00

Non-CEO Duality 0.56 0.64 0.85 0.44 0.64 -0.04 0.06 0.10 -0.04 0.04 0.76 1.00

Big 4 External Auditors 0.50 0.52 0.49 0.24 0.41 -0.06 0.06 0.07 -0.06 -0.07 0.54 0.70 1.00

Internal Audit Department 0.64 0.52 0.70 0.50 0.73 0.14 0.25 0.09 0.14 0.00 0.81 0.87 0.67 1.00

Unqualified Audit Opinion -0.62 -0.09 -0.54 -0.64 -0.52 -0.23 -0.40 -0.05 -0.43 -0.17 -0.61 -0.45 -0.15 -0.53 1.00

Independent Board Members 0.69 0.31 0.43 0.59 0.80 0.38 0.49 0.06 0.34 -0.11 0.79 0.61 0.46 0.69 -0.61 1.00

Family Council/Assembly -0.15 0.38 0.27 -0.10 0.05 -0.36 -0.44 0.09 -0.36 0.19 0.04 0.26 0.09 0.17 0.23 -0.11 1.00

Well-Defined and Written

Strategy 0.46 0.39 0.55 0.31 0.51 0.05 0.17 0.08 0.05 -0.04 0.64 0.71 0.56 0.65 -0.36 0.53 0.22 1.00

Documented charter laying down the BOD composition and

responsibilities

0.55 0.46 0.63 0.48 0.58 0.11 0.22 0.09 0.11 -0.01 0.70 0.74 0.59 0.70 -0.43 0.58 0.07 0.68 1.00


39

Firms having a corporate governance code are

more likely to have non-family minority shareholders

as well as financial, audit and industry experts sitting

on their boards. Big 4 external auditors are more likely

employed by firms with a corporate governance code,

that employ financial and strategy experts on their

boards of directors and that show a segregation of

CEO/Chairman duties. Family firms with financial,

audit and strategy experts on their BOD and a

corporate governance code tend to segregate the duties

and responsibilities of the CEO and the Chairman.

Firms with established risk committees, and financial,

industry and strategy experts as well as non-family

minority shareholders on their boards and non-CEO

duality are more likely to have an internal audit

department. Firms with independent board members

on their BOD have a tendency to have an internal audit

department, a corporate governance code, segregation

in the CEO/Chairman Duties and experts sitting on

their boards. Firms having a documented charter

laying down the BOD composition and

responsibilities and a well-defined and written strategy

tend to have independent board members, experts

(financial, audit, industry and strategy) sitting on the

BOD, segregation of CEO/Chairman responsibilities,

an internal audit department, in addition to Big 4

external auditors.

4.2 Governance score

The maximum governance score in the sample is 80

over 100, while the minimum score is 0 over 100. The

average and the median are 42 and 50 respectively. A

higher governance score reflects better corporate

governance practices. Based on the Frequency Table

reported in table 4, results show that 100% of family

firms that have a corporate governance score equal to

or above the mean enjoy the following: presence of

financial expert and industry expert on the BOD,

presence of non-family minority shareholders and

independent board members, and existence of a

corporate governance code.

Table 4. Frequency table

Total Group 1 Score < Median Group 2 Score >=Median Frequency

of 0 Frequency

of 1 Frequency

of 0 Frequency

of 1 Frequency

of 0 Frequency of

1 FAMILY COUNCIL/ ASSEMBLY 51% 49% 59% 41% 43% 57% WELL-DEFINED AND WRITTEN

STRATEGY 43% 57% 82% 18% 5% 95%

DOCUMENTED CHARTER

LAYING DOWN THE BOD

COMPOSITION AND

RESPONSIBILITIES

48% 52% 90% 10% 6% 94%

FINANCIAL EXPERT ON BOD 29% 71% 59% 41% 0% 100% STRATEGY EXPERT ON BOD 56% 44% 84% 16% 30% 70% AUDIT AND ACCOUNTING

EXPERT ON BOD 48% 52% 84% 16% 13% 87%

INDUSTRY EXPERT ON BOD 20% 80% 41% 59% 0% 100% NON-FAMILY MINORITY

SHAREHOLDERS ON BOD 35% 65% 70% 30% 0% 100%

AUDIT COMMITTEE 65% 35% 70% 30% 59% 41% GOVERNANCE COMMITTEE 68% 32% 79% 21% 57% 43% NOMINATION COMMITTEE 99% 1% 100% 0% 98% 2% REMUNERATION COMMITTEE 65% 35% 70% 30% 59% 41% RISK COMMITTEE 92% 8% 92% 8% 92% 8% HUMAN RESOURCES

COMMITTEE 100% 0% 100% 0% 100% 0%

CORPORATE GOVERNANCE

CODE 43% 57% 87% 13% 0% 100%

NON CEO DUALITY 56% 44% 100% 0% 13% 87% BIG 4 EXTERNAL AUDITORS 38% 62% 70% 30% 6% 94% INTERNAL AUDIT

DEPARTMENT 49% 51% 93% 7% 6% 94%

UNQUALIFIED AUDIT OPINION 76% 24% 52% 48% 98% 2% INDEPENDENT BOARD

MEMBERS 32% 68% 66% 34% 0% 100%

On the other hand, 100% of family firms with a

governance score below the mean have CEO duality

and do not have a nomination nor a Human Resources

committee.

It is also important to mention that all firms

included in the sample do not have a Human Resources

committee, while only 2% of the latter firms do have

nomination committees and 8% of both firms with low


40

and high corporate governance scores have a risk

committee.

Moreover, 94% of family firms with good

corporate governance score have an internal audit

department as well as a documented charter compared

to 7% and 10% respectively for firms with below the

mean corporate governance score. In addition, 95% of

firms with high scores have a well-defined written

strategy versus 18% for the firms with poor corporate

governance.

As for family governance criteria, results show

that 88% of firms having a corporate governance score

above or equal to the median have family members

compensation that is in line with the market and non-

family members. On the other hand, 72% and 67% of

family firms with poor governance scores exhibit

family members’ compensation exceeding that of the

market and that of non-family members respectively.

Also, results indicate that 70% and 63% of

family firms with a low governance score have

involvement of the first and second generations

respectively, while only 16% have a third generation

intervention in the business. However, the percentage

of family firms with good governance score having

third generation involvement is also considered low, at

only 20%.

In addition, 37% of family firms with above the

mean governance scores have involvement of the first

and second generations, while 67% and 70% of firms

with weak governance have the first and second

generations respectively participating in the business.

On the other hand, the third generation involvement in

the business is still low for both family firms with

good and weak governance scores representing only

20% and 16% respectively.

Finally, the table shows that 49% of total firms in

the sample have a family council or assembly which

reflects a significant improvement from 2009.

4.3 Regression

Based on our sample, the regressions show a negative

relationship between the ME-GOV and the

compensation of family members relative to non-

family members. In other words, the better the

governance score for the family firm, the less likely

the firm would pay a family member higher than a

non-family member.

Table 5. Probits

MODEL 1 MODEL 2 MODEL 3

PARAMETERS Coefficient z-Statistic Coefficient z-Statistic Coefficient z-Statistic

INTERCEPT -5.647 -1.931 -7.041 -2.450 -6.524 -2.505

(0.0535) (0.0143) (0.0122)

FAMILY MEMBERS

COMPENSATION RELATIVE

TO THE MARKET

-0.381 -0.801 -0.633 -1.313 -0.168 -0.394

(0.4229) (0.1893) (0.6939)

FAMILY MEMBERS

COMPENSATION RELATIVE

TO NON- FAMILY MEMBERS

-0.867 -1.981 -1.163 -2.320 -0.733 -1.775

(0.0476) (0.0203) (0.0759)

FAMILY COUNCIL /

ASSEMBLY

1.303 2.091 1.419 1.872 0.606 1.425

(0.0365) (0.0612) (0.1542)

AGE 0.161 3.650 0.181 3.991 0.170 4.367

(0.0003) (0.0001) (0.00)

LOG OF TOTAL ASSETS -0.062 -0.618 -0.032 -0.291 -0.053 -0.552

(0.5366) (0.7714) (0.581)

# OF 1ST GENERATION -0.652 -2.538 0.499 1.035

(0.0111) (0.3005)

# OF 2ND GENERATION -0.314 -2.478

(0.0132)

# OF 3RD GENERATION 0.004 0.122

(0.903)

MCFADDEN R-SQUARED 0.681 0.717 0.625

S.D. DEPENDENT VAR 0.501 0.501 0.501

AKAIKE INFO 0.559 0.525 0.635

CRITERION

SCHWARZ CRITERION 0.721 0.710 0.798

HANNAN-QUINN CRITER. 0.625 0.600 0.701

RESTR. DEVIANCE 166.055 166.055 166.055

LR STATISTIC 113.017 119.115 103.823

PROB(LR STATISTIC) 0.000 0.000 0.000

OBS WITH DEP=0 63 63 63

OBS WITH DEP=1 57 57 57


41

The first regression model reveals a negative link

between the first generation and governance score.

However the more the second generation takes the

lead and get involved, the lower the governance score.

The participation of the third generation seems to be a

mute issue as its coefficient is insignificant.

Regression results further show a positive

rapport between corporate governance and the

presence of a family council or assembly in the sample.

However, the positive correlation between family

council and the corporate governance score does not

seem to work its way to the involvement of the new

generations in the business. This indicates that for

family firms to have enhanced corporate governance,

they not only need to establish a family council or

assembly but also to focus on its mission, role and

effectiveness. The main role of the family council is

defining the family’s shared vision and values, acting

as the family’s voice to the business and the point of

contact with the BOD, discussing and dealing with

family matters, providing frameworks for educating

and developing the skills of family members, dealing

with family employment policies and most

importantly dealing with succession planning. In our

sample, a significant number of family firms having an

ineffective family council.. On the other hand, 59% of

the companies having an above-the-median

governance score, have their family council dealing

with succession planning and acting as the family’s

voice to the business and point of contact with the

BOD. Thus the role of family council is extremely

important and valuable since it enables the

management concentrate on achieving growth and

profitability goals, and assists in unifying the voice of

the family, giving a well-determined direction for both

the board and the management.

In addition, our sample shows that more than half

the firms prefer to appoint a family member as CEO,

especially that selecting a non-family member is filled

with emotional, business and governance challenges.

Further, around 40% of firms with a good governance

score conduct an objective and fair performance

assessment for the appointed CEO. Finally, around

one third of family firms in the sample have a shared

vision for the business which clearly articulates the

situation going forward as well as the objectives that

family members need to achieve in order for their

businesses to be successful.

5 Conclusion

The purpose of this study is to examine the quality of

corporate governance in Middle Eastern family

businesses.

The modern Middle Eastern family business is

employing second and third generation family

members to run the business, which is all the more

evidence for the need of proper corporate governance

mechanisms to ensure the sustainability of the firms,

especially those who have plans of entering capital

markets. The main findings of our research on the

governance structures of Middle Eastern family

businesses reveal expected results inadequate

governance structures, evidenced by a majority of

firms having Chairman/CEO duality, substantial

family involvement in managerial decisions, and a

significantly low ratio of independent directors to total

directors.

The family-run business is not an anachronism,

but a viable and prevalent model for competing

effectively in the global economy, achieving

impressive long-term growth, attracting top talent, and

increasing family wealth over generations. However,

in order to take a place in the worldwide roster of

highly successful family-run firms, these businesses

must eliminate or curb the restless entrepreneur

syndrome, let go of emotional attachments to core but

less profitable businesses, and institute guidelines that

provide clear lines of separation between family and

business activities. A challenging global economy and

internal transition to new generations of family

management make these changes all the more critical

and timely, but they can be successfully implemented

through careful planning and commitment to the

sustainability of the business.

The involvement of the third generation in the

business plays an insignificant role in enhancing the

firm’s performance in terms of corporate governance,

and a negative relationship is identified between the

governance score and the second generation by the

time the first generation is still involved in the

business.

Families need to focus on drawing clear

distinctions between family and company activities.

This can be accomplished by creating a formal

governance structure to govern the family and

business. The presence of an effective family council

or assembly has a positive influence on the

governance within family firms, especially if the

council is committed to fulfilling its well-defined role

and objectives. A sizable portion (33%) of our sample

is still uncertain as to the benefits of governance to the

family. This is a clear indicator of the need to educate

businesses within the Middle East on the importance

of governance for ensuring the successful continuity

of the family business.

The study comes with some limitations. Family

businesses were compared at a particular point in time,

the year 2013, and as such, the questionnaire did not

capture at what particular point the business is within

the development of each generational phase.

Designing an effective governance structure is

straight forward; however, implementation should be

managed carefully and introduced gradually, over a

long period of time. Families should use the

governance structure to include and involve various

family members who might not otherwise be actively

engaged with the business.

Corporate governance has become a major factor

affecting the success of emerging market businesses.


42

At a time when the increasingly global economy

creates opportunities, but also competitive threats,

instituting good corporate governance practices is an

important part of any strategy to prosper. For small,

medium-sized and family owned companies, which

comprise the majority of companies in the Middle East

and North Africa (MENA) region, corporate

governance procedures can help facilitate a smooth

intergeneration and transfer of wealth and reduce

conflicts within families. Good governance is an

essential component for ensuring the integrity of

financial reporting and effective business

management.

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44

AUDIT, ACCOUNTING & REPORTING

SECTION 2

THE IMPACT OF THE “GOING CONCERN” ON AUDITORS’ JUDGEMENT. ANALYSIS OF THE ITALIAN CONTEXT FROM

AN INTERNATIONAL PERSPECTIVE

Graziella Sicoli*, Paolo Tenuta**

Abstract The present work aims to analyse the concept of going concern on the one hand, through a case study of three companies which have recently come under observation of the CONSOB and have been inserted in the so-called “black list” and, on the other, the consequences that the removal of the presumption of continuity can have on the kind of assessment the auditors make. The aim of the present work is twofold: the first part analyses the principle of going concern from a business and economic perspective. Once this has been completed, the work will go on to offer an overview of the dynamics that can bring a company to a crisis point, and how these affect the judgments expressed by the auditors***. Keywords: Going Concern, Continuity, Black List, Audit *Department of Business Science and Law, University of Calabria - Ponte P. Bucci 87036 Arcavacata Rende CS (Italy) Tel: +39 0984492255 **Department of Business Science and Law, University of Calabria - Ponte P. Bucci 87036 Arcavacata Rende CS (Italy) Tel: +39 0984492191 ***For academic reasons Sections 2, 5, 5.2, 5.2.1 and 6 are to be attributed to Graziella Sicoli and Sections 1, 3, 4 5.1 and 5.1.1 are to be attributed to Paolo Tenuta

1 Introduction

The economic situation in Italy, being heavily

influenced by the global financial crisis, threatens the

ability of companies to maintain and consolidate their

business activities over time. The fact of uncertainties,

often nothing to do with the company itself, can cast

doubt on the presumption of continuity. This context

is a threat to a company’s future, and thus demands

greater attention on the part of administrators and

auditors, whose role it is to verify all the facts

carefully, so as to be in a position to decide what

criteria and procedures to adopt when drawing up the

company accounts and expressing their professional

judgement. All this falls within the current debate on

the analysis of the “going concern”, reiterated in

article 2423 of the Civil Code, the first item of which

states, “the evaluation of the accounts is to be carried

out in line with the criterion of prudence, and with a

view to the future prospects of the company

concerned.” One can also find the same concept in

international accounting regulations, in particular in

the IAS (items 23 and 24).

If, after making a thorough assessment, the

management of a company believes that a number of

factors put at risk the company’s ability to continue

operating, explicit reference to this must be included

in the company balance sheets.

The drafting of a budget on the assumption of the

company’s certain market future in a context in which

such an assumption is untenable, implies considerable

risks both for the administrators and for the organs of

control, above all in the case of default. The person

whose job it is to inspect the company accounts must


45

carry out certain procedures so as to be in a position to

ascertain the correctness of the work of the

administrators. In brief, the auditor must verify

whether the conclusions reached by the administrators

are valid and/or whether there are grounds to suspect

that that there are serious doubts as regards the

company’s future, which should be included in the

company financial statements. For all aspects linked to

the work of auditing we refer specifically to the

auditing rule no. 570 “ going concern”.

At this point it is important to mention that in

December 2014 the ISA Italia auditing rules were

adopted, under the aegis of the Ministry of Finance;

this was the result of a collaboration between a

number of the professional associations and orders:

ASSIREVI (Italian auditors), CNDCEC (National

Council of Chartered Accountants), INRL (National

Institute of Statutory Auditors) and CONSOB (Italian

Securities and Exchange Commission) with reference

to articles 11 and 12 of the Italian law (D. lgs.

39/2010).

What emerges clearly from all this is the

presumption of going concern is by no means to be

taken for granted; indeed, it is reasonable to doubt

whether such an assumption holds for a number of

companies, and whether it will continue to hold for

many others in the foreseeable future.

Talking these considerations as a starting point,

the present work aims to analyse the concept of going

concern on the one hand, though a case study of three

companies which have recently come under

observation of the CONSOB and inserted in the so-

called “black list” and, on the other, the consequences

that the removal of the presumption of continuity can

have on the kind of assessment the auditors make.

Recently, in fact, we have witnessed a progressive

reduction of the issuing of clean bill of health by

auditors at the expense of an increase in assessments

with reservations or, indeed, declarations withholding

any judgement at all.

The aim of the present work is twofold: the first

part analyses the principle of going concern from a

business and economic perspective, underlining the

diverse factors involved, as well as the variety of

strategies that can be adopted to overcome business

crises and, hopefully, to return to normal conditions.

Once this has been completed, the work will go on to

offer an overview of the dynamics that can bring a

company to a crisis point, and how these affect the

judgements expressed by auditors, in particular the

correctness and truthfulness of the information

contained in company financial statements.

2 Going concern and auditor: literature review

The concept of going concern was first regulated with

the approval in 1995 of Document 21 by the Joint

Commission for the drawing up of Auditing

regulations by the National Council of Chartered

Accountants and the National Council of Accountants

and Commercial Inspectors (Cndcr, 1995). Although,

given the somewhat one-sided view of the matter, this

document has certain limitations, it clarified how the

work of the auditor should help assess the reliability of

the account (Marasco, 2004), even though this is no

absolute guarantee of the company’s ability to operate

in the future. Following a process of harmonization of

the rules governing international auditing, Document

no. 21 was integrated in Auditing Regulation 570,

which was issued in October 2007 by the Joint

Auditing Commission. This principle deals with the

responsibilities of the auditor when reviewing a

company’s books, in particular how the company

management use the presumption of going concern in

their reports (Aspes, Campedelli, 1999; Marasco,

1995; Bava et. al., 2012).

The presumption of going concern has been the

object of numerous studies both by academics and

accountants and they all agree on the need for this

condition to be periodically reviewed by the

administrators when drawing up company financial

statements (Caratozzolo, 2006; Quatraro,1992; Quagli,

2003; A.Av.v., 2007; Superti Furga, 2004). In the case

where this presumption cannot be made all other

auditing principles (competence, consistency in

applying assessment criteria and so on) will no longer

be deemed tenable (Pontami, 2011).

The following elements undermine the

presumption of going concern (Carrieri, 2008;

Braidotti et. al., 2009; Soprani, 2009; Cndcr, 1995):

1. negative equity and lack of working capital;

2. negative structural margins;

3. difficulties in obtaining new credit lines or

finance for investment;

4. negative cash flow;

5. impossibility of meeting debt repayment

deadlines;

6. the fact of heavy losses from running costs;

7. violation of covenants contained in loan

contracts;

8. sizeable reductions of market share;

9. the presence of legal battles the outcome of

which could have serious consequences for the

company’s future viability and many others.

The first paragraph of Article 2423 and the

accounting principle OIC 11 state that, when drafting

a financial statement, the different items must be

carefully evaluated with a view to the company’s

prospects as a going concern, in other words the assets

and liabilities must be accounted for on the

assumption that the company is in a position to carry

on operating and capable of dealing with its liabilities

as part of its normal economic activity (Carrieri 2008;

Oic, 2005).

Further normative regulations in relation to the

presumption of going concern are contained in the

first paragraph of Article 24238 of the Civil Code, as

well as in the modification of Article 1 of 2/2/2007 (D.

Lgs 2/2/2007, no. 32 ), which - with reference to the


46

minimum content of the financial assessment of the

business management - required the administrators to

describe the current and future risks their company

may be exposed to3.

On the subject of going concern, for companies

who resort to markets for risk capital, in February

2009 the supervisory authorities - the CONSOB, the

Bank of Italy, and the IVASS (formerly ISVAP) -

issued a unitary document which, inspired by the

recommendations of a number of international

professional bodies, supplied further clarifications not

only on the behaviour that administrators and auditors

are obliged to adopt with regard to the drawing up

compulsory financial statements, but also on the

control systems that companies must put in place in

order to ensure that the potential risks, current or

future, are stated publically in a clear and transparent

manner, as well as the uncertainties that the company

may have to face in the future running of the

business4. In brief, the document of the

aforementioned three agencies recommends that, with

a view to improving the transparency of financial

statements and the grounds on which assessment of

whether a company is a going concern is based, the

information must be clearly set out, preferably the

section concerning accounting policies. In the event

that this is not possible, publication of the financial

statement must be postponed until such time as this

has been made available.

The OIC has also devoted considerable time and

attention to the going concern concept; in the

accounting principle devoted to general considerations

on the theme of issuing financial statements document

11 issued by the OIC makes it clear that: “the issuing

of a financial statement understood as a tool for

providing information on the equity, financial and

economic situation of a working company, that is to

say a company characterised by going concern, is

based on accounting principles”. This means that in

the event of lack of evidence to support the

assumption of continuity, the normal principles of

accounting used when drawing up financial statements

cannot be applied. The assumption of continuity has

been further clarified with the publication of document

OIC 295.

The auditing principle no. 570 supplies a series

of indicators whose function is to set the alarm bells

3 Still on the subject of the aforementioned document, for the

companies who have to draft consolidated balance sheet, since the year 2008 they have been obliged to provide in their statement a reliable and thorough analysis of the company’s situation and the trend and result of the company’s performance, as well as a description of the major risks and uncertainties to which the company is exposed. 4 Banca D’Italia- CONSOB- ISVAP: Document 2. information

to be supplied on the financial relations of the going concern, on the financial risks, on the control of the reduction in value of the company’s activities and on the uncertainties regarding the use of estimates. 5 For further information see “OIC, Principi contabili dei CNDC

dei CNR” modified by the OIC in relation to the reform of company law, op. cit. from page 19 onwards.

ringing (Bava et al, 2012), by summarising the major

existence-threatening dangers that can place the future

prospects of a company at risk.

Among the ones listed by the aforementioned

document we find those financial and economic

factors which can involve, for example, negative

equity or deficit of operating capital, fixed term loans

nearing their repayment deadlines with no or little sign

of the money available to repay the debt or extend the

loan. Another warning signal is an overdependence on

short-term loans to finance long-term activities,

previous financial statements or forecasts that express

negative cash flow, the inability to honour loan

repayments and so on.

With regards to the going concern debate overall,

one has to observe capital in its dynamic form, i.e. its

ability to generate future income. In this context,

therefore, the economic value of capital can be given a

specific definition: it is the present value of the

prospect of future gains, evaluated on the basis of the

risks to which such gains are exposed.

Company indicators used by managers, however,

can often be influenced by situations that are difficult

to quantify in monetary terms, such unforeseen events

as, for instance, the loss of administrators, or key

managers without any prospect of finding adequate

replacements, the sudden loss of important markets,

distribution contracts, concessions or suppliers. Many

of these aspects are observed by the auditor during

their periodic visits, and point to problems that can

often lead to business crises.

Other indicators that can have an impact on the

running of a company are, for example, a reduction of

capital below the legal limit, or irregularities

concerning other legal norms, legal or tax disputes

which in the event of an adverse ruling could lead to

financial penalties that the company could ill afford to

meet; the same applies to fines incurred for polluting

or the extra money required for the recycling of waste

produced by the company and so on.

From an international perspective we find that

the going concern concept underpins accountancy

rules and practice (Braidotti et al, 2009).

Moreover, in paragraphs 23 and 24 it is affirmed

that the statement must be drawn up on the

understanding that the company’s future prospects are

sound, apart from the situation where the ownership

intends to go into liquidation or cease operating

(Soprani, 2009; Forgione, 2008).

3 Planning for the future, professional judgement and the auditor’s report

Faced with the uncertainties that can make the going

concern requirement problematic, the company

management could set out their future plans, planning

a series of direct actions aimed at recovering

economic and financial equilibrium thereby

maintaining and reinforcing the company’s advantages

vis-à-vis their competitors. Such plans are usually


47

elaborated by the management with the help of

qualified advisors. Carrying out these plans is

entrusted to a figure within the company or an outsider

with special competence in the specific case. The

usefulness of such strategies, however, tends to

diminish over time, given that if the difficulties are not

overcome straight away, the problems within the

company can be accentuated as a result of further

unfavourable events or conditions, in this way

exacerbating the company’s problems.

Through such plans the economic and financial

results are forecast on the basis of the decisions the

company intends to put into future operation (Carboni,

2009), or with the elaboration of a business plan

through which the would-be entrepreneur will be in a

position to respond to a variety of demands,

concerning the products on offer, the markets targeted,

the nature of the competitive advantage that the

company believes it can achieve, the economic

potential of the business plan and the number of

resources required.

After identifying all the probative elements

collected, the task of the auditor is to carry out a

comprehensive examination of the financial statement

and its reliability (Pisoni et al, 2012), through final

analytical procedures, or analysis of the indices, trends

or key elements in order to ascertain whether the

account overall is in line with the evidence the auditor

has uncovered, his/her knowledge of the business

sector and the type of business involved. The legal

role of the auditor is to express, through a final report,

a professional opinion on whether the accounts

conform to legal standards and whether they give a

truthful and reliable picture of the company’s situation

as regards its assets, its economic and financial

position and so on. This opinion, contained in the

report, is expressed in the terms stipulated by Article

14 (D. lgs 39/2010); it can be positive without

reservation, positive with reservations, negative, or the

auditor may feel unable to express an opinion.

Furthermore, the auditor can draw attention to certain

aspects requiring elucidation.

The auditor’s report should contain:

a) the legal grounds on which the auditor’s

opinion is based;

b) the recipient of the report, i.e. the person who

has appointed the auditor to carry out the work of

drafting the report;

c) an introductory section containing the

account in question and the different responsibilities

undertaken by the auditors;

d) the nature and import of the budget, detailing

the purpose of the inspection, the work carried out and

whether there is sufficient information provided;

e) the auditor’s professional opinion;

f) requests for further information if required;

g) an opinion on the reliability and clarity of the

budget statement;

h) the date and place of issue as well as the

signature of the auditor who has carried out the

inspection.

If, after having gone through all the necessary

procedures, the auditor considers that the assumption

of going concern is based on solid foundations and the

management has supplied a clear plan of the future

direction of the company in question, the auditor will

express a positive opinion without reservations; if the

information is not entirely satisfactory, the auditor will

express a positive opinion with certain reservations

and in the case where information is lacking a

negative opinion (Manzana, 2009). Where the

administrators provide a feasible and well-reasoned

strategy for overcoming the crisis, the auditor can give

a clean bill of health, even when doubts about the

company’s future remain. Otherwise the auditor may

approve the budget statement, but add a note

underlining the on going problems.

Recent clarification on the different types of

judgement on the verification of the concept of going

concern, in particular on the use of the disclaimer, i.e.

the impossibility of expressing an opinion, has been

supplied in a research paper by Assirevi6. This paper

makes it clear that the auditor should abstain from

forming an opinion only in extreme cases, for example

where details of numerous serious problems and

uncertainties are provided in the company accounts.

When, on the other hand, such problems are not fully

addressed in the company accounts, the auditors are

advised to express reservations or give a negative

opinion, if they consider that such omissions have the

effect of making the company accounts as a whole

unreliable.

4 Ideas, aims and research methods

The lack of evidence for considering a company a

going concern, or where serious doubts remain as to

its future can be traced to events and/or conditions

prior to the effective default of the company. This

being the case, the duty of administrators, auditors and

inspectors is to analyse, demonstrate and verify that

the future prospects are such that the company can be

considered a going concern, and thus in a position to

draft financial statements and accounts in line with

regulations governing them.

In the light of all this, the present work proposes

to start by analysing the concept of the going concern

with reference to three public companies quoted on

the Milan Stock Exchange whose situations were so

6 ASSIREVI is a private non profit association of auditing

companies started in 1980, and successively recognised. Its aim is to analyse various issues connected with the work of auditing in order to support a technical and professional support to members and spread the word about the role of the auditors. The professionals involved in the work of the association number roughly 6,000 spread throughout the country. The association numbers 14 consultancy firms among its members, that currently make up the majority of firms that carry out audits for public authorities (Enti di Interesse Pubblico).


48

critical that they came under review of the CONSOB

and were inserted in the black list7. The paper will

then go on to examine what are the consequences for a

company when it fails to be considered a going

concern, according to the different types of opinion

expressed by the auditor.

The three case studies concern the following

companies: Meridiana Fly (formerly Eurofly), Viaggi

del Ventaglio and EEMS. The study has a dual aim.

To start with, we analyse the grounds for which each

company was no longer

considered a going concern (financial, economic

problems etc.). We then go on to focus on the effects

that the uncertainties and problems have on the

opinions expressed by the auditors, regarding the

truthful and reliable representation of their

predicament in the company accounts.

The choice to consider Meridiana Fly, Viaggi al

Ventaglio and EEMS was based on the fact that they

represent widely different spheres of activity, but also

because of the different ways they responded to their

crisis. The outcomes differ: some succeed in

overcoming their difficulties, while others, try as they

might, are unable to break free from their

predicament. Moreover, each company experiences a

different sort of difficulty, and adopts a wide range of

strategies in the hope of returning to normal

operational conditions.

The aim of our work, the results of which are

reported in detail in the final section, is to represent

the different factors that can culminate in a loss of

going concern status, and the strategies that can help a

company overcome a crisis. The paper then provides

an overview of the dynamics that can lead to a crisis

and the repercussions of this on the opinions

expressed by the auditors with reference to the correct

and truthful representation of the company’s situation

in budget statements.

5 Methodology

The research was carried out in a series of phases:

1. in the first phase after analysing the

compulsory documentation available on-line we

extracted the risks and danger signals brought to light

by the administrators. We analysed the budget

statements, consolidated accounts, the work of

7 The CONSOB has among its roles “the protection of

investors and the transparency of the property market”. It decides when a company should go on the blacklist, which was set up in 2002. The companies on the list find themselves “ in a situation of multiple losses”. The reasons which trigger the Consob’s decision to put a company on the black list and thereby put it under surveillance are generally backed by the firms whose task it is to carry out the auditing of these companies financial statements. The companies on the black list are obliged to supply monthly updates on their situation to the capital markets, The number of companies on the black list has varied over the years from 15 at the end of 2006 and 17 in 2007 up to 23 in March 2015. This confirms a sharp increase in the number of companies in difficulty over the past few years.

statutory auditors, the minutes of board meetings on

company performance, the documents of corporate

governance and the auditors reports;

2. in the second phase we studied the

restructuring plans proposed by the administrators;

3. in the third and final phase we analysed the

opinions expressed by the auditors on the uncertainties

regarding the company’s future, and hence their

judgement on whether the company was a going

concern.

As regards Viaggi del Ventaglio, this company

was inserted in the black list in February 2005. At the

time it was struggling with numerous problems,

including notable losses which had led to a reduction

of working capital by over a third. Given this

situation, the CONSOB deemed it necessary to keep

the market updated on the company’s financial and

economic situation, so that potential investors would

be in a position to make an informed choice. The

information on the company’s situation runs from

October 2005 until May 2010, after which on 15 July

2010 the company officially went into receivership

(Tribunale Civile e Penale di Milano- Sectione

Falimentare Fasc. No. 517/10).

Regarding Meridiana Fly, it was included in the

black list in 2007. The data available revealed

considerable operating losses of over 11 million euros.

As a consequence the CONSOB requested the

disclosure of data in order to keep the market up to

date with the developments of the economic and

financial situation of the company with the aim of

notifying potential investors. Compulsory notification

of the situation followed and from 2007 every request

was respected (transparency regime) until June 2013

when the company was delisted. Thereafter, the

company withdrew from the Stock Market in the hope

of facilitating rescue operations with other subjects

working in the same sector. Today the company

continues to operate in the air travel business.

Since June 2013, when the company was

delisted, Meridiana Fly has been under no obligation

to disclose its net financial position8.

The third company analysed is EEMS. This

company was included in the black list relatively

recently, on 30 September, 2012. It was given special

attention by the CONSOB on account of its 51 million

euro losses. Upon joining the black list EEMS was

obliged provide monthly data on its business and debt

situation. The table below provides information on the

company’s net financial position up till March 2015.

8 In June 2013 Meridian Fly left the Milan Stock Exchange.

After delisting the company hoped to undertake extraordinary measures including agreements with other companies operating in the same sector. According to the CEO the company left the Stock Market to concentrate on recovering profitability,


49

Table 1. Viaggi del Ventaglio blacklisted in October 2005

Company

NFP 31

October

2005

NFP 31

October

2006

NFP 31

October

2007

NFP 31

October

2008

NFP 31

October

2009

NFP 31

October

2010

NFP 31

October

2011

NFP 31

October

2012

NFP 30

Giugno

2013

I Viaggi del

Ventaglio -105,5 -55 -10,4 -20,7 -15,3 -17,1 nd nd nd

Note: NFP= Net financial position

Source: http://www.soldionline.it

Table 2. Eurofly blacklisted August 2007

Company NFP 31

August 2007

NFP 31

August 2008

NFP 31

August 2009

NFP 31

August 2010

NFP 31

August 2011

NFP 31

August 2012

NFP 30

June 2013

Eurofly

(Meridiana Fly) -11,402 -11,263 -4,07 -12,16 -6,72 -68,22 nd

Source: “Black list Consob”, document retrieved from www.marketmovers.it

Table 3. EEMS Italia blacklisted September 2012

Source: “Black list Consob”, document retrieved from www.marketmovers.it

5.1 The Eurofly group

Eurofly s.p.a. was set up in Turin in 1989, focusing

mainly on air passenger transport and other activities

related to the use, repair and maintenance of aircraft.

There have been many changes both as regards the

company management, and its modus operandi in the

constant research for a better product to meet the

demands of its customers.

In 2006 Eurofly was forced to face difficulties

that were not only cyclical, i.e. linked to the increasing

level of competition in the business, especially the

growth of low cost airlines (Carboni, 2009), but also

structural, i.e. linked to the company’s commercial

and industrial internal processes. These negative

factors led to a serious fall in profitability. Nor was the

situation helped by other factors, such as climatic and

political instability in certain key areas of the globe

where the company operated, for instance in Egypt

and the Caribbean. Moreover, profit margins in the air

charter operations declined as a result of difficulties in

the tour operator sector, which was dependent, in its

turn, on changes in the purchasing habits of its

clientele; another problem to contend with was an

increase in the cost of fuel, as well as in the repair and

maintenance of the company’s fleet. Interest rates in

the USA and Europe rose at the time, thereby

worsening the credit situation; to make matters worse,

certain travel companies were unable to repay what

they owed, a sign of the general deterioration in the

credit worthiness of the tour operator sector as a

whole. Finally, the company suffered further losses

from the fact that their reserves were held in dollars at

a time when the dollar lost value vis-à-vis the euro.

The company closed its operations in the year

2006 with losses of over 29 million euros (compared

with losses of just 2.8 million euro in 2005)9.

Gross earnings (EBITDA) were minus 9.5

million euro, compared with plus 4.7 million in 2005.

As we can see the net financial position suffered

a deterioration in 2006, compared with the previous

year, by over 23 million euro, as a result of the

company’s worsening performance. In particular,

operating activities absorbed up to 28.8 million euro;

investment and disinvestment generated a profit of 2.7

million euro, financing and capital operations

generated an overall financial flow of 7.9 million euro.

When the company closed its doors it presented a net

financial position of minus 27.9 million, 7.9 million of

which was current net debt.

5.1.1 The auditor’s ruling on the Eurofly balance

sheet, the industrial plan 2007-2009 and the group’s

recovery

The consultancy firm Deloitte & Touche concluded

that it was impossible to express an opinion on the

company’s balance sheet of 31 December 2006, on

account of a number of uncertainties relating basically

to the lack of information about the rescue plan

launched by the board in an attempt to overcome the

serious difficulties that had led to the heavy losses10

.

9 “Bilancio d’esercizio al 31 dicembre 2006”, document found

on www.meridiana.it 10

“Bilancio d’esercizio al 31 dicembre 2006”, document found on www.meridiana.it

Company NFP

30 September 2012

NFP

30 June 2013

NFP

31 December 2014

NFP

31 March 2015

EEMS Italia - 51,21 - 28,62 - 30,80 - 35,06

http://www.soldionline.it/

http://www.marketmovers.it/

http://www.marketmovers.it/


50

Table 4. Previous losses 2005/2006. Amounts in Euro/000

2006 2005 Difference

Revenue from sales and services 289.835 271.474 18.360

Other revenue 6.858 6.512 346

Total revenue 296.693 277.986 18.706

Direct commercial costs 8.163 3.200 4.962

Revenue net of direct comm. costs 288.530 274.786 13.744

Fuel 88.947 72.472 16.475

Staff costs 43.390 39.143 4.247

Maintenance services and materials 40.347 33.137 7.209

Other operating costs and wet lease 71.077 84.156 (13.079)

Other buYESness costs and overheads 19.125 14.160 4.965

Costs subtotal 262.886 243.068 19.818

EBITDAR 25.644 31.718 (6.074)

Operating leases 35.120 27.034 8.086

EBITDA (9.476) 4.684 (14.160)

Amortization 6.260 4.836 1.424

Impairment of non-current assets 2.465 0 2.465

Other adjustment provisions 5.649 2.000 3.649

Allocation of provision and charge funds 2.090 559 1.531

Amotization and provisions 16.464 7.396 9.068

EBIT (25.940) (2.712) (23.228)

Financial income/costs (5.322) 42 (5.364)

Profit before tax (31.263) (2.671) (28.592)

Taxes (2.123) 1.685 (3.809)

Result of the divestiture of activities 0 1.581 (1.581)

Profit for the year (29.139) (2.775) (26.364)

Source: “Concise Profit and Loss/Revenue account of Financial Statements 2006”, retrieved from www.meridiana.it

Table 5. Net financial position

Amounts in Euro/000 2006 2005

Funds 5.149 32.272

Derivatives included in included in cash - 8.477

Cash 5.149 40.749

Current financial claims 3.000 -

Current bank debt 9.273 18.529

Banking contracts included in banking debts - 8.142

Current part of non-current debt 2.312 2.203

Other current financial debts 4.500 -

Current financial debt 16.085 28.874

Current net financial debt 7.936 (11.875)

Non-current financial credits 8.000 18.906

Non-current bank debts 3.783 4.270

Debt securities - -

Other non-current debts 24.138 30.604

Non-current financial debt 27.921 34.874

Net financial debt 27.857 4.093

Source: “Financial Statements 2006”, retrieved from www.meridiana.it

Given the company’s serious predicament, the board set out a three year recovery plan for the period 2007-2009. The project envisaged an upturn in activity through the intervention of and close collaboration with the shareholder Meridiana spa, a focus on short haul domestic flights on a limited number of routes with the aim of increasing income,

improving efficiency and reducing unit costs, as well as obtaining better conditions as regards the purchasing of supplies and external services, through the setting up of a computerised platform covering

http://www.meridiana.it/



51

organisation and competences11

, research and the protection of niche markets in order to secure a competitive advantage over business rivals. The plan envisaged the reconversion of the company from one involved exclusively with charter flights, to a commercial airline. Moreover, the plan entailed debt restructuring, in other words a renegotiation with its creditors-the three main banks, which together held 80% of the debt

12- and two injections of capital, one in

kind, i.e. through the conferring of goods from the main shareholder Meridiana, and the other in cash through capital markets.

On 28 June 2007 the board approved the industrial plan for 2007-2009. The fulfilment of the provisions contributed to the financial and economic recovery of the group. The problems concerning the future development of the company were considered overcome, thereby ensuring a healthy balance sheet for the year up to 31 December 2007.

Even though some uncertainty still remains as regards the company’s future, the administrators claim that the company is a going concern. After the delisting from the Milan Stock Exchange the company continued to operate and on 31/12/2012, thanks to the backing of the parent company AKFED it became possible to obtain credit. In particular, AKFED undertook to: release added financial resources, underwrite new shares following an injection of capital, and reconvert loans into net assets. Despite the uncertainty surrounding future scenarios and the doubts concerning the company’s ability to continue operating, thanks to the considerable support of the holding company, Eurofly had sufficient resources to continue operating. On 18/03/2014 AKFED formally committed itself in writing to continued support of the company through a series of financial undertakings, not unlike those given formerly, thereby ensuring enough equity and financial resources to justify the assumption of going concern. Nevertheless, the auditing firm declared itself unable to express any opinion as regards the financial statement of 31/12/2013. 5.2 Viaggi del Ventaglio and EEM Italia We decided it would be illuminating to compare the case of Eurofly with the other two companies, whose difficulties led to their respective auditors feeling unable to express any opinion on their financial statements. These two company are Viaggi del Ventaglio, which began operating in1976 in the tourist and package holiday sector, and EEM Italia which made semi-conductors from 1969 until 2012, when it ceded certain activities and now operates in the photovoltaic sector.

From an analysis of the economic and financial situation of the Viaggi del Ventaglio group in 2009,

11

“Piano industriale 2007/2009 press conference 28 June 2007”, document found on www.meridiana.it 12

“Press conference 28 December 2007”, document found on www.meridiana.it.

we find a reduction of their debt situation, which can be attributed, in part, to a reduction of their debt to factoring companies, owing to a suspension of credit by the latter, and partly to a reduction of debts to banks, both in current accounts and loans.

One worrying factor, however, was the money owed to suppliers in terms of unpaid credit lines.

As a result in 2009 the company management attempted to set up a series of negotiations for the relinquishing of different assets as well as for the cession of control of the company and the recapitalisation through new partners. For a number of reasons, summarised in the company report, these negotiations did not produce a positive result and the shareholders assembly, in July 2009 after approving the financial situation in which capital had descended below the legal minimum on account of a loss of 15m euro, decided to fully cover the loss through a reduction of capital to 120m euros and a new increase in capital of up to 77m euros, with the undertaking to raise 6m euros by 30 November. The assembly also nominated commissioners to liquidate the company if by 1 December the above-mentioned sum had not been paid into the company accounts.

In December 2009, having recognised that the 6m euro had not arrived and that the three liquidators had not accepted the mission, the board decided to wind up the company, delegating to the chair the task of applying to the courts to be taken into receivership. The chair was also mandated to call a new assembly to nominate other liquidators who, on acceptance, would present the request for receivership to the Court in Milan. On 18 February 2010 the company’s request was accepted by the Court (former article 166 bankruptcy law) on the basis of a plan proposed by the company. In order to extinguish its debt the idea was to sell off the assets, and to realize the value of trademarks, specialised personnel and so on. Next, the plan entailed the cession of operating branches of the group to a new company (Newco) and, finally, the conversion of the credit held by third parties into shares of the group leader. However, in July 2010 the receivership was revoked by the commissioner appointed by the Court on the grounds that the party concerned had proposed an increase in capital, whereas Article 2447c.c. requires a reduction of capital to cover the losses. Moreover, the party had not given a deposit to cover the costs in line with Article 163, no. 4. Furthermore, the new proposal also contained other unacceptable elements: on the one hand it entailed the repayment of privileged creditors through the issue of shares without any prior demonstration of the likelihood of a worse outcome though the bankruptcy courts, thereby violating Article 160, para. 2 of the Bankruptcy Law, and on the other the profiles presented concerning future decisions regarding capital were far too vague, all of which rendered the new proposal uncertain and unacceptable. Owing to the liquidators’ inability to formulate a credible rescue package, therefore, the Court had no alternative but to declare the company bankrupt.


52

Table 6. Net financial debt (in thousands of Euro)

2009 2008 Difference

Fund 425 374 51

Other available available funds 3.474 14.301 (10.827)

Liquidity 3.899 14.675 (10.776)

Current financial credi 1.569 1.022 547

Current bank debts 8.179 9.544 (1.365)

Current part of non-current debt 2.931 3.015 (84)

Other current financial debt 4.290 18.348 (14.058)

Current financial debt 15.400 30.907 (15.507)

Group net financial debt 9.932 15.210 (5.278)

Non current bank debt 602 885 (283)

Other non-current financial debt 4.460 4.557 (97)

Group net non-current financial debt 5.062 5.442 (380)

Group net financial debt 14.994 20.652 (5.658)

Source: “Consolidated financial statements 2009”, document retrieved from http://www.fallimentoivvspa.it/

The report of the consultancy firm PKF Italia spa

on the company accounts of the Viaggi del Ventaglio group concluded without expressing any opinion

13.

Given the losses by the company which had reached the limit stipulated in Article 2446 of the Civil Code, uncertainties given the lack of any real negotiation with the banks either as regards finding the necessary resources to overcome the conditions of financial crisis or as regards the restructuring of the debt. Moreover, there were uncertainties over the outcome of a dispute concerning the non-payment of rents, relating to contracts with a number of hotels, which could lead the company into further difficulties. All this cast serious doubts on the company’s ability to continue in business and hence the assumption of going concern.

5.2.1 Analysis of the economic and financial

situation of the EEMS group on 31 December 2012

and the report by Reconta Ernst & Young spa

From analysis of the company accounts of the EEMS Italia group we can see a reduction in turnover compared with 2011. In the course of 2012 the semi-conductor sector suffered a downward trend, as the continuation of the global economic crisis had a decidedly negative effect on the sales of electronic goods, leading to heavy losses in the DRAM commodity segment. Faced with this difficult situation the company began procedures to get out of loss making areas, and these were realised in the years 2012 and 2013 through the cession of assets by EEMS Sozhou and EEMS Suzhou Technologies in favour of the Chinese group Wuxi Taiji Industrial

14. The

photovoltaic sector recorded a drop of 37% compared with the previous year. In particular, the renewable energy resources sector suffered a blow due to yet another change in the regulations governing the

13

“Corporate Governance 2008/2009” document found on http://www.fallimentoivvspa.it/ 14

“Bilancio consolidato e di esercizio al 31 dicembre 2012,” document found on www.eems.com

industry which came into force in August 2012 (V° Conto Energia), hindering market operations, i.e. limiting installations of less than 12 Kw and reducing incentives.

For all these reasons the company approved an industrial plan for 2013-2016, in an attempt to concentrate on specific market sectors, on the grounds that certain areas were characterised by a premium price for European products and by small plant size less affected by competition from Chinese manufacturers and an improvement in production costs as a result both of the automation of production lines and from the direct supply of raw materials from Taiwan at low cost. The plan also foresaw the sustainability of the company as a going concern through debt restructuring and the concession by the banks of the resources required to guarantee the revival of the company’s activities. Discussions are on-going and new facts and developments could emerge at any time, which could prejudice the outcome.

Reconta Ernst & Young , who were appointed to carry out the audit of the company accounts, issued on 31 December 2012

15 underlined the impossibility of

expressing an opinion on account of the grave uncertainties as to the outcome of the restructuring with the credit institutions, which cast considerable doubt on the company’s ability to carry through its plan and honour its commitments. In the year 2013 the administration decided to renegotiate the previous financing agreement, but the parent company met with serious difficulties which made it unable to carry out part of the repayment before 31 March 2014.

15

“Relazione della società di revisione del 18 giugno 2013” document found on www.eems.com

http://www.fallimentoivvspa.it/


53

Table 7. Selected data from the Profit and Loss/Revenue account

Data in thousands of Euro 2012 2011 %

Total operating income and expenses 67.712 107.153 - 37%

Operating income before amortization and recovery/devaluation of

non-current activities (12.166) (8.983) 35%

Operating income (27.560) (27.617) 0%

Result of the period of activities expected to continue (38.697) (29.938) 29%

Result of the period of activities expected to be yielded (47.987) (6.250)

Total overall net profit (86.684) (36.458) 138%

Number of shares 43.597.120 43.597.120

Number of Employees in activities expected to continue 224 224

Source: “Consolidated financial statements 2012”, retrieved from www.eems.com

The peculiar nature of the photovoltaic sector

where the group now operates in, owing to unstable prices and the continual modifications of the regulations governing the industry, has led to a marked reduction in sales, compared to the forecasts in the recovery plan. Nevertheless, in spite of the uncertainties, the administrators were convinced that there were good grounds for believing in the company’s future, and thus achieving the goals set out in the industrial plan. The auditors, however, bearing in mind the aforementioned uncertain financial and economic landscape felt unable to express any opinion as regards both the consolidation accounts of 31 December 2013 and the six monthly abbreviated statement in August 2014. In detail the auditors’ doubts concerned the duration of the crisis, the negative equity and the lack of financial equilibrium; moreover, the parent company was not in a position to honour its undertakings. This being the case there were no grounds for launching a new sustainable industrial plan. The administrators, on the other hand, maintain that the presumption of going concern must be related to the definition of an agreement with new investors, as well as the positive conclusion to their request for an agreement with creditors/admission into receivership presented by the parent company. To sum up, the prospects remain unclear and not particularly hopeful, and consequently the auditors have withheld any opinion on whether the company can be considered a going concern. 6 Conclusions The aim of this work is twofold: first, through a case study of three companies, who had come under the watchful eye of the CONSOB and inserted into the so-called blacklist, an analysis was carried out into the concept of going concern, and secondly we looked at what happens when a company is no longer considered a going concern, with particular reference to the auditor’s judgement. Indeed, in a time like the present with businesses struggling to cope with the economic and financial crisis, this concept has come under increasing review, especially as there are numerous factors that threaten a company’s survival.

The companies analysed are: Viaggi del Ventaglio, Meridiana Fly and EEMS. They were all

included on the CONSOB blacklist at different times, and hence subject to continuous scrutiny and required to supply periodic updates in order to keep the market informed on their situation. As regards the three companies, our objective was to understand not only their economic and financial problems and the uncertainties that had determined the loss of going concern status, but also how all this affected the judgements expressed by the auditors.

In the case of Eurofly, this company was obliged to provide updates on its situation up to its delisting from the Milan Stock Exchange in June 2013. Thereafter the company concentrated on setting up extraordinary measures with other subjects operating in the same sector, and it continues to operate today providing services in the air travel business.

The variety of problems encountered led the Eurofly board to set up a three-year plan for 2007-2009. The achievement of the conditions entailed in the plan contributed to the company’s recovery. Yet doubts remain as to the company’s future. The management has confirmed that the group has access to adequate financial resources to continue operating in the future thanks to the support of the parent company AKFED, which committed itself formally in March 2014 to support the company through a series of financial interventions all of which should guarantee the company’s future as a going concern. Despite this the auditors fear that significant problems remain unsolved, which could in certain circumstances in the future drag the company back into difficulties, and thus they feel unable to express an opinion on the company accounts issued on 31/12/2013.

In the second case study analysed concerning Viaggi del Ventaglio, in the year 2009 the management undertook a number of negotiations with a view to offloading certain assets as well as ceding control of the company and recapitalisation through the entry of new partners. This strategy proved unsuccessful, however, and in July 2009 a shareholders meeting was convened to ratify a situation in which the company’s equity had fallen below the minimum allowed by law. Negative equity, failure to honour loan covenants, and the lack of progress in negotiations with credit institutions on finding the necessary resources to overcome the crisis all led to the company going under. On the 18

http://www.eems.com/


54

February 2010 the company entered into receivership. Given the liquidators’ inability to come up with a credible rescue plan, the Court declared the company bankrupt. In the light of all this and in particular of the company’s heavy losses, on the same date the report of the consultancy firm PKF Italia on the company accounts of the group concluded that it was not in a position to express any opinion.

In the final case study on EEMS Italia the various negative results on the running of the company led to the drafting of an industrial plan for the 2013-2015 period. Whether the plan has been a success is still a matter of debate and the recovery is still uncertain, also because future events may occur linked to the sectorial difficulties in general which are impossible to predict and therefore assess. Nevertheless, EEMS continues to operate, despite still being included in the black list, and despite a series of negative financial results, which have led the auditors, today as in the past, to declare themselves unable to express an opinion on the company’s prospects.

From the results of the three case studies it emerges that the three companies have numerous common elements as regards the circumstances that have triggered the loss of going concern status. Obviously this work does not pretend to be exhaustive in its reach, yet it does help to focus attention on certain situations which if not adequately dealt with can trigger crises and therefore put the company’s future at risk. Some companies do everything possible to tackle their predicament, by making strategic decisions, restructuring plans, renegotiating the debt burden and searching for new inputs of capital, yet all these efforts are no guarantee that they will overcome their difficulties.

Turning now to the opinions expressed by the auditors in the case studies, we can see that, notwithstanding the work of the administrators in supplying all the financial information required, the auditors still feel unable to express an opinion given the uncertainties and the possibility of negative developments in the economy at large which could impinge on the companies involved and put their survival at risk.

In conclusion, when things go well everything is much simpler and any financial problems can be dealt with within the company, but when the company’s future is threatened maximum professionalism is required. The key issue is not merely a drop in profits but the company’s survival, and also involves the financial and legal responsibilities of the administrators as well as the wellbeing of creditors and everyone else involved. References 1. A.A.V.V., (2007), Basic Financial Accounting.

Rilevazioni per il bilancio di esercizio e il bilancio

consolidato, McGraw – Hill, Milano.

2. Aspes, G, Campedelli, B. (1999), Principi di revisione

internazionali: il processo di revisione, Giappichelli,

Torino, 1999.

3. Assirevi - Associazione Italiana Revisori Contabili,

Documento di ricerca n. 176, Delibera IX/3856 del 25

luglio 2012 Regione Lombardia – Chiarimenti sulla

continuità aziendale, Milano, 2013.

4. Bauer, R. (2010), “La continuità aziendale nelle

relazioni del revisore”, Amministrazione & Finanza,

Milano.

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56

CONFIDENCE OF ACCOUNTANTS IN APPLYING INTERNATIONAL FINANCIAL REPORTING STANDARDS

Rajni Mala*, Parmod Chand**

Abstract

Research on how accountants could increase their confidence in interpreting and applying International Financial Reporting Standards (IFRS) is lacking. This study examines whether the accuracy of judgments made by accountants varies as a consequence of their level of confidence, and whether their confidence in exercising judgments could be enhanced by greater familiarity with IFRS. The results of the study support that accountants who are more confident make judgments that better reflect the economic substance of a transaction than accountants who are less confident. The results further indicate that familiarity with IFRS enhances the confidence of accountants and the most accurate judgments are made by those accountants who are not only familiar with IFRS but also have confidence in their judgments. Keywords: IFRS, Professional Judgments, Confidence, Familiarity *Corresponding author. Department of Accounting and Corporate Governance, Macquarie University, North Ryde, NSW 2109, Australia Tel: (612) 9850 8530 Fax: (612) 9850 8497 **Department of Accounting and Corporate Governance, Macquarie University, North Ryde, NSW 2109, Australia Tel: (612) 9850 6137 Fax: (612) 9850 8497

1 Introduction

The fact that International Financial Reporting

Standards (IFRS) promulgated by the International

Accounting Standards Board (IASB) embody a

principles-based or ‘substance over form’ regime

(Chambers & Wolnizer, 1991; Doupnik & Richter,

2003) means that many decisions concerning the

accounting treatment of a transaction are based on the

professional judgments of accountants. This study

examines whether accountants are confident in using

IFRS, and if they are, whether these confident

accountants are more likely to choose accounting

treatments that reflect the economic substance of a

transaction than accountants who are less confident.

The study also examines whether accountants’

confidence in exercising judgments could be enhanced

by greater familiarity with IFRS.

Approximately 128 countries have adopted or

intend to adopt IFRS for all their domestically listed

companies. The implicit assumption in accounting

convergence is that this will lead to high quality and

comparable financial reporting. However, even though

the adoption of IFRS is widely promoted, there are

still many inherent challenges in implementing and

applying IFRS within and across countries (see

Doupnik & Richter, 2003; Verschoor, 2010;

Wustemann & Wustemann, 2010; Hodgdon et al.,

2011). Owing to the significance of the role played by

judgment in the application of IFRS, it is extremely

important to examine how accountants’ choice of

accounting treatments could be enhanced when

judgments are made that reflect the economic

substance of a transaction, because an inappropriate

judgment can lead to serious economic consequences

for users of accounting information, as well as for

firms.

Accountants’ confidence in using IFRS to

exercise their judgment to determine the appropriate

form of financial disclosure is crucial. Confidence is

the belief of the decision maker in the quality of the

decision made (Sniezek, 1992). It can be perceived as

a process variable that is considered a determinant of

performance or an outcome variable that reflects an

individual’s confidence in the performance of a task

(Bonner, 2007). Confidence in this study is

conceptualised as an outcome variable, where

confidence is described as the degree of belief in the

accuracy of judgments made (see Einhorn & Hogarth,

1978; Lichtenstein et al., 1982; Reber, 1995). In

psychology, a number of studies which examined the

effects of confidence on judgment accuracy have

reported that higher confidence in one’s judgments

leads to more accurate judgments being made

(Woodman & Hardy, 2003; Kebbell, 2009; Lee et al.,

2011). Hence, it becomes crucial to investigate


57

whether accountants are confident in their judgments

that require the use of IFRS and whether this

confidence leads to choosing the accounting

treatments that best reflect the economic substance of

a transaction.

Research on judgment and decision making

suggests that familiarity has a positive effect on

judgments. Familiarity has been defined as “specific

knowledge a person has about the aspects of work”

(Goodman & Leyden, 1991, p. 578). Familiarity in our

conceptualization is a knowledge-based variable

which facilitates greater confidence in accountants and

hence improves the quality of their judgments. The

positive effects of familiarity on task performance

have also been confirmed in experimental problem-

solving tasks (Littlepage et al., 1997), studies of team

familiarity in medical teams (Reagans et al., 2005),

and in software development studies (Boehm, 1981;

Curtis et al., 1988; Walz et al., 1993; Banker &

Slaughter, 2000; Brooks, 1995). While the general

benefits of task familiarity are apparent from these

studies, it is still not clear whether familiarity with

IFRS will enhance accountants’ confidence and

support them to choose the accounting treatments that

best reflect the economic substance of a transaction

when applying principles-based accounting standards.

This research therefore is timely and relevant.

Three hypotheses are used as a basis for the

examination of the effects of confidence on the

reporting judgments of accountants and to examine

whether familiarity with IFRS as a confidence

enhancing factor will assist them in selecting an

accounting treatment that best reflects the economic

substance of a transaction. A lease task was chosen

and accountants were required to exercise their

judgment on whether a leased item should be

recognised as an operating lease or a finance lease.

International Accounting Standard (IAS) 17 Leases is

a conventional principles-based standard which

emphasizes the substance of a lease transaction in

making a classification as a finance lease or an

operating lease (Jamal & Tan, 2010; Agoglia,

Doupnik, & Tsakumis, 2011).

The first hypothesis posits that there will be

differences in the judgments based on the degree of

confidence accountants have in exercising their

judgment. Specifically, the first hypothesis implies

that accountants who have greater confidence in their

judgments are more likely to choose accounting


a transaction than accountants who are not confident.

As expected, the results of the study provide strong

support for the notion that accountants who are more

confident make judgments which better reflect the

economic substance of a transaction than accountants

who are less confident.

The second and third hypotheses examine the

potential role that familiarity plays in enhancing the

confidence of accountants. The second hypothesis

presumes that accountants who are familiar with IFRS

are able to use specific knowledge that links the

principles of the accounting standards with business

transactions, will spend less time referring to the

contents of the standards and will focus more attention

on exercising their professional judgment; hence, they

will choose the accounting treatment that best reflects

the economic substance of a transaction. The results

indicate that accountants’ familiarity with IFRS have a

significant positive influence on their judgments.

Further, the study examines the impacts of both

familiarity with IFRS and confidence on the

judgments of accountants. The results indicate that

familiarity with IFRS enhances the confidence of

accountants and the most accurate judgment is made

by those accountants who are familiar with IFRS as

well as confident in their judgments.

Our findings have practical implications that are

important for both accountants and standard setters

because they show that accountants’ confidence in

their judgments is crucial for choosing accounting


a transaction. This study has implications for the

convergence of accounting standards which advocates

for high quality financial reports. The results of this

study imply that countries adopting IFRS can only

realize gains if the necessary investment in accounting

education and training has been made so that

accountants feel familiar with IFRS and their

confidence is consequently enhanced.

The remainder of the paper is organized as

follows. Section 2 outlines the relevant literature and

develops our hypotheses. Sections 3 and 4 describe the

experiment used to test the hypotheses and present the

results. Section 5 provides a summary and offers the

conclusions and implications of our study.

2 Theory and hypotheses development 2.1 Confidence in judgment and decision making Confidence is a crucial factor in the judgment and

decision making process because it reflects the degree

of “assuredness” in one’s judgment or decision (Reber,

1995). According to Peterson and Pitz (1988),

confidence can be assessed by obtaining the decision

makers’ self-review on their belief in the possibility

that the decision they have made is correct. The higher

the probability stated by the decision makers, the

higher the level of confidence they have in their

judgments. Sniezek (1992) argued that confidence in

judgments may be as important as the quality of the

judgments themselves, because confidence will

determine whether and how those judgments or

decisions are used by decision makers, or even by

others. Bonner (2007) pointed out that, although some

prior studies in accounting have examined confidence

as a process variable in individuals’ judgment and

decision making (JDM), most studies tend not to

examine the effects of confidence on subsequent JDM,


58

hence, the relationship between the two variables is

still not well understood.

According to Lee and Dry (2006) people are

sensitive to the accuracy of information when

evaluating how accurately they perform. They

observed that the type of decision made by individuals

is linked to the kind of information presented to them,

and that their confidence is affected by the frequency

and accuracy of the advice. They also showed that

people are less confident in their estimated decisions

when they have to make many decisions.

A number of studies in psychology which

examined the effects of confidence on judgment

accuracy have reported that higher confidence in

judgments leads to higher accuracy in judgments

(Woodman & Hardy, 2003; Kebbell, 2009; Lee et al.,

2011). For example, Kebbell (2009) conducted an

experiment with 100 undergraduate participants to

examine witnesses’ confidence in their level of recall

accuracy in relation to film footage of criminal

behaviour. The study reported a significant positive

relationship between witnesses’ confidence and the

recall accuracy of their answers. Similarly, Lee et al.

(2011) explored the interaction between students’

confidence in their judgment, their actual accuracy

and time taken in answering 100 general knowledge

questions. The results support their prediction that

accuracy increases with higher confidence ratings. In a

meta-analysis of 48 studies on competitive

performance, Woodman and Hardy (2003)

documented a significant positive relationship

between individuals’ confidence and their

performance. The result is consistent with the

proposition of motivation theory which suggests that a

higher level of confidence may lead to increased

performance by increasing individuals’ motivation to

succeed in a given task (Benabou & Tirole, 2002).

In accounting, findings regarding the effects of

confidence on judgment accuracy have been mixed.

For example, Pincus (1991) examined the

relationships between individual auditor

characteristics, decision accuracy and audit judgment

confidence. The study reported that confidence and

accuracy were not significantly related and suggested

that confidence may be a process variable rather than

an output variable. Weber (1978) tested 40 auditors’

decision processes in assessing the overall reliability

of internal control for a manufacturing company's

inventory system, and even though the study failed to

provide a test of the significance of the confidence-

accuracy relationship, they reported that those subjects

who used decision aid were significantly more

confident in their judgments and made significantly

more accurate decisions than those who did not,

therefore supporting the existence of a positive

relationship between confidence and accuracy.

Similarly, Hageman (2010) conducted an experiment

with 114 participants to examine the role of

confidence in tax return preparation. The results

indicate that tax preparers with higher levels of

confidence in their ability to accurately prepare a tax

return demonstrated higher levels of accuracy in their

performance of the task using a tax decision support

system.

A number of studies in auditing that have

investigated the appropriateness of auditors’

confidence in the judgments they make have also

reported mixed findings that auditors sometimes

display overconfidence and sometimes

underconfidence in the decisions they have made

(Hunton et al., 2004). For example, Solomon et al.

(1985) found that auditors' judgments in general-

knowledge (almanac) questions were miscalibrated

and significantly overconfident. Similarly, Hunton et

al. (2004) reported that financial auditors may be

overconfident in their ability to recognize heightened

risks associated with an enterprise resource planning

(ERP) system. Overconfidence in a decision is

regarded as having a greater degree of perceived

accuracy on a given task than is reflected in the actual

accuracy of the performance (Lichtenstein et al., 1982;

Paese & Sniezek, 1991). According to Bonner (2007),

overconfidence is one of the most problematic biases

in judgment and decision making; the outcome can

have serious consequences if individuals fail to

recognise the inaccuracy of their task performance,

and this may lead to inaccurate resource allocation.

Generally, studies have shown that overconfidence in

task performance is negatively associated with

judgment accuracy (Sniezek et al., 1990; Hageman,

2010; See et al., 2011).

Underconfidence in decision making occurs

when there is greater accuracy in the decisions made

than the self-assessed judgment accuracy of those

decisions (Lichtenstein et al., 1982). Underconfidence

may result in a good judgment being discarded,

resulting in failure to benefit from a good decision

(Staw, 1976). In the study by Tomassini et al. (1982),

auditors were required to establish probability density

functions on account balance for 6 real world cases.

The results show substantial underconfidence in all

areas of the distribution. Similarly, the study by

Solomon et al. (1985) found that auditors’ judgments

in assessing the accuracy of particular account

balances in financial statements were predominantly

underconfident.

Both overconfidence and underconfidence can

lead to inaccurate resource allocation, thus an

appropriate level of decision confidence is as vital as

decision accuracy in its effect on the ultimate outcome

of a decision (Sniezek & Henry, 1989). While studies

have been conducted in psychology, auditing and

taxation contexts, research investigating the

confidence in the context of IFRS reporting is missing.

Our study fills this void by examining whether

accountants who are more confident in their

judgments are likely to choose the accounting


a transaction than accountants who are not confident.


59

2.1.1 Effect of confidence on reporting judgments of

accountants when interpreting and applying

IFRS (H1)

To examine the confidence effect on judgment

accuracy, a lease decision context for the classification

of the proposed leasing arrangements between a lessor

and a wholly-owned financing subsidiary who then

subleases to an airline company as either financing

lease or operating lease is selected. Under IAS 17,

paragraphs 10 to 12 include the general principles for

the lease treatment, primarily based on the criterion of

whether the lessee has transferred to the lessor the

‘significant’ risks and rewards of ownership of the

asset.

Grounded in prior research, mixed directions of

judgment accuracy may be expected due to an

individual’s confidence. Confidence in a certain range

may be associated with more accurate judgments,

while overconfidence may be associated with less

accurate judgments. In this study, it is expected that

accountants who are confident will potentially

evaluate the business transactions more thoroughly,

process the given information more carefully, and not

make judgments based on estimations (Lee & Dry,

2006). Additionally, accountants who are confident

are expected to analyse the transactions more

vigilantly and to be motivated to be successful in

performing the task (Benabou & Tirole, 2002).

Therefore, this study predicts that accountants who are

thorough and vigilant, as well as being motivated to be

successful in the task, will feel confident in their

judgments. It is further predicted that those

accountants who are more confident that their

judgments are accurate are likely to make more

accurate judgments. Accordingly, the following

hypothesis is formulated.

H1: Accountants who are more confident in their

judgments are likely to choose the accounting

treatment that best reflects the economic substance of

a transaction when applying IFRS than accountants

who are less confident.

2.2 Effect of familiarity on judgment and decision making

Another major factor that has been found to affect an

individual’s performance and decision making is

familiarity. A person who is familiar with a certain

task may perceive the task to be less complex than

those who are unfamiliar or have fewer relevant

experiences (Campbell, 1988). To develop an

understanding of the effects of familiarity on

individuals’ judgments and decision making, Schank

(1999) provided a theoretical basis to indicate how

training and prior exposure to a task help decision

makers to make better judgments. In his theory,

human information processing relies on memory

processes and the categorical structures that organize

the information stored in memory. Schank (1999)

pointed out that human memory is organized by

categories, with a memory index to store new

information, retrieve existing knowledge, and create

new indices for novel information. When people

process information, the mind consults the memory

index to establish links between related categories and

assemble the relevant knowledge needed to

understand and interpret the information. In this

process, how the categories are structured significantly

influences the outcome of a decision task. The

categorical knowledge structures can be developed

through training and prior exposure/experience to a

decision task, which in turn leads to improvements in

the judgment and decision making process (Kopp &

O’Donnell, 2005).

In psychology, a number of studies provide

evidence that a person’s familiarity with a task or

situation has a positive influence on judgments and

performance. For example, the studies of Goodman

and Leyden (1992), Littlepage et al. (1997) and

Espinosa et al. (2007) in group settings have

consistently reported that familiarity with tasks

positively affects group members’ performance in the

areas of mining, problem solving and software

development. Littlepage et al. (1997) concluded that

the positive effect is the result of improvement in

individual ability through a transfer of specific

knowledge or strategies between prior and current

tasks. Similarly, Reinhard et al. (2011 and 2013)

showed that those participants who have high

familiarity have greater accuracy in making judgments

of truth and deception. The authors explained that

participants with high familiarity are less likely to

direct attention away from valid cues and rely on

invalid cues to make judgments. Reinhard et al. (2013)

also reported that participants in the high-familiarity

category were also more confident in their decision

making and better calibrated than participants in the

low-familiarity category.

In auditing, extant studies have reached similar

conclusions that familiarity with a particular judgment

task influence the judgment and decision making of

auditors. Anderson and Maletta (1994) reviewed prior

studies and concluded that auditors who are less

familiar with a particular judgment task are more

cautious and risk averse than those with greater task

familiarity. Further, a small number of studies in

accounting substantiate that familiarity in accounting

standards improves the judgments of analysts and

accountants. For example, Bae et al. (2008) reported

that foreign analysts whose home-country accounting

standards do not differ greatly from the firm’s home-

country accounting standards, i.e., they are more

familiar with the accounting standards used by the

firm, tend to be more accurate in earnings forecasting.

Byard et al. (2011) examined whether the European-

wide mandatory adoption of IFRS had improved the

forecast accuracy of foreign analysts relative to

domestic analysts. The findings indicate that only

those foreign analysts familiar with IFRS experience


60

an improvement in forecast accuracy because they are

better able to analyse IFRS-based financial statements.

Similarly, Chand et al. (2010) found that the

complexity of the accounting standard and the

professional accountant's familiarity with the standard

affected the accountant’s ability to interpret and apply

the standard in a consistent manner. In their study,

professional accountants demonstrated more

consistency in their judgments when they were

required to interpret accounting standards which they

were familiar with. Therefore, in the accounting

context, professional accountants would be required to

have appropriate training and exposure before being

able to proficiently interpret and apply accounting

standards. The level of familiarity of professional

accountants with an accounting standard largely

depends on the extent to which they are trained and

exposed to the standard (Chand et al., 2010). Overall,

it can be seen from prior studies that familiarity

positively affects the judgments and decision making

of professionals.

2.2.1 Effect of familiarity with IFRS on the reporting

judgments of accountants when interpreting and

applying IFRS (H2)

Existing research in psychology and accounting has

suggested that familiarity has an impact on judgment

and decision making, particularly when the task is

complex. It is argued that the interpretation of

principles-based standards is a complex task due to the

high cognitive demands placed on accountants to

interpret and apply the accounting standards (Devi,

2003). Accountants need to interpret uncertainty

expressions, evaluate a number of broad principles,

and exercise their own judgments to determine the

appropriate form of financial disclosure. Therefore,

professional accountants need to be well-trained and

extensively exposed to principles-based standards

before they are sufficiently familiar with the standards

to accurately interpret and apply them.

In the context of this study, it is expected that

accountants who are familiar with the accounting

standards will be able to use specific knowledge that

links the principles of the accounting standards with

business transactions, will spend less time referring to

the contents of the standards, and will focus more

attention on exercising their professional judgment.

Moreover, they are likely to rely on more relevant

information to make judgments and will be able to

interpret and apply accounting standards in an

accurate manner compared to those accountants who

are less familiar with the standards. Therefore, this

study predicts that accountants who are familiar with

the accounting standards will more accurately

interpret and apply accounting standards and will

therefore choose the accounting treatments that best

reflect the economic substance of a transaction than

those accountants who are less familiar with the

standards. Accordingly, the following hypothesis is

formulated:

H2: Accountants who are more familiar with

IFRS are more likely to choose the accounting

treatment that best reflects the economic substance of

a transaction when interpreting and applying IFRS

than accountants who are less familiar with IFRS.

2.3 Influence of familiarity with IFRS and accountants’ confidence on their judgments (H3)

The psychology and auditing literature shows that

confidence on the judgments has a positive effect on

judgment. The findings show that a higher level of

confidence leads to greater accuracy in the judgments

made. Similarly, findings in psychology literature

show that when individuals are familiar with the tasks

being undertaken, they are able to establish links

between related categories and assemble the relevant

knowledge needed to understand and interpret the

information, leading to accurate judgments.

This study expects that those accountants who

are more familiar with IFRS as a result of possessing

well-developed knowledge structures will be more

confident in their judgments and hence will make

more accurate judgments. Accordingly, the following

hypothesis is formulated:

H3: Familiarity with IFRS is likely to enhance

the accountant’s confidence in their judgment and

accuracy when they interpret and apply IFRS.

3 Research method 3.1 Participants and design It was necessary for the research setting of this study

to represent a country that has harmonised with IFRS.

Malaysian Accounting Standards (MAS) are generally

harmonised with IFRS. Hence, Malaysia provides an

appropriate research setting for undertaking the

current study.

The participants in our experiment were 82

Malaysian Certified Practising Accountants (CPA)

with an average of five years’ professional work

experience. The respondents had relevant education,

training and experience in dealing with MAS which,

as noted above, is well harmonised with IFRS.

Because our experiment asks participants to choose

the accounting treatment that best reflects the

underlying economics of transactions for a company

faced with the treatment of a lease transaction, it was

important for us to feature Malaysian-based

accountants who had experience in making financial

reporting decisions in this context. To preserve internal validity and to enable

differences in the reporting judgments of accountants to be attributable to the two variables of interest (confidence with the judgment and familiarity with IFRS), particular care was taken in designing the scenario. Potentially confounding variables that could also affect the reporting judgments of accountants


61

were controlled. For the given scenario, participants were simply instructed to choose the accounting treatment that best reflected the underlying economics of transaction for a company faced with lease treatment decision.

3.2 Procedures The participants were provided with a research instrument containing two sections. The first section required respondents to provide demographic data such as gender, age, level of formal education, employer details and years of work experience. Respondents were asked to identify their familiarity level with IFRS with the options ranging from very familiar to not familiar (where 1 denoted ‘very familiar’ and 4 denoted ‘not familiar’). In order to group the participants as familiar with IFRS or not familiar with IFRS, the median split technique was employed to split the accountants into two groups according to their level of familiarity. Fifty accountants (61% of the sample) were familiar with IFRS while thirty two accountants (39% of the sample) were not familiar with IFRS.

The respondents were also asked to indicate how confident they were that their judgment was correct on a seven-point Likert scale (where 1 denoted ‘extremely confident’ and 7 denoted ‘not confident at all’). Again, the median split technique was employed to group the participants who were confident with their judgment and those who were not confident with their judgment. Twenty-eight accountants (34% of the sample) were confident that their judgment was accurate, while fifty four accountants (66% of the sample) were not confident that their judgment was accurate.

The second section includes the case scenario based on a hypothetical airline company. The participants were provided with the proposed leasing arrangements between a lessor and a wholly-owned financing subsidiary who then subleases to an airline company. The sublease is for 12 years, which is 60% of the aircraft’s economic useful life of 20 years. The airline company has no purchase option at the end of the lease term; however, the wholly-owned financing subsidiary has an option to purchase the aircraft at the end of the lease. The present net value of the lease payments is 64% of the aircraft’s fair market value. In the alternative other scenario, the lessee enters into a guarantee agreement with the lessor regarding the payment in favour of the wholly-owned financing subsidiary.

3.3 Pre-test To obtain an indication of the accounting treatment that best reflects the underlying economics of transaction and event in the financial statements (i.e., the most accurate judgment) on the scenario, a pre-test was conducted. The research instrument was pre-tested with fifteen senior accounting academics from Macquarie University in Australia and five senior

professional accountants in Sydney, Australia. To determine whether to “treat the lease arrangement as an operating lease”, the mean score of the judgments made by all the participants in the pre-test was used.

A lease can only be recognised as a financing lease by an entity when any one of the conditions under IAS 17 paragraphs 10 – 12 has been satisfied. The sublease is for 60% of the aircraft’s economic useful which does not meet the criterion that the “lease term is for the major part of the economic life of the asset”. Additionally, the airline company has no purchase option at the end of the lease term. The Net Present Value of the Minimum Lease Payment (MLP) is 80% of the fair value of the asset, which also does not meet the criterion that “the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset”. Moreover, the lessee has an option to renew the lease for a further 5 years at the prevailing market rental rate at the end of this lease term, which does not meet the criterion of a financing lease. Therefore, none of the conditions of IAS paragraphs 10 – 12 had been satisfied. Consequently, the most accurate judgment in this scenario is that the lease should be treated as an operating lease.

The pre-test mean score for the accountants’ judgment was 6.5 (non-tabulated), which indicates that the lease should be treated as an operating lease. Since accuracy is unobservable for many accounting tasks, the mean judgment is an indication of judgment consensus amongst the respondents (Libby, 1981; Ashton, 1985; Abdolmohammadi & Wright, 1987). Research has shown that consensus is a fairly good surrogate for accuracy in accounting tasks (Solomon & Shields, 1995). Therefore, in this study the consensus in the judgment of experts is used as a proxy for judgment accuracy.

4 Results and discussions 4.1 Demographic details of respondents

85 accountants participated in the research, but there were only 82 valid responses (i.e. a usable response rate of 96%).

16 As shown in Table 1 of the usable

responses, 28 accountants were confident that their judgment was correct while 54 accountants were not confident that their judgment was correct. Additionally, of the usable responses, 32 accountants were not very familiar with IFRS while 50 accountants were familiar with IFRS. The mean age category of the respondents in the confident group was 35 years and in the familiarity group was 36 years. The average number of years in formal education was 17 years for the respondents in the confident group and 17.5 years for the respondents in the familiarity group. The average level of professional experience was 5 years for the confident group and 7.7 years for the familiarity group.

16

Three responses were not included in the analysis of the results because they were incomplete.


62

Table 1. Demographic data of respondents

Demographic Data Confident that the

Judgment is correct

Familiarity with

IFRS

Sample Size Confident Not Confident

28 54

Familiar Not Familiar

50 32

Level of Experience in years

(Mean)

5

7.7

Level of Formal Education in years

(Mean)

17

17.5

Age (Mean) 35 36

4.2 Effect of confidence on the reporting judgments of accountants (H1)

H1 is tested using a 2 x 2 ANOVA where “confidence

in judgment” is the between-subject independent

variable with the accountant’s lease treatment decision

serving as the dependent variable. The participants are

dichotomized into a confident group and a less

confident group using the median split.

The ANOVA results with dichotomized variable

reveal that participants who are in the confidence

group are significantly more likely to make a lease

treatment decision which best reflects the economic

substance of a transaction (mean = 5.25) than the less

confident group (mean = 4.28, F = 14.216, p = 0.000).

These results in Table 2 provide support for H1.

Table 2. Descriptive statistics and Univariate analysis of effect of confidence on the judgments of respondents

Source of Variance Mean Standard Deviation F Significance Level

Confident

with judgment

n=28

5.25 1.236 14.216 0.000*

Not Confident

with judgment

n=54

4.28 1.036

Note: *Significant at p < 0.01

4.3 Effect of familiarity on the reporting judgments of accountants (H2)

H2 is tested using a 2 x 2 ANOVA where “familiarity

with IFRS” is the between-subject independent

variable with the accountant’s lease treatment decision

serving as the dependent variable. The participants are

dichotomized into a familiar group and a less familiar

group using the median split.

The ANOVA results with dichotomized variable

reveal that participants who are in the familiar group

are significantly more likely to make a lease treatment

decision which best reflects the economic substance of

a transaction (mean = 4.84) than the less familiar

group (mean = 4.25, F = 4.998, p = 0.028). These

results in Table 3 provide support for H2.

4.4 Influence of familiarity and accountants’ confidence on their judgments (H3)

It was expected that the accountants’ confidence in

their judgments would be enhanced when they were

familiar with IFRS, hence they would choose the lease

treatment decision which best reflected the economic

substance of the transaction. Therefore, a positive

correlation between the confidence of individual

accountants with their judgments (i.e. a lower value on

the seven-point Likert scale) and the familiarity level

of accountants (i.e. a lower value on the seven-point

Likert scale) will be shown.

The results show that the correlation between the

two variables is positively correlated (non-tabulated

Pearson correlation coefficient is 0.057). The follow-

up nonparametric correlation tests also show that the

correlation between the two variables is positively

correlated (non-tabulated Kendall’s correlation

coefficient is 0.057 and Spearman’s correlation

coefficient is 0.057).

Between-subjects ANOVA tests show that, as

expected, the most accurate decision was made by the

accountants who were confident in their judgment as

well as familiar with IFRS (mean = 5.62) than the

accountants who were less familiar and confident,

familiar and less confident and less familiar and less

confident in their judgment (mean 4.36, F = 17.250, p

= 0.000).17

17

For the purpose of showing the difference in judgments, the familiar and confident accountants were placed in one group, while the less familiar and confident, familiar and less confident, less familiar and less confident were placed in another.


63

Table 3. Descriptive statistics and Univariate analysis of effect of familiarity

with IFRS on the judgments of respondents


Not familiar with IFRS

N=32 4.25 1.218 4.998 0.028*

Familiar with IFRS

N=50 4.84 1.131


Table 4a. Descriptive statistics of effects of familiarity with IFRS and confidence on judgments of respondents

Confidence with judgment Familiar with IFRS Mean Standard Deviation N

Confident with judgment

Less Familiar with IFRS

Familiar with IFRS

Total

4.75

5.62

5.25

1.422

0.957

1.236

12

16

28

Not confident with judgment Less Familiar with IFRS

Familiar with IFRS

Total

3.95

4.47

4.28

0.999

1.022

1.036

20

34

54

Total Less Familiar with IFRS

Familiar with IFRS

Total

4.25

4.84

4.61

1.218

1.131

1.194

32

50

82

Table 4b. Descriptive statistics and Univariate analysis of effect of familiarity

with IFRS and confidence on judgments of respondents


Familiar and Confident

N=16 5.62 0.957 17.250 0.000*

Less familiar and confident,

familiar and less confident and

less familiar and less confident

N=66

4.36 1.118


5 Conclusion and implications

Using a sample of professional accountants from

Malaysia, we examined whether the accuracy in the

judgments of accountants varies as a function of their

confidence and whether their confidence in exercising

judgments could be enhanced with greater familiarity

with IFRS. The results provide strong support for the

claim that accountants who are more confident about

their judgments make more accurate judgment.

The results further demonstrate that familiarity

with IFRS enhances the confidence of accountants,

which has a positive influence on the accuracy of the

accounting judgment. A possible explanation for this

positive relationship between familiarity with IFRS

and judgment would be that the accountants who are

familiar with IFRS are likely to base their judgments

on relevant cues or heuristics and thus will pay much

attention to the relevant aspects of the accounting

transaction, therefore making the appropriate

judgment. Overall, the findings show that the most

accurate judgment is made by those accountants who

are familiar with IFRS as well as being confident in

their judgments.

An important implication of the results is that it

would be premature for the IASB and standard setters

of countries adopting IFRS to assume that adopting

IFRS will automatically lead to high quality financial

reports. The results of this study imply that

accountants, the preparers of the financial reports,

need to acquire relevant interpersonal skills such as

confidence in the outcomes of tasks being undertaken

to produce high quality financial reports. To help

accountants acquire such interpersonal skills, it is

imperative for organizations to mount in-house

training on the interpretation and application of IFRS,

which will assist accountants to familiarize themselves

with IFRS. This will certainly facilitate the

improvement of accountants’ judgments which will

also enhance the decision usefulness of accounting

information.

This study contributes to the wide and still

growing literature on factors that are important tools

for improving judgment. Prior research in psychology

and accounting generally indicates that confidence and

familiarity improve the judgments of individuals,

which is strongly supported by our findings. This

study provides the motivation for future research to


64

learn what other judgment improvement tools are

important for accountants.

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66

AUDITORS CHARACTERISTICS AND AUDIT DELAY: EVIDENCE FROM INDONESIAN REGIONAL GOVERNMENTS

Sutaryo Sutaryo*, Yediel Lase**

Abstract

Overdue financial statements reporting, more specifically audit delay, can cause losses in its capacity in decision making. We investigate the effects of auditor characteristics on local governments’ audit delay by studying 127 Indonesian local governments. We find that auditor professional proficiency and auditor educational background have significant effect on the audit delay of local government financial statements. Our results also indicate the intersection of some auditor characteristics in affecting audit delay. Our findings mainly suggest that the auditor professional proficiency should be improved to shrink audit delay. Keywords: Audit Delay, Local Governments, Auditor Characteristics, Auditor Professional Proficiency, Auditor Educational Background, Auditor Tenure *Corresponding author. Faculty of Economics and Business, Universitas Sebelas Maret. Jl. Ir. Sutami 36A, Surakarta 57126, Indonesia Tel: +62271647481 Fax: +62271638143 **Indonesia Supreme Audit Council

1 Introduction

It has been widely known that timeliness of financial

reporting is crucial especially with regard to its impact

on decision making. Financial reports are useful if

they provide information to decision maker before that

information could not be able to influence the decision

(Kieso, 2012). Timeliness of financial reporting

depends on the audit period as financial report must be

released after the audit has been done (Johnson, 1998).

Auditors, therefore, are expected to work without

delay, at least within the professionally and ethically

limit (Carcello et al, 1992; DeAngelo, 1981). Audit

delay refers to the distance between the end of

financial period and the date of audit reporting (Payne

dan Jensen, 2002; Johnson et al, 2002). ```

Studies on the audit delay for local governments

have been done in the US and Europe. Payne and

Jensen (2002) document that managerial incentive is

associated with timeliness of reporting and quality of

financial reporting. Moreover, experience and

reputation of auditors reduce the audit delay. Cohen

and Leventis (2012), in the context of regional

governments in Greece, find that strong opposition,

size of local government, incumbent status,

population, internal audit team as well as remarks are

the determinants of audit delay.

The present paper investigates the determinants

of audit delay especially with regard to auditor’s

characteristics which are measured by educational

background, tenure, and professional capability. We

study in the context of public sector organizations,

more specifically Indonesian local governments. Little

is found on the determinants of audit delay for public

sector in Indonesia as most of papers discuss the audit

delay for profit organizations (Merdekawati dan

Arsjah, 2011; Rahmawati, 2008). According to the

Indonesian Public Accounting Standard (SAP),

financial report of government must deal with four

principles which are relevant, reliable, comparable and

understandable. To be reliable, financial report have to

provide information which have predictive ability,

complete and on time.

The Indonesian government has regulated the

timeliness of financial report of local government18

.

Financial reports have to be submitted 3 months after

the end of fiscal period to the Supreme Audit Council.

Then, the council has to exam those reports and

releases the audit report within 2 months to the local

parliament. Based on the summary of exam report for

the second semester of 2012, it could be seen that 94

financial reports (18.08%) were delayed reported.

This paper could be considered as the first paper

discussing the determinants of audit delay of local

government in Indonesia. This paper also adds to the

literature by taking into account the role of

characteristics of auditor.

18

Decree of Ministry of Internal Affairs No. 13/2006 and Act No. 15/ 2004.


67

2 Literature review 2.1 Agency theory

Agency theory deals with the contract between

principal and agent to perform on behalf of principal

with some authorities to agent to make decisions

(Jensen and Meckling, 1976). This theory emphasizes

on the separation between principal and agent.

However, this separation could lead to a conflict

between principal and agent (agency problem/ agency

conflict) which rises because manager may pursue

private benefits (Ugurlu, 2000; Jensen dan Meckling,

1976). It is assumed that agent has more information

than principal (information assymmetry) which then

could lead to the capability of principal to effectively

monitor the agent to ensure that agent behaves for the

interests of principal. The other assumption is that

principal and agent behave rationally in which they

will maximize their wealth. It means that agent might

have private interests which is contradictory with the

interest of principal. It is generally known as moral

hazard problem (Adams, 1994; Mustapha dan Ahmad,

2011). The last issue is adverse selection bias in which

the principal might not select the appropriate agent in

terms of expertise (Gilardi, 2001). The principal has to

allocate agency cost to minimize agency problem such

as the monitoring cost to audit the financial report

(Adams, 1994; Primadita dan Fitriany, 2012).

2.2 Agency theory in public organization

Halim and Abdullah (2006) argue that agency theory

can be applied in the public organization. In such

institution, the agency relationship is in the form of

society to parliament, parliament to executives

(government), government to minister, and

government to bureaucracy (Gilardi, 2001). In

Indonesia, based on the Government Rule (PP) No. 6/

2005, regional head which can be governor, mayor

and regent are directly elected by public in a general

election. In such mechanism, public delegate their

governmental authority to the regional head. It means

that the regional heads serve as agent while public is

the principal (Sutaryo and Winarna, 2013).

2.3 Examination of local government financial report as a monitoring mechanism

Adams (1994) explains that audit (examination) on

financial reports by external auditor is an example of

monitoring mechanism to ensure that agent behave in

line with the interest of principal. In the context of

Indonesian local governments, since 2006, it has been

implemented that local government financial reports

have to be audited yearly. Based on the Indonesian

Law No. 15/2004, it is clearly defined that audit is the

process of problem identification, analysis, and

evaluation which is conducted independently,

objective, and professional based on standards to

assess the truth, accuracy, credibility, and reliability of

information regarding the managing and responsibility

of state budget.

Audit to local government financial reports is

conducted by the Supreme Audit Council (BPK), an

independent state institution which is assigned to

examine the management and responsibility of state

budget according to the Indonesian constitution of

1945. BPK has authority to conduct three kinds of

examination which are financial examination,

performance examination and special purpose

examination. Financial examination is aimed at

providing reasonable assurance whether financial

reports have been presented properly in all materials

based on accounting principles applied in Indonesia or

comprehensive accounting basis which are not

generally applied in Indonesia. Following the

examination, BPK releases opinion which is a

professional statement as an auditor conclusion

regarding the fairness of information presented in the

financial reports.

The Law also regulates the duration of financial

reporting as well as the examination of the reports.

The Regulation of Ministry of Home Affairs No.

13/2006 mandates that regional heads (governor,

mayor and regent) have to submit the financial reports

to the BPK three months after the end of fiscal year.

According to the Law No. 15/2004, it is mentioned

that the BPK has to complete the examination within

two months and provide the reports to regional

parliament.

2.4 Audit delay

A number of studies measure audit delay as the time

difference between end of fiscal year and the audit

report (Payne dan Jensen, 2002; Johnson et al, 2002;

McLelland dan Giroux, 2000; Carslaw dan Kaplan

1991). The longer the audit delay could be considered

that the timeliness of financial report becomes

dwindle. The timelines of financial report is associated

with the quality of information to make decision

(Kieso et al., 2012). In this study, we measure audit

delay as the difference between the receiving of

financial report until the providing the report to local

parliament. It is more appropriate in the context of

Indonesia as the regulations have clearly divided the

period of financial reporting from local government to

the BPK and the period of audit of BPK. As explained

earlier,

2.5 Auditor characteristics

The process of examination/ audit is supposed to be

affected by auditor characteristic. Auditor

characteristic is generally identified based on the

characteristic of audit institution such as public

accountant office (KAP). Cohen and Leventis (2012)

and Carslaw and Kaplan (1991) disentangle auditor


68

characteristic to international KAP and local KAP.

Lowensohn et al (2007) categorize auditor

characteristic to big five KAP and non-big five.

Primadita dan Fitriany (2012) study the effect of audit

tenure and specialization on asymmetry information.

They divide tenure and specialization based on the

level of KAP. In this paper, we identify auditor

characteristics at the individual level. In an

examination, the team consists of person in charge,

technical control, team leader and team members.

Therefore, we employ education background, repeat

assignment (tenure), and professional capability to

proxy auditor characteristics.

Education background could be identified based

on the discipline at the university level, more

specifically accounting discipline. Setyaningrum

(2012) explains that accounting education is a

mandatory requirement to examine financial report.

Moreover, she documents that the higher the

education levels the more comprehensive accounting

knowledge that auditors have. In addition, she argues

that education quality of examiner should be higher

than executive, so that the examiner would be able to

assess the conformity of executive to the applied

standards. Setiawan dan Fitriany (2011) also explain

that accounting expertise, proxied by accounting

education background, is strongly needed for an

auditor to examine financial reports to provide

accurate and suitable information and to reduce the

probability of fraud in the reporting process.

Auditor tenure refers to the number of repeat

assignment in the same object. Almutairi et al (2009)

explains that the longer the tenure would reduce the

independency of auditor and reduce the auditor

objectivity. On the other side, one might also argue

that the audit quality would be improved with the

longer the tenure as the auditors have more

experiences and familiarity with the client especially

with regard to financial reporting. Almutairi et al

(2009) measure tenure as the consecutive years of the

relations between auditor and client. Payne and Jensen

(2002) argue that the longer the auditor tenure would

improve the capability to facilitate the preparation of

financial reports.

Auditor professional proficiency could be

measured based on the professional certification in

accounting. The standard of SPKN requires that

auditors should collectively have appropriate

professional capability. Moreover, it is also mentioned

in the standard that auditors should collectively have

expertise certification. Hutchison dan Fleischman

(2003) point out that accounting expertise certification

indicates the extent to which accountants are

competent in accounting and compliance with the

professional standards. Hutchison dan Fleischman

(2003) explains various expertise certifications for

accountant and auditors such as Certified Public

Accountant (CPA), Certified Fraud Examiner (CFE),

Certified Government Auditing Professional (CGAP),

Certified Information Systems Auditor (CISA),

Certified Internal Auditor (CIA) and others.

2.6 Hypotheses

LKPD (Local government financial report) is prepared

based on the accounting principles regulated in the

Indonesian Government Accounting Standard. To

examine this report, it is regulated that auditors must

have capability in auditing and accounting as well as

having good understanding on accounting principle

for local government. In general, BPK’s auditors have

education background in accounting. However,

complexity in examination process requires them to

equip them with some other competencies such as

information technology, law and engineering. In

addition, BPK also recruits auditors with non-

accounting education. However, they are massively

educated and trained with accounting and auditing

before assigned to audit. As the financial reports are

highly associated with accounting discipline, it is

expected that those having accounting background

should complete the audit on time. Therefore, we

hypothesize as follows:

H1: Education background in accounting is

negatively associated with audit delay

Auditors with repeat assignments in the same

local governments are expected to have more

experiences and familiarity with the client so that it

will ease them to complete the audit on time and

appropriate. However, on the contrary, Li (2007) finds

that auditor tenure is negatively associated with audit

conservatism due to the over trust behavior. Such

attitude could lead to negative behaviors for instance

reducing audit samples and neglecting audit

procedures. As there is a conflicting argument,

therefore, we hypothesize as follows:

H2: Auditor repeat assignments affect the audit

delay

With regard to the audit expertise, it is widely

known that professional certification is offered for

example public accountant, Certified Public

Accountant (CPA), Certified Information System

Auditor (CISA), Certified Fraud Examiners (CFE)

dan others. Those certifications are recognition to the

professionalism of an accountant in that field. Those

having such expertise are expected to have more

competences.

Better capability is considered to positively

correlate with timelines of audit. Schelker (2010)

empirically reveals that states in the US which require

auditors to have at least CPA have less spending and

liabilities and have higher bond rating compare to

those do not regulate such requirement. Therefore, we

hypothesize as follows:

H3: Auditor professional proficiency is

negatively associated with audit delay


69

3 Methodology 3.1 Data

This study is a cross-sectional research. Our data

consist of 127 local governments (district/ municipal

level) which have reported their 2012 audited financial

statements and data on auditor characteristics are

available. Detailed information on data sources are

provided in Table 1.

Table 1. Data sources

Data Sources

Examination Report Supreme Audit Council

Examination Summary Supreme Audit Council

Summary Report of Bezzeting Supreme Audit Council

Progress Report of Examination Supreme Audit Council

Tenure of Regent/ Mayor Directorate of Regional Autonomy of Ministry of Home

Affairs

Source: www.otda.kemendagri.go.id

3.2 Empirical model and variables

Our empirical model to be estimated is as follows:

AUDTIMEi = β0 + β1 EDUi + β2 TENRi + β3 PROFi +

β4 REMARKSi + β5 AUDOPi + β6SCHEDi + β7 TYPEi

+ β8 ACCETYi + β9 REELCi + ε

AUDTIME is audit delay which is measured as

the natural logarithm of total dates (the distance

between received dates of financial report until the

reported date). EDU is the educational background of

auditor which is measured as the percentage of

number of auditors possesses accounting degree over

the total auditors within the team. TENR is repeated

assignment which is defined as the percentage of

number of auditors examining the similar entity in two

consecutive years. PROF is the proxy of auditor’s

capability which is measured as the percentage of

auditors having professional certificate to total

auditors within the team. REMAKS is the sum of

number of exceptional items and number of restricted

items in the audit report. AUDOP is the opinion of

audit which is a dummy variable taking a value of 1

for unqualified (without opinion) and 0 otherwise.

SCHED is the audit schedule which is measured as a

dummy variable taking a value of 1 for financial

reports which are audited in the first semester and 0

for second semester. TYPE is types of local

government which is measured as a dummy variable

taking a value of 1 for municipal and 0 otherwise.

ACCETY is number of accounting entity within a

local government. REELC is a dummy variable to

measure the incumbency of head of region, taking a

value of 1 for regions with incumbent and 0 otherwise.

4 Results and discussion 4.1 Descriptive statistics and correlation

We investigate the determinants of audit delay

especially with regard to auditor’s characteristics

which are measured by educational background,

tenure, and professional capability.

Table 2 and 3 exhibit the descriptive statistics

and correlation matrix of variables. The average audit

delay (AUDTIME) is 4.26 or 70.8 days which is

longer than the regulation (60 days). The average

accounting education (EDU) is 0.7 which means 70%

of auditors have accounting education background. In

average, 46% of auditors are professionally certified

(PROF). The average tenure (TENR) is 14% which

shows that there is relatively regular rotation. As

shown in Table 3, PROF, SCHED and TYPE are

significantly correlated with AUDTIME.

Table 2. Descriptive statistics of variables

N Min Max Mean Std. Deviation

AUDTIME 127 3.81 5.03 4.26 0.28

EDU 127 0.33 1.00 0.70 0.14

TENR 127 0.00 0.50 0.14 0.13

PROF 127 0.13 0.83 0.46 0.15

REMARKS 127 0 12 3.76 2.89

AUDOP 127 0 1 0.65 0.48

SCHED 127 0 1 0.69 0.46

TIPE 127 0 1 0.15 0.35

ACCETY 127 15 96 41.61 16.22

REELC 127 0 1 0.17 0.37

http://www.otda.kemendagri.go.id/


70

Table 3. Correlation matrix of variables

AUDTIME TENR PROF EDU REMARKS AUDOP SCHED ACCETY TIPE REELC

AUDTIME Pearson Correlation 1

Sig. (2-tailed)

TENR Pearson Correlation -.095 1

Sig. (2-tailed) .345

PROF Pearson Correlation -.326a .096 1

Sig. (2-tailed) .001 .341

EDU Pearson Correlation .143 .050 .311a 1

Sig. (2-tailed) .152 .617 .002

REMARKS Pearson Correlation .008 .462a -.090 -.047 1

Sig. (2-tailed) .938 .000 .372 .639

AUDOP Pearson Correlation .030 -.410a .018 -.028 -.581

a 1

Sig. (2-tailed) .768 .000 .855 .779 .000

SCHED Pearson Correlation -.380a -.329

a .061 .027 -.466

a .722

a 1

Sig. (2-tailed) .000 .001 .547 .787 .000 .000

ACCETY Pearson Correlation .100 -.383a .069 -.012 -.490

a .510

a .433

a 1

Sig. (2-tailed) .319 .000 .493 .908 .000 .000 .000

TIPE Pearson Correlation .276

a -.064 .013 .150 -.103 .179 .104 -.057 1

Sig. (2-tailed) .005 .527 .900 .133 .306 .073 .301 .572

REELC Pearson Correlation .019 .008 -.112 -.235b -.124 -.035 .119 .075 -.123 1

Sig. (2-tailed) .853 .935 .267 .018 .216 .729 .237 .453 .222

Note: b and a indicate significance at the 5%, and 1% levels, respectively


71

4.2 Empirical results

We exclude 26 outliers from our sample which

indicated by case wise list technique. We estimate our

model on the determinants of audit delay by

employing an ordinary least square. Table 4 presents

the regression results without interaction variables.

Professional certification (PROF) is negatively

associated with audit delay. Those who are not

certified have longer average audit delay than that of

professionally certified auditors.

Table 4. Regression results

1 2 3 4

CONSTANT 4.122 4.291 3.857 4.014

54.340 51.374 34.999 40.225

TENR -0.196

-0.134

-1.403

-1.112

PROF

-0.425

-0.533

-4.068

a

-5.331

a

EDU

0.303 0.467

2.684

a 4.572

a

REMARKS 0.009 0.004 0.009 0.008

1.242 0.565 1.227 1.288

AUDOP 0.245 0.228 0.277 0.257

4.269

a 4.262

a 4.916

a 5.220

a

SCHED -0.423 -0.404 -0.437 -0.427

-8.194

a -8.384

a -8.643

a -9.682

a

ACCETY 0.003 0.004 0.003 0.003

2.571

b 3.208

a 2.862

a 3.315

a

TIPE 0.185 0.186 0.170 0.161

4.088

a 4.420

a 3.811

a 4.161

a

REELC 0.104 0.075 0.131 0.120

2.336

b 1.795

c 2.932

a 3.052

a

R2 0.486 0.555 0.513 0.640

ADJ R2 0.447 0.521 0.476 0.605

Observation 101 101 101 101

Note: The values in parentheses are t value. b and a indicate significance at the 5%, and 1% levels,

respectively

The average accounting education (EDU) is

positively and significantly associated with audit

delay. It could be concluded that the higher the

proportion of team members having accounting

education, the longer the audit time. It may be

explained by the facts that audit does not necessarily

depend on the accounting expertise but it should also

be complemented by other expertise (law, information

technology, engineering...). We do not find evidence

on the impact of tenure (TENR) on audit time. All

control variables (AUDOP, SCHED, ACCETY, TIPE,

dan REELC) are significantly associated with audit

time.

Table 5 exhibits the regression results of

interactions between our main variables (educational

background, tenure, and professional capability). We

do find a significant and negative coefficient for the

interaction between professional capability (PROF)

and tenure (TENR). The negative effect of

professional capability on audit delay will be

strengthened if the auditors are tasked in a repeated

assignment. Likewise, the interaction between

professional capability (PROF) which is measured as

the percentage of auditors having professional

certificate to total auditors within the team and

education background (EDU) is negative and

significant. It means that the professional capability

supported by accounting education could be more

beneficial to minimize the audit delay.

5 Conclusion

Our study is aimed at investigating the determinants of

audit delay. We emphasize on the auditor’s

characteristics which are educational background,

tenure, and professional capability. We study audit of

local government financial report in the context of

Indonesia. We do find that auditor capability is the

most important factor to ensure the timeliness of audit.

Consequently, the capability of professional auditor is

separately regulated in the Standards for State

Financial Examination (SPKN) of the Supreme Audit

Council (BPK). However, our study fails to find

evidence on the impact of repeated assignment

(tenure) has an impact on audit delay.


72

Table 5. Regression results with interaction variables

1 2 3 4 5 6

CONSTANT 4.318 4.141 3.940 4.102 4.021 4.158

42.271 56.322 28.233 53.715 14.381 50.542

TENR -0.207

-0.649

-0.507

-0.974

PROF -0.443

-0.592

-2.653

a

-1.024

EDU

0.243

0.437

1.478

1.214

TENRxPROF 0.210 -0.600

0.256 -2.468b

TENRxEDU

0.584 -0.120

0.640 -0.646

PROFxEDU

0.056 -0.200

0.073 -1.731c

REMARKS 0.005 0.010 0.012 0.008 0.006 0.005

0.757 1.396 1.660 1.021 1.002 0.701

AUDOP 0.222 0.243 0.272 0.247 0.260 0.238

4.054

a 4.350

a 4.846

a 4.254

a 5.196

a 4.143

a

SCHED -0.403 -0.428 -0.443 -0.421 -0.424 -0.413

-8.095

a -8.461

a -8.787

a -8.083

a -9.358

a -8.006

a

ACCETY 0.003 0.003 0.003 0.003 0.004 0.004

3.025

a 2.516

b 2.576

b 2.678

a 3.430

a 2.939

a

TIPE 0.185 0.188 0.170 0.186 0.161 0.192

4.341

a 4.233

a 3.836

a 4.072

a 4.087

a 4.257

a

REELC 0.077 0.104 0.140 0.100 0.115 0.083

1.805

c 2.386

b 3.123

a 2.227

b 2.910

a 1.841

c

R2 0.558 0.508 0.530 0.478 0.635 0.492

ADJ R2 0.514 0.470 0.484 0.438 0.599 0.453

Observation 101 101 101 101 101 101

Note: The values in parentheses are t value. b and a indicate significance at the 5%, and 1% levels,

respectively

Some limitations of this present paper are

admitted. First, this paper relies on a cross-sectional

data of 127 local governments which could not

capture the differences in period. Second, we do not

take into account some control variables such as

auditor tenure and advance education of auditor.

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74

OWNERSHIP, CORPORATE GOVERNANCE AND MANDATORY TAX DISCLOSURE INFLUENCING

VOLUNTARY FINANCIAL DISCLOSURE IN INDONESIA

Agung Nur Probohudono*, Eko Arief Sudaryono*, Nurmadi Harsa Sumarta*, Yonatan Ardilas*

Abstract

This study examines the impact of ownership, corporate governance and mandatory tax disclosure on voluntary financial disclosure in Indonesia using 102 Indonesian listed companies in the period of 2009 to 2012, a total sample is 408 annual reports. The results show that proportion of independent director, managerial ownership, institutional ownership, foreign ownership and mandatory tax disclosure are assosiated with voluntary financial disclosure. Analysis reveals a moderate level of 59,90% score of disclosure in the period of 2009 to 2012 in Indonesian listed companies. Statistical analysis shows that the lowest disclosure score is in 2009 with the “Projected Information” as the subcategory of the disclosure. The highest voluntary financial disclosure is in 2012 with the “stock price information” as the subcategory of the disclosure. This study implies that ownership, corporate governance and mandatory tax disclosure are the key factors to explain communicating companies’ voluntary financial disclosures.

Keywords: Voluntary Financial Disclosure, Ownership, Corporate Governance, Mandatory Mandatory Tax Disclosure, Indonesia *Fakultas Ekonomi dan Bisnis Universitas Sebelas Maret, Surakarta Indonesia

1 Introduction

Indonesia is a country in Southeast Asia that lies on

the equator and is located in between Asia and

Australia continent. Furthermore, Indonesia is

surrounded by The Pacific Ocean and Indian Ocean.

With 17,508 islands scattered around, Indonesia has

become the greatest archipelago country in the world.

The economic growth that is 6.5% in the end of 2011

has led Indonesia to be a developing country with the

highest economic growth in Southeast Asia.

The recent disclosure has become the main focus

in many researches (Bamber and Mcmeeking 2010;

Gisbert and Navallas 2013; Wang, Ali and Al-Akra

2013). The objective of the disclosure is to reduce the

asymmetry information that is laid between the agent

and the principal, in accordance with the public doubt

that increased toward the financial statement and the

traumatic happened after the Enron issue in 2001

about the corporate governance and since then the

disclosure has become the main attention in the

developing country, especially in term of transparency

(Reed, 2002; Barth and Schipper, 2008).

The disclosure in the financial statement would

make the users understand the content easier, so the

users would accept all the information provided by the

management (Qu et al, 2013; schipper, 1991; Parker

2007).

Disclosure, the requirement in the capital market,

is used to gain interest from the investors or the

potential investors, and also used to gain a bigger

amount of analysis. (Gul and Leung, 2004; Lang and

Lundholm, 1996; Healy and Palepu, 2001; Hodge et

al., 2004).

Disclosure is one of the main foundations in the

Good Corporate Governance because the information

availability is very important to minimize the

asymmetric information that lay between the insider

and the outsider. (Cheung et al., 2010; Probohudono et

al., 2013a; Latridis dan Alexakis, 2012; Gisbert dan

Navallas, 2013). Better management of a company

would likely to increase the management’s incentive

to reveal the company’s information to the

shareholder. (Jensen, 2000; Chau and Gray, 2002).

Monitoring from the independent board would

likely to increase the value of the financial statement,

especially in raising the disclosure (Gul and Leung,

2004; Lang and Lundholm, 1996; Healy and Palepu,

2001; Hodge et al., 2004). Other research, how to

increase the Financial Instruments Disclosures by

Taylor et al. (2001), is influenced by several aspects,

such as Income tax; either income tax exposure or

income tax transparency. Disclosure is also influenced

by various policies, such as the tax elusion policy by

the management and the tax management. (Hasseldine

dan Morris, 2013; Huseynov dan Klamm, 2012;


75

Minnick dan Noga, 2010; Fischer et al., 1992; Watts,

1977)

The voluntary disclosure is also one of the

important aspects and used to add the value of the

financial statement (Bamber dan Mcmeeking, 2010;

Tsalavoutas, 2011; Lo, 2003; Einhorn, 2007). The

voluntary disclosure is the management’s free choice

in providing the financial statement and the

information that might be useful in the decision-

making by the financial statement users (Meek et al.,

1995; Probohudono et al., 2013b; Ntim, Lindop dan

Thomas, 2013).

The decision to reveal the information from a

company is likely depended on the individual

management’s consideration according to their

welfare level. The manager could use their wisdom

either to disclose or not to disclose the information to

facilitate their contribution in the opportunistic

attitude for their interest (Watts dan Zimmerman,

1990; Warfield et al, 1995).

Jensen and Meckling (1976) said that the

ownership separation and the control of the company

gave the agent (manager) support to service their self-

interest by sacrificing the principal (stockholder)

interest. The main problem with this company is the

asymmetric information between the manager and the

stockholder. The manager, the self-interested agent,

have information about the recent future performance

and the stockholders have less information about the

possibility that might happen in the future.

Shleifer and Vishny (1997) suggested that well

planned structure management could help to ensure

the company to achieve the optimal disclosure policy.

However, Taylor et al. (2010) also suggested that the

disclosure pattern of the financial risk management is

significantly and positively related to the strength of

the company structure management.

2 Literature review

This research used an agency theory because the

theory have been used in various researches,

(Probohudono et al., 2013; Taylor et al. 2010). Jensen

and Meckling (1976), have defined the agency theory

as the agency relationship under one contract or more

(principal) that have a deal with another side (agent) to

do some business and their members authority to take

some decisions.

Berle and Means (1932) argued that the

separation is not without risks; there are risks in the

separation, such as the different information that the

principal have got from the agent (manager) called

asymmetry information.

Asymmetric information have caused the loss

toward the principal side, because it isn’t likely to

have the entire and the real picture about the company

activity (Fama and Jensen, 1983; Herry and Hamin,

2005; Eisenhardt, 1989). The company management

issue, like the monitoring mechanism, have a great

connection to the agency theory (Mat Nor and Sulong,

2007; Maijoor, 2000)

2.1 Independent commissioner proportion

Xie et al, (2003) in his research have proved that the

independent board and the independent commissioner

board are effectively monitored the decisions and the

company managerial activities, while other researches

suggested that the independent committee board have

given advices and guidance to the management

(Dahya and McConnell, 2005). Chen and Jaggi (2000)

in their research suggested that the independent

commissioner proportion would stimulate the

management to raise the company voluntary

disclosure, the independent commissioner proportion

is expected to give a big effect to the management’s

decisions to widely give the information disclosure

(Forker, 1992; Fama and Jensen, 1983; Williams,

2002)

H1: The independent commissioner proportion

have a positive effect on the voluntary financial

disclosure to the listed companies in Indonesia Stock

Exchange (IDX).

2.2 Managerial ownership

High managerial ownership would likely to open a

management gap to manipulate the profit and to

monopolize the information. It happened because of

the lack of control of the stock market that caused the

manager to make an accountant option that matched to

his self-interest of the self-motivation than the

company interests (Sanchez-Ballesta and Garcia-

Meca, 2007).

Eng and Mak (2003) in their research argued that

the low managerial ownership would likely to increase

the needs and the supports of the disclosure from

outside. Morck et al., (1988) argued when the

managerial ownership increased, the market’s skills

controlling the company would be less effective in

supporting the manager to take decisions to maximize

the value of the company.

H2: Managerial Ownership have a negative

effect on the voluntary financial disclosure to the

listed company in IDX.

2.3 Institutional ownership

Institutional ownership, based on their great

shareholder, have a bigger interest to reduce the

agency cost because they could gain bigger benefit of

monitoring and could gain greater vote that made it

easy to take a corrective action if necessary. (Morck,

et.al., 1997; Bushe and Goodman, 2007). El-Gazzar

(1998) noted that the institutional ownership is

positively connected to the voluntary disclosure.

H3: Institutional ownership have a positive effect

on the voluntary financial disclosure to the listed

company in IDX.


76

2.4 Foreign ownership

Foreign ownership is an ownership where the

company have a number of percentages from the

foreign investors who invested in the domestic market.

The foreign investors would likely to have less

information that is more transparent, thus the foreign

investors demanded a higher disclosure in the

financial statement (Ananchoticul, 2007; Mangena

dan Tauringana, 2007).

Haniffa and Cooke (2002) in their research found

the significant interaction between the company

disclosure and the level of the foreign ownership.

Based on that explanation, there is a hypothesis:

H4: The foreign ownership have a positive effect


company in IDX.

2.5 Public ownership

Public ownership is an ownership that have various

kinds of shareholders with low percentages. The

public ownership is studied first by Berle and Means

(1932) who suggested that big companies in the US

have been owned by small shareholders. Hardiningsih

(2008) in her research suggested that there are

differences in the public ownership proportion that

could affect the policy and the disclosure

comprehensiveness by the company.

H5: The public ownership have a positive effect


company in IDX.

2.6 Mandatory tax disclosure

In his research, Bardertscher et al (2013) said that the

companies are trying to do tax management in their

business activity. Indeed, it is to reduce the loss risk in

the business, hence the tax regulation and the tax

payment are important for the investors.

Taylor et al. (2011) in his research suggested that

the withholding taxes, foreign sourced income and tax

haven affected and connected to the disclosure pattern.

So in conclusion the tax structure affected the

corporate disclosure pattern.

Indonesia rule mandatory about listed companies

(Bapepam-LK rules No.X.K.6) issued by Indonesia

Capital Market Supervisory Agency (Bapepam-LK)

explains about the disclosure of tax that supports the

quality from the financial statement. The items must

be disclosed in the financial statement are:

1. The explanation about the connection

between the tax income and accounting profit.

2. The fiscal reconciliation and the recent tax

accounting.

3. The statement that the Taxable Profit as the

result of the reconciliation has become the basis in

filling out the yearly tax.

4. The asset detail and the deferred tax liability

that is admitted in the financial position report for

each proposal period and the total differed tax load

(income) that is admitted in the income statement if

the total is not available from the total asset or the

deferred tax liability admitted in the financial position

statement.

5. There is tax dispute or not in the disclosure.

H6: The mandatory tax disclosure have a

positive effect on the voluntary financial disclosure to

the registered company in Indonesia Stock Exchange

(IDX)

3 Methodology

The subjects in this research are all companies listed

on the Indonesia Stock Exchange (IDX) in 2009,

2010, 2011, and 2012. There are 408 subject

companies in this research.

3.1 Dependent variable

In this research, the voluntary financial disclosure is

estimated with the voluntary financial disclosure index

(VFDI) that is adapted from the research Bruslerie and

Gabteni (2001), Ho and Taylor (2013), Chow and

Boren (1987), Akhtaruddin and Haron (2010), and

Meek et.al (1995). The voluntary financial disclosure

index is categorized based on qu et al. (2013) such as

indicators, financial review, projected information,

foreign currency information, stock price information,

and other useful financial information. There are 35

items in this index (see Apendix A).

3.2 Independent variable

The independent variable used in this research is the

independent commissioner proportion, managerial

ownership, institutional ownership, foreign ownership,

public ownership and mandatory tax disclosure .

3.3 Control variable

There are four variables in this research, such as

leverage, size, profitability. Those three variables are

controlled variables so there are no any outside factors

that affected the indicators being estimated.

4 Results 4.1 Descriptive result The SPSS output descriptive statistic result suggested

the total observation in the research (N) is 408

companies. Among the 408 companies the mean of the

Voluntary Financial Disclosure (VFD) variables is

0.599, the lowest disclosure value is 43% and the

highest disclosure value is 77%.


77

Table 1. Variables and variables measurement

Name Acronym Measuring

Dependent variables

Voluntary Financial

Disclosure

VFD Total disclosure items disclosed by companies / total

disclosure value indexs.

Independent variables

Independent Commissioner KOMIND The total independent commissioner / total commissioner

boards

Managerial Ownership MANOWN Total stocks managerial ownership/ total company stocks

Institutional Ownership INSTOWN Total stocks institutions ownership/ total companies stocks

Foreign Ownership FOROWN Total stocks foreigners ownership/ total companies stocks

Public Ownership PUBOWN Total Stock public ownership / total companies stock

Mandatory tax disclosure TAXDISC Mandatory tax disclosure score achieved / maximum

mandatory tax disclosure score

Control variables

The companies

measurement

SIZE Log total assets

Leverage Leverage Total liabilities / total assets

Profitability Profitability Netto / total assets

Table 2. Descriptive statistic

N Minimum Maximum Mean Std. Deviation

VFD 408 .4285714285715285 .7714285714286715 .599019607843237 .067498325044170

KOMIND 408 .2000 1.0000 .447500 .1347125

MANOWN 408 .0000 .7926 .024441 .0873720

INSTOWN 408 .0000 1.0000 .397893 .3400467

FOROWN 408 .0000 .9900 .244320 .3132506

PUBOWN 408 .0000 1.0000 .285333 .2051262

TAXDISC 408 .6000 1.0000 .762745 .0874667

Size 408 4.3273 8.8032 6.518225 .8797187

Leverage 408 .0057 27.1341 .696406 1.5281194

Profitability 408 -.4480 6.1628 .094852 .3439190

Valid N (list wise) .

Note: see Table 1 for acronym

The maximum KOMIND value is 1 and the

minimum is 0.2. The mean of the MANOWN

companies in the research is 2% with the deviation

standard is 9%. The lowest institutional ownership

value of the INSTOWN among the 408 samples is 0%

and the highest is 100%. The lowest foreigner

ownership of the FOROWN is 0% and the highest is

99% by the Bentoel International Investama Tbk. The

mean of the PUBOWN is 29% and the deviation

standard is 21%. The mean of the TAXDISC is 76%

and the standard deviation is 87%.

4.2 Descriptive result per item

Table 3. Descriptive voluntary financial disclosure item

Voluntary Financial Disclosure Item Pool 2009 2010 2011 2012

Total Voluntary Financial disclosure index 59.90% 57.73% 59.33% 60.78% 61.76%

Performance indicators 71.02% 70.22% 70.47% 71.20% 72.18%

Historical figures for last five years or more 92.40% 93.14% 92.16% 92.16% 92.16%

Profitability ratios 95.83% 95.10% 95.10% 96.08% 97.06%

Cash flow ratios 12.25% 8.82% 11.76% 13.73% 14.71%

Liquidity ratios 86.27% 85.29% 86.27% 86.27% 87.25%

Gearing ratios 86.76% 86.27% 86.27% 86.27% 88.24%

Net tangible assets per share. 12.75% 10.78% 10.78% 13.73% 15.69%

Explanation provided for change in sales. 96.81% 98.04% 97.06% 96.08% 96.08%

Explanation provided for change in operating

income/net income 85.05% 84.31% 84.31% 85.29% 86.27%

Financial review 52.80% 49.16% 52.38% 53.92% 55.74%

Disclosure of intangible valuations 16.67% 9.80% 16.67% 19.61% 20.59%


78

Table 3. Descriptive voluntary financial disclosure item (continued)

Voluntary Financial Disclosure Item Pool 2009 2010 2011 2012

Dividend payout policy 70.10% 65.69% 68.63% 70.59% 75.49%

Review of operations by divisions – operating

profit 35.05% 30.39% 34.31% 38.24% 37.25%

Review of operations – productivity 97.79% 99.02% 98.04% 97.06% 97.06%

Review of current financial results, discussion of

major factors underlying performance 98.04% 98.04% 98.04% 98.04% 98.04%

Human Resources: Cost of training operations 41.67% 40.20% 40.20% 42.16% 44.12%

Return on capital employed 10.29% 0.98% 10.78% 11.76% 17.65%

Projected information 36.70% 32.60% 35.29% 38.97% 39.95%

Cash flow forecast 20.34% 12.75% 17.65% 25.49% 25.49%

Capital expenditure and/or R&D expenditures

forecast 23.53% 19.61% 22.55% 25.49% 26.47%

Earnings forecast 31.13% 25.49% 29.41% 32.35% 37.25%

Projection of future sales 71.81% 72.55% 71.57% 72.55% 70.59%

Foreign currency information 59.25% 56.13% 59.31% 60.29% 61.27%

Impact of foreign exchange fluctuations on current

Results 73.77% 73.53% 73.53% 73.53% 74.51%

Foreign currency exposure management description 49.75% 45.10% 49.02% 51.96% 52.94%

Major exchange rates used in the accounts 92.16% 92.16% 92.16% 92.16% 92.16%

Effect of currency fluctuation on future operations 21.32% 13.73% 22.55% 23.53% 25.49%

Stock price information 78.36% 78.29% 78.43% 78.29% 78.43%

Volume of shares traded (trend) 73.53% 74.51% 72.55% 73.53% 73.53%

Volume of shares traded (year-end) 97.06% 98.04% 97.06% 97.06% 96.08%

Size of shareholdings 97.30% 99.02% 99.02% 97.06% 94.12%

Type of shareholder 97.30% 97.06% 98.04% 97.06% 97.06%

Share price information (trend) 75.74% 74.51% 75.49% 76.47% 76.47%

Share price information (year-end) 93.63% 95.10% 95.10% 92.16% 92.16%

Domestic and foreign shareholdings breakdown 13.97% 9.80% 11.76% 14.71% 19.61%

Other useful financial information 45.29% 42.35% 43.73% 47.06% 48.04%

Effect of acquisitions and expansion on results 32.84% 27.45% 31.37% 35.29% 37.25%

Effect of disposal and cessation on results 14.46% 10.78% 12.75% 16.67% 17.65%

Statement concerning wealth created, e.g. value

added statement 96.81% 97.06% 97.06% 97.06% 96.08%

Breakdown of borrowings (e.g., lending institution,

date of maturity, security) 31.62% 27.45% 28.43% 34.31% 36.27%

Breakdown of earnings by major product lines,

customer classes, and geographical location 50.74% 49.02% 49.02% 51.96% 52.94%

Source: data processing result

Table 4. Descriptive voluntary financial disclosure (subcategory)

Pooled 2009 2010 2011 2012

Total Voluntary Financial Disclosure 59.90% 57.73% 59.33% 60.78% 61.76%

Performance Indicators 71.02% 70.22% 70.47% 71.20% 72.18%

Financial Review 52.80% 49.16% 52.38% 53.92% 55.74%

Projected Information 36.70% 32.60% 35.29% 38.97% 39.95%

Foreign Currency Information 59.25% 56.13% 59.31% 60.29% 61.27%

Stock Price Information 78.36% 78.29% 78.43% 78.29% 78.43%

Other useful financial information 45.29% 42.35% 43.73% 47.06% 48.04%

Source: data processing result

From the table it seemed that the communication

in the voluntary disclosure have changed from 2009 to

2012. The lowest disclosure score is in 2009 with the

“Projected Information” as the subcategory of the

lowest disclosure level. The highest voluntary

financial disclosure is in 2012 with the “stock price

information” as the subcategory of the highest

disclosure level.


79

4.3 Multiple regression result

VFD = + KOMIND+ MANOWN+ INSTOWN+ FOROWN+ PUBOWN+ TAXDISC

+ SIZE + LEV+ PROFIT

Table 5. Multiple regression result

Variables B T Sig

(Constant) .226 6.305 .000*

KOMIND -.065 -2.806 .005*

MANOWN -.061 -1.691 .092***

INSTOWN -.037 -2.214 .027**

FOROWN -.042 -2.473 .014**

PUBOWN .004 .198 .844

TAXDISC .091 2.525 .012**

Size .033 8.889 .000*

Leverage -.007 -1.652 .099***

Profitability .044 2.398 .017**

* Significance = 1%

** Significance = 5%

*** Significance = 10%

Note: see Table 1 for acronym

The hypothesis assessment result suggested that

the independent commissioner proportion, managerial

ownership, institutional ownership, foreign ownership

and mandatory tax disclosure have an effect on the

voluntary financial disclosure level, while the public

ownership isn’t have an effect on the voluntary

financial disclosure level.

The independent commissioner proportion

(KOMIND) variables’ value for the regression

coefficient is 0.065 and the significance value is

0.005, it means that the KOMIND have negative

coefficient and significantly related on level 5%. The

result is not in line with the research done (Chen and

Jaggi, 2000; Forker, 1992; Fama and Jensen, 1983).

According to Eng and Mak (2003), the research’s

result suggested that the increasing independent

commissioner proportion would reduce the voluntary

disclosure. It is consistent with the substitution

interaction between the independent commissioner

and the disclosure on monitoring the management.

The increasing independent commissioner proportion

will increase the independence from the board and the

independent commissars will get all information

needed to monitor the management. Therefore the

substitution interaction from the independent

commissioner’ monitoring can be replaced by the

voluntary disclosure, and vice versa.

The managerial ownership (MANOWN)

variables’ value for the regression coefficient is -0.061

and the significant value is 0.092. Because the

significant value is less than 0.1, it meant that the

ownership managerial variables (KOMIND) are on the

negative coefficient and have a significant correlation

on the moderate level. The result is in line with the

research done by Eng and Mak (2003). It is similar to

the theory explained by Jensen and Meckling (1976)

that when the managerial ownership decreased, then

the foreigner investors would raise the monitoring of

the management performance, hence would add the

monitoring cost in order to decrease the agency

problem. Therefore, in the research, Eng and Mak

(2003) have explained, to reduce the monitoring cost

so that the management could provide the wider

voluntary disclosure to the outside shareholder.

The institutional ownership (INSTOWN)

variable’s value for the regression coefficient is -0.037

and the significant value is 0.27. It meant that the

INSTOWN have negative coefficient and related to

the significance. The result is not in line with the

researches by E-Gazzar (1998) and Huafang and

Jianguo (2007), but it is in line with the researches by

Alhazaimeh et al. (2013) and Eng and Mak (2003)

who said that the INSTOWN have a negative effect on

the voluntary disclosure, but it is not have evidence

that could explain the phenomenon.

Zourarakis (2009) in his research found that

there is a negative effect between the institutional

ownership and the voluntary disclosure. It suggested

that if the institutional ownership are higher, only a

few people would control the share. Therefore, the

ownership became centered. When the ownership is

concentrated, the monitoring became less needed and

the communication between the stakeholder and the

management would be deeper. Therefore the voluntary

level would lessen. The voluntary disclosure would

likely be given to satisfy the stakeholders,

consequently the stakeholder became lessen and

centered, and then the voluntary disclosure given

would be lower.

The foreign ownership (FOROWN) variable’s

value of the regression coefficient is -0.042 and the

significance is 0.014. The coefficient is negative and


80

significance. Putri and Diyanty (2014) explained that

the negative effect of the foreign ownership on the

voluntary disclosure have caused an assumption that

such result happened because many companies or

foreign institutions have stock ownership on the public

company in Indonesia, which not all of them are from

overseas. Many domestic businessmen purposely

created foreign certificates and names for the

companies to broaden the control access in a

company. As a consequence, the positive effect of the

foreign ownership would not show up in the company

information disclosure, in the other hand the negative

effect of the big control is owned by one block holder

that used foreign companies as a medium have a role.

The public ownership (PUBOWN) variables’

value of the regression coefficient is 0.004 and the

significance value is 0.844. PUBOWN isn’t have an

effect on the voluntary financial disclosure.

The result is in line with the researches’ research

from Mujiyono and Nany (2006), Susanto (1992), and

Na’im and Rakhman (2000) that suggested that the

public ownership is not affect the disclosure.

Generally the public ownership are the investors with

low ownership percentages that caused the investors is

not have authority to get the particular information,

which in this research is the company voluntary

financial disclosure. Besides, the public investors tend

to use technical analysis tools than fundamental

analysis in deciding its investment policy and in

monitoring the companies, thus it would not affect the

voluntary disclosure level.

The mandatory tax disclosure (TAXDISC)

variables are positively coefficient and significance,

because its regression coefficient’s value is 0.091 and

the significance is 0.012. The research is in line with

the research done by Taylor et al. (2011) that

suggested that the international tax exposure is

positively and correlated to the financial disclosure

level in Australia. The mandatory tax disclosure used

in the research is the mandatory disclosure that issued

by Indonesia Capital Market Supervisory Agency

(BAPEPAM-LK No. X.K.6). Taylor et al. (2011)

explained, if the management minimizes the

mandatory tax disclosure level in the company, the

management will get motivated to sort out the

information that will be given to the stakeholder,

where it will reduce the company voluntary disclosure

level. The selected information will affect the annual

report, as it is a source (in term of tax data) that needs

review and audit testing about the truth of the

mandatory tax disclosure , which is given by the

management (Bartelsman and Beetsman, 2003).

5 Conclusion

This research suggests that the voluntary financial

disclosure level in the companies in Indonesia

increases every year. It cannot be separated from the

management awareness about the importance of the

disclosure on how the companies will survive in the

future. This disclosure is used as a tool to reduce the

information gap between the principal and the agent

that is feared to be the agency problem where there is

a contract that cannot be done by one of the sides

and/or the loss side in the decision-making (Fama and

Jensen, 1983).

The research suggests a result that the voluntary

financial disclosure in Indonesia is in the moderate

level of the disclosure. The financial disclosure is a

disclosure to see a company’s state in a short time and

also to predict the financial condition of a company

for a few years, so the investors can use it as a

consideration to determine the investment.

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Apendix A. Checklist index voluntary financial disclosure

Performance Indicators

1. Historical figures for last five years or more (f)

2. Profitability ratios (f)

3. Cash flow ratios (f)

4. Liquidity ratios (f)

5. Gearing ratios (f)

6. Net tangible assets per share (d)

7. Explanation provided for change in sales (d)

8. Explanation provided for change in operating income/net income (d)

Financial Review

9. Disclosure of intangible valuations (f)

10. Dividend payout policy (f)

11. Review of operations by divisions – operating profit (b)

12. Review of operations – productivity (b)

13. Review of current financial results, discussion of major factors underlying performance (b)

14. Human Resources: Cost of training operations (a)

15. Return on capital employed (a)

Projected Information

16. Cash flow forecast (f)

17. Capital expenditure and/or R&D expenditures forecast (f)

18. Earnings forecast (f)

19. Projection of future sales (d)

Foreign Currency Information

20. Impact of foreign exchange fluctuations on current Results (f)

21. Foreign currency exposure management description (f)

22. Major exchange rates used in the accounts (f)

23. Effect of currency fluctuation on future operations (e)

Stock Price Information

24. Volume of shares traded (trend) (b)

25. Volume of shares traded (year-end) (b)

26. Size of shareholdings (f)

27. Type of shareholder (f)

28. Share price information (trend) (b)

29. Share price information (year-end) (b)

30. Domestic and foreign shareholdings breakdown (b)

Other Useful Financial Information

31. Effect of acquisitions and expansion on results (b)

32. Effect of disposal and cessation on results (b)

33. Statement concerning wealth created, e.g. value added statement (b)

34. Breakdown of borrowings (e.g., lending institution, date of maturity, security) (c)

35. Breakdown of earnings by major product lines, customer classes, and geographical location (c)

Note: a = Adapted from Bruslerie and Gabteni (2011)

b = Adapted from Ho and Taylor (2013)

c = Adapted from Chow and Boren (1987)

d = Adapted from Akhtaruddin and Haron (2010)

e = Adapted from Meek, et.al (1995)

f = Adapted from Qu, et al. (2013)


84

CORPORATE GOVERNANCE

& PERFORMANCE

SECTION 3

FINANCIAL MANAGEMENT: THE IMPACT OF PERFORMANCE INDICATORS ON

THE ORGANIZATIONAL PROFITABILITY

Hayat M. Awan*, M. Ishaq Bhatti**, Zahid Razaq***

Abstract This paper investigates the financial management performance involved in increasing the firms’ profitability. It contributes to a single list of performance indicators which never existed in the literature empirically with reference to third world countries, like Pakistan. Stratified random sampling technique was used to select a sample of 200 manufacturing firms with process performance management system (PPMS) criteria to check the impact of performance indicators on the overall business performance index using ROE, ROA. The results of AHP analysis show that the “Supportive Culture” and “PPMS facilitate the competitive advantage” are the major facilitators for those organizations who have implemented the PPMS whereas firms without implementation of PPMS have major inhibitors as “ Non supportive culture” and ”Have another Performance System”. And the Measuring financial performance, Quality performance, Delivery reliability performance, customer satisfaction performance and employees satisfaction lead to increase in the organizational Profitability. This study will be helpful to the top management of the organizations from manufacturing sector regarding the implementing decision of the PPMS. The organization can choose the best indicators used by firms in order to achieve the overall excellence. Keywords: Profitability, ROA, ROE, ANOVA, Key Indicators, Critical Factors *Air University Multan Campus, Pakistan **Department of Finance, King Abdulaziz University and LaTrobe University, Austraila ***B.Z. University, Multan, Pakistan

1 Introduction

Since the beginning of the 1990s, performance

measurement has become a vital issue for academics

and practitioners. The proficient literature has

suggested that managers should design new

performance measurement systems that include

financial and non-financial measures (Gosselin, 2005).

Usually firms use the performance management in

order to keep an eye on their operations and

objectives. A performance management system serves

four purposes i,e. to measure, monitor, compare and

manage the performance. There are many systems in

practice by the firms for performance management.

The traditional and modern systems are different in

terms of the performance indicators and the point of

focus. The traditional systems actually used the

financial measures and focus the organizational

performance in broader sense, whereas the modern

systems use both types of performance indicators

(financial and non-financial) as suggested by the

researchers and they measure the organizational

performance narrowly. The process performance

management system (PPMS) is one of the modern

systems for performance management. The PPMS

uses both types of performance indicators and focus

on process performance for managing the overall

organizational performance.


85

The main purpose of this study is to affirm the

steps involved in PPMS suggested by Oakland (2010)

in the manufacturing sector in Pakistan. The other

purpose of the study is to investigate either the

profitability of the firms which are using the PPMS for

performance management, is significantly different

from the others firms which are not using the PPMS.

The last purpose of the study is to know that what are

most important inhibitors and facilitators regarding the

implementation of PPMS. This study is the descriptive

research, which has used the survey research method

and some statistical techniques in order to find the

purpose of the study. The section 2 discusses the

literature review and section 3 deals with the research

methodology. Sections 4 and 5 describe data analysis

and conclusion respectively.

2 Literature review

The phenomenon performance measurement is used

by the organizations in order to ensure that they are

going on right direction, or achieving targets in terms

of organizational goals and objectives. The

performance measures are used to evaluate and control

the overall business operations. They are also used to

measure and compare the performance of different

organizations in the industry, plants, departments,

teams and individuals (Ghalayini and Noble, 1996;

Neely et al, 2000; 2005). The business performance

measurement is not an untapped topic. A large number

of researches have been conducted by the researchers

on this topic. According to Neely (2000), almost 3,615

researches on business performance measurement

were published in three years 1994 to 1996, which

means that for every five working hour one article on

the issue was published. The overall organizational

performance could be measured by using financial

indicators, operational indicators or by using both. The

financial indicators may include the sales growth,

profitability and Earning per share, which are

organization specific and if we consider the market

then the market to book and stock market returns and

its variants are taken as the financial indicators of the

organization’s overall financial performance. The

second types of indicators are operational indicators

which are also called the non-financial indicators of

the organization’s performance. They include the

market share, new product introduction, quality of the

products, marketing effectiveness, manufacturing

value-added and other measures of technological

efficiency (Venkatraman and Ramanujam 1986,De

Toni and Tonchia 2001 and Browne et al 1997).

2.1 Performance management systems

Heckl and Moormann (2010) have identified the

following systems for measurement of performance of

the organizations.

Balanced scorecard

Self-assessment,

Traditional controlling,

Activity based costing

Process performance measurement system.

Work flow based monitoring and

Statistical control system.

All above mentioned systems have different set

of objectives and characteristics but also have some

common set of elements with each other. Heckl and

Moormann (2010) have differentiated these

approaches on the basis of two dimensions; the first

one is the focus and the second is scope as shown in

figure 1 below.

Figure 1. Positioning of performance management systems

2.1.1 Balance scorecard

Kaplan and Norton (1992) have developed the

balanced scorecard instrument to clarify and

operationalize the organization vision with respect to

four perspectives (financial, customer, internal process

& learning and growth perspective). This system is

developed in order to describe the overall business

performance in terms of financial and non-financial

indicators on continuous basis. This framework is


86

based upon four important aspects which include the

financial, customer, internal process & learning and

growth. This system can be used for three main

purposes which are the reporting of strategic

performance, linking the strategy with performance

measures and to describe different perspectives in

numerical terms. This system is very important as it

focuses on strategic business units of the

organizations. It focuses on the business process as far

they are critical for achieving the business mission and

goals (Kueng and Krahn 1999, Aitken and Brinkworth

2010).

2.1.2 Self Assessment

The origin of self -assessment system is found in

Japan. In 1951 the Japan has introduced an award

system for Quality driven organization. Following the

Japan the USA also has introduced the award system

named as Malcolm Baldridge National Quality Award

(MBNQA) in 1988 in order to appreciate the Quality

driven organizations. Afterward the organizations start

to focus on self-assessment system in order to improve

their product quality. Focus was the overall

performance of the organizations but not the processes

(Kueng and Krahn 1999). The managers of the

organizations can measure the performance of the

overall business on the basis of predefined criteria of

the performance evaluation and framework. This

system is called self-assessment system for

performance measurement of the business

organizations (Hakes 1996).. This system is developed

and recommended by the quality management

associations (e.g. European foundation of Quality

Management, EFQM). By this system the

organizations can measure and manage their overall

performance on the regular basis to keep check either

they are going to the right direction. This system

provides number of benefits to organizations, like

monitoring the organization’s performance by keeping

the checking on the strengths and weaknesses of the

organizations. But this system measures the overall

performance of the organizations but not the process

or activity independently (Rolstadas 1998 and Heckl

and Moormann 2010).

2.1.3 Traditional controlling

The traditional controlling also focuses on the whole

business to control and manage the performance

(Kueng 2000). Key indicators to assess the

profitability, growth and risk factors are determined

and then the senior management continuously

observes these indicators. By this process the senior

management becomes able to assess any problem in

the business and takess any corrective measures

(Heckl and moormann 2010).

2.1.4 Activity based costing

The activity based costing (ABC) was firstly

introduced in mid-1980’s by the computer aided

manufacturing international with the framework of the

cost management systems programs. This system

came into the existence during the considerations of

the modern manufacturing, logistics and IT changes

and the process and cost structures of the

organizations. These days the organizations don’t

consider the indirect cost and value added activities

costs but they only used to consider the direct costs.

The activity based costing system of performance

management developed the concept of considering the

all other indirect costs as well. The ABC system

focuses on the very small unit of the business in order

to measure the performance. But its major

consideration is cost indicator (Kueng and Krahn

1999).

2.1.5 Process performance measurement system

This system focuses on the performance of the each

and every single process of the business in order to

assess, control and manage the performance of the

overall business. Actually this system takes the

process as the foundation of the overall business. So

performance of the process is easily assessed and

controlled as compare to overall business. In this

approach with respect of vision and mission statement

of the overall business the objectives of the single

process are defined and then indicators for the process

performance are determined in order to make

complete grip over the process performance (Neely

2000).

2.1.6 Work flow based monitoring

The work flow based monitoring facilitates the top

management by automatic and semi-automatic

assessment of the process variations, coordination of

the different process activities and communication

between the workers of the processes. The different IT

systems used automatically record the information of

the different activities which may be very useful for

the future planning and decision making (Heckl and

Moormann 2010). The data gathered automatically

provide many useful insights into the activity based

costing, time related to completions of process and

different workload on process workers. The traditional

performance system focus on entire performance level

of the organizations but the workflow system focuses

on the process based performance (zur Muhlen 2004).

The limitations of the work flow based monitoring

may include the qualitative performance and

performance data about activity or processes which

are conducted manually and are very difficult to

monitor and achieve. It is very difficult to assess this

kind of data. The work flow monitoring system

monitor the performance of the process during its


87

execution so the chance of mistake is minimized

(Kueng and Krahn 1999).

2.1.7 Statistical control system

The statistical control system uses different statistical

techniques in order to find any variations in the

process (Juran and Gyrna, 1993). The main target of

these techniques is to find maximum variation

accurately as they can (Kueng and Krahn 1999). And

then this data provided by the statistical control

system is used to control the variation found in the

processes. The main objective of this system is to

achieve the stable processes, because the more stable

process may lead toward more accurate prediction of

the behaviour of the process, which at the end gives

reliable predictions about the quality of the products

(Heckl and Moormann 2010).

As a summary the balanced scorecard and self-

assessment systems are related to same category,

because of their common focuses on the performance

of the whole organization, although they have

different approaches. Statistical process control,

activity based costing and workflow based monitoring

are usually used for the measuring the performance of

a single process and focuses only on efficiency aspect.

Traditional controlling also considers the organization

as a whole and focuses on the efficiency, whereas the

process performance measurement system focuses on

an individual business process, rather on the

performance of the whole organization or an

organizational unit.

2.2 The process performance management

2.2.1 What is a process?

According to Zairi (1997) the process is an approach

for converting inputs into outputs. It is the way in

which all the resources of an organization are used in

a reliable, repeatable and consistent way to achieve its

goals (Palmberg 2009). Aitken and Stephen (2010)

have defined the process as “A sequence of tasks

undertaken by actors within a single community”

Essentially; there are four key features to any process.

A process has to have:

Predictable and definable inputs;

A linear, logical sequence or flow;

A set of clearly definable tasks or activities;

A predictable and desired outcome or result.

2.2.2 Framework for measuring process

performance

The business process performance is not any-thing

absolute due to the large number of available

performance indicators, figures and measures. The

performance of a same process can be different on the

basis of performance measured by different measures

and performance indicators. An organization’s

objectives and vision is used to provide the basis for

determinations of measures of process performance.

The performance measures should be aligned with the

wishes and objectives of the organization as the entire

organization should be aligned with the wishes and

requirements of its stakeholders and clients. Moreover

the process performance is a multi-dimensional

concept and should not be measured on the single

dimension like profitability. A very valuable frame

work is given in the literature which gives a stronger

process perspective. This distinguishes between the

input, throughput and output and it advises the

researchers to determine the performance indicators

according to this classification. The input of the

process may include the labor, machinery or plant, and

other sources of capital (Scheer 2010). We can make

decision about the customer’s satisfaction by the

quality and quantity of the input. During the

throughput phase the operations are done on input to

convert it into valuable output. An output may include

some valuable goods and services. The organizations

can measure their performance at any stage like at

input level, throughput level, or results or output level.

(Figure 2) (Heckl and Moormann 2010).

Figure 2. Stages of performance measurement in the process


88

As previously stated that the organizations can

judge their performance at any stage of the process

(e.g. input, output, throughput), so the performance

indicators could be like input related, output related or

throughput related.

2.2.3 Steps for PPMS

In his book the total organizational excellence the

Oakland (2010) has identified the following steps in

measuring and managing a organization performance

which can be applied for business process

performance management.

2.2.3.1 Defining the organization vision, mission,

and goals and strategies

In the first step of the PPMS the organization’s vision,

mission, goals and strategies to achieve these goals are

defined. Almost over a thousand of the books and

articles about defining the organization’s vision have

appeared in the press but the technically vision is yet

hypothetical phenomenon. The vision is something

which could not be directly observable and apparently

carries meanings beyond any single and simple

description (Larwood 1995; Hui and Chuan 2002).

The organization vision, mission, goals and strategies

are very important to define because they set the

direction for the organization (Oakland and Gadd,

2002). The first step in the PPMS is to define the

organization’s vision, mission, goals and strategies.

The vision and missions are broad terms which carry

the futuristic desires of the organization’s top

management (Zairi and Sinclair 1995). But the

organizational goals are rather short-term objectives of

the organizations which are derived directly from the

mission statement of the organization and are stated in

terms of physical values. And this mission rather than

the organization’s objectives drives the organization’s

strategy (Leong and Ward, 1990; Kaplan 2001 and

Kellen 2003).

2.2.3.2 Business process documentation

This is the second step in the PPMS in which the

organizations points out all the processes involved in

the overall business of the organization and then draw

diagrams of these processes on the paper (Zairi and

Sinclair 1995). First of all the management define

their processes and the boundaries of the processes

and then they document all the processes. Without the

proper documentation of the process there are often

conflicting views about the process that what the

process exactly is? The main benefit of the process

documentation is that it includes the systematic

descriptions of the process which brings agreement

among all team members and managers that what

constitute a process (Elzinga et al, 1995).

2.2.3.3 Defining the Critical Success Factors (CSFs)

The third step of the PPMS is defining the critical

success factors (CSFs). These CSFs are defined on the

basis of organization’s vision, mission, goals and

strategy. The CSFs can be defined as the important

factors which organization must accomplish in order

to achieve the mission of the organization (Oakland

2001). Basic rule behind choosing the CSFs is that

they should be necessary and sufficient to achieve the

overall organization mission (Zairi and Sinclair 1995;

Oakland 2001).

2.2.3.4 Defining the core processes

In this fourth step of PPMS the organizations define

their core processes on the basis of their critical

success factors. Actually the core processes of the

organizations are the most important processes to

achieve the mission of the organizations. The core

processes and the CSFs of the organization should be

linked together (Zairi 1997; Oakland 2001).

2.2.3.5 Defining the Key performance Indicators

(KPIs)

The most important step of the PPMS is the defining

of the key performance indicators of the organization.

There are two categories of performance indicators;

the qualitative and quantitative. We can divide the

performance indicators as the internal and external

performance indicators also. The Costs / financial,

Quality, Time, Delivery reliability, Flexibility are

largely accepted indicators of organizational

performance (White 1996 and Koufteros and Doll,

1998, Cyrus et al 2013). But several authors have

defined other indicators as well on the basis of their

case study researches. Sinclair and Zairi (1995) have

found the customer satisfaction, quality, delivery,

employee factors, productivity, financial performance,

safety and environment / social performance as the

indicators of business performance used by many

organizations. Parmenter (2009) has identified the

customer’s satisfaction, employees’ satisfaction,

environment/community, financial, internal process

performance and learning and growth as the

performance measurement perspectives. The

performance indicators must be based upon the

competitive strategy of the organization (Sinclair and

Zairi 1995).

2.2.3.6 Benchmarking

The improvements can only be done if the

benchmarking is done for performance of any process,

activity, task or overall organization (Parmenter

2009). If the improvements have been made then these

improved results could be the new standards for that

particular process, activity, task or overall

organization. The benchmarks could be the previous


89

performance the company or performance of the

competitors company (Sinclair and Zairi 1995).

2.2.3.7 Process Analysis

This is the overall seventh step of the PPMS but it is

the start of second phase of PPMS. The evaluation of

the performance starts from this step. In this step the

organizations evaluate the performance of the each

and every process and compare it with standards or

benchmarks (Oakland 2002; Heckl and Moormann

2010 and Skrinjar et al, 2010).

2.2.3.8 Identifying the skill needed

This is the very next step after the process evaluation

stage. During this stage the skill needed to improve

the overall performance of the organizations are

identified. This step is not always done but when there

are some technological changes occurred in the market

or when company has adopted these changes then this

step become important to perform. During identifying

the skill needed to performance various task the HR

department of the organizations come into action in

order to identify the proper skills needed provide to

the employees of the organization (Oakland 2001;

2010).

2.2.3.9 Providing the skill needed

After identifying the list of skill needed the HR

department of the organizations provide the necessary

skills to respective employees, who lack these

necessary skills. In this process a necessary training

and education about the overall organizational

mission, vision, goals and strategies are provided to

employees (Oakland 2001; Neely 2005).

2.2.3.10 Managing the Process

On the basis of the processes performance data the

process managers try to manage the performance of

their processes. The process managers firstly clearly

understand the results of the process performance data

and then make positive and effective decisions about

the improvements in the process performance (R.

Skrinjar 2010). At first the performance of the

processes is measured and compared with the

benchmarks or standards and any improvements are

suggested for the processes. By this the performance

of the processes can be increased which contributes

towards the overall performance of the organization

(Oakland 2001).

2.2.3.11 Process improvements

This is the important step of the second phase of the

PPMS in which the organizations start improvements

in the processes by rearranging the process activities.

The flow charts are drawn in this stage and different

performance indicators are redefined by the managers.

The improvement programs are started and the skills

and knowledge of the employees is fully utilized. A

proposed framework of continuous improvements by

Oakland (2001) is that the managers should start by

defining the problem, review the information,

investigate the problem, verify the solutions, and

execute the change (Oakland 2002).

2.2.3.12 Feedback generation

Feedback is the primary source of continuous

improvement and the employees remain motivated

and work with full commitment from this feedback.

Managers try to provide the feedback of the

performance against organizational goals, new

opportunities, performance against internal standards

and external standards to their subordinates (Oakland

2001).

2.2.3.13 Assigning the responsible person

When there is not any responsible person for any

activity then who will take the responsibility of that

particular activity. In this step the responsibility of

process performance is delivered to any manager, who

keeps the check on the outcome of his assigned

process (Scheer 2010 and R. Skrinjar 2010). The

management then asks for any undesirable outcome of

the process directly to the responsible person. The

responsible person is then has an authority to make

any decision regarding the process. The other benefit

of the assigning the responsible person is that the

rewards and incentives could be delivered to right

person (Oakland 2002).

2.2.3.14 Upgrading the strategies and organizational

goals

This is the last step of PPMS where the whole cycle is

complete. In this step the feedback is used to update

the organizational strategies, objectives and goals by

the budgetary control team within the organization.

The whole process is revised on continuous basis in

order to manage the overall organizational

performance. This is also an important step and if this

step is not performed then the whole process is

useless. The feedback should be used to update the

benchmarks and strategic planning (Oakland 2001).

3 The methodology and model

This study explores the dimensions of organizational

performance in terms of performance indicators;

defines indices of overall performance indicators and

its dimensions; establishment of the relationship of

performance indicators to Pakistani manufacturing

sector’s companies from four different industries

which have applied the PPMS. The research questions

identified for this study are stated as:


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1. Whether the organizations in Pakistan are

following these steps as suggested in literature?

2. Is there any difference between the firms who

have applied the PPMS and who have not applied

PPMS in terms of profitability?

3. What are facilitators and inhibitors behind the

implementation decision of PPMS?

4. What is the effect of each performance

indicator on the profitability of the firms?

This study is descriptive which involves the

practices and different performance indicators from

the organizations using the PPMS in order to manage

their performance in a better way. This will help the

other organizations in the same industry to follow the

best practices organizations or set them as benchmark.

The selection of the variables and indicators is the

result of in-depth survey of the literature.

3.1 Research model

This study is about process performance management

and the most of its part is related to key performance

indicators selection process and the effect of

performance indicators on the profitability of the

organizations. The numbers of items in each

performance indicator are developed in the qualitative

part of the study where as the ultimate number of

performance indicators are the result of factor

analysis. The overall study has followed the

framework presented in (figure 3, which is due to

Bhatti et al. (2014)).

Figure 3. The framework of the study (from Bhatti et al (2014))

3.2 Sample and population

The target population of this study is the

manufacturing sector of the Pakistan. In order to have

a full extent of the whole population, we have selected

four most important sub sectors from the

Manufacturing sector (automobiles, electronics, sports

and textiles). The data is collected from the top level

management of the 200 manufacturing companies in

Pakistan through a structured questionnaire out of

which a stratified sample of 100 companies

implemented the PPMS.

3.3 Data collection tools and techniques

This study is based upon the primary and secondary

data. For this purpose the primary data is gathered

through a structured questionnaire to be filled by top

management of the selected manufacturing

organizations of Pakistan. And In order to get the

secondary data regarding the profitability of the

organizations the annual reports of the organizations

are analysed. The sources of the secondary data are

the websites of the organizations, databases of the

organizations and the website of the KSE. For the

purpose of data analysis the statistical package SPSS

17 (statistical package for social science) and MS-

Excel are used. We applied statistical techniques like,

descriptive Statistics, Factors Analysis, AHP and

Multivariate Regression Analysis

4 The findings

4.1 Descriptive statistics

We have used steps of process performance

management suggested by Oakland (2001). In order

to conduct our analysis to check whether the

manufacturing organizations in Pakistan are also using

these steps for performance management. So for this

purpose we include a question that whether the

organizations are applying these steps for performance


91

management. In our research instrument there were

five options available in front of each step. The

options include the 1= Never(0%), 2= Occasionally

(1-30%), 3=Frequently(31-60%), 4=Most Times(61-

99%), 5=Always(100%). From total 200 organizations

visited, there were only 100 organizations from

different industries of manufacturing sectors which are

using the PPMS for their performance management.

The descriptive statistics of the responses of the

respondents is given in table (1).

Table 1. The descriptive statistic for the PPMS steps

No PPMS S.D Mean

A)

1

2

3

4

5

6

B)

1

2

3

4

5

6

7

8

Strategic process planning

Define the organization vision, mission, and goals and strategies.

Business process documentation

The critical success factors are defined based on the organization’s vision,

mission, goals and strategies.

The core processes are defined on the basis of critical success factors.

The Key performance indicators (KPI) are defined for the processes.

Develop or identify the benchmarks and standard for the process performance.

Process evaluation

Process Analysis and Compare the performance with the benchmarks or

standards.

Skills needed to perform the tasks in the major processes are defined.

Skills training for tasks required to design and manage major processes are

provided.

Process managers use performance data to manage their processes.

Process improvement programs are in place to identify and improve problems

and defects.

Feedback is generated and given it to employees.

The responsible person is assigned for the performance of the particular

process.

Feedback is used to improve and develop the strategies to achieve the

organization goals.

0.810

0.832

0.685

0.836

0.962

0.460

0.826

1.056

0.826

0.772

1.071

1.654

1.654

0.819

4.71

4.61

4.61

4.57

4.54

4.71

4.64

4.68

4.64

4.82

4.54

4.07

4.07

4.68

The results related to the questions for defining

the vision, mission and goals and documentation of

the business processes show that the most of the

organizations using PPMS always follow these steps

(mean=4.71, mean=4.61 respectively). The third step

is related to “the critical success factors are defined

based on the organization’s vision, mission, goals and

strategies”. The results related to this question show

that the most of the organizations using PPMS always

follow this step (mean=4.61). Then in the next step of

PPMS the organizations defined their core processes

on the basis of previously defined CSFs. The most of

the respondents from organizations which are using

the PPMS are in point of view that they always follow

this step (mean = 4.57). The step 5 of the PPMS is

about defining the Key performance indicators (KPIs),

which is very important step in the whole process. In

this step the organizations define their key

performance indicators on the basis of their

competitive strategy and core processes. Each and

every core process has different performance

indicators. The respondent’s responses show that the

most of the organizations using PPMS are following

this step (mean = 4.54). Then in the next step the

organizations identify the benchmarks and standard

for the process performance. These benchmarks can

be processes within the organization and can be

processes of competitors’ organizations. The

descriptive statistics according to this step shows that

most of the organizations always follow this step

(mean = 4.71). The first six steps of the PPMS are

related to Strategic process planning phase. And the

next eight steps are all related to second phase of

PPMS which is Process Evaluation phase. The next

step which is the first step of second phase of PPMS is

about process analysis and comparing the performance

with standard and benchmarks. The results related to

this step (mean = 4.64) show that the most of the

organizations always follow this step. The second step

of process evaluation is about the identification of

skill needed to perform tasks in the major process. The

mean value of the responses related to this process is

4.68, which reveals that the most of the organizations

using PPMS always follow this step. The next and

third step of the second phase of PPMS is to provide

the skill training to employees needed to perform the

tasks related to design and manage the major

processes. The results about this step reveals that the

most of the organizations in Pakistan which are using

the PPMS to manage their performance are following

this step (mean = 4.64). The other steps involved in

the second phase are; process managers use the

performance data to manage their performance (mean

= 4.82), process improvement programs are in place to

identify and improve problems and defects (mean =

4.54), feedback is generated and given it to employees


92

(mean = 4.07), the responsible person is assigned for

the performance of the particular process (mean =

4.07) and feedback is used to improve and develop the

strategies to achieve the organization goals(mean =

4.68). The results show that the organizations in

Pakistan, which are using the PPMS, are following

these steps “always” or “most of times”.

4.2 Analysis of variance (ANOVA)

Analysis of variance is conducted on the profitability

variables to see difference between the firms which

are using the PPMS and others which are not using the

PPMS. This is also the second objective of the study.

The results of the ANOVA are given in table 2.

Table 2. ANOVA for the profitability of the firms

Sum of Squares df Mean Square F Sig.

Sales Growth Between groups 214.436 1 214.436 .424 .517

Within groups 41517.477 198 506.311

Total 41731.913 199

Income Growth Between groups 476.210 1 476.210 .440 .509

Within groups 88750.957 198 1082.329

Total 89227.167 199

ROA Between groups .034 1 .034 1.972 .164

Within groups 1.433 198 .017

Total 1.467 199

ROE Between groups 4.416 1 4.416 2.730 .102

Within groups 132.680 198 1.618

Total 137.096 199

The results in the table 2 show that there is no

significant difference between the firms who are

implementing PPMS and those who are not applying

PPMS with respect to profitability. The reason behind

the same profitability is that the firms who have not

applied the PPMS are using another performance

management system for the management of their

performance. The other reason behind the same

profitability is that the firms selected for this study are

the best performers in their respective industries;

therefore they have not any significant differences

with respect to profitability. Again the ANOVA is

conducted on the Indices of performance Indicators to

see difference between the choices of firms of

manufacturing sector which are using the PPMS and

which are not using the PPMS. The results of the

ANOVA are given in (Zahid, 2012). The results of

ANOVA on the basis of PPMS implementation show

that there is significant difference between firms’

choice of performance indicators. Both the firms

which have applied the PPMS and which have not

have significant differences with respect to financial,

time, flexibility, delivery reliability, safety and

employees satisfaction indicators of the performance.

4.3 AHP (Analytical hierarchy process)

In order to achieve the third purpose of the study that

which are the important inhibitors and facilitators

behind the implementation of PPMS, we have applied

the AHP (analytical hierarchy process). AHP is a

multi-criteria decision making (MCDM) method.

MCDM is a well-known class of decision making that

was firstly come into to action by the Wind and Saaty

(1980). The AHP actually converts respondents’

preferences into ratio-scale weights that are pooled

into linear additive weights for the alternatives. These

resultant weights are used to rank the alternatives and

thus assist the decision maker in making a strategic

decision (Forman and Gass 2001). The major

distinction of AHP is that it structures any complex

and multi-dimensional problem hierarchically. By

applying the AHP a matrix of pair-wise comparison of

the elements can be constructed where the entries

indicate the strength with which one element

dominates another with respect to a given criteria.

This scaling formulation is translated into largest

Eigen-value problem which results in a unique vector

of weights for each level of the hierarchy (always with

respect to the criteria in the next level) which in turn

results in a single composite vector of weights for the

entire hierarchy. This vector measures the relative

priority of all entities at the lowest level that enables

the accomplishment of the highest objective of the

hierarchy. These relative priority weights can provide

guidelines for the allocation of resources among the

entities at the lower levels of the hierarchy. These

defined hierarchy levels can be helpful for the

determining the number of key strategic decisions of

the organizations (Wind and Saaty 1980). A detailed

analysis of the data was conducted in order to

prioritize the possible reasons behind the


93

organizational decision about implementing the

PPMS. The global weights are listed in Table 3. The

factors of facilitator are divided into three Tiers based

on the global weights. The first Tier is composed of

critical factors. “The supportive culture” and “PPMS

facilitate the competitive advantage” lie in this tier I.

The business organization who intends to implement

PPMS is required to make the ground for the

supportive culture and ambition for getting the

competitive advantage. There are four factors which

belong to tier II (Supporting factors). These factors are

“Want to involve people in measurement” “Top

management commitment” “PPMS is an efficient

system” “Clear understanding of the process”. The

management should enhance these factors to support

the critical factors. Whereas in Tier-III items are

“stakeholders’ pressure” and “have only single option

available”.

Table 3. Global priority weight for facilitators

No Facilitators Weights

1 Supportive culture 0.22226

2 PPMS facilitate the competitive advantage 0.18456

3 Want to involve people in measurement 0.14062

4 Top management commitment 0.13857

5 PPMS is an efficient system 0.13069

6 Clear understanding of the process 0.1239

7 Stakeholder’s pressure 0.04348

8 Have only single option available 0.01592

In this study there were 200 organizations

visited, out of these 200, there were 100 such

organizations which are not using the PPMM for

managing their performance. So for the sake of the

analysis there was a question of possible reasons

behind not implementing the PPMM for

organizational performance management. A detailed

analysis of the data is conducted in order to prioritize

the possible reasons behind the organizational

decision about not implementing the PPMS.

According to the global priority weights obtained

through the AHP (Table 4), we observe that two

factors namely “Have another performance system”

and “not supportive culture” lie in Tier-I. This result

indicates that the management of an organization not

implementing PPMS should analyse the benefit of

PPMS along with the existing system, and make the

effort to make the supportive culture for PPMS and

the least important reason is the performance

measurement is the waste of time (weight=0.015).

Table 4. Global priority weights for Inhibitors

No Inhibitors Weights

1 Have another performance management system 0.2591

2 Not supportive culture 0.2179

3 Time / resource constraints 0.1342

4 Existence of inherited system(“inertia”) 0.1134

5 Lack of Top Management commitment 0.0913

6 Lack of process understanding 0.0790

7 Lack of clear mission / vision 0.0661

8 Performance measurement is waste of time 0.0387

4.4 Regression analysis

The calculation of the performance indicators indices

is given in the (Zahid, 2012). The multivariate

regression analysis is performed in order to check the

impact of performance indicators indices on the

profitability of the firms. The results of the

multivariate regression are given in the table 5. The

results indicate that the Financial Index has a positive

significant impact over the organizations ROE (p

value = 0.08). The Quality has a positive significant

impact over the ROE (p value = 0.026) followed by

the ROA (p value = 0.029) and sales growth (p value

= 0.057). The Delivery Reliability has also a

significant impact over the ROE (p value = 0.056).

The Customer Satisfaction has a significant impact

over the ROE (p value = 0.040). The employees’

satisfaction has a significant impact on the ROE (p

value = 0.056) and lastly the learning and growth

index has a significant impact over the ROE (p value

= 0.045). Measuring the financial performance,

Quality performance, Delivery reliability

performance, customer satisfaction performance and

employees satisfaction lead to increase in the

organizational return on equity (ROE), and the

measuring the quality performance leads toward the

improvements in the sales growth and Return on

Assets (ROA) of the organizations.


94

Table 5. Regression coefficients for performance Indicators

Source Dependent Variables df Mean Square F Sig.

Cost Sales Growth 1 64.246 .128 .722

Income Growth 1 755.176 .761 .386

ROA 1 .001 .092 .763

ROE 1 3.453 2.422 .124

Financial Sales Growth 1 5.244 .010 .919

Income Growth 1 911.255 .918 .341

ROA 1 .001 .155 .695

ROE 1 4.361 3.059 .085

Quality Sales Growth 1 1887.949 3.753 .057

Income Growth 1 517.646 .522 .473

ROA 1 .047 4.951 .029

ROE 1 7.362 5.164 .026

Time Sales Growth 1 137.944 .274 .602

Income Growth 1 728.303 .734 .395

ROA 1 .006 .604 .440

ROE 1 2.079 1.458 .231

Flexibility Sales Growth 1 53.512 .106 .745

Income Growth 1 8.512 .009 .926

ROA 1 .001 .083 .774

ROE 1 .827 .580 .449

Delivery Reliability

Sales Growth 1 291.168 .579 .449

Income Growth 1 63.783 .064 .801

ROA 1 .001 .146 .704

ROE 1 5.371 3.767 .056

Safety Sales Growth 1 98.778 .196 .659

Income Growth 1 469.843 .473 .494

ROA 1 .005 .554 .459

ROE 1 1.935 1.357 .248

Customer Satisfaction

Sales Growth 1 606.422 1.205 .276

Income Growth 1 676.445 .681 .412

ROA 1 .022 2.366 .128

ROE 1 6.237 4.375 .040

Employees Satisfaction

Sales Growth 1 305.118 .607 .439

Income Growth 1 169.624 .171 .681

ROA 1 .001 .117 .734

ROE 1 5.363 3.762 .056

Social Sales Growth 1 91.392 .182 .671

Income Growth 1 5.092 .005 .943

ROA 1 .015 1.548 .218

ROE 1 .456 .320 .574

Learning & Growth

Sales Growth 1 41.010 .082 .776

Income Growth 1 .120 .000 .991

ROA 1 .005 .537 .466

ROE 1 5.915 4.149 .045


95

5 Summary and conclusions

The phenomenon performance measurement is used

by the organizations in order to ensure that they are

going on right direction and achieving their preset

targets in terms of organizational goals and objectives.

For this purpose the performance measures are used to

evaluate and control the overall business operations.

They are also used to measure and compare the

performance of different organizations both within the

organization and outside of the organization. The

performance can be compared within the departments,

sub departments, teams and individual processes

(Ghalayini and Noble 1996). This study is an attempt

to know that whether the manufacturing organizations

of Pakistan are following all steps for PPMS as

suggested by Oakland (2001). What are the potential

inhibitors and facilitators regarding the implementing

and not implementing the PPMS and what is impact of

each performance indicator on the profitability of the

organizations.

On the basis of the results and data analysis we

can conclude that the manufacturing organizations in

Pakistan are following all steps involved in process

performance management system as suggested by the

researchers. The most important facilitators behind

implementing the PPMS are supportive culture and the

“PPMS facilitate the competitive advantage” and the

least important facilitator is stakeholder’s pressure on

the firms to implement the PPMS, which means that

the there is no pressure from any stakeholder on the

company to implement the PPMS. The most important

inhibitors behind not implementing the PPMS are that

the firms have another performance management

system and not supportive culture in the organization.

And least important inhibitor is “performance

management is the wastage of time”, which means

that organizations which have not applied the PPMS,

do not consider that the “performance management as

wastage of time” is the important inhibitor behind not

implementing the PPMS. And the companies which

have not applied the PPMS have another performance

management system or they do not have supportive

culture for implementing the PPMS.

The results of regression show that the

Measuring the financial performance, Quality

performance, Delivery reliability performance,

customer satisfaction performance and employees

satisfaction lead to increase in the organizational

return on equity (ROE), and measuring the quality

performance also leads toward the improvements in

the sales growth and Return on Assets (ROA) of the

organizations. In order to simplify our results we can

say that by measuring the overall organizational

performance has a significant impact over the

profitability of the organizations significantly. The

results of ANOVA show that the companies who have

applied the PPMS and who have not applied the

PPMS have the same profitability. There is not any

significant difference between the selected industries

regarding the using of performance indicators except

the textile and automobiles regarding the use of

learning & growth performance indicator.

From these results we conclude that KPI

performance measurement importance could also be

expressed by next statement: KPI tells you where

performance has been in the past, where it is now, and

perhaps more useful, where performance is likely to

be in the future“ (Smith, 2001).

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THE RELATIONS BETWEEN OWNERSHIP STRUCTURE AND CORPORATE PERFORMANCE: EVIDENCE

FROM BAHRAIN STOCK EXCHANGE

Reem Khamis*, Wajeeh Al-Ali**, Allam Hamdan**

Abstract

In this article we examine the relation between ownership structure and corporate performance; the sample of the study included 42 out of 48 companies (resembling 87.5% of the population) of all sectors in Bahrain Stock Exchange in five years from 2007-2011. Several dimensions of ownership structure were studied and two different measurements of performance were used (ROA and Tobin’s Q) to capture the different results from using each one of them and to assess the relevance of each measurement to performance and to justify the conflicting results found by previous studies. Another objective of this study was to explore the patterns of ownership structure found in Bahraini market. The results of the study revealed that institutional ownership is the most common pattern of ownership structure that exists in Bahraini market. The results of testing the effect of ownership structure on performance were conflicting as expected depending on the measurement of performance that was used. Several recommendations were given to investors depending on the results obtained from the study and several points were cleared out to be addressed by future studies.

Keywords: Ownership Structure, Ownership Concentration, Foreign Ownership, Institutional Ownership, Managerial Ownership, Company Performance

*Brunel University, UK **Ahlia University, Bahrain

1 Introduction

The relation between ownership structure and firm value and performance has been studied early since 1932, when researchers studied the conflict between owners and management and how it affects corporate value. Berle and Means (1932) indicated that an increase in professionalization of management, companies may operate for managers’ benefit not for the benefit of owners. This what was known later as agency problem, when there is a conflict between the owners of the firm and the people who manage that firm when they work to achieve their own benefits rather than the benefits of the owners. Managers often have the discretion and incentives to pursue strategies and practices that benefit themselves at the expense of shareholders (Fama and Jenson, 1983). Different ownership structures affects agency problem differently, so it is crucial to know the firm’s ownership structure to determine the nature of agency problem and costs associated with it and how corporate value and performance might be affected by that issue, for example , managers of publicly held firm has different objectives than a manager of a family business and so.

Knowing the firm’s ownership structure and determining its effect on corporate value and performance have concerned many researchers around the world from developed to developing countries but

few in the middle east and fewer in GCC countries and this study may be the first one to do so in Bahrain. This study provides empirical evidence from Bahrain on the effect of ownership structure on corporate performance, using different measures of corporate performance and different dimensions of ownership structure to justify the conflicting results found by different researchers. It also investigates the patterns of ownership structures in Bahraini financial market in addition to providing useful information to other interested parties that may benefit from it such as investors and researchers.

1.1 Problem statement and study questions

The study may provide answers to many questions that may be asked by any interested individual or institute. The first question that may arise, do ownership structure really matter? If yes; how do they affect corporate performance? What is the best ownership structure that maximizes the firm’s value? What are the patterns of ownership structure in Bahraini market? What are the other factors that may affect corporate performance?

1.2 Study objective

The study aims at exploring the effect of ownership structure on corporate performance in Bahrain using two different ways of measuring corporate


98

performance and different dimensions of ownership structure to know how exactly these factors affect corporate performance and how investors can benefit from this information to make the correct investment decision.

The paper is organized as follows: Section 2 background and literature review. Section 3 describes research design and methodology. Sections 4 present empirical results. Section 5 provides a brief summary and concluding remarks.

2 Background and literature review

Corporate performance and factors affecting it is an important topic in finance, as many researchers were concerned about the firm performance and what makes one firm more successful than another. There are two different lines of research in the business research world. The first one is concerned about factors in the external economic atmosphere that affects the firm’s successfulness, and the second one is concerned about the internal organizational characteristics. Both lines do not give proper attention to the competitive position of the firm itself (Hansen and Wernerfelt, 1989).

Evaluation of the firm performance is an important issue to management of the company, investors and researchers. For managers, evaluation of the firm performance is sometimes tied to their compensation to alleviate the agency problem. To investors, performance is an important indicator for successfulness of their investment or not. In the following section, we will take a look on some performance measure and later on, we will use some of them in measuring the variables of the study.

Ownership structure and its effect on performance of the firm is one of the most covered topics in the literature of corporate finance although the results of most studies are conflicting and that may be because of the difference between these studies in the measurement tools used to measure ownership structure or the dimensions of ownership structure that is studied.

The issue of ownership structure was studied as early as the property rights were known. Berle and Means (1932) were from the earliest ones to study this topic and indicated that there is a significant relationship between ownership structure and company value. Perhaps it is useful to indicate that researchers from different countries found different results. Some researchers found that there is significant relationship between these two variables others couldn’t find this relationship. That’s could be because they studied the issue from different perspectives. Thus we found it easier to classify ownership structures that were reviewed according to the dimension that was studied and then we will take a look on the previous studies that studied ownership structure in different countries from around the world.

Ownership structure is divided into two dimensions which are: degree of concentration and identity of the owner which is also divided into sub dimensions which are: family ownership, institutional

ownership, government ownership, foreign ownership, and insider or management ownership.

2.1 Concentration of ownership

This dimension is concerned with the degree of dispersion of ownership among certain shareholders. Ownership could be diluted among large number of shareholders or concentrated in small number of shareholders or block holders. The problem of diffuseness of ownership among large number of shareholders is that there will be weakness in monitoring management (Morck et al. 1988), but the advantage is that, there will not be a structure large enough to over control management. In some cases, management would exploit the resources of the firm affecting its value and performance negatively (Berle and Means, 1932).

Some studies such as (Demesetz and Lehn, 1985; Demesetz and Vilalonga, 2001; Kumar, 2003 and Rowe and Davidson, 2002) found that there is no significant relationship between concentrated ownership and company value.

Other studies such (Pivovarsky, 2003; Sanda, Mikailu and Garba, 2005; Joh, 2002 and Xu and Wang, 1997) found a significant relationship between the two variables. Some studies found a positive relationship but insignificant relationship between the two variables such as (McConnell and Servaes, 1990).


Usually foreign investors perform a detailed analysis before investing and they tend to invest in profitable companies. Foreign investors are expected to bring in the latest technologies which allow companies to perform better in an efficient manner thus performance is expected to improve (Caves, 1996; Kumar, 2003)

Again researchers found conflicting results as some found a relation between foreign ownership and company value such as (Bai et al., 2005; Sarkar and Sarkar, 2000 and Patibandle, 2002). Others found a negative relationship such as (Sarac, 2002 and Kumar, 2003)


This dimension of ownership is related to the total percentage of equity owned by institutional investors. Fama, 1980 claimed that institutional ownership is beneficial to the firm and leads to improving its performance and value. Shleifer and Vishny, 1986 explained that possible relation in two points: The first one is that outside block owners have the ability to overcome the problem of controlling managers. The second one is that large block shareholders may also improve the effectiveness of takeover mechanism by overcoming the problem of free rider which rises from the lack of control by shareholders. (Berger, 2003 and Sarac, 2002) found a positive relationship with a moderate statistic effect between institutional ownership and firm value. Others like Wan (1990) found a positive, statistical and significant correlation between the two variables.


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This dimension with the concentration ownership dimension forms the agency problem which still a debate between researchers, as when the management controls the firm, it is expected to work in its own interest and if owners control managers, they are expected to work in the interest of the firm thus improving its performance and value and not wasting the firms resources or abuse them. As expected, researchers also found conflicting results regarding managerial ownership as some found a positive relationship such as (Severin, 2001 and Kumar, 2003). Others didn’t find that relationship such as (Demsetz and Villalonga, 1999; Rowe and Davidson, 2002 and long and So, 2002).

2.5 Family ownership

Family ownership is very common worldwide. Perhaps it’s one of the most presented types of ownership structures around the world. La Porta et al. (2003) mentioned that family ownership is the most common type of organizations in 27 countries worldwide. Some studies found a positive relationship between family ownership and corporate value and performance while others did not find this relationship. A study like Villalonga and Amit (2006) found that firm only makes value when the founder of the firm acts as the COE of the firm. The most important issues that were studied are the founding family owner effect and generation difference effect. In an overall perspective, it can be seen that when family owners are in the management there will be what called incentive alignment where the conflict between owners and management will be reduced thus agency costs will be reduced too. The other important issue which was discussed that other types of owners think only about profit maximization but family owners look at the long term commitment to the company and they try to create competitive advantages that requires large investments at the beginning. (Hsu and Chen, 2009).

Some researchers found a negative effect of family ownership as when the family acts as the block holder of shares, the minority owners will be affected negatively specially when protection laws are weak in certain countries thus a conflict will be created and the performance of the firm will deteriorate. The other issue is that family owners, usually are involved in management thus there may be a bias in choosing management to the family relations issue versus the efficiency issue and that will affect performance for sure, this argument is known as manager discouragement. (Smith and Amoako – Adu, 1999).

2.6 Governmental ownership

In the early years of last century governments played an important role in planning market economy to overcome problems arising from social monopoly (Meade 1948). But in 1970’s and 80’s huge amount of government owned companies went through privatization to reduce the government role in market

mechanisms. Few governments around the world are still owning and controlling its markets such as China, Russia and some Eastern Europe countries.

There is a debate about the advantages and disadvantages of governmental ownership and the positive and negative effects of it on firm performance.

In the positive side, the total effect of government ownership on society as a whole is considered but not the success of the individual firms. It is known that governmental ownership cures market failures as when the social cost of monopoly becomes high, governments interfere to restore the purchasing power of its citizens thus protecting them. The other issue is governmental ownership of some industries is considered of strategic importance to the whole nation such as natural resources, utilities and infrastructures. As some studies found positive effect of government ownership among private ownership in some industries such as utilities.

In the negative side, governmental ownership is considered to be inefficient and bureaucratic. (Stulz, 1988). As the control rights and cash flow rights of decision maker are interfered, there will not be significant cash flow as all profits are allocated to the firm or to the national budget. Thus, there will be lack of incentives to maximize firm’s profits.

Some studies concluded that government owned firms depends largely on the quality of the government itself which varies from one country to another. (La Porta et al., 1999).

The relation between ownership structure and performance has been investigated in many studies around the world. This part will review some of these studies that are related to our study in somehow from different countries.

Severin (2001) investigated the relationship between ownership structure, other variables and the economic performance in a sample of French companies. The results of his study indicated that there is a non-linear relation between ownership structure and performance. He also found that debt level has a negative effect on performance and a company size had a positive effect on performance.

Pinteris (2002) conducted a study on a panel data of 228 Argentine banks from 1997 to 1999. The study explored the relationship between ownership structure, board composition and performance. Results showed that there is statistically negative relation between the proportion of insider directors and performance.

In Turkey, Sarac (2002) conducted a study on a sample of 138 Turkish manufacturing companies. The results showed that a relation between ownership structure and net profit. It also proved that there is a positive relation between institutional ownership and profitability.

A study conducted by Reyana & Valdes (2012) in Mexico on a sample of 90 companies listed in Mexico Stock exchange over five years, explored the relationship between corporate governance, ownership structure and performance. Results indicated that there is a negative relation between CEO ownership and


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performance. There was a positive relationship between governance mechanisms and performance.

A study by Tsegba (2011) was conducted on a sample of 73 companies listed in Nigerian Stock exchange. It investigated the relation between ownership structure and performance. It concluded that there is a negative relation between ownership concentration and performance. There was also a negative relationship between insider ownership and performance. The last finding was that there is a positive but insignificant relation between foreign ownership and performance.

Kummar (2003) investigated the relation between ownership structure and performance using ROA measurement on a sample of 5224 Indian companies from 1994 to 2000. He found an evidence that institutional ownership and managerial ownership are related to performance.

Nadia (2004) explored the impact of ownership structure on 15 private banks listed in Amman Stock exchange. The study found that there is a high concentration of ownership in Jordanian banks although it didn’t affect performance which was measured using the accounting measurement Returns On Assets (ROA).

Another study which was conducted in Jordan by Jaafar & El- Shawwa (2009) on a sample of 132 Jordanian companies listed in Amman Stock exchange from 2002 to 2005. The study examined the influence of ownership concentration and board characteristics on performance. The study found that ownership concentration, board size and multiple directorships has a significant and positive relationship with performance.

Bjuggren, Eklund and Wiberg (2007) explored the relationship between ownership structure and performance on Swedish companies from 1997 to 2002. The study found that using dual class shares, which give different voting rights and dividends to public shareholders and founders of the company, has a negative effect on company’s performance.

Perrini, Rossi and Rovetta (2008) used a sample of companies in Italian market from 2000 to 2003 to explore the relation between ownership structure and performance. It concluded that ownership concentration of the five biggest shareholders of the

company has a positive influence on firm valuation while management ownership benefited only un concentrated companies.

A study conducted by Sulong and Nor (2008) on Malaysian listed firms, investigated the effect of dividends, ownership structure and board governance on firm value. The study found that dividend has a positive significant relationship with firm value. It also showed that concentrated ownership and managerial ownership have insignificant effect on firm value which was unexpected.


This part will include three sections. Study sample and resources of data, second section will be measuring of variables and statistical tools, and study models and the last one will be validity of data.

3.1 Study sample and resources of data

This study will be conducted in Bahraini Stock Exchange which is an emerging market because most previous studies were conducted in developed ones like US, UK and European markets or other developing markets such as Nigeria, Pakistan, Malaysia and other developing Asian economies but fewer studies were conducted in the region specially in the GCC markets. Bahrain Stock exchange contains 48 listed companies. Companies were selected according to the following criteria:

a) Data is available in the period of 5 years (2007 to 2011).

b) Companies have not been closed or emerged with any other company during the study period.

Six companies were excluded from the sample and they were either non Bahraini or were closed during the study period, which left us with 42 companies representing 87.5% of the original sample.

Data was obtained from Bahrain Stock exchange data base. The data is considered panel data which resembles time series (2007 to 2011) and cross sectional data that resemble a group of companies. Panel data is considered as one of the best types of data because it contains two types of data. The procedure of selecting the sample is summarized in table 1.

Table 1. Sample selection

No Sector Listed Companies Excluded Companies Study Sample

1 Commercial Banks 8 0 8 2 Investment Sector 12 0 12 3 Insurance Sector 5 0 5 4 Service Sector 9 0 9 5 Industrial Sector 3 0 3 6 Hotel-Tourism 5 0 5 7 Closed Companies 2 2 0 8 Non Bahraini Companies 4 4 0

Total 48 6 42


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3.2 Hypothesis development This study will find the effect of ownership structure on one dependent variable which is company performance. The main hypothesis may be formed as follows:

Ha1: There is a significant relationship between ownership structure and performance among Bahraini companies.

Thus, the study hypothesis may be divided into one main hypothesis and four sub hypotheses according to the ownership dimension that will be studied: 3.2.1 Ownership concentration and performance The findings of previous studies are contradicted, as some of them like (Joh, 2002 ; Severin, 2001 ; Xu and Wang , 1997) found a positive effect of ownership concentration on performance as concentrated companies had a better performance. Other studies like (Kumar, 2003 ; Rowe and Davidson, 2002; Demsetz and Villalonga, 1999) couldn’t find that positive relationship. Thus the first sub hypothesis may be formed as follows:

Ha1.1: There is a significant relationship between ownership concentration and performance among Bahraini companies. 3.2.2 Institutional ownership and performance Reviewed previous studies concerning the relation between institutional ownership and company performance indicated a positive, significant statistical relationship between the two variables like (Wan, 1999). Other studies like (Berger, 2003 and Sarac, 2002) found a relationship between the two variables but in a moderate statistic effect. Thus the second sub hypothesis may be formed as follows:

Ha1.2: There is a significant relationship between institutional ownership and performance among Bahraini companies. 3.2.3 Foreign ownership and performance Previous studies that studied the effect of foreign ownership on performance found different results. Some like (Kummar, 2003 and Sarac, 2002) couldn’t find any relation between the two variables. Others, like (Sarkar and Sarkar, 2000 and Patibandle , 2002) found a positive relationship between foreign ownership and company performance. Thus, the third sub hypothesis may be formed as follows:

Ha1.3: There is a significant relationship between foreign ownership and performance among Bahraini companies. 3.2.4 Management ownership and performance Results obtained from previous studies concerning the relationship between managerial ownership and company performance, were also confusing. While some of them found a positive influence of managerial

ownership on performance.(Severin, 2001 and Kummar, 2003). Others like (Demsetz and Villalonga, 1999; Rowe and Davidson, 2002; Long and So, 2002) found like managerial ownership does not enhance performance. Thus the fourth sub hypothesis may be formed as follows:

Ha1.4: There is a significant relationship between management ownership and performance among Bahraini companies. 3.3 Study models This study tries to find the effect of ownership structure on company performance. Thus, ownerships are considered as independent variables and company performance is considered as the dependent variable. The study also uses two different measurement tools to measure the dependent variable (company performance). The first one is simple Tobin’s Q formula and the second one is Return on Assets (ROA) formula. Based on that two study models may be developed as follows: 3.3.1 First model The first model was developed using Tobin’s Q as measurement tool to measure the dependent variable (company performance). 3.3.2 Second model The second model was developed using Return On Equity (ROE) as a measurement tool of the independent variable (company performance). 3.4 Measuring of variables The selection of variables is based on an examination of previous empirical studies, table 2 shows the dependent variable, the independent variables, and the control variables employed for all estimated models of the study. 3.4.1 Dependent variables; corporate performance The main purpose of the study is to investigate the influence of ownership structure and other control variables on firm value in Bahrain stock exchange. Which means that firm performance will be considered as dependent variable. To measure firm performance three major ways were found in the literature:

a) Financial ratios which are obtained from balance sheet and income statement. Studies that were reviewed and used this method are (Long and So, 2002; Pinteris, 2002; Kumar, 2003; Shahid, 2003).

b) Tobin’s Q (e.g. Ruan et al., and Sevein, 2001).

c) Combined method which uses both measures combined together, financial ratios and Tobin’s Q (e.g. Abu Serdaneh et al., 2010 and Demset and Villalonga, 1999 and Wan, 1999).


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iti

tititititi

tititititi

Industry

EPSIncomeFirmAgeLeverageSize

ManagerialnalInstitutioForeignConcenQsTobin

,10

,9,8,7,6,5

,4,3,2,10,'

Where Tobin's Qi,t: is a continuous variable: dependent variable: is the firm value measured by Tobin's Q model,

for the company (i) and the year of (t). β0: is the constant. β1..10: is the slope of the independent and controls variables. Conceni,t: is the ownership concentration, for the company (i) and the year of (t). Foreigni,t: is percentage of foreign ownership, for the company (i) and the year of (t). Institutionali,t: is the percentage , for the company (i) and the year of (t). Manageriali,t: is the percentage of managerial ownership, for the company (i) and the year of (t). Sizei,t: is a continuous variable: company size, for the company (i) and the year of (t). Leveragei,t: is a continuous variable: Financial Leverage is the ratio of total debt to the book value of total assets, for the company (i) and the year of (t). FirmAgei,t: is a continuous variable: is the number of years since the firm first appeared in the BSE database, for the company (i) and the year of (t). Netincomei,t: is a net income for the company (i) and the year of (t). EPSi,t: are earnings per share for the company (i) and the year of (t). Industryi,t: is a type of sector for the company (i) and the year of (t). εi: random error.

iti

tititititi

tititititi

Industry

EPSIncomeFirmAgeLeverageSize

ManagerialnalInstitutioForeignConcenROA

,10

,9,8,7,6,5

,4,3,2,10,

Where ROAi,t: is a continuous variable: dependent variable: is the firm value measured by return on assets, for

the company (i) and the year of (t). β0: is the constant. β1..8: is the slope of the independent and controls variables. Conceni,t: is the ownership concentration, for the company (i) and the year of (t). Foreigni,t: is percentage of foreign ownership, for the company (i) and the year of (t). Institutionali,t: is the percentage , for the company (i) and the year of (t). Manageriali,t: is the percentage of managerial ownership, for the company (i) and the year of (t). Sizei,t: is a continuous variable: company size, for the company (i) and the year of (t). Leveragei,t: is a continuous variable: Financial Leverage is the ratio of total debt to the book value of total assets, for the company (i) and the year of (t). FirmAgei,t: is a continuous variable: is the number of years since the firm first appeared in the BSE database, for the company (i) and the year of (t). Incomei,t: is a net income for the company (i) and the year of (t). EPSi,t: are earnings per share for the company (i) and the year of (t). Industryi,t: is a type of sector for the company (i) and the year of (t). εi: random error.

Demset and Villalonga (1999; 2001) compared

between using financial ratios and Tobin’s Q. They claimed that accounting ratios are used widely due to their simplicity but they may be affected by accounting practices. On the other side Tobin’s Q which measures market value of the firm by using replacement cost and market value of equity may generate incorrect data regarding companies that depend on intangible capital. But on the other hand; using Tobin’s Q captures the expected future performance of firm in addition to the past and current performance (Wan, 1999). The original Tobin’s Q formula requires some figures that may not be obtainable because the data is not available, thus researchers usually use a simplified formula for Tobin’s Q, the correlation between the two formulas

was found to be very high (97%) as calculated by Chung and Pruitt (1994), which means that it is reliable to use it instead of the original Tobin’s Q formula. In this study both measures (ROA and Tobin’s Q) will be used as using each measure individually may generate conflicting results concerning the same variables so combined measures will be used to capture features of each measure and the possibility of changing the results (Abu Serdaneh, Zriekat and Al- Shaikh, 2010).


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Table 2. The labels and measurement of the variables

Variable

Label

Definition and Measurement

Dependent variables:

Corporate performance:

Return on Assets ROA Is the ratio of the net income to the total assets.

Simple Tobin's Q Tobin's Q Is the (Market value of equity + Book value of short term liabilities) ÷ Book value of total assets.

Independent variables:

Ownership structure:

Ownership Concentration Concen This dimension will be measuring the ratio of concentration/dispersion in a way that is similar to what was done

in previous studies concerned with the same issue which is the ratio of total percentage of shareholding by the

largest shareholder (Top1) divided by the sum of share holdings of largest five shareholders in the company.

Foreign ownership Foreign It is the percentage of total shares held by foreign shareholders to the total number of shares. Or the proportion of

stocks owned by foreign investors.

Institutional ownership Institutional This dimension is related to the proportion of equity owned by institutional investors to the total number of

shares.

Managerial ownership Managerial In many studies such as Morck et al. (1988) and Chen et al. (2003) directors’ share holdings was used as a proxy

of managerial ownership which is measured by total percentage of shares directly held by executive directors.

Control variables: The main objective of the study is to measure the effect of ownership structure on corporate value. It is expected

that corporate value is not only affected by ownership structure dimensions but also other variables that will be

controlled in the study. These control variables were chosen according to previous studies and they were used

extensively. (e.g. Kumar, 2003; Berger, 2003; Nadia, 2004).

Firm size Size Natural log of total assets. This variable was studied widely in previous studies and it was found that larger firms

mostly has higher value and this may be explained to their experience and they may be more efficient due to

economies of scales, the ability to employ skilled managers, ability to reach wider range of customers and

diversify their operations .

Financial leverage Leverage The ratio of total debt to total assets. It affects the firm’s ability to borrow money and the cost of doing so which

affects the firm’s profitability and value due to the increase of interest rate and financial obligations of the

company.

Firm Age FirmAge The firm age is related to the shareholders distribution as companies with older ages entered many business

cycles and they have more shareholder distribution. The age of incorporation is taken rather than the age of listing

the stock in the market.

Net Income Income Information regarding net income of the company can be taken from the balance sheet and income statement of

the company.

Earnings Per Share EPS is the (net income - dividends on preferred shares) ÷ number of outstanding shares. It indicates profitability of the

firm and some researchers consider it as a performance measure.

Industry Sectors Industry Companies who belong to different sectors differ in their free cash issues and as a consequence in their dividends.

In our study, Bahrain Stock Exchange contains 6 sectors. They were resembles by a dummy variable from 1 to 6 .

e.g. bank sector =1 , Investment =2 , …etc.


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3.5 Data validity tests

This study belongs to the General Linear Model

(GLM) which requires certain conditions before

applying it. Table (3) summarizes the tests that were

conducted to validate the date of the study.

3.5.1 Normal distribution test

To test normality of the data (Jarque-Bera) test was

conducted and results showed that all the data of the

study was normally distributed as p-value more than

5% except two variables which are ownership

concentration and, company age and earnings per

share where p-value less than 5%. To overcome this

problem, natural logarithm of these variables was

taken.

3.5.2 Time series stationarity test

Studies that use time series data as this study consider

these series to be stable otherwise there might be

autocorrelation because the time series are not stable.

To test the stationarity of the time series Unit Root

Test was used, which include: Augmented Dicky-

Fuller Test (ADF) and Phillips-Person Test (PP).

From table (1) we notice that the results of both tests

were more than the critical value at 1% which means

that the time series from 2007-2011 are stable.

3.5.3 Multicollinearity test

The strength of the general linear model depends on

the independency of each variable of the independent

variables used in the model. If this condition was not

met, then the linear model is not considered to be good

to be applied and used. To test the independency of

the independent variables, (Collinearity Diagnostics

Test) was used by measuring the tolerance of each

independent variable and then finding the (Variance

Inflation Factor (VIF)) as this test is used a measure of

the effect of correlation between the independent

variables .Gujarati (2003). If the value of (VIF) is

more than (10), that indicates that there is a problem

with the multicollinearity of the measured independent

variable. From table (4), we notice that VIF value is

less than (10) for all the independent variables, which

means that the study models do not suffer from

multicollinearity problem.

3.5.4 Autocorrelation test

Autocorrelation problem appears in the model when

two following observations are related which will

affect the validity of the model as the independent

variables will be affecting the dependent variables in a

high degree because of that correlation. To test the

presence of that correlation Durbin Watson (D-W) test

was used. Table (4) part (B) indicates that (D-W) for

the two models is not located in this range (d-statistic

dL 1.665 – dU 1.874) which means that there is a

positive correlation in the two study models (Gujrati,

2003) to overcome this problem Lag (-1) was used

when testing the study models.

3.5.5 Homoscedasticity test

When using linear regression models and Ordinary

Least Squares (OLS), variance of random error should

be constant and the average of it should equal zero,

that when it is said that the model has

homoscedasticity. And if the variance is not constant it

is said that the model has Heteroscedasticity then

some statistical methods are used to overcome this

problem, one of them is (White test) which is used

automatically when using programs like (E-views)

when detected by the program itself. From table (4)

part (B) p-value for white test is less than 0.05 for

both study models which means that the two study

models has homoscedasticity and the random error is

constant so the models are valid to be used.

4 Descriptive study

The first step in statistical analysis is descriptive

statistics for the study variables as mentioned in table

(5). After that in tables (6) and (7) we divided the firm

performance into firms with high performance and the

other with low performance based on the value of the

median to compare between firms according to

performance. In table (6) firms were divided to firms

with high T’Q (high performance) and firms with low

T’Q (low performance) which their T’Q value is less

than the median. When doing so we end up with two

samples and then we find the Mean and Standard

deviation for the characteristics of the firm (dividends,

ownership concentration, foreign ownership,

institutional ownership, managerial ownership) and

other control variables (company size, financial

leverage, company age, net income, EPS). To identify

the significance in the variance between the means of

the two samples t-statistic test and z-statistic tests

were used. The same can be said about table (7) where

performance was divided based on ROA

measurement.

In table (8), we looked at the other side, where

we divided the characteristics of the firm (ownership

concentration, foreign ownership, institutional

ownership, managerial ownership) into two parts

according to the median value and in each part the

mean and standard deviation was found to T’Q and

ROA values one at a time. Based on that we can

describe the study variables.


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Table 3. Normal Distribution and Time Series Stationarity Tests

Variable Normal Distribution: Jarque-Bera Test

Time Series Stationarity: Unit Root Test

J-B p-value Skewness Kurtosis ADF Test PP Test

Dependent variables: Tobin's Q 2.886

** 0.236 0.312 1.739 4.259

*** 6.211

***

Return on Assets 2.324**

0.313 0.625 3.178 4.870***

9.287***


Concentration ownership 11.181 0.004 1.263 4.132 6.370

*** 5.287

***

Foreign ownership 1.044**

0.593 -0.331 2.473 4.035***

3.874***

Institutional ownership 4.743

** 0.093 0.694 1.849 4.560

*** 4.225

***

Managerial ownership 3.658**

0.161 -0.771 2.634 6.741***

5.455***

Control variables:

Firm Size 5.456

** 0.065 -0.823 4.016 7.455

*** 5.292

***

Financial Leverage 3.452**

0.178 0.029 1.462 3.683***

4.032***

Firm Age 6.102 0.047 -0.227 2.297 5.677

*** 5.213

***

Net Income 2.461**

0.292 0.240 1.793 6.996***

11.826***

Earnings per Share 100.748 0.000 2.702 9.315 7.611

*** 18.358

***

Note: Distributor naturally at: **5%; ADF test Critical Value at 1% is 3.468; at 5% is 2.878; and at 10% is 2.575; Time Series Stationarity at: ***1%; **5%; and *10%

Table 4. Multicollinearity, Autocorrelation and Homoskedasticity Tests

Part A: Multicollinearity Test: Collinearity Statistics Test

Variables

Tolerance

VIF

Independent variables: Concentration ownership

0.804


0.560

1.785

Institutional ownership

0.461


0.897

1.115

Control variables: Company Size

0.725

1.379 Financial Leverage

0.831

1.204

Company Age

0.685

1.460 Net Income

0.669

1.495

Earnings per Share

0.793

1.261

Panel B: Autocorrelation and Homoskedasticity Tests

Model

D-W Test

White Test (p-value)

Model 1: Tobin's Q Model

0.722

2.570

(0.001)

Model 2: Return on Assets Model

1.614

2.407

(0.001)

Note: Durbin–Watson d Statistic at k=10, and n=210 is: dL 1.665 – dU 1.874

Table 5. Descriptive statistics of study variables

Variables

Label

Mean

Std. Deviation

Minimum

Maximum

Dependent variables: Tobin's Q

Tobin's Q

1.024

0.374

0.201

2.336 Return on Assets

ROA

3.713

31.357

-300.030

38.670


Concen

55.324

24.668

0.000


Foreign

28.632

27.133

0.000

94.510


Institutional

51.049

27.342

0.000


Managerial

4.525

11.087

0.000

47.140

Control variables: Company Size BD'000'000 Size

981

2,282

5

12,344

Financial Leverage

Leverage

0.428

0.293

0.001

0.934 Company Age

FirmAge

26

13

1

54

Net Income BD'000'000

Income

11

54

-315

212 Earnings per Share

EPS

-1.300

30.371

-422.240

79.924


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Table 6. The company characteristics depending on the level of performance measured by Tobin's Q

Variables

Companies with high Performance

Companies with low Performance

Difference

No. Obs.

Mean

Std. Deviation

No. Obs.

Mean

Std. Deviation

t-statistic

z-statistic


102

57.118

24.139

102

52.791

25.580

1.243

1.330**

(0.108)

(0.029)

Foreign ownership

101

26.085

26.126

98

30.615

28.004

-1.180

1.048

(0.120)

(0.111)


101

48.949

29.418

98

51.486

24.936

-0.655

1.233**

(0.256)

(0.048)

Managerial ownership

101

4.824

12.167

98

4.495

10.223

0.206

0.415

(0.418)

(0.498)

Control variables: Company Size BD'000'000 102

506

1,082

102

1,455

2,973

-3.028***

1.890***

(0.001)

(0.001)

Financial Leverage

102

0.463

0.286

102

0.393

0.298

1.714**

1.050

(0.044)

(0.110)

Company Age

102

28.520

12.704

102

22.176

11.799

3.695***

1.540***

(0.000)

(0.009)


102

14

57

102

8

51

0.872

2.030***

(0.192)

(0.000)

Earnings per Share

101

-3.084

42.716

102

0.485

4.777

-0.839

2.591***

(0.201)

(0.000)

Note: t-test and z-test top, p-value (bottom), one-tailed; Significance at: *10%; **5% and ***1% levels.

Table 7. The company characteristics depending on the level of performance measured by ROA

Variables



Difference

No. Obs.

Mean

Std. Deviation

No. Obs.

Mean

Std. Deviation

t-statistic

z-statistic


102

54.684

24.172

102

55.225

25.730

-0.155

1.330**

(0.439)

(0.029)

Foreign ownership

102

21.095

22.251

97

35.908

29.657

-3.998***

2.742***

(0.000)

(0.000)


102

45.193

28.681

97

55.462

24.760

-2.698**

1.613**

(0.004)

(0.006)


102

5.674

13.087

97

3.597

8.800

1.307***

0.700

(0.096)

(0.356)


107

Table 7. The company characteristics depending on the level of performance measured by ROA (continued)

Variables



Difference

No. Obs.

Mean

Std. Deviation

No. Obs.

Mean

Std. Deviation

t-statistic

z-statistic

Control variables: Firm Size BD'000'000 102

177

309

97

1,785

3,011

-5.365***

3.221***

(0.000)

(0.000)

Financial Leverage

102

0.289

0.232

97

0.566

0.284

-7.618***

3.361***

(0.000)

(0.000)

Firm Age

102

26.363

12.436

97

24.333

12.814

1.148

0.770

(0.126)

(0.297)


102

18

36

97

31

67

1.908**

3.221***

(0.029)

(0.000)

Earnings per Share

102

0.533

4.772

97

-3.132

42.712

0.861

3.711***

(0.195)

(0.000)

Note: t-test and z-test top, p-value (bottom), one-tailed; Significance at: *10%; **5% and ***1% levels

Table 8. Company performance measured by Tobin’s Q and ROA depending on characteristics of the company

Statistics

Concentration ownership

Foreign ownership



High Level

Low Level

High Level

Low Level

High Level

Low Level

High Level

Low Level

Descriptive

Tobin's Q

No. Obs.

99 105 98 101 99 100 25 174 Mean

1.005 1.042 0.982 1.068 1.062 0.989 0.896 1.04

Std. Deviation

0.312 0.425 0.402 0.351 0.421 0.329 0.325 0.38 Difference

t-statistic

-0.710 -1.613* 1.362* -1.840** p-value (t-test) (0.239) (0.054) (0.087) (0.034) z-statistic

1.318** 0.938 1.311** 0.969

p-value (z-test) (0.031) (0.171) (0.032) (0.152)

Descriptive

Return on Assets

No. Obs.

99 105 98 101 99 100 25 174 Mean

0.841 6.554 1.941 5.775 2.997 4.768 5.601 3.64

Std. Deviation

11.545 6.628 9.436 9.909 9.861 9.796 5.596 10.3 Difference

t-statistic

-4.365*** -2.794** -1.271 0.931 p-value (t-test) (0.000) (0.003) (0.103) (0.177) z-statistic

1.708** 2.301*** 1.463** 0.862

p-value (z-test) (0.003) (0.000) (0.014) (0.224)

Note: Significance at: *10%; **5% and ***1% levels.


108

Table 9. Company performance depending on industry sector

Variables

Banks

Investment

Insurance

Service

Industrial

Hotel-Tourism

F-statistic

Chi-Square

Dependent variables:

Tobin's Q

0.858

1.003

1.141

1.191

0.709

1.079

6.599***

36.707***

Return on Assets

0.804

-2.147

3.211

11.299

6.100

7.778

15.272***

86.734***



41.981 62.911 49.926

48.676

65.023

70.011

7.657***

31.859***

Foreign ownership

20.126 46.012 42.272

15.579

16.020

16.248

14.054***

49.056***


53.974

56.419

52.302

33.731

68.950

53.240

6.178***

23.201***


0.000 4.022 5.320

11.493

0.000

1.448

6.407***

29.208***

Firm Size BD'000’000 2,331 1,673 123 122 323 34 8.052***

106.699***

Financial Leverage 0.662 0.543 0.622 0.217 0.208 0.097 43.925***

106.832***

Firm Age 24.026 23.000 25.400 26.556 35.667 26.400 2.741**

18.872***

Net Income BD'000'000 24 3 2 16 21 3 1.106 13.649**

Earnings per Share 0.015 -4.750 0.029 0.067 0.042 0.030 0.200 30.552***

No. Obs.

40

60

25

45

15

25

Note: Significance at: *10%; **5% and ***1% levels


109

4.1 Company performance

Company performance was measured using T’Q and

ROA measurements. The Mean for T’Q was more

than (1) which gives a positive indication about the

value of companies listed in Bahrain Stock Exchange

as this means that it achieved a market value that is

higher than its book value. The lowest value of T’Q

was (0.201). The highest value was (2.336). The

highest T’Q was achieved by service sector while the

lowest value was achieved by industrial sector.

Regarding the second measurement (ROA), it had a

mean of 3.782% during the study period and the

standard deviation was very high which means there is

huge difference between companies in achieving

returns on their assets. Lowest (-45.4%) – highest

(24.34%). The highest ROA was achieved by service

sector and the lowest value was achieved by

investment sector. All these results may be found in

table (9).

4.2 Ownership concentration

In table (5) we notice that ownership concentration

“which was measured by dividing number of shares

owned by the largest investor by the total number of

shares owned by the largest five investors.” is 55.3%

with a very high standard deviation which means that

the sample is dispersed.

From table (6) we notice that ownership

concentration was higher in companies with high

performance as ownership concentration in companies

with higher performance (using T’Q measurement)

was 57% whereas ownership concentration in

companies with lower performance was 52.8%. This

difference was statistically significant at 5% according

to z-test while it was not according to t-test. This

means that whenever the performance of the company

increases, it attracts more investors who wish to

control the company to invest in it. Whereas if we

looked at table (8) where we divided concentration

into two parts according to the median value and then

we found the mean and standard deviation for the T’Q

values, we notice that T’Q values for companies with

low ownership concentration was higher than

companies with high ownership concentration. This is

an indication that ownership concentration does not

contribute in improving the company performance as

investors invest in companies with high performance

without working on improving and increasing the

company performance following their investment.

Industrial sector has the most concentrated ownership

and bank sector had the least as seen in table (9).


Foreign ownership was measured by the percentage of

shares owned by non - Bahraini investors in BSE.

From table (5) we notice that foreign ownership

percentage in BSE is 28.632% and the highest

percentage of foreign ownership was 94.51% that was

because Bahraini laws allow GCC citizens to invest

and own freely in the country while other companies

was with 0% foreign ownership. In table (6) we notice

that foreign ownership was less in companies with

higher performance using T’Q and ROA

measurements. And that difference was statistically

significant at less than 1% in performance using ROA

measurement but it wasn’t the same using T’Q. In

table (8) we notice that low percentage of foreign

ownership in companies is followed by lower

performance using both measures (ROA and T’Q) and

that was statistically significant using both measures.

Which indicates that foreign ownership and

performance has negative relationship in both

directions. Foreign ownership was the highest in

investment sector and the lowest in service and

industrial sector as seen in table (9).


Institutional ownership was the most form of

ownership presented in the Bahraini market. As 51%

of companies’ shares were owned by institutional

investors. In some companies, the percentage of

institutional ownership reached 94.5%. The relation

between institutional ownership and performance was

cleared out in table (6, 7) as we notice that

institutional ownership decreases in companies with

high performance and it increases in companies with

low performance and that difference was statistically

significant. Also it was found that companies with

high institutional ownership have lower dividend

yields with statistical significance while company

performance measured by T’Q increased when

institutional ownership increased. Institutional

ownership was the highest in industrial sector and the

lowest in service sector as seen in table (9).


Bahraini market may be characterized by the low

managerial ownership in its companies. The mean

percentage of this ownership dimension was 4.525%

meanwhile, the standard deviation was very high,

while in some companies, managers owned 47% of

the shares, and other companies presented 0%

managerial ownership according to the measurement

tool used in our study. Managerial ownership did not

differ in companies with high or low performance

using T’Q measurement while there was difference at

10% using ROA measurement as companies that

achieved high ROA was characterized by high

managerial ownership and vice versa, companies that

are characterized by high managerial ownership had

high ROA but that was not statistically significant.

Managerial ownership was the highest in service

sector and it reached 0% in bank and industrial sectors

as cleared out in table (9).


110

5 Empirical study

After validating the data used in our study using

statistical tests to ensure that this data goes with the

conditions of applying General Linear Model and

Ordinary Least Squares (OLS) as been cleared in the

section methodology. As data is considered as panel

data that combine time series (2007-2011) and cross

sectional data (42 companies). Based on that Pooled

Regression and the results of this test can be found in

table (10).

Table 10. Pooled Least Squares Regression Results

Variables

Pooled Least Squares

Model 1: Tobin's Q

Model 2: ROA

t-Statistic

p-value

t-Statistic

p-value


Constant

-0.174

0.863

0.190

0.850


1.427

0.161

-2.014**

0.045

Foreign ownership

0.538

0.594

-0.747

0.456


2.518**

0.016

-0.273

0.786


-1.742*

0.089

0.388

0.699

Control variables:

Firm Size

-1.833*

0.074

0.973

0.332

Financial Leverage

5.322***

0.000

-2.490**

0.014

Firm Age

0.327

0.745

1.137

0.257

Net Income

1.762*

0.080

5.568***

0.000

Earnings per Share

1.295

0.203

-0.263

0.793

Industry Dummy

5.284***

0.000

2.863***

0.005

R-squared

0.391

0.482

Adjusted R-squared

0.239

0.451

F-statistics

2.573**

15.320***

p-value (F-statistics)

0.017

0.000

No. of Observations

210

210

Note: t-Critical: at df 209, and confidence level of 99% is 2.326 and level of 95% is 1.960and level of

90% is 1.645; F-Critical (df for denominator n-β-1 = 210-10-1 = 199) and (df for numerator =β =11 and

confidence level of 99% is 2.34 and confidence level of 95% is 1.84 and confidence level of 10% is 1.6;

Significance at: *10%; **5% and ***1% levels.

The study hypothesis may be tested as follow:

5.1 Testing the first Sub-hypothesis; relationship between ownership concentration and performance

Ownership concentration is considered to be as one

dimension of ownership structure. Many studies

explored the effect of ownership concentration on

company performance. Morck et al. (1988), claimed

that the diffuseness of ownership would weaken the

monitoring power on management or it may be an

advantage to the management by not letting any block

shareholders control the firm in their favor against

minority shareholders. In both cases company

performance would be affected. Table (10) clears out

that the effect of ownership concentration on company

performance in Bahrain Stock Exchange using T’Q,

we notice that t-statistic was positive which indicate

the presence of a positive relation between

concentration and performance, nevertheless, this

relation was not statistically significant, where t-

statistic was less than the critical value and p-value

was more than 5%. This is consistent with what was

found by some researchers such as, (McConnell and

Servaes, 1990) when they found that there is a positive

but insignificant relation between the two variables.

And it is also consistent with (Perrini, Rossi and

Rovetta, 2008), when they indicated a positive effect

of ownership concentration on performance.

The relation between concentration and

performance using ROA, we notice that it was a

negative relation and statistically significant at less

than 5%. Which make us accept the hypothesis that

indicate that ownership concentration has a negative

effect on ROA. Which means that companies that has

high ownership concentration will have reduced ROA.

This result is consistent with (Abuserdaneh, Zureikat

and Al- Sheikh, 2010) where they found a negative

and statistically significant relation between

ownership concentration and performance in the

Jordanian market. But however our results contrasted

what was found in Nadia (2004) study which was

conducted on the Jordanian banks using ROA

measurement and it indicated that ownership

concentration did not affect performance.


111

5.2 Testing the second Sub-hypothesis; relationship between foreign ownership and performance

The effect of foreign ownership was studied by many

researchers like (Caves, 1996 and Kummar, 2003)

where they mentioned in their studies that usually

foreign investors buy shares in successful companies

and in some how they are expected to bring in the

most recent technologies to the firm thus they play an

important role in improving the performance in the

firms they invest in. In table (10), we notice that the

effect of foreign ownership on performance using T’Q

was positive, which is consistent with studies like (Bai

et al., 2005 , Sarkar and Sarkar , 2000 and Patibandle,

2002) and a negative effect on performance using

ROA model which consistent with studies like

(Solung and Nor, 2008). But both models failed to

find a statistically significant effect neither positively

nor nigativelly.

5.3 Testing the third Sub-hypothesis; relationship between institutional ownership and performance

Fama (1980), indicated in his study that institutional

ownership improves firm performance, many studies

like (Shleifer and Vishny, 1986) that institutional

ownership would affect performance in two ways: the

first one that it makes outside block shareholders

overcome the controlling managers and the second

one is: that it would reduce the free rider problem

which arise from the lack of shareholders control.

Institutional ownership is the most common form of

ownership structure in Bahrain Stock Exchange as

mentioned in the descriptive statistics section as they

own over 51% of the companies’ shares, but the

question here is does this type of ownership affects

performance? In table (10), we may see the regression

results where we can see the effect of institutional

ownership on performance using T’Q model, we

notice that it was a positive effect and statistically

significant at less than 5%. This result is consistent

with what was found in some studies like (Wan,

1990) and partially with what was found by others like

(Berger, 2003 and Sarac, 2002) where they found a

positive relation but with moderate statistic effect

between the two variable. Using ROA model, the

effect was negative and without any statistical

significance between institutional ownership and

performance. This result contrast what was mentioned

in the study of (Abuserdaneh, Zureikat and Al-

Sheikh, 2010) where the effect of institutional

ownership on performance was positive when using

ROA model.

5.4 Testing the fourth Sub-hypothesis; relationship between management ownership and performance

This dimension is related to the agency theory, as

when management owns a large portion of the firm, it

is expected to work in its own favor and when it owns

less portion, it is expected to work in the favor of the

firm itself. In Bahrain, although management

ownership percentage is minimal, there was a negative

effect with statistical significance at less than 10% on

performance using T’Q model which is consistent

with what was found by researchers like (Demsetz and

Villalonga, 1990 and Rowe and Davidson, 2002) and

a positive insignificant effect using ROA model which

is consistent with studies like (Severin, 2001 and

Kummar, 2003).

5.5 Testing the effect of control variables on performance

The findings of the study were conflicting regarding

the effect of company size on performance. We can

see in table (10) that company size has a negative

effect that is statistically significant at less than 1% on

performance using T’Q model. We can see also in the

same table that it has a positive effect that is not

statistically significant on performance using ROA

model.

The results were conflicting again. We noticed

that financial leverage has a positive effect with

statistical significance at less than 1% on performance

using T’Q model and a negative effect with statistical

significance at less than 5% on performance using

ROA. Although company age has a positive relation

with performance as seen in table (10) but it was not a

statistical significant effect on performance. The study

proved that net income has a positive significant effect

on performance using T’Q and ROA models. In table

(10), we can see that EPS has a positive insignificant

effect on performance using T’Q model and a negative

insignificant effect on performance using ROA model.

Our results confirmed that the sector that the

company belong to has a positive significant effect at

less 1% on performance. This is consistent with what

was mentioned previously in the descriptive statistics

which indicated that the performance of the company

is different according to the sector it belongs to.

5.6 Comparing the study models

To know which of the study models represents the

relation between the study independent variables

(ownership structure & dividends) and the dependent

variable (company performance), Adjusted R-

Squared was measured, as seen in table (10), which is

used to compare between the models of the study.

Whenever Adj. R2 increases this means that the model

represents the relation more. From table (10), we

notice that Adj. R2 for ROA model equal 45.1% and


112

for T’Q equal 23.9%. Based on that we may consider

ROA model represents the relation between variables

more. This is consistent with what was found by

previous studies such as Abu Serdaneh et. al. (2010) ,

where they used both models to measure performance

and they found that ROA model represents the relation

more but they indicated that this needs to be

confirmed by other studies that follow the same

methodology.

6 Conclusion and recommendation

The main objective of the study was; knowing what

really affect company performance. Four factors of

ownership structure were chosen and believed to be

from the most important factors that affect

performance. ownership structure were from the

earliest factors to be studied as (Berle and Means,

1932) were from the first researchers to study the

effect of ownership structure on performance. Few

studies were conducted in the Middle East and very

few or no studies were conducted about this topic in

the GCC area. In Bahrain, this is the first time that this

topic has been studied. So, this study is considered to

be the first study to cover this gap.

It is beneficial to know what really affects

company performance in this area and whether

ownership structure really affect performance. The

study also aimed at investigating the most common

type of ownership structure that presents in Bahraini

market. It also consider giving investors some hints

about what may be the best choice of companies to

invest in that achieve the best performance according

to the statistical analysis conducted by the study.

To conduct this study, the sample was chosen to

be the whole Bahraini Bourse which includes all the

listed companies in Bahrain Stock Exchange during a

period of 5 years from 2007 to 2011. Six companies

were excluded because they were either non-Bahraini

or closed during the study period. The study after that

considered ownership structure dimensions as

independent variables and company performance as

the dependent variable. Ownership structure was

studied from different dimensions. The dimensions

that were chosen to represent ownership structure

were: ownership concentration, institutional

ownership, foreign ownership and managerial

ownership. Several control variables were chosen

based on previous studies and what was believed to be

affecting the variables of the study. The study built

two different regression models to study the effect of

ownership on performance. The first model used

simplified Tobin’s Q formula as an indicator of

performance and the second model used Return on

Assets as an indicator of performance. The two

models were used to capture the differences between

them and justify the conflicting results found by

different previous studies and then we compared

between them using statistical tools to determine

which indicator is better to be used as an indicator of

company performance.

Different validity tests were conducted on data

and the models to validate them before testing them.

The data and the models were valid and any errors that

were found were overcome using statistical tools. Four

hypotheses were developed regarding the relation

between each independent variable (ownership

concentration, institutional ownership, foreign

ownership and managerial ownership) and company

performance. The models after that were tested and

some descriptive statistics were defined, the following

results were obtained:

a) The results of testing regression models were

conflicting depending on the performance indicator

that was used (T’Q or ROA).

b) The most common type of ownership

structure found in Bahraini market was institutional

ownership.

c) The most profitable sector that achieved the

highest profits during the study period was the bank

sector and the least one was.

d) The best performance using T’Q indicator

was achieved by service sector and the lowest was by

industrial sector. Using ROA, the highest performance

was achieved by service sector and the lowest was by

investment sector.

e) Ownership concentration was found to be

having positive effect but not statistically significant

on performance using T’Q indicator. And it has a

negative statistically significant effect on performance

using ROA measurement.

f) Institutional ownership was found to be

having positive and statistically significant effect on

performance using T’Q indicator. And using ROA

indicator, the effect was negative with no statistical

significance.

g) Foreign ownership was found to be having

positive effect using T’Q indicator and negative effect

using ROA indicator with no statistical significance

using both indicators.

h) Managerial ownership was found to be

having negative statistically significant effect on

performance using T’Q and a positive insignificant

effect using ROA indicator.

i) The effect of company size on performance

was found to be negative with statistical significance

using T’Q and a positive effect that is not statistically

significant using ROA indicator.

j) The effect of financial leverage on

performance was found to be positive and statistically

significant using T’Q and a negative effect that is

statistically significant using ROA indicator.

k) Company age was found to be having

positive effect with no statistical significance on

performance.

l) Net income was found to be having positive

significant effect on performance using ROA and T’Q

indicators.


113

m) EPS was found to be having positive effect

on performance using T’Q and a negative effect on

performance using ROA. Both effects were not

statistically significant.

n) Company sector was found to be having a

positive statistically significant effect on performance.

o) The best indicator of performance that was

used by the study was ROA over T’Q. As it was found

to be more related and it reflects the truth about

performance more than the other indicator as was

proved by statistical tests when the hypothesis of the

study were tested.

Based on the study results; Investors are strongly

encouraged to look at low debt companies when they

expect high profits. The study found that ownership

concentration affects performance negatively when

applying ROA indicator so lows that protect minority

shareholders and their rights are surely welcome.

The study is considered to be limited because it

studies performance in companies in a period of five

years only 2007-2011. This time series may be un-

stable because the global financial crisis occurred

during this period. Future studies may take longer and

different time series. The study was conducted in

Bahraini market and it is considered to be a small

sample to be studied and it is considered to be an

emerging market. Further studies may be conducted

on the whole GCC market, because the GCC

economies are considered to be having a lot of

similarities in lows and nature of economy. The study

found that ROA indicator is more representative and

related to performance. This needs to be confirmed by

other studies following the same methodology to

confirm what was found in our study or other data

needed to be known when applying the T’Q indicator

to correctly assess its relevance to performance.

Family ownership was not studied in our research

although it exists in Bahrain because of lack of data;

Bahrain Stock Exchange is encouraged to announce

the data that is related to family ownership so that its

effect on performance may be studied in future.

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115

EXAMINING THE RELATIONSHIP BETWEEN CEO REMUNERATION AND PERFORMANCE OF MAJOR

COMMERCIAL BANKS IN SOUTH AFRICA

Mahlomola Khumalo*, Andries Masenge**

Abstract The relationship between CEO remuneration and firm performance continues to receive much attention. Although the focus of most of the studies is across sectors, attention is increasingly being directed towards the banking industry. At the same time, controversy around what is deemed excessive remuneration of CEOs in the light of not so impressive firm performance across sectors continues. The 2008 global financial crisis and subsequent problems in the banking industry have increased interest in the dynamics of CEO remuneration and bank performance. This study, which examines the relationship between CEO remuneration and bank performance in South Africa, aims to bring a new perspective to the on-going research and debate. The data used is for the years 2008 – 2013, and a purposive sampling method was employed to select a sample frame that consists of five major commercial banks in South Africa. The results suggest that not all measurement instruments used confirmed that a relationship between CEO remuneration and bank performance existed. In the overall, the results of the study do show that the remuneration of the CEO in the banking industry is such that it does have a significant influence on the performance of a bank. Keywords: CEO Remuneration, Bank Performance, Regression, South Africa

*University of South Africa, South Africa **University of Pretoria, South Africa

1 Introduction

Concerns over incomes inequality and what is deemed

excessive - Chief Executive Officer (CEO)

remuneration - continues to feature prominently in the

executive remuneration discourse, and the 2008

financial crisis has made the situation in this respect

no better for the banking industry, in particular. The

controversy has escalated so badly that the assumed

excessive CEO remuneration is described as obscene

in some quarters (The Star, 2014:3). And CEO

remuneration in South Africa has not escaped

criticism. In fact, recently two CEOs from the banking

industry, in particular, caused a public outcry with

their pay which was for having been a mere nine

month in their top positions. This pay caused serious

discomfort amongst some industry role-players

because it could not be justified, more especially, from

a moral point of view, considering the situation in

South Africa where incomes inequality is such a major

talking point (Business Times, 2014:9).

Notably, the remuneration debate across

industries remains varied with a plethora of

viewpoints advanced within and outside of the

academic realm. Nonetheless, there has been

increased momentum to tackle this runaway problem

of CEO remuneration that is being partly blamed for

the global banking crisis of 2007 – 2008 (Gregg,

Jewell & Tonks, 2012). However, in South Africa,

where the payment gap between executives and

employees is the biggest in the world, efforts to arrest

the abnormal escalation have not been made due to the

absence of prescriptive measures by regulatory

authorities and lack of disclosure of sensitive but

essential information about key performance

indicators by the banks (Business Times, 2014), (The

Star, 2014:3). Unlike in South Africa, in the United

Kingdom (UK) and Australia, legislation imposes

binding shareholder votes when approving

remuneration policies, with the Australian model

demanding the removal of the board should its

remuneration policy be rejected by the shareholders

two years running (Business Times, 2014a:9 &

2014b:4).

Increased controversy surrounding and studies

on CEO remuneration and bank performance have

been approached from theoretical frameworks that

include but not limited to the examination of “agency

problem” by the likes of Barro and Barro (1990), Ely

(1991), Houston and James (1995), Hubbard and Palia

(1995), and Akhigbe, Madura and Ryan (1997).

“Managerial power” was found by Dorff (2005) to be

presenting a challenge to corporate governance

effectiveness in the determination of executive

remuneration (Crumley, 2008). A varied combination

of variables such as CEO compensation (plus long-


116

term incentive plans and CEO age) and size (total

assets and number of employees) of the organisation

(Gregoriou and Rouah, 2003); bonuses and attraction

and retention of executives (Beer and Katz, 2003);

executive equity (Daily and Dalton, 2002), and stock

based compensation and bonus (Hill & Stevens, 2001)

has also been used to build theoretical frameworks

used to examine CEO pay and organisational

performance. Crumley (2008) added to the discourse

with the use of firm-specific characteristics like

performance (stock market price and return on equity)

and size (sales, assets and number of employees)

together with CEO characteristics (age, tenure,

education and stock ownership). A search for related

South African studies has proven that not much

literature with these and other related approaches

existed.

The aim of this study, therefore, is to add to the

extant literature by means of examining the

performance of a sample of major commercial banks

in South Africa in relation to the pay plus bonus of

their CEOs. The significant distinguishing feature of

this study is the use of financial performance variables

that include profitability, efficiency and asset quality

measures relative to the CEO remuneration measures

such as basic pay plus bonus. Noticeably, CEO

characteristics have been deliberately excluded

because previous studies such as those by Crumley

(2008), Gregoriou and Rouah (2003), and Daily and

Dalton (2002) have significantly demonstrated that

they had weak or no association with CEO

remuneration.

The structure of the rest of this paper include

review of related literature, method used to conduct

the research, results drawn from the research, analysis

and discussion of the outcome of the research, and

conclusion and recommendations.

2 Review of related literature

It is imperative that the raging debate surrounding the

CEO pay and bank performance is clearly understood

lest the contribution of this paper is not fully

appreciated. The merits or the demerits of the

arguments advanced on the subject continue to evolve

over the years with the industry specific approach to

the debate proving to be more appropriate in helping

to identify the performance variables that are

important to the pay-performance relationship (Sigler

and Poterfield, 2001). In contrast, the approach that

pooled data from a cross-section of industries has the

shortcoming of using the same independent variables

for all companies regardless of industry uniqueness,

according to Sigler and Poterfield (2001).

Bank specific approach in various studies on

CEO remuneration and organisation performance have

commonly looked at the “agency problem”,

“managerial power”, firm-specific characteristics such

as performance (stock market price and return on

equity) and size (sales, assets and number of

employees), and CEO characteristics (age, tenure,

education and stock ownership). Accordingly,

Akhigbe, Madura and Ryan (1997), and Barro and

Barro (1990), among others, examined the difficulties

that were created by the goals of management which

were not aligned to those of shareholders and the

attempts of the banking industry at ameliorating those

difficulties (Crumley, 2008).

Dorff (2005), in his study of managerial power

as it relates to executive compensation, confirmed the

view that the power that the chief executive had over

the directors resulted in excessive compensation. This

scenario is certainly a poser to the independence and

effectiveness of the board. It is for this reason

therefore that the solution, as argued by Dorff (2005),

lies in part in the corporate governance reform that

curtails managerial power over directors through

competitive elections for directors (Crumley, 2008).

The study by Joyce (2001), which tested the

relationship between bank performance and CEO

compensation in publicly traded banks and savings

and loans institutions, gave mixed results. The study

found weak support for the agency theory as it relates

to the relationship between the performance of the

firm and CEO salary and bonus, and that there was a

small but positive relationship between the

performance of the firm and CEO salary and bonus

compensation. The generally weak correlation

between return on assets and CEO salary and bonus

compensation findings lend support to the findings of

other authors such as Murphy and Salter (1975) who

have not found a strong relationship between return on

assets and CEO salary and bonus compensation.

Furthermore, the study by Joyce (2001) was not able

to support the findings of Veliyath and Bishop (1995),

who found a strong relationship between stockholders

equity and executive compensation.

Gregoriou and Rouah (2003), besides finding

that CEO compensation increased with increasing

return on assets and no tenure effect on CEO

compensation, they found that CEO compensation

increased with the size of firm as well as with the

value of the long-term incentive plans and CEO age.

Studies by Gregg, Jewell and Tonks (2012), Aduda

(2011) and Crumley (2008), Hubbard and Palia (1995)

found that CEO compensation increased with the size

of the firm, and this supported the findings of

Gregoriou and Rouah (2003).

Studies that sought to examine the relationship

between firm performance and basic CEO pay plus

bonus have confirmed that in fact there was indeed a

relationship between bonuses and the motivation of

CEO. This hypothesis about bonuses and CEO

motivation is supported by Beer and Katz (2003)

where the use of bonuses is better explained as

possibly being the way to attract and retain executives

(Crumley, 2008). Furthermore, Hill and Stevens

(2001) found that in addition to stock based

compensation bonus plans contributed to a relative

increase in financial performance of the firm.


117

CEO remuneration package remain complex and

controversial. Evidence, at least in the context of

South Africa, does not exist that supports the view that

the bank CEO salary has been proven to be

appropriate let alone optimal. There must be other

considerations when structuring a bank CEO

remuneration package that are aimed at attracting,

retaining and motivating a talented CEO who would

work in the interests of the bank’s shareholders (Sigler

and Porterfield, 2001). The income inequalities that

exist in the country are making the determination of an

optimal remuneration package a challenge in the light

of competition for talent.

Most of the studies on bank CEO remuneration

seem to have taken little into account regarding how

the remuneration package of the CEO is initially

determined upon his entry into his current position. It

would not be farfetched to postulate that the

competition for talent or demand-supply

considerations do play a role in the determination of

the CEO remuneration package. However, it remains

to be seen if the remuneration package set at

recruitment or retention point is, in fact, optimal in

that it confirms the potential or actual contribution of

the CEO. Determining bonus payment may be

complicated but not as it is with the determination of

the entry-point basic salary of the bank CEO when

supply-demand for talent is taken into account.

Therefore, optimality assessment of the entry-point

basic salary ought to be considered in the subsequent

studies to counter the assertion, as advanced by Crotty

(Business Report, 2012), that the claim that the value

created by the company in the year under review

might not be attributable to extraordinary efforts and

talents of the CEO but the industry developments such

commodities boom, in case of a mining company;

consumption boom, in case of a retailer; or

government infrastructure spend in case of a

construction company. This then follows that the use

of the pre-existing remuneration package levels, as it

was the case with the previous studies, has the

potential to limit the methodological analysis of the

relationship between CEO remuneration and bank

performance. As Joyce (2001) hypothesised, the level

of CEO remuneration may be a function of such

factors as strategic concepts; industry characteristics

(e.g. barriers to entry and technological intensity), and

intra-organisational politics, and as such the level of

CEO remuneration may not be optimal as it is

assumed.

3 Methodology

The purpose of this paper was to examine the

relationship between CEO remuneration and financial

performance of the five major banks in South Africa.

Previously, various studies have advanced models that

examined the link between the two variables,

dependent (CEO remuneration) and independent (bank

performance). However, inconsistency prevails in

terms of both the CEO remuneration structure and

bank performance measurement methodologies. For

example, to mention a select few studies, Sigler and

Porterfield (2001) used CEO compensation as a

dependent variable and tenure, return on assets, beta

of the bank’s common stock and changes in revenue

as independent variables; Crumley (2008) used CEO

compensation (annual salary plus bonus) as a

dependent variable and independent variables that

include bank performance (stock market price return,

return on equity), size (sales, assets, number of

employees), and CEO characteristics (age, tenure in

present position, education, stock ownership by CEO);

Joyce (2001) used CEO compensation (annual salary

plus bonus) as a dependent variable with firm

performance characteristics (return on assets, CEO

tenure, CEO common stock ownership) as

independent variables, and Akhigbe, Madura and

Ryan (1997) used CEO compensation (annual salary,

bonus, stock options) as a dependent variable and

independent variables that include firm-specific

characteristics (size), bank performance (earnings per

share, return on assets, return on equity) and CEO-

specific characteristics (age, tenure, education, CEO

stock ownership).

The challenge of having consistency in the

choice and type of measures or indicators of both CEO

compensation and bank performance was also pointed

out by other authors like Lin and Zhang (2009), Choi

and Hasan (2005) and Berger et al (2005) who used

such measures as profitability [return on assets

(ROA) and return on equity (ROE)], efficiency [cost

to capital (COI)], and asset quality [ratio of impaired

loans to gross loans (also known as non-performing

loans or NPL)] in their works (that also looked at

governance in the banking sector, though). Barnes

(1987) and Al-Shammari and Salimi (1998) in their

related earlier works, according to Al-Hawari and

Ward (2006:136), raised similar concerns about the

problem of not having “generally accepted list of

ratios or standard methods to measure financial

performance”.

However, profitability, efficiency and asset

quality indicators are used in this study as measures of

bank performance. Other bank characteristic, size,

which includes sales, assets and number of employees,

is used contemporaneously with the aforementioned

bank performance measures.

In this study, the chosen CEO remuneration

measures or indicators deliberately excluded deferred

remuneration benefits such as retirement benefits

(pensions, provident funds and retirement annuities),

profit sharing and stock options. This was so because,

according to Joyce (2001), it was pointed out by Kerr

and Bettis (1987) and Finkelstein and Hambrick

(1989) that valuation of long-term incentives was

problematic in terms of practicability and

methodology considerations. This means that CEO

remuneration herein is defined as basic annual salary

plus bonus because this allows for comparability with


118

other studies of executive remuneration as the

majority of previous studies limited CEO

remuneration to cash payments (Agarwal, 1981 and

Joyce, 2001). Lewellen and Hunstman (1970),

according Joyce (2001), in their study of managerial

pay and company performance, indicated that salary

plus bonus that was used as a measure of executive

remuneration in a regression analysis was an

acceptable substitute for a more comprehensive

measure of remuneration which includes pension

benefits, stock options, stock bonus, profit sharing and

deferred pay.

Furthermore, to obviate the problem of

inconsistency and to ensure comparability, in this

study, CEO characteristics (age, tenure in present

position, education, stock ownership by CEO) have

been excluded. Gregoriou and Rouah (2003) pointed

out that tenure had no effect on bank performance.

Similarly, Crumley (2008), in his regression analysis,

found that bank CEOs in the US were not paid for

their tenure, age, educational level or stock ownership.

Furthermore, Daily and Dalton (2002), in their earlier

study, stated that equity ownership had no effect on

bank performance.

3.1 Data, variables and model

3.1.1 Data

A purposive sampling method was used to generate a

sampling frame that consist of the five largest

commercial banks in South Africa in terms of assets

and market share. These are the banks with the largest

geographic footprint coupled with the most

comprehensive financial services offerings in the

country, unlike the other banks which are largely

niche-based. The research design of this study makes

use of the data that comprises of bank specific

performance characteristics and bank CEO

remuneration schemes. The data collected is for a

period of five years from the year 2009 to 2013. This

is a period of the beginning of relative stability

immediately after the global financial crisis of 2008. A

five-year time-scale is consistent with cyclical reviews

usually carried out by banks as seen in their reports.

3.1.2 Variables

As previously alluded to the bank performance

measures of profitability, efficiency, size and asset

quality are used as independent variables. Return on

equity (ROE), defined as the rate of return to

shareholders or the percentage return on each Rand of

equity invested in the bank, and return on assets

(ROA), another measure of profitability, are used as

independent variables. The choice of ROE was

motivated by what Kumbirai and Webb (2010)

describe as “the most important indicator of a bank’s

profitability and growth potential”, where Cronje

(2007) asserts it could be regarded as the “ultimate

measurement of profitability”. Noting from previous

studies, Bradley (2013), wrote that ROE, has been

criticized for being open to manipulation by

management due to the fact that it was a mere

accounting figure although it logically remained the

most enduring and popular as its focus was on

shareholder returns - which happened to be of primary

importance to the investor.

ROA, on the other hand, was used

contemporaneously as a measure of profitability

because it was found, according to Sigler and

Porterfield (2001), to be the most comprehensive

standard in the determination of bank profitability. Lin

and Zhang (2009:23) and Ahmed (2009) in Kumbirai

and Webb (2010:39) defined ROA as profits relative

to total assets or the ability of management to acquire

deposits at a reasonable cost and invest them in

profitable investments. This additional profitability

measure was introduced with the view to making the

study more complete (Bradley, 2013).

Firm size is described by Crumley (2008) and

various other studies as having one of the most

important influences on remuneration. However, in

this study firm size is measured by the value of total

assets, level of sales or revenue and number of

employees. Total assets measure is used in order to

take into account the presumed contribution of the

CEO in the totality of the performance of the firm.

Cost to income (COI), defined as income

generated per Rand cost, was used as a measure of

efficiency as explained by Kumbirai and Webb (2010)

and asset quality measure, the ratio of impaired loans

to gross loans or non-performing loans (NPL, as

explained by Lin and Zhang (2009), were the other

independent variables used in this study.

The CEO remuneration comprising of annual

basic salary plus bonus was the dependent variable

being examined in relation to the bank performance

variables. As already pointed out basic salary and

bonus were selected as the only bank performance

measures to constitute the dependent variable in order

to obviate issues of complexity and calibration of

remuneration. Both salary and bonus are in cash.

3.1.3 Model

As already stated the study focuses on examining the


performance and the attendant regression model

specification involving a dependant variable and

independent variables. The specified variables include

annual basic salary plus bonus, representing the

remuneration, and ROA, ROE, COI, NPL and size

constituting performance.

The basic regression model is formulated as

follows:

Dependent variable (Annual Basic Salary plus

Bonus) = Independent variables (ROA, ROE, COI,

NPL, Assets, Sales, Employees)


119

3.1.4 Hypothesis

The hypotheses used by Crumley (2008) in his related

study were modified as specified below to test for the


performance:

HO: 1 – A positive relationship does not exist

between a return on assets (ROA) and CEO

remuneration (basic salary plus bonus).


between a return on equity (ROE) and CEO



between the rate of cost to income (COI) and CEO



between the non-performing loans (NPL) [or rate of

impaired loans to gross loans] and CEO remuneration

(basic salary plus bonus)


between total assets and CEO remuneration (basic

salary plus bonus)


between sales [or revenue] and CEO remuneration



between number of employees and CEO remuneration


Since the focus of this study is on the

relationship between remuneration and performance

these hypotheses were tested using linear least squares

regression analysis. The regression analysis was used

to predict CEO remuneration based on bank

performance.

4 Results

In this section the statistical techniques employed to

analyse and interpret the sample data are discussed

and the results are outlined.


Variables N Mean Median Std. Deviation Minimum Maximum

CEO Total Remuneration (Rand

in thousands) 25 13025.03 11162.00 6825.37 5079 34410

Return on Equity (ROE) (%) 25 17.26 16.34 4.95847 9.7 28.66

Total assets (Rand in millions) 25 586120.00 674000.00 310312 9000 1016000

Return on Assets (ROA) (%) 25 1.92 1.07 1.84191 0.68 6.21

Cost to Income (COI) (%) 25 54.36 57.63 7.29253 32.26 63.35

Non-performing loans (NPL) (%) 25 5.46 5.41 1.48977 2.79 8.67

Sales/Revenue(Rand in millions) 25 9587.16 8957.00 6087.282 449 21527

Number of employees 25 32008.36 34904.00 15015.63 4154 53351

Table 1 shows the descriptive statistics for

sample banks for the period 2009-2013. The final

sample for 2009-2013 comprised of 5 major

commercial banks which resulted in 25 observations.

The mean remuneration (basic salary plus bonus) of

the CEOs was R13,025,030. The mean return on

equity (ROE) and return on assets (ROA) for the

period was 17.6% and 1.92%, respectively. The mean

total assets was R586,120.00 million while the mean

sales/revenue was R9,587.16 million. The mean

number of cost to income (COI) was 54.36% whereas

non-performing loans (NPL) had a mean number of

about 5.46%. The mean number of employees was

32008.

It is evident from the above results that there are

large variations among the variables. CEO total

remuneration varies from a minimum of R5,079,000

to a maximum of R34,410,000. Return on equity

varies from 9.7% to 28.66% whilst return on assets

varies from 0.68% to 6.21%. Total assets has a

minimum of R9,000 million and a maximum of

R1,016,000 million. Cost to income ranges between

32.26% and 63.35% whilst non-performing loans

range between 2.79% and 8.67%. Sales/revenue are

between a minimum of R449 million and a maximum

of R21,527 million. Last but not least, the number of

employees varies between 4154 and 53351. Although

these variations show that there are significant

differences between the smallest and largest values,

they do not give reasons for the variability of the

values.

4.1 Regression analysis

To examine the relationship between CEO

remuneration and bank performance, regression

analysis was used. Specified, select bank performance

measures (return on equity, total assets, return on

assets, cost to income, non-performing loans,

sales/revenue and number of employees) were used to

predict CEO remuneration. CEO remuneration in the

regression is the dependent or response variable and

the specified select bank performance measures are

the independent or predictor variables.


120

HO1: A positive relationship does not exist

between a return on assets (ROA) and CEO


Hypothesis 1 test if there is a positive

relationship between return on assets and CEO

remuneration (basic salary plus bonus). Table 2

depicts the results of the test that was run to respond to

hypothesis 1 (Ho1). The correlation coefficient

between ROA and CEO remuneration is (r=0.248)

with r-square (R2

= 0.062) in table 2 which implies

that ROA explains 6.2% (R2

*100) variation of the

remuneration. The relationship between ROA and

remuneration is not significant at 5% critical level

(p=0.231 > 0.05). A p-value that is at 23.1% suggests

that changes in ROA are not associated with changes

in the CEO remuneration. In other words, a positive

relationship does not exist between a return on assets

and CEO remuneration. Hypothesis 1 is therefore not

rejected.

Table 2. Regression analysis: The independent variable is the returns on assets (ROA) and dependent

variable is the CEO remuneration (basic salary plus bonus). Model Summary

Model R R Square Adjusted R Square Std. Error of the Estimate F Sig.

1 .248 .062 .021 6753.824169 1.511 .231

H02: A positive relationship does not exist

between a return on equity (ROE) and CEO


Hypothesis 2 test if there is positive relationship

between ROE and CEO remuneration (basic salary

plus bonus). Table 3 depicts the results of the test that

was run to respond to hypothesis 2 (Ho2). The

correlation coefficient between ROE and CEO

remuneration is (r=0.108) with r-square (R2

= 0.012)

in table 3, which implies that ROE explains 1.2% (R2

*100) variation of the remuneration. The relationship

between ROE and remuneration is not significant at

5% critical level (p=0.6091 > 0.05). A p-value that is

at 60.9% suggests that changes in ROE are not

associated with changes in the CEO remuneration. In

other words, a positive relationship does not exist

between a return on equity and CEO remuneration.

Hypothesis 2 is therefore not rejected.

Table 3. Regression analysis: The independent variable is the returns on equity (ROE) and

dependent variable is the CEO remuneration (basic salary plus bonus). Model Summary


1 .108 .012 -.031 6931.677107 .269 .609

HO3: A positive relationship does not exist

between the rate of cost to income (COI) and CEO


Hypothesis three test if there is a positive

relationship between COI and CEO remuneration

(basic salary plus bonus). Table 4 depicts the results of

the test that was run to respond to hypothesis 3 (Ho3).

The correlation coefficient between COI and CEO


= 0.096)

in table 4 which implies that ROE explains 9.6% (R2


between COI and remuneration is not significant at

5% critical level (p=0.132 > 0.05). A p-value that is at

13.2% suggests that changes in COI are not associated

with changes in the CEO remuneration. In other

words, a positive relationship does not exist between a

cost to income and CEO remuneration. Hypothesis 3

is therefore not rejected.

Table 4. Regression analysis: The independent variable is the cost to income (COI) and dependent



1 .310 .096 .057 6629.317080 2.441 .132


between the non-performing loans (NPL) [or rate of

impaired loans to gross loans] and CEO remuneration



relationship between NPL and CEO remuneration

(basic salary plus bonus). Table 5 depicts the results of

the test that was run to respond to hypothesis 4 (Ho4).

The correlation coefficient between NPL and CEO


= 0.428)

in table 5 which implies that NPL explains 42.8% (R2


between NPL and remuneration is significant at 5%

critical level (p=0.000 < 0.05). A p-value that is at

0.0% suggests that changes in NPL are associated with

changes in the CEO remuneration. In other words, a

positive relationship does exist between non-

performing loans and CEO remuneration. Hypothesis

4 is therefore rejected.


121

Table 5. Regression analysis: The independent variable is the non-performing loans (NPL) and

dependent variable is the CEO remuneration (basic salary plus bonus). Model Summary


1 .654 .428 .403 5274.091007 17.195 .000


between total assets and CEO remuneration (basic

salary plus bonus)


relationship between total assets and CEO

remuneration (basic salary plus bonus). Table 6

depicts the results of the test that was run to respond to

hypothesis 5 (Ho5). The correlation coefficient

between total assets and CEO remuneration is

(r=0.346) with r-square (R2

= 0.120) in table 6 which

implies that total assets explains 12.0% (R2

*100)

variation of the remuneration. The relationship

between total assets and remuneration is not

significant at 5% critical level, but it is significant at

10% level (p=0.090 < 0.10). A p-value that is at 9%

suggests that changes in total assets are associated

with changes in the CEO remuneration. In other

words, a positive relationship does exist between total

assets and CEO remuneration. Hypothesis 5 is

therefore rejected.

Table 6. Regression analysis: The independent variable is the total assets and dependent



1 .346 .120 .082 6540.648414 3.135 .090


between sales [or revenue] and CEO remuneration


Hypothesis 6 test if there is positive relationship

exists between Sales and CEO remuneration (basic

salary plus bonus). Table 7 depicts the results of the

test that was run to respond to hypothesis 6 (Ho6). The

correlation coefficient between Sales and CEO


= 0.306)

in table 7 which implies that Sales explains 30.6% (R2


between Sales and remuneration is not significant at

5% critical level (p=0.004 < 0.05). A p-value that is at

4% suggests that changes in sales [or revenue] are not


other words, a positive relationship does exist between

sales [or revenue] and CEO remuneration. Hypothesis

6 is therefore rejected.

Table 7. Regression analysis: The independent variable is the sales [or revenue] and dependent



1 .553 .306 .275 5809.927094 10.122 .004


between number of employees and CEO remuneration


Hypothesis 7 test if there is relationship between

number of employees and CEO remuneration (basic

salary plus bonus). Table 8 depicts the results of the

test that was run to respond to hypothesis 7 (Ho7). The

correlation coefficient between number of employees

and CEO remuneration is (r=0.246) with r-square (R2

= 0.060) in table 8 which implies that employees

explains 6% (R2

*100) variation of the remuneration.

The relationship between number of employees and

remuneration is not significant at 5% critical level

(p=0.237 > 0.05). A p-value that is at 23.7% suggests

that changes in the number of employees are not


other words, a positive relationship does not exist

between the number of employees and CEO

remuneration. Hypothesis 1 is therefore not rejected.

Table 8. Regression analysis: The independent variable is the number of employees and dependent variable is

the CEO remuneration (basic salary plus bonus). Model Summary


1 .246 .060 .019 6758.576667 1.477 .237

The following Table 9 is a summary of

regression results of hypotheses 1 to 7. The results are

based on the 5% significant level and 10% significant

level.


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Table 9. Summary of Findings

Hypothesis Variable tested Methodology Results

H01 Return on assets (ROA) and CEO remuneration Regression Accept Null

H02 Return on equity (ROE) and CEO remuneration Regression Accept Null

H03 Cost to income (COI) and CEO remuneration Regression Accept Null

H04 Non-performing loans (NPL) and CEO remuneration Regression Reject Null

H05 Total assets and CEO remuneration Regression Reject Null

H06 Sales [or revenue] and CEO remuneration Regression Reject Null

H07 Number of employees and CEO remuneration Regression Accept Null

A regression analysis was employed with the

view to predicting CEO remuneration based on bank

performance. This procedure was used to either accept

or reject the Null Hypothesis. Null hypothesis one,

two, three and seven were accepted. Conversely, null

hypothesis four, five and six were rejected.

5 Limitations of the study and suggestions for future research

It is acknowledged that this study, same as it is the

case with other studies, this study is limited in its

theoretical, methodological and empirical domains

(Joyce, 2001). It is recognised that the sample

consisted of only five major commercial banks. There

is a possibility that the findings might differ if the

research focused on a random sample of all registered

publicly traded banks.

Similarly, in its definition of CEO remuneration

(basic salary and bonus), this study did not include

deferred forms of compensation such as stock options,

stock bonus, pension and other long deferred forms of

compensation (Joyce, 2001). As Joyce (2001) also

pointed out, previous studies such as that by Lewellen

and Hunstman (1970) have shown that cash

compensation (salary plus bonus) is acceptable

substitute for a more comprehensive measure of

compensation that includes pension benefits, deferred

pay, stock options, stock bonus, and profit sharing.

With a bigger sample, variations in compensation

structures might be more pronounced and thus making

cash compensation (basic salary plus bonus) approach

not acceptable. Future studies should, therefore, focus

on a more comprehensive measure of compensation

that includes pension benefits, deferred pay, stock

options, stock bonus and profit sharing. It is possible

that a study that uses a more comprehensive measure

of compensation could provide valuable insight into

the relationship between executive compensation and

company performance (Joyce, 2011).

Another limitation of the study is that regression

or correlation analyses cannot be interpreted as

establishing cause-and-effect relationships. A more

comprehensive study using a larger sample, longer

study period, characteristics of CEO of major

commercial banks and peripheral factors such as

human capital characteristics, industry characteristics

and intra-organisational politics which might give

different results must be considered.

6 Conclusions and recommendations

Some extant empirical research supports the view that

agents such as CEOs can influence the behaviour of

their employees, and therefore, the performance of

their firms (Joyce, 2001). Based on this agency theory,

it would be in order to expect some level of

association between certain firm specific factors and

CEO remuneration. However, the results of this study,

which examined the relationship between CEO

remuneration and the performance of the largest five

commercial banks in South Africa, have proven to be

not entirely consistent with the hypothesis that there

was a relationship between bank specific performance

measures and CEO remuneration.

The results of the analysis have revealed that a

positive relationship between CEO remuneration

(basic salary and bonus) and bank performance as

measured by return on assets (ROA) does not exist.

This finding is very close to the findings of other

authors such as Murphy and Salter (1975); Aupperle,

Figler, and Lutz (1991); Akhigbe, Madura, and Tucker

(1995); Madura, Martin, and Jessel (1996), and Joyce

(2001) who have not found a strong relationship

between return on assets and CEO remuneration.

Accordingly, this study failed to support the findings

of such authors as Lilling (2006) and Canarella and

Gasparyan (2008) whose studies, though not specific

to the banking industry, also used ROA as a measure

of firm performance but found a positive relationship.

The number of employees, return on equity

(ROE) and cost to income (COI) have also been found

to be insignificant in predicting changes in the CEO

remuneration. In other words, association between

CEO remuneration and number of employees, ROE

and COI does not exist. The fact is that, in this study,

no association existed between CEO remuneration and

number of employees and this contrasts with the

findings of the study by Joyce (2001) who found

instead that a strong relationship existed. CEOs in the

banking industry in South Africa were not paid for the

number of employees, level of return on equity and

costs incurred for income generated.

Non-performing loans (NPL), total assets and

sales or revenue indicate that a relationship with the

CEO does exist. CEOs in the major commercial banks

in South Africa were compensated for positively

managing non-performing loans and increasing total

assets and sales or revenue.


123

This study contributed to the literature in the area

of executive compensation by examining the

association between CEO remuneration and

performance for a select number of generally accepted

measures for major commercial banks, designated as

such in terms of size (assets and turnover/revenue). In

addition, the study has brought to the fore the

significance of non-performing loans (NPL) as

predictor variable of CEO remuneration which should

be included in future research.

Although no positive relationship was found

between CEO remuneration and bank performance as

measured by return on assets, return on equity and

cost to income, these variables remain important

factors in managerial and organisational performance

and investor relations. It remains important for

management to ensure that assets utilisation is

maximised in order to yield a good return for the

benefit of shareholders and other stakeholders such as

bank employees.

The variable, number of employees in the

organisation, as a predictor of CEO remuneration

remains contentious. Not enough research exist that

support the idea that CEOs in the commercial banking

industry were paid for the number employees in their

organisations.

Lastly, there continues to be a lot to learn about

the determinants of CEO remuneration, as indicated

by the above suggestions for future research.

However, it is hoped that other researchers will

address some of these issues in future research.

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THE EFFECTS OF BUSINESS GROUP CONTROL ADVANTAGES AND AFFILIATE LEVEL ADVANTAGES ON

AFFILIATE PERFORMANCE☆

Roderick Bugador*

Abstract

This study views the network of control in a corporate business group as its source of competitive advantages. These control advantages are distributed among the business group affiliates and eventually influence their performance. This paper examines this by providing a reconceptualization of both the nature of business group and affiliate level advantages using the data of the top 20 Philippine corporate groups. The study found out that the group level control advantage affects the affiliate performance more than their individual level advantages. This result confirms the capability of business groups to influence and control their group internal market. This also implies that the business group affiliates have not yet developed significant capabilities which are independent to that of their business group. Keywords: Corporate Groups, Business Group Advantages, Affiliate Level Advantages, Business Group Affiliation, Director Interlocks, Network Analysis *College of Economics and Business, Hankuk University of Foreign Studies, 81 Oedae-ro, Mohyeon-myeon, Cheoin-gu, Yongin-si, Geonggi-do, 449-791 Korea Tel: +82313304773 *This work was supported by Hankuk University of Foreign Studies Research Fund of 2015

1 Introduction

The empirical thrust in the existing business group

literature has been centered around confirming if

business group affiliation enables firms to perform

better than their non-business group counterparts with

the assumption that affiliation to business groups (here

also abbreviated as BG or BGs) confer advantages,

especially in developing or emerging economies

(Carney et al., 2011; Khanna, 2000; Khanna and

Palepu, 2000). In other words, the objective is to

explain whether the business group affiliation is more

efficient than non-business group affiliation thereby

alluding to the concept of business group advantages

in the outcome perspective. However, this traditional

approach offers a rather limited explanation in our

understanding on the question of how and when is

actually the nature of the competitive advantages of

business groups, let alone its performance and

characteristics, without comparing them to non-

business groups or standalone firms. The conventional

belief is that the business group advantages are easily

endowed as long as the firm is affiliated with the

business group.

This paper argues that business group affiliation

does not necessarily guarantee the premium of

business group advantages as affiliation and

advantages are not the same thing. The business group

affiliation provides legitimacy of an affiliate

belonging to a business group but may not function

towards the operationalization and creation of

business group advantages. This is because the

business group advantages are not always endowed

but also built by the affiliates owing to their specific

operational circumstances and individual firm-level

capabilities (Mahmood et al., 2011). In other words,

there is an interplay between the advantages that are

found at the group level and those that are derived

from the affiliate level (Birkinshaw and Hood, 1998).

Therefore, the previous literature fails to recognize the

extent to which the individual affiliates operationalize

the business group advantages by discounting the

contribution and heterogeneity of the affiliates within

the business group (Choo et al., 2009).

This paper contributes to the above discussion by

incorporating transaction cost economics, resource-

based view and social network, and reconsiders the

value of the prevailing assumptions between the

relationship of business group advantages and affiliate

performance. This paper also holds that the analysis of

the advantages of business groups is only valid if the

nature of these advantages is known and justly

measured empirically, especially when comparing to

non-business group firms. Thus far this has not been

fully reconciled in the existing literature (Carney,

2008; Delios and Ma, 2010). Hence, the previous

studies which compare BGs to non-BGs remain

problematic at this point.


126

In addressing the issues above the succeeding

sections are organized as follows. It begins with a

review on the theoretical underpinnings of business

groups and their competitive advantages, dubbed here

as the business group advantages or BGAs. This is

followed by a conceptual framework and hypotheses

which explains the performance at the affiliate level,

not through their mere affiliation with the business

group but by the extent to which they explore and

exploit the business group advantages of their business

group according to their network position. The

framework points to the role and heterogeneity of the

affiliates in combining the advantages that are specific

to the group and those individual strengths or the

affiliate level advantages which eventually lead to the

variation in their individual affiliate level

performance. This is examined using the case of the

top 20 business groups from the Philippines. Lastly,

the later sections provide the discussion and

theoretical implications of the study. Their

applications are related to the context of diversified

business groups in developing or emerging economies.

2 Theory and hypotheses 2.1 The nature of business group advantages

The dynamics of the advantage of the business group

structure are different from that of the typical single

firm or standalone firms. These are both in cognitive

and functional dimensions (Dyer and Singh, 1998;

Lavie, 2006; Prahalad and Bettis, 1986). Historically,

these advantages stem from the response to specific

country characteristics, such as market imperfections,

and the managerial capabilities of the affiliate firms.

They epitomize the capabilities to control or manage

multiple portfolios or a group internal market within a

complex environment such as the emerging economies

(Chang and Choi, 1988; Rugman, 1981). They are a

summation of knowledge that has been internalized,

owned and controlled by the business group over time

(Chang and Hong, 2000; Demsetz, 1988; Dierickx and

Cool, 1989). The resulting structure of business group

advantages are found and distributed among the

affiliates in the business group (Heugens and

Zyglidopoulos, 2008). As the sources of advantages,

such as knowledge and experience, are controlled as a

group, business group advantages accrue exclusively

to business group affiliated firms (Chang and Hong,

2000).

Within the literature, there are three generic

components when describing the control structure of

business group advantages. These advantages are:

Firstly, reduced transactions costs through the group

internal capital, labor, internal buying and selling and

market information search. The business group

advantages on transaction costs clearly explain the

incentive of reducing the risks and costs for searching

or developing information and advantages in the

external market (Hennart, 1982; Li et al., 2006;

Williamson, 1973). The business group structure

provides an array of internal resources which an

affiliate can exploit. For example, internal group

capital is a very good source of capitalization for

affiliates during investments, including foreign

investments, and expansion (Gonenc et al., 2007). In

the developing and emerging economies, capital

market functioning is not only inefficient but

oftentimes missing. Secondly, transferable group

managerial skills and experience in product and

geographical diversification, contacts and

intermediation capabilities, and state relations. The

business group advantage on group managerial skills

and experience provides a combination of context

specific and transferable skills among BG affiliates

(Kock and Guillén, 2001; Tan and Meyer, 2010).

Amsden and Hikino (1994)argue that the repeated

industry-entry patterns of business groups are realized

because of their ‘contact capabilities’ with the state

and foreign multinationals, followed by ‘project

execution capabilities’. According to them, these

project execution capabilities refer “to the skills

required to establish or expand operating and other

corporate facilities, including undertaking pre-

investment feasibility studies, project management,

project engineering, procurement, construction and

startup operations”. These capabilities are generic to

business groups and not industry-specific. They are

difficult to trade because they are embodied in the

organisation’s owners, managers, and routines (Amit

and Schoemaker, 1993; Penrose, 1959). Thirdly,

economies of scale and scope such as allocation and

co-development of resources in the area such as in

R&D/technology and marketing and distribution,

group brand and reputation. These are the generic

advantages of multi-unit organizations such as the

business groups, which can use leverage in their

multiple portfolio operations (Chandler, 1990; Colpan

and Hikino, 2010).

2.2 The affiliate level advantages

The concept of business group control advantage

explains the kinds of advantages which are found at

the group level but it does not explain all the potential

advantages that are found at the individual affiliate

level. Some research on interorganisational networks

have identified that individual nodes have very

specific qualities compared to the entire network

(Ahuja et al., 2012; Jones et al., 1997). These specific

qualities, such as capabilities, directly affect the

performance of the focal affiliates (Mahmood et al.,

2011). Hence, with regards to advantages, what

individual business groups affiliates have are both the

subset of the BGAs and affiliate level advantages

(here also abbreviated as ALAs). Both, or their

interactions, explain the outcome, such as

performance of business group affiliates and

eventually the whole business group. By building on


127

BGAs, affiliate firms can develop specific advantages

independently. These advantages are unique resources,

capabilities and strengths specific to an affiliate firm.

This BGAs and ALAs bundle is a function of the

recombination capabilities by the individual affiliates

(Teece et al., 1997; Verbeke, 2009). This bundle

defines the overall advantage of each individual

affiliate as well as the heterogeneity of the affiliates

within a business group. The variance among the

advantages of the affiliates occurs due to the level and

extent of BGA operationalization by each affiliate

where some affiliates operationalize or depend on

BGAs greater than others. The reason is that each

affiliate has specific objectives, roles, operational

scope and performance. Hence, the affiliates can use

the business group structure to complement the

missing and potential advantages.

2.3 The performance of business groups and their affiliates

The performance of business groups is one of the most

important issues in the literature (Colpan et al., 2010).

It includes the different levels of analyses particularly

at the macro and micro levels. At the macro level,

business group performance is examined based on its

role in the economic development and value adding

activities in the economy (Khanna and Yafeh, 2007;

Sargent and Ghaddar, 2001). These are apparent in the

development of human resources, industrial technology

and production of the most valuable goods in the

economy. On the other hand, the micro level BG

performance as an enterprise whether an affiliate or the

group aggregate level remains a puzzling topic to many

researchers (Buysschaert et al., 2008; Khanna and

Rivkin, 2001; Singh et al., 2007). Thus far, the

comparison between the financial performance of

business groups to non-business groups provide an

inconclusive result. The real issue, perhaps, is not about

the comparative value of the performance of business

groups against other firms but understanding what is

actually driving the performance of business groups

internally.

In this paper, the analysis is set at the BG

affiliate level rather than at the group level as depicted

in Figure 1. The rationale behind this approach are as

follows. The nature of the performance of a business

group, or the group-level performance, is too complex

to measure (Carney et al., 2011). In general the

financial performance of business groups, such as in

the accounting related performance, the direct measure

is the total performance of all the affiliates in the

group. However, the problem here is that most of the

affiliates declare and produce individual financial

statements. Hence, the consolidation of these can be a

challenge not mentioning that some of the issues such

as profit allocation, transparency and pyramiding

mechanisms employed by some business groups

(Faccio et al., 2010; Mevorach, 2009). Therefore,

looking at the performance at the affiliate level is

more practical. After all, the source of group

performance are the individual affiliates so

understanding affiliate performance affords us to see

group performance indirectly.

Figure 1. The hypothesized effects of BGA and ALA on the performance of business group affiliates

2.4 Business group advantages and performance

The explanatory variables on the performance of

business group affiliates have not been fully

established in the literature. The empirical approach

has been to compare the performance of BG affiliates

to standalone firms without correctly specifying the

terms of reference. The traditional way is to use a

dummy variable, such as 1 or 0, to differentiate BGs

to non-BGs with reference to performance, see for

example Khanna and Palepu, (2000); Khanna and

Rivkin, (2001); Gaur and Kumar, (2009). Another is

the macro-level explanation, particularly the political

economy (Guillén, 2000; Khanna and Palepu, 1999),

which explores the advantages of business groups

between the macro environment and the group level.

This undermines the group and affiliate level

interaction or the role of the advantages originating

from affiliate level. That is, business group affiliates

are assumed to inherit identical advantages coming

from the business group. Therefore, all business group

affiliates are expected to embody the advantages of

the business group regardless of their individual

affiliate-specific differences. Apparently, this is not

always the case (Dyer and Singh, 1998; Lavie, 2006).

The problem of the preceding approaches is that they

underestimate the potential complexities of the effects

of group-specific factors, such as the dynamics of the

group resources and capabilities, on the performance

of the business group affiliates. It is not about business

group affiliation alone but the extent to which BG


128

affiliates are endowed and positioned within the scope

of the business group advantages. Thus, this paper

hypothesizes that the performance of business group

affiliates can be best explained by capturing relevant

factors such as the business group control advantages.

H1. The stronger are the business group control

advantages of the business group the higher the

performance of their affiliates.

2.5 The mediating role of affiliate level advantages

In addition to resolving the complexities of the effects

of the business groups to the affiliates, and to their

performance, the issue of affiliate heterogeneity within

the business group has not been taken into

consideration by previous studies (Choo et al., 2009;

Mahmood et al., 2011). Thus far, the traditional

analysis of the effects of the business group to their

affiliates assumes a single focus, that is only at the

group level. There are two problems in the

unidirectional conceptualization. First, the business

group advantages are assumed to be transferred easily

to any affiliate as long as they are affiliated to the

business group, hence the traditional concept of ‘BG

affiliation’ or empirically, the “1, 0 flaw”. Second, the

affiliate firms are assumed to exclusively embody the

business group advantages and overlook their

individual development of advantages which would

arise from the interaction of their specific operational

circumstances and firm-level capabilities. In short, the

affiliates can bring new advantages to the group and in

turn make the BGAs dynamic. As discussed above,

business group affiliates also possess different kinds

and types of advantages which do not necessarily

represent that of the business group (Granovetter,

2005; Zaheer and McEvily, 1999). Therefore, the

advantages of business groups should be

conceptualized at two levels, i.e. at the group and the

affiliate levels, and both affect the affiliate

performance.

H2. The affiliate level advantages mediate the

positive relationship between business group

advantages and the performance of the business group

affiliate firms.

3 Methodology 3.1 Research design

There are three different units of analysis in a business

group: the subsidiary (domestic or foreign), the

affiliate firm (can be a division), and the group (all

firms). This paper focuses its analysis at the affiliate

firm level and its interaction with the group level. The

paper has adopted a quantitative analysis using various

secondary data. The objective is to provide a specific

explanation of the business group’s affiliate level

performance by using business group control

advantages and affiliate level advantages as the

explanatory variables. To do this, the main

observations were only consisted of BG affiliated

firms in one country’s setting that is the Philippines.

The reasons for this are the following. Firstly, the

BGA and ALA are new conceptual propositions,

hence, it is rational to apply them exclusively to BG

affiliated firms. Secondly, the existing literature

compares BGs to non-BGs but failed to recognise the

important variations within the BG population itself,

such as BGAs and ALAs, thus making the BG and

standalone comparisons invalid. And thirdly, using

one country study provides greater control in terms of

understanding the heterogeneity among the advantages

of both business groups and their affiliates in a

common location. As to the choice of country, the

Philippines is home to many business groups and

extensive analyses about them are scarce. In fact,

Sullivan and Unite (2001) pointed out that the thirteen

largest domestic Philippine BGs controlled 392

companies from 18 different industries in 1993. Their

study also found that out of 196 publicly listed

companies in 1997, seventy-five firms were fully

controlled by business groups in addition to thirty-

eight others with significant ownership. In addition,

the majority of the Philippine BGs fit with the type

and characteristics of business groups that are being

targeted by this study: (1) non-state owned; (2)

diversified (related and unrelated); and (3) have a

common controller (such as family or kinship related).

These types of business groups are geared towards

developing their unique business group advantages

without depending upon a strong state intervention

such as those business groups from China.

3.2 Data measurement and process

This study processed various secondary data in three

phases. These include literature analysis and data

preparation, business group sample confirmation and

measurement of group and affiliate network measures.

In the first phase, the study collected and reviewed

research articles, including books, on business groups

from different sources. The purpose of which was to

build the theoretical grounding of the study as well as

to establish an initial list of business groups from

previous studies. Specifically, this stage provided an

initial list of business groups particularly from the

Philippines. The second phase involved two stages:

these were the confirmation of the business group list

and business group affiliation analysis. To carry out

this phase the study utilized a combined data from two

primary databases namely OneSource and OSIRIS.

OneSource was used to obtain a list of 839 Philippine

companies including the names and positions of 5714

board of directors (which also include the highest

executive positions such as CEO or COO). On the

other hand, OSIRIS was used to confirm the

consistency of the data, specially the financial

sections, for the period of 2010-2012. Also, the data


129

was cleaned from name duplicates, particularly the

complete name of the board of directors.

Using the combined database, the first stage in

the second phase was to purposely identify the firms

which were included in the initial list of Philippine

business groups. This was to make sure that there are

references and validity in the selection of the final

business group sample for the study. Next, the study

conducted an affiliation analysis using both the data of

the companies and their board of directors (Borgatti

and Halgin, 2011; Carrington et al., 2005). The

objective of this analysis was to identify the firms

which were tied up with other firms byhaving the

same board of directors; that is, director interlocks.

This was done through social network analysis (SNA)

techniques using UCINET and NetDraw softwares

(Borgatti et al., 2002). The inclusion of firms in a

group was decided based on the strength of the

common ties among them and from the secondary

data, such as annual reports, which provided the

names of other affiliate firms and capital cross-

shareholdings within the business group. Therefore,

the selection of business group sample in this study

was done through a combination of subjective and

objective analyses. This process is definitely reliable

as compared to previous studies. Lastly, the third

phase moved from confirmation to measurement of

the business group network characteristics using the

UCINET program. This study utilizes these group

network measures to represent the structure of group

and affiliate level advantages on human resources,

particularly with regard to managerial skills and

experience, and power distribution. Therefore, the

analysis was done at two levels, one at the business

group level and one at the affiliate level respectively.

3.3 Variables

3.3.1 Measure for affiliate performance

In this paper the dependent variable is the business

group affiliate performance by return on sales (ROS),

averaged for the years 2010 - 2012. The ROS is one of

the accepted accounting based measures of firm

performance. The choice of ROS over other

performance measures is crucial as some of these

measures may not be affiliate specific but group

specific. An example of this is return on assets (ROA),

which is highly contingent on the overall assets and

control by the group rather than by the individual

affiliate.

3.3.2 Measure for business group control advantages

One of the explanatory variables of this study is a

group level measure to represent BGA, particularly

the centralization of the business group. The business

group centralization measures how a certain group

advantage is controlled or endowed by the group

within an affiliate. Hence, it is a valid measure of

business group advantages. However, for the overall

descriptive analysis of the sample groups, this study

presented all the five important group network level

measures that are commonly used in the literature

(Borgatti and Halgin, 2011; Mahmood et al., 2011).

The first three are descriptive measures and are

sample dependent, which means that their values are

influenced by the composition in the group such as the

number of firms (or nodes), directors (or actors) and

incidence (or event). The last two are the comparative

measures of a business group network. They are the

basic measures which compare the characteristics of a

certain networks to others.

The first of the five measures is the diameter,

which is the size of a network in geodesic sense, the

bigger the network the higher the values. The next one

is the average tie, which is measured by adding all the

actual ties in the group divided by all the ties that are

present (or edges). In the context of this study, the

value for this measure reflects the average number of

incidence that the same board of directors occupies sit

in certain affiliates at the same time. Next is the

average degree which is the measure of the average

number of ties (in and out connections) or

relationships which flow on each affiliate (or node) in

the network. This is the average amount of

information or power that is found in each affiliate.

The fourth one is density which is measured by adding

all the actual ties divided by the expected ties. The

value of one represents a fully connected group

network while zero is the opposite. It is the measure of

cohesion and integration in the group. Finally,

centralization is the measure of the degree to which

the group revolves around a single or few affiliates (or

nodes), the higher the value the more centralised the

group network.

3.3.3 Measure for affiliate level advantages

The other explanatory variable in this study is the

affiliate centrality which is an affiliate level measure

to proxy for ALA. The centrality defines the

importance of the position of a certain affiliate on a

particular ALA, such as in financial and human

resources, within the group. This measure is also

common in previous studies (Chung, 2006). Also, for

the purpose of descriptive analysis, this study

conducted all the centrality measures of each affiliate

across the groups. This was done by examining the

four basic network measures on the centrality of an

actor, in this case the affiliate, in a certain network

(Borgatti and Halgin, 2011). The measures reflect the

centrality of a certain position of an actor within a

contextual network, that is resources. Firstly is degree

centrality, which measures how central is the affiliate

in the group network with regard to power and

information; the higher the number the higher the

connection of an affiliate to the rest of the group.

Secondly, there is a 2-step reach or closeness to

others, which ascertains the reach of an affiliate to


130

every other affiliate in two steps or less. Thirdly, an

eigenvector which measures how connected is a

certain affiliate to other well-connected affiliates.

Fourthly and lastly, betweenness centrality, measures

the location of a certain affiliate in the brokerage and

flow of information, and influence within the group’s

network.

4 Results

4.1 Descriptive network analysis

Through the social network analysis, the study was

able to confirm the top 20 business groups with a total

of 257 affiliate firms and 2754 directors from the

original data (see Table 1). The top 20 business groups

are basically chosen based on their prominence in the

network mapping analysis in NetDraw (see Figure 2),

followed by in depth analysis of their annual reports

and other sources such as websites. The network

measures for the group are listed in Table 2a and

Table 2b, whilst the affiliate ones in Table 3.

Table 1. Combined data from OneSource and Osiris

Business Group firms/Affiliates Non-Business group firms Total

No. of Firms 257 582 839

No. of Board of Directors 2754 2960 5714

Figure 2. Network map of the top Philippine business groups and their affiliates

4.1.1 Group level

The details and network measures of the top 20

business groups are shown in Table 2a and Table 2b

below. The group size of the business groups varies

from 4 to 33. About twelve (or 60%) of them have less

than 10 affiliates. There are three of them with more

than 10 affiliates, while there are four with 20 and one

with more than 30 affiliates respectively. With regard

to diameter the values are influenced by the size of the

business group. Half or fifty percent (50%) of the

group have a diameter of 1, particularly those with

less than 10 affiliates, and the rest have 3, 2 and 5

respectively. The affiliate which is the biggest and

highest in diameter and seems to be an outlier is the

AYALA Business Group. This group is also the oldest

business group in the Philippines which started

operations in the late 19th

century.


131

Table 2a. Group network measures of the top 20 Philippine business groups

No. Group Name Age

Group Size

(257

Affiliates)

Diameter Average

Tie

Average

Degree (per

node) Density

Centrali-

zation

1 ABOITIZ GROUP 92 22 3 1.16 10.18 0.48 12.98

2 ALLIANCE

GLOBAL GROUP 19 6 1 3.33 5 1 16

3 ALSONS GROUP 57 4 1 3.67 3 1 14.81

4 APC GROUP 19 7 1 3.43 6 1 18.33

5 AYALA GROUP 178 33 5 0.47 7.27 0.23 4.42

6 CONCEPCION

GROUP 50 6 1 2.73 5 1 25.14

7 DMCI GROUP 58 5 1 4.3 4 1 20.14

8 FILINVEST

GROUP 57 4 1 3.3 3 1 24.37

9 JG SUMMIT

GROUP 55 15 3 1.98 9.47 0.68 21.48

10 LOPEZ GROUP 84 25 2 1.43 14.16 0.59 13.21

11 LT GROUP 75 6 1 1.6 5 1 12

12 METROBANK

GROUP 6 10 3 0.96 4 0.44 25.68

13 METRO PACIFIC

GROUP 50 16 2 1.38 11.62 0.77 7.25

14 ONGPIN GROUP 5 5 1 6.8 4 1 19.32

15 PHINMA GROUP 55 8 3 1.82 4.25 0.61 22.96

16 RAMOS GROUP 77 9 1 2.86 8 1 12.28

17 SAN MIGUEL

GROUP 122 25 3 0.95 15.31 0.56 10.2

18 SM GROUP 54 19 3 0.99 6.84 0.38 17.64

19 WELLEX GROUP 42 8 1 6.04 7 1 13.58

20 YUCHENGCO

GROUP 56 24 3 1.49 13.75 0.63 15.27

AVERAGE 60.55 12.85 2 2.53 7.34 0.77 16.35

Table 2b. Descriptive statistics of the network measures for the top 20 Philippine business groups

Group Network

Measures

Total

Sample Range Minimum Maximum Mean Std. Deviation

Group Size 20 29.00 4.00 33.00 12.85 8.84

Diameter 20 4.00 1.00 5.00 2.00 1.17

Average Tie 20 6.33 .47 6.80 2.53 1.71

Average Degree 20 12.31 3.00 15.31 7.34 3.85

Density 20 .77 .23 1.00 .77 .26

Centralization 20 12.26 4.42 25.68 16.35 5.88

On the other hand, the average tie for the

AYALA group is the lowest among the sample at .47

or less than 1 tie for all 33 affiliates. This is expected

as the bigger the group (by number of affiliates) the

higher the need to distribute more people in all the

affiliates as board members or top executives. This

problem may create “holes” in the group network.

Average tie means the average “thickness” of the

overall relationship within the group which is shared

by all affiliates such as in information. Half of the

other business groups have an average tie of about 1 to

2. This means that fifty percent (50%) of the business

groups in the sample have one to two boards of

directors who sit at each affiliate firm at the same

time. The other seven business groups have an average

tie of more than 2 but less than 5, while the last two

groups have 6 ties. These results reflect the differences

of the volume of people, information and power that

flow within the business groups.

As regards average degree there are nine

business groups with an average degree value of 3 to 5

degrees. This means that on average each affiliate of

the nine business groups gives and receives 3 to 5

connections within their business group. The others,

six of them have 6 to 10 degrees while the last five

have more than 10 degrees. These results suggest that


132

the affiliates in each business group are very much

connected with one another since the higher the

number of degrees the highly connected the affiliates.

As to density, half of the sample has a full

measure of 1, which means that fifty percent (50%) of

the business groups in the sample have a one hundred

percent (100%) connection among their affiliates.

These business groups are connected by at least one

tie and do not contain any “hole” in the network, that

is a star network. However, all of these groups have

less than 10 affiliates, which in the context of human

resource deployment is easy to achieve. The others

with more than 10 affiliates have a density ranging

from .23 or twenty-three percent (23%) to .77 or

seventy-seven percent (77%) showing some holes that

exist within the network or containing some affiliates

which are not connected with other affiliates. This

means that there are broken points in the network

which may prevent the flow of information, such as

sharing of experiences, to and from other affiliates.

Finally, the measures of centralization for all the

business groups in the sample range from 4.42 to

25.68. Of that, only six groups have a centralization

measure of above 20 or twenty percent (20%). High

value means that the business group is highly

centralized and the information and power are

concentrated in one or few affiliates. In general, the

maximum value of 25.68 or twenty-six percent (26%)

centralisation is not very high, which means that most

of the business groups in the sample are moderately

centralized.

4.1.2 Affiliate level

The network measures of the 257 affiliates are

presented in Table 3 by their average value in

reference to their role in the business group. On

average the affiliates in the sample display a high level

of degree centrality. The average value for this is .62

or sixty-two percent (62%) which means that most of

the affiliates enjoy central position as regards to

information and power in their business group. In

terms of 2-Step reach or closeness, the affiliates score

for this is .95 or ninety-five (95%) which means that

most of the affiliates can reach other affiliates within

two steps or less. This means easy access for affiliates

when seeking information such as on managerial

experiences of other affiliates. The next one is

eigenvector of the affiliates which has an average

value of .35 or thirty-five percent (35%). This is

expected to be low for all given high degree centrality

and closeness. This means that many affiliates are not

especially well connected to others, as most of them

are well connected to one another in their group.

Lastly, betweenness has the lowest average value of

.02 or two percent (2%) which means most of the

affiliates in the group does not have the role as go-

between or brokers. Again this is expected as the

degree centrality and closeness values are high for

most of the affiliates. This simply means that most of

the information is not difficult to access within the

business group. On the other hand, the range and

standard deviation (SD) of the network measures

among the affiliates show considerable variation. This

reflects the heterogeneity of the affiliates across

different business groups.

Table 3. Descriptive statistics of the network measures for the 257 Philippine business group affiliates

Affiliate Network

Measures

Total

Sample Range Minimum Maximum Mean

Std.

Deviation

Degree 257 .97 .03 1.00 .6239 .33096

Closeness 257 .94 .06 1.00 .9520 .11319

Eigenvector 257 .73 .00 .73 .3502 .18281

Betweenness 257 .46 .00 .46 .0231 .06176

4.2 Mediation analysis

This study performed a simple mediation analysis

using the Baron and Kenny (1986) causal-steps

approach. In addition, a bootstrapped confidence

interval for the ab indirect effect was obtained using

procedures described by Preacher and Hayes (2004).

The initial explanatory variable was BGA

(centralization); measured in percentage, the outcome

variable was affiliate performance (return on sales-

ROS, in USD Mil.); and the proposed mediating

variable was ALA (degree centrality), measured in

percentage. This is depicted in Figure 3, which shows

the path diagram that corresponds to the mediation

hypothesis. Preliminary data screening suggested that

there were no serious violations of assumptions of

normality or linearity. All coefficients reported here

are unstandardized, unless otherwise noted; a = .05

two-tailed is the criterion for statistical significance.

The total effect of BGA on affiliate performance

was significant, c = .23, t= 2.06, p < .04; each 1-

percent increase in BGA in centralization predicted

approximately a .23 increase in affiliate’s ROS

performance in USD Mil. Hence, H1 is supported. The

BGA was significantly predictive of the hypothesized

mediating variable, ALA; a = .018 (unstandardized), t

= 5.41, p = .000. When controlling for BGA, ALA

was significantly predictive of performance, b = -


133

38.12 (unstandardized), t= -2.96, p = .004. The

estimated direct effect of BGA on performance,

controlling for ALA, was c′ = .43, t = 3.40, p < .001.

Performance was predicted from BGA and ALA, with

adjusted R2

= .15 and F (2, 75) = 6.747, p < .002.

Figure 3. Mediation analysis on the effects of BGA and ALA on

the performance of business group affiliates

The indirect effect, ab, was -.19. This was judged

to be statistically significant using the SPSS script

(PROCESS) for the Indirect procedure (Preacher and

Hayes, 2004), bootstrapping was performed; 1,000

samples were requested; a bias-corrected and

accelerated confidence interval (CI) was created for

ab. For this 95% CI, the lower limit was -.3742 and

the upper limit was -.0669. In this case, both the a and

b coefficients were statistically significant, the

bootstrap test for the ab product was significant, and

the bootstrapped CI for ab did not include zero. By all

these criteria, the indirect effect of BGA on

performance through ALA was statistically

significant. Thus, supporting H2.The direct path from

BGA to performance (c′) was also statistically

significant; therefore, the effects of BGA on

performance were only partly mediated, negatively, by

ALA. The upper diagram in Figure 3 shows the path

coefficients for this mediation analysis; the lower

diagram shows the corresponding standardized path

coefficients (with unstandardized ab coefficients).

Comparison of the coefficients for the direct

versus indirect paths (c′ = .43 versus ab = -.19)

suggests that a relatively small part of the effect of

BGA on performance is mediated by ALA. The

negative coefficient also suggests that both the

explanatory variables are cancelling out each other’s

effects on performance. There may be other mediating

variables through which BGA might influence

performance, particularly some other types of ALA.

5 Discussions and conclusion

The literature on business groups which argues that

business group affiliate firms are advantageous as

compared to non –business groups or standalone firms

in emerging economies provides an inconclusive

result (Carney et al., 2011; Khanna and Palepu, 2000).

This paper argued that this inconclusive result is due

to the lack of theoretical explanation about the context

of the advantages of business groups, as also cited in

the works of Delios and Ma, (2010), p. 737 and

Mahmood et al., (2011). As such, there is a gap on

determining the parameters of comparison, not to

mention the absence of the rationale behind the

comparison at the onset. This paper addressed this

issue through the following. It has provided the

theoretical and operational explanations of the control

advantages that are unique to business groups in

emerging economies (Gonenc et al., 2007). Over and

beyond the previous studies, this paper has not only

presented the theoretical framework of the business

group advantage at the group and affiliated level, but

also demonstrated, although limited, on how to

analyze its structure by using the social network

analysis approach. In particular, this study measured

the structure of BGAs, at the group and the affiliate

levels, on information and control by analysing the

interlocking directorates within the board of directors

and top executives of the top 20 business groups from

the Philippines. These executives and directors hold

seats in all the affiliates of the business groups.

Therefore, this paper has analyzed the overall business


134

group advantages of the sampled business groups

which cover all the affiliates with both domestic and

international operations. The BGAs, then, are

applicable in both the domestic and international

contexts. The descriptive results of the study also

support the concept of group advantages at the

affiliate level. This is based on the significant

variation within the network measures of the sample

affiliates. This variation clearly reflects the

heterogeneity among the affiliates which is in this

context being argued as the specific advantages at the

affiliate level. Finally, the results of the mediation

analysis support the hypotheses of the study that the

performance of the affiliates is significantly

influenced by both BGAs and ALAs and not their

mere affiliation with the business group.

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