CHAPTER III: THEORETICAL FRAMEWORK
3.1. Research Model
The primary objective of this study is to investigate the effectiveness of corporate governance in Indonesian listed companies. Since corporate governance practice is compulsory for the JSX listed companies, effectiveness is defined by the compliance of companies with the corporate governance principles of the Jakarta Stock Exchange (JSX) rules for corporate governance. In addition to this definition, the theory described in chapter two suggests that good corporate governance minimises the agency problems, then ensures efficient management, and can increase the value of the company. Therefore, effectiveness is also defined as an increase of company performance (Shleifer and Vishny, 1997 quoted by Brown and Caylor, 2005a; Van den Berghe and De Ridder, 1999).
This study delineates the corporate governance principles based on the JSX decree on corporate governance (JSX, 2003) and code of corporate governance issued by NCCG (2001).
In fact, the principles focus on the issue of board governance only. In regard to the attributes of board governance discussed in the literature review, the corporate governance practice in this paper is specified by the following characteristics:
1. The Board of Commissioner Characteristics:
a. The board size.
b. The proportion of independent commissioners in the composition of a board 2. The Audit Committee Characteristics.
a. The audit committee size.
b. The proportion of independent commissioners in the composition of the audit committee.
c. Board leadership structure.
1). The chairperson is an independent commissioner.
2). The chairperson is not an independent commissioner.
d. Number of member who hold financial or accounting qualifications.
To investigate the first definition of effectiveness, the question is: to what extent are JSX listed companies compliant with the JSX corporate governance requirements? In addition, it is also interesting to examine what factors drive the companies to comply with the regulation.
The literature suggests that corporate governance practice can be influenced by external factors and internal factors (Iskander and Chamlou, 2000). The external factors affecting the practice are investment opportunity, type of industry, information and environment while the internal factors are size of the company, bad financial conditions, leverage, product uniqueness and ownership structure (Adams and Mehran, 2003; Gillan, Hartzell and Starks 2003; Hermalin and Weisbach, 1988; Barnhart and Rosenstein, 1998).
In addition to the external and internal factors suggested by the literature, this paper investigates two additional factors which may influence the companies to implement corporate governance principles. These factors are: length of tenure of the company listing and dual listing of a company in overseas international capital markets (e.g. listed in the United States’ capital market). This study attempts to confirm the results of previous research, (for example the study of Black, Jang and Kim, 2006), by testing the influence of the length of listing period on the stock exchange. The reason for inclusion of a dual listing variable is that companies in Asian countries, which implement an impressive corporate governance
practice, are identified as the companies which are listed in other recognised international capital market Allen, such as in the United States (2000b, p.28).
Overall, the first theoretical framework, which is suggested by this thesis, is depicted in figure 3.1. The factors influencing the corporate governance practice such as the structure of board governance or the implementation of code of corporate governance principles are summarised in the left box. Seven factors are investigated to seek whether these factors are significant in explaining the differences of corporate governance practices. These factors are size of company, type of industry, leverage, ownership structure, previous company performance, dual listing, and length of period listing of a company in the JSX.
Turning to the second definition of effectiveness, this paper attempts to identify the relationship between corporate governance and company performance. This thesis investigates the relationship using an OLS method. Next, the analysis which tests whether there is an endogenous problem between these variables will be conducted in the future.
Therefore, for the next research, whether corporate governance and company performance are Figure 3.1: Factors Influencing Corporate Governance Practice in Indonesia
External/Internal Factors:
1. Size of company 2. Type of industry 3. Leverage
4. Ownership structure:
Institutional
ownership-unrelated 5. Previous company
performance 6. Listing in other
recognised stock market in overseas 7. Tenure of listing
Corporate Governance Practice
interrelated shall be investigated. If there is this kind of relationship, to prevent spurious regression results, a statistical model of the relationship in a simultaneous equation was performed. The statistical model is explained further in the following chapter, but the results of the simultaneous model will not be reported in this minor thesis. The theoretical framework for the investigation of the second definition of corporate governance effectiveness in Indonesia is depicted in figure 3.2 and figure 3.3.
Figure 3.2 suggests one-way relationship between corporate governance and company performance. Specifically, the corporate governance regulation of Jakarta Stock Exchange is related to board governance. Therefore, the thesis analyses the relationship between board governance, which are board of commissioners and audit committee, and company market performance, proxied by Tobin’s Q. The relationship between company which the board governance complies with the JSX regulation and company performance is positive. In addition to board governance as the dependent variable, to examine the relationship between corporate governance and company performance, some other controlling variables are considered. They are size of company, type of industry, leverage, ownership (insider ownership and institutional ownership). The relationship between each of controlling variables, except industry, and company performance are positive. The sign of the association between industry and company performance is still unclear, but
Figure 3.3 suggests two-way relationships between corporate governance and company performance. Literature suggests interrelationship among corporate governance, ownership structure and company performance. These relationships are endogenous which are depicted inside the circle as a system. Outside the system are exogenous variables which influence the system. The exogenous variables are tenure of listing, type of industry, size of company, leverage, and dual listing in other recognised overseas stock market. The expected signs is explained in the section 4.5.3.
Corporate Governance Characteristics:
1. The Board of Commissioner a. The board size.
b. The proportion of independent
commissioners in the composition of a board
2. The Audit Committee
a. The audit committee size.
b. The proportion of independent
commissioners in the composition of the audit committee.
c. Board leadership structure.
1). The chairperson is an independent commissioner.
2). The chairperson is not an independent commissioner.
d. Number of member who hold financial or accounting qualifications.
Company Performance
Controlling Variables:
1. Size of company (+) 2. Type of industry (+/-) 3. Leverage (+)
4. Ownership structure (Insider ownership (+) and institutional ownership (+))
Figure 3.2: One-way Relationship between Corporate Governance and Company Performance (+)
Finally, three types of research will be conducted: descriptive, explanatory and evaluative research. The descriptive study describes the corporate governance practice of the JSX listed companies. Then, using explanatory research, this thesis seeks answers to two issues: the factors influencing the corporate governance practice of the JSX listed companies and the interrelationship between corporate governance and company performance. Finally, all results from these two former studies allow the researcher to judge whether the corporate governance practice in Indonesia is effective.
Figure 3.3.: Interrelation between Corporate Governance and Company Performance Ownership
structure (Insider ownership and institutional ownership)
Corporate Governance Practice; relating to:
Characteristics of Board Governance
Company Performance (Accounting based
performance and Market-based performance)
External/Internal Factors:
1. Tenure of listing
2. Type of industry 3. Size of company 4. Leverage 5. Listing in other
recognised overseas stock market