Corporate Governance Practice in Indonesia, Status Quo?
An Empirical Study of the Relationship between Corporate Governance Practice and Performance of Listed Companies
Subject : Minor Thesis (Master Business –Accounting) Name : Siti Nuryanah
Student ID : 3664255
Supervisor : Prof. Anona Armstrong Prof. Sardar M. N. Islam
Victoria Graduate School Faculty of Business and Law
Victoria University
DECLARATION STATEMENT
This thesis entitled Corporate Governance Practice in Indonesia, Status Quo? An Empirical Study of the Relationship between Corporate Governance Practice and Performance of Listed Companies is the original academic work of the author. It contains no material has been submitted previously in respect of any other academic award.
Siti Nuryanah
ABSTRACT
This thesis investigated corporate governance in Indonesia. It assessed the effectiveness of corporate governance in Indonesia by observing listed companies on the Jakarta Stock Exchange (JSX). The evaluation of their effectiveness was based on a survey of the compliance of the listed companies with the Indonesian corporate governance guidelines.
In this preliminary investigation, the study found that the implementation of corporate governance in the JSX listed companies is still minimal. This finding is similar to previous study (CGFRC-Standard & Poor’s, 2004) which found that some companies still do not comply with corporate governance regulation. Further, this paper reports the analysis of the relationship between board governance and company performance. Using ordinary least square (OLS), the study finds a relationship between board governance attributes and Tobin’s Q. Specifically, the characteristics of board of commissioners, which are board leadership and composition of board independence, relate positively with Tobin’s Q. A similar result was also shown in the relationship between the independency of the audit committee and Tobin’s Q. In contrast to these three governance attributes, the signs of audit committee characteristics, leadership and accounting/financial literacy, was different with hypotheses.
Findings show that the companies which do not have these characteristics have better Tobin’s Q than the companies which comply with the regulations. As reported by the Jakarta Stock Exchange (JSX), there are members of audit committee who still hold double positions, that is similar positions in other companies, thus this might leads inefficient audit committee.
Despite the success of the study in confirming all these relationships, this study cannot find an association between size of board governance (both size of board of commissioners and audit committee size) and company performance. Overall, the findings of this study support the proposal that the regulators be stricter in imposing the corporate governance regulations.
ACKNOWLEDGEMENTS
Finishing this minor thesis, no words can be said but Alhamdulillahirabbil-aalameen, all praise is due to Allah, the Lord of the Worlds. Next, she is Prof. Anona Armstrong, the principal supervisor, the first person to whom I want to express my gratitude. I am grateful for her priceless time; even though she is very busy, she still gives me guidance, supports, and suggestions. Another person that I want to thank is Prof. Sardar Islam, the co-supervisor. I believe that I could not finish this thesis without his assistance and his supports. In fact, his support encourages me to go beyond my initial proposal.
Another person who deserves my gratitude is my husband, Toto Aditama. Without his support and his understanding, it is impossible for me accomplishing this thesis. In addition, I want to say thanks to my parents, mama and papa, who always pray for my success and happiness. I believe I cannot achieve all things that I have without your supports and love.
Finally, to sisters and brothers in Melbourne, thanks for being my good friends. What a wonderful time I have spent with you all here, in Melbourne!
TABLE OF CONTENTS
DECLARATION STATEMENT ...i
ABSTRACT ...ii
ACKNOWLEDGEMENTS ...iii
TABLE OF CONTENTS ...iv
CHAPTER I: INTRODUCTION... 1
1.1. Background of the Study...1
1.2. Statement of the Problem ...3
1.3. Objectives of the Study ...5
1.4. Significance of the Study ...5
1.5. Overview of the Thesis ...6
CHAPTER II: CORPORATE GOVERNANCE: LITERATURE REVIEW ... 8
2.1. Theory of Corporate Governance...8
2.2. Board Governance: Board of Directors and Board Committee ...11
2.2.1. Board of Directors ...12
2.2.2. Board Committee Structure ...22
2.2.3. Measuring the Relationship Between Corporate Governance and Company’s Performance ...25
2.3. Conclusion...28
CHAPTER III: THEORETICAL FRAMEWORK ... 30
3.1. Research Model...30
3.2. Research Questions ...36
3.3. Hypotheses ...38
3.4. Operationalising Key Concepts and Research Instruments ...39
CHAPTER IV: RESEARCH METHODOLOGY ... 41
4.1. Available Research Methods...41
4.2. Construction of a Corporate Governance Checklist...41
4.3. Data ...42
4.4. Research Design...44
4.5. Empirical Design: Variables and Measurements ...44
4.5.1. Factors influencing corporate governance practice ...44
4.5.1.1. Dependent variables...44
4.5.1.2. Independent variables ...45
4.5.2. The relationship between corporate governance practice and company performance ...47
4.5.2.1. Dependent variables...47
4.5.2.2. Independent variables ...48
4.5.3. The interrelationship among corporate governance practice, ownership and company performance...50
4.5.3.1. Endogenous variables ...50
4.5.3.2. Exogenous variables ...50
4.6. Statistical Model and Data Analysis ...51
CHAPTER V: RESULTS OF THE STUDY: THE RELATIONSHIP BETWEEN
CORPORATE GOVERNANCE AND COMPANY PERFORMANCE ... 56
5.1. Introduction ...56
5.2. Descriptive Statistics...56
5.3. Regression Analysis and Tests for OLS Assumptions...59
5.3.1. Regression analysis of preliminary estimated model ...59
5.3.2. OLS Classical Assumptions for Preliminary Estimated Model...61
5.3.3. Regression analysis of final model ...65
5.4. Hypothesis Testing...68
5.5. Summary ...70
CHAPTER VI: DISCUSSION: IMPLICATIONS FOR INDONESIAN CORPORATE GOVERNANCE ... 71
6.1. Compliance of the JSX Companies with the Corporate Governance Regulation...71
6.2. The Relationship between Company’s Compliance with Corporate Governance and Company Performance...72
CHAPTER VII: CONCLUSION AND RECOMMENDATIONS FOR FUTURE STUDIES... 74
7.1. Development of the Study...74
7.2. Conclusions ...74
7.3. Limitation and Suggestions for Future Studies...76
REFERENCES ...77
Appendix 1: Summary of Literature Review ...87
CHAPTER I INTRODUCTION
1.1. Background of the Study
The economic crisis which hit Asia, beginning in the middle of 1997, made Indonesia’s economy plunge into a financial crisis. It is believed that the fundamental fragility of its economy caused Indonesia and the other crisis-hit countries to experience the problem (Claessens and Fan, 2002). In addition, the weakness of corporate governance worsened the condition plunging the country into a prolonged financial crisis (Johnson, Boone, Breach and Friedman, 2000; Barton, Felton, and Song, 2000). Investigating five hit-crisis countries in East Asia, Capulong, Edwards, Webb and Zhuang (2000, p. 2) identified that the main reason of corporate governance weakness in East Asia was because of ‘highly concentrated ownership structure, excessive government intervention, under-developed capital markets, and weak legal and regulatory framework for investor protection.’ The highly concentrated structure of ownership, which is family-based ownership, reduces the effectiveness of shareholders’ protection. It appears that because the ownership concentration causes an
‘agency’ problem, ‘it may have left the insiders with excessive power to pursue their own interests at the expense of minority shareholders, creditors, and other stakeholders’
(Capulong, Edwards, Webb and Zhuang 2000, p. 2).
Recognising the culprits, the agency theory of corporate governance provides an apt solution. The theory (Farrar, 2005) suggests that good corporate governance minimises the agency problems, then ensures efficient management and, finally, can increase the value of the company (Shleifer and Vishny, 1997 quoted by Brown and Caylor, 2005a; Van den Berghe and De Ridder, 1999). Therefore, Capulong, Edwards, Webb, and Zhuang (2000)
argue that a sound corporate governance system is important so that a conducive business environment for a corporate sector can be created. This system should protect investors’
interests, minimise systematic risks, and maintain financial stability. Overall, a good corporate governance policy can increase market confidence and finally boost macro economic conditions (Nam and Nam, 2005).
To achieve the economic recovery, the Indonesian government has established some recovery programs, one of which is improving the corporate governance of Indonesian companies. Initially, the institution namely the National Committee for Corporate Governance (NCCG) was established. Then in April 2001, the Committee issued a code for practice of good corporate governance, which is believed to be the best practice for Indonesian companies. Following the corporate governance improvement programs and to get market confidence, the Jakarta Stock Exchange (JSX), as one of the Self Regulatory Organisations (SROs) in Indonesia, also released the decree of JSX’s Director No. Kep-315/BEJ/06/2000.
Specifically, the decree requires the publicly listed companies to have a board governance structure that includes Independent Commissioners, an Audit Committee, and a Company Secretary.
Comparing the contents of NCCG’s codes and JSX’s decree, they state the functions of board governance similarly. The board of directors, which is charged with the daily management of the company, is under a supervisory of board of commissioners. Therefore, based on Van den Berghe and De Ridder (1999, p. 59), it can be concluded that the corporate governance model of an Indonesian company is an example of a two-tier or dual governance system. There are ‘two individual boards, one responsible for day-to-day policy and composed exclusively of executives, and a second type of supervisory board which is made up exclusively of non-active directors’ (Van den Berghe and De Ridder, 1999).
In spite of the similarity, JSX’s corporate governance principles are stricter than the NCCG’s code as firstly, the JSX’s regulation is mandatory for publicly listed companies while NCCG’s codes are voluntary for Indonesian companies (NCCG, 2001; BAPEPAM, 2000; JSX 2000; BAPEPAM 2004). Next, the JSX’s specifically states that at least 30% of the composition of board commissioners should be independent commissioners (JSX, 2000).
On the other hand, the minimum number of outside members of board commissioners is only 20% under the NCCG’s code (NCCG, 2001). Although the JSX’s code is stricter, the principles issued by NCCG are more comprehensive as they discuss the issue of shareholders, the board of commissioners, the board of managing directors, the audit systems, and the corporate secretary. In contrast, the decree of JSX’s directors contains only the issue of board governance and does not give thorough information as the NCCG’s code does.
It has been five years since Indonesia, along with the other countries in East Asia impacted by the economic crisis, began its economic recovery programs in which strengthening the corporate governance systems is one of the items on the agenda.
Nevertheless, there has been no official evaluation undertaken by the regulators or the government except for a corporate governance country assessment completed by the World Bank in 2004. In fact, such evaluating activities are crucial to determine the efficiency and effectiveness of the regulation. Moreover, it ensures the enlisted companies keep on the right track of the corporate governance principles.
1.2. Statement of the Problem
Despite the fact that none of the official assessments were initiated by the Indonesian government, there are a few studies which have reported the implementation of corporate governance in Indonesia. Firstly, the JSX’s report (2003) indicated that whilst the compulsory JSX’s corporate governance principles began in the 1st of July 2000, the principles had not
been effective even by the end of the tolerant period of implementation, the 31st December 2001. Oddly, as the period ended, there were still some companies had not implemented the requirements (JSX, 2003). Furthermore, the study of Indonesian LQ45 Companies undertaken by Corporate Governance and Financial Reporting Centre (CGFRC) of NUS Business School, and Standard & Poor’s (2004) found that in spite of the board governance requirement for listed companies to disclose the corporate governance practice, a majority of the companies did not disclose the number of independent directors on the board. The study also identified that there were some companies, which did not disclose the existence of an audit committee and some reported that the audit committee was in the process of being formed. Finally, with regards to macro economic indicators, whilst the theory argues that sound corporate governance increases market confidence, the market capitalisation of Indonesia remained small. In fact, compared to the other crisis prone countries, Indonesian market capitalisation was the smallest; representing only approximately 21% and 26% of the GDP in 2002 and 2003 respectively (World Bank, 2004). In contrast to Indonesia, in 2002, for example, the percentage of market capitalisation to GDP of the other counties was much higher; 178% for Malaysia, 165% for Singapore, 44% for Thailand, and 28% for the Philippines (World Bank, 2004).
The evidence above, slow market reaction, indicates that the JSX’s corporate governance regulation is not effective. The statistics also show that the practice of corporate governance in Indonesia is still dubious. Furthermore, they indicate a status quo for Indonesian corporate governance. In fact, there is still a long way to go in the implementation of successful Indonesian corporate governance. In fact, the determination of the Indonesian government to implement a sound corporate governance system is crucial so that it can get the investors’ confidence back.
Therefore, it is important to find out whether the Indonesian corporate governance reforms are effective. The term ‘effective’ here has two main meanings, which are firstly, having five years of corporate governance implementation, whether all the listed companies has complied with the corporate governance regulation and secondly whether the implementation of corporate governance amongst these companies relates positively with companies’ performance as the theory suggests.
1.3. Objectives of the Study
The purpose of the study is to determine the effectiveness of corporate governance standards in Indonesia by investigating Indonesian publicly listed companies in the Jakarta Stock Exchange (JSX) as these companies are subject to the corporate governance codes issued by the JSX. Two kinds of approach were taken in this thesis, namely, a descriptive study and a relationship analysis. Specifically, the descriptive study determined the characteristics of the selected companies according to their compliance with corporate governance principles. Next, under the relationship analysis, the study investigated whether there is a positive association between the implementation of corporate governance and corporate performance. Further, in the relationship analysis this study developed a model to examine the relationship between corporate governance and company performance. In fact, the model whether a one-way relationship or a two-way relationship (interrelationship) between the variables needs to be detected further. Therefore, the robustness of the results of the study can be achieved.
1.4. Significance of the Study
Two main parties interested in the study of Indonesian corporate governance are the policymakers and the companies. The results of this study can be used by the policymakers to take further steps related to strengthening corporate governance systems. In addition, the
findings and suggestions from this study help a company to evaluate and improve its corporate governance.
This study is useful for both parties as this study differs from the previous research into the Indonesian corporate governance case. While the prior studies observed only one or two years of sample, this study takes a longer period to sample, a panel data, which is from 2002-2004. As the effective period for corporate governance practice started from 2002, it is useful to examine the companies’ response behaviour in response to the corporate governance regulations from 2002. Hence, by sampling a longer period this study accommodates the time lag effect of the code for good corporate governance implementation. Therefore, it captures a better picture of the effectiveness of corporate governance in Indonesia. Finally, the right statistical model of the study ensures the reliability of the results.
1.5. Overview of the Thesis
The structure of this thesis is as follows. The next chapter reviews the literature relating to corporate governance. The reviews include the literature which specifically examines the Indonesian corporate governance experience and the studies which investigate the relationship between corporate governance and a corporate performance.
Chapter three discusses the theoretical framework of the study. Included in this chapter are research model, research questions, hypotheses, and operationalisation key concept and research instruments.
Following chapter three, chapter four discusses the research methodology.
Furthermore, this part describes the literature research, construction of a research instrument, sampling selection, research design and data analysis.
Next, in chapter five, the research results of the study were presented. Chapter five contained the details of the descriptive study and the relationship analysis. The best-fit model
was selected based on a test of the robustness of the findings. However, for the completion of this minor thesis, only part of the study results, the regression analysis are presented. Further analysis of the relationships of corporate governance and corporate characteristics will be pursued in future research.
The final two chapters address the implications of the study, the general purpose of the study and answers of the study’s research questions. Following this chapter, the conclusion is presented along with the discussion of the study limitation and the recommendation for future research of the study.
CHAPTER II CORPORATE GOVERNANCE: LITERATURE REVIEW
2.1. Theory of Corporate Governance
The term of ‘Corporate Governance’ had not become a fashionable concept in Asia until this decade when it was stimulated by the occurrence of Asian financial crisis and the phenomena of outrageous corporate collapses such as Enron and Worldcom. Nevertheless, Farinha (2003, p.3) argues that ‘the issues it addresses have been around for much longer, at least since Berle and Means (1932) and the even earlier Smith (1776)’. Yet, it was the seminal Cadbury Report 1992 in the UK which became the magna carta of the corporate governance concept and was the foundation for development of standards or codes of practice. Since then, many other versions of standards or codes of corporate governance have been developed by international institutions such as the OECD (Organisation for Economic Co-operation and Development) and the ADB (Asian Development Bank). Hence, many countries have adopted corporate governance best practices or have developed their own guidelines, and then imposed the practice on their economic sectors. Accordingly, corporations around the world have implemented corporate governance voluntarily or compulsorily. This corporate governance standards implementation around the world, where there are some countries follow same version of codes of practice while there are other countries developed their own code of practice, shows consensus and dissent amongst scholars. Further, this makes the issue of corporate governance still pertinent to be discussed. These following paragraphs discuss further the consensus and dissent of corporate governance issue regarding to the definition and the model of corporate governance while the consensus and dissent related to board governance and the literature review is presented in other section in this chapter.
The dissent of corporate governance is started with the issue of its definition. There is no single definition of the term ‘Corporate Governance. Corporate governance has been attracting many scholars from various backgrounds, as it is believed that it potentially covers a large number of distinct economic phenomena (AcadData, 2006). While there is no single definition of the term ‘Corporate Governance’, Farinha argued (2003) that the substance of the definition is related to the theory of firm and based upon conflicts of interest between insiders and outsiders, namely shareholders, corporate managers and debt holders. The conflict of interests exists as a consequence of the separation of ownership and control in the company. Therefore, to balance diverging interests, ‘a rule for the game’, namely corporate governance, is important.
In spite of no single definition of corporate governance, in its narrowest context, corporate governance refers to ‘a set of arrangements internal to the corporation that define the relationships between managers and shareholders’ (Iskander and Chamlou 2000, p.6).
‘This set of arrangements refers to control of corporations and to systems of accountability by those in control’ (Farrar 2005, p.3). Embodying a legal regulation in the centre of the structure, the control of corporation also includes the system of accountability of the company, particularly related to the self-regulation system and ‘best practice’ norms (Iskander and Chamlou 2000; Farrar 2005). Next, in the broad sense, corporate governance includes
‘the entire network of formal and informal relations involving the corporate sector and their consequences for society in general’ (Keasey, Thompson, and Wright, 1997 in Farrar 2005, p.
6). All in all, it can be concluded that the structure of corporate governance includes mechanisms both internally and externally.
Turning to the model of corporate governance practice, it is believed that there is no single model of corporate governance (AcadData, 2006). Shleifer and Vishny (1996, p.750) argue that this stems from differences in the nature of the legal system of each country around
the world. In fact, many factors have come together in different ways affecting the legal systems (Iskander and Chamlou, 2000). Nonetheless, globalisation brings harmonisation.
Hence, currently, there are two corporate governance systems prominently adopted by developed countries. They are the Anglo-American ‘market-based’ model and the
‘relationship-based’ or ‘Rhineland’ model (Van den Berghe and De Ridder, 1999; Iskander and Chamlou, 2000; Allen, 2000a).
The first model can be found in countries such as the United States, Canada, and the United Kingdom whilst examples of the second model can be found in Germany and Japan (Iskander and Chamlou 2000; Tabalujan 2002). In fact, the corporate governance model amongst these countries can be differentiated based on essential elements of good corporate governance systems: legal protection of investors and some form of concentrated ownership.
The legal system in the Unites States, for example, as identified by Shleifer and Vishny (1996) is an extensive system that does not only accommodate large shareholders’
interests but also protects minority shareholders. Indeed, the system supports ‘active public participation in the stock market and concentration of ownership through takeovers’ (Shleifer and Vishny, 1996; p.770). Nonetheless, because of the influence of the American political system, creditors or banks in this country have relatively fewer rights than they do in Germany and Japan.
Identifying the legal system in Germany and Japan, Shleifer and Vishny (1996) differentiate these countries’ legal systems and the United States’. The legal system in Germany provides more supports for creditors rather than for the other large shareholders, but no support to small investors to active in the market. Meanwhile, regarding to the protection for shareholders and creditors, the Japanese governance system is identified as between the United States and Germany. Japan has powerful banks and long-term shareholders and its
To conclude, because shareholders become permanent large investors whilst stock market plays important roles, it can be argued that the Anglo-American model focuses on dispersed controls and free market operation hence it emphasises the primary objective of company which is the maximisation of shareholders’ value (Van den Berghe and De Ridder, 1999). On the other hand, because the legal system supports long-term investors, more lasting institutional relationships, the second model is much concern with a socially corrected market economy where the objective of company is broader than in free market operation, therefore it emphasises the maximisation of stakeholders’ value (Van den Berghe and De Ridder, 1999).
Comparing to the rest of the world, Shleifer and Vishny (1996) found that the countries, other than the United States, Germany and Japan, have less substantial legal protection of investors. Therefore, ‘firms remain family-controlled and … have difficulty raising outside funds, and finance most of their investment internally’ (Mayer, 1990 quoted by Shleifer and Vishny, 1996). Indeed, for Asian case, the existence of controlling shareholders and the regulatory weaknesses become obstacles for the convergence towards the Anglo- American model (Allen, 2000b). Therefore, ‘it is apparent that many companies (in Asia) follow more the form rather than substance of corporate governance (of Anglo-American principles)’ (Allen 2000b, p.26).
2.2. Board Governance: Board of Directors and Board Committee
In the discussion of corporate governance, board governance is the apex of the system.
This is because the effectiveness of corporate governance practice is a function of the board.
Implicitly, the term of ‘board governance’ relates to the board of directors and includes board committee structures and roles on the board such as corporate secretary (JSX, 2003; Korac- Kakabadse, Kakabadse & Kouzmin, 2001; NCCG, 2001; JSX, 2000).
2.2.1. Board of Directors
To begin with, the monitoring activity by the principal has become important since the separation of ownership and control within the company, thereby to minimise the agency costs (Jensen and Meckling, 1976). Therefore, a board of directors has a vital role to play in a corporation, as its responsibility is to manage and direct the management (Farrar 2005, p.69).
Three main characteristics for good board of directors are related to composition, size, and leadership structure (Van den Berghe and Levrau, 2004). These characteristics which found in the academics literature are similar to characteristics employed in corporate governance rating systems.
According to Van den Berghe and Levrau (2004), discussion on board composition concentrates on the role and the proportion of inside, outside, and independent directors. In practice, there is a company which its board comprises more outsider than insider but there is also a company has more insider than outsider. There are six different perspectives that can explain the difference of board composition among companies. These perspectives, from which the board roles are derived, are resource dependent theory, agency theory, stakeholder theory, stewardship theory, institutional theory, and management hegemony theory (Van den Berghe and Levrau, 2004; Hung, 1998). In his paper, Hung (1998) summarises the six governing-boards theories that can be seen in the following quotation and depicted in figure 2.1.
“Resource dependency theory assumes that corporations depend upon one another for access to valuable resources and therefore seek to establish links in an attempt to regulate their interdependence... Stakeholder theory believes that there are many groups in society besides owners and employees to whom corporation is responsible; hence, the objective of a corporation should only be achieved by balancing the often conflicting interests of these different groups... Agency theory is concerned with the basic agency structure of two major parties, a principal and an agent, who are engaged in cooperative behaviour, but have divergent interests and attitude toward risk; hence, agency theory is concerned with resolving problems in the contract governing the relationship between the principal and the agent... Stewardship theory, in contrast to agency theory, assumes that managers
essentially want to do a good job; there is no motivation problem or non-alignment of interest between management and ownership and the governing board will then be mainly responsible for the setting the strategies... Institutional theory assumes that organisations are constrained by social rules, and follow taken-for-granted conventions that shape their form and practice... Managerial hegemony theory refers to a situation when the governing board of organisation serves simply as a
‘rubber stamp’ and all strategic decisions are dominated and pre-empted by the professional managers.” (Hung 1998, pp. 104-108)
Figure 2.1. A Typology of the Theories Relating to Roles of Governing Boards (Hung 1998, p.105)
Because of the different board perspectives, hence, board composition between companies or amongst countries might be different; it depends on which theory of board being adopted. In fact, based on these six theories, six roles of governing boards can be identified: linking role (from resource dependency theory), coordinating role (from stakeholder theory produces), control role (from agency theory), strategic role (from stewardship theory), maintenance role (from institutional theory), and support role (from managerial hegemony theory) (Hung, 1998). Related to these board theories and derived board roles, Van den Berghe and Levrau (2004) point out specifically that the agency theory is countervailing perspective to stewardship theory; while the agency theory recommends the majority of non-executive directors on the board, the stewardship theory supports a bigger composition of executive directors.
Despite the diverse perspectives on board composition, it is clear that there is a requirement for independent directors and non-executive directors as all corporate governance recommendations around the world suggest these types of directors should be included within a board. Based on the theory of Berle and Means (1932), it is believed that independent directors will minimise the cost as it makes the monitoring role and the strategic planning role of the board more effective (Farrar 2005, p. 364). Nonetheless, empirical studies have had difficulty in finding evidence which supports this theory. This can be seen for example from the regression study of Lawrence and Stapledon (1999). Examining the impact of independent directors on corporate performance and executive remuneration, they could not find either whether these types of directors affect firm value (both in term of accounting and share-price measurement) or a relationship between the proportion of independent directors and the level or pattern of CEO’s remuneration. The similar result of the relationship between independent boards and firm performance is shown by the study of Abdullah (2004), which takes sample from Malaysian Listed Companies. Abdullah (2004) assumes that the study failed finding the
relationship between the variables due to using the financial ratios as a proxy for firm performance. Compared to company’s growth measurement, which reflects long-term performance of the firm, the financial ratios might have measured short-term firms’
performance. The positing statement of Abdullah implies that the time lag should be considered when investigating the relationship between board independence and the company’s performance.
Support for the belief that independent directors matter for boards still seems difficult to find even with other methodological approaches. A study by Barnhart and Rosenstein (1998), examined the sensitivity of simultaneous equations, They found some support for a curvilinear relation between insider ownership and company’s performance, but weak evidence for a curvilinear relation between performance and the proportion of outside directors. Another study, a long horizon study by Bhagat and Black (2002) also confirm no evidence that companies with bigger numbers of independent directors can perform better than other companies. Furthermore, this study suggests that the strategy by low-profitability companies of hiring more independent directors, in order to increase performance, does not work. Finally, consistent evidence is found by DeAndreas, Azofra, and Lopez (2005). Their study, combining regression analysis with simultaneous equations, cannot find any clear relationship between the proportion of outside directors (a proxy for board independence) and firm value.
Having discussed the board composition as one of elements of good boards, the second important characteristic for good board of directors is the size of the board. Board size might influence the dynamics in board functions. As for example, a large and diverse board of directors may increase the board performance in terms of knowledge and skills. On the other hand, this type of board potentially may face group dynamics problems, which in turns make the board less effective (Van den Berghe and Levrau, 2004).
Hermalin and Weisbach (2003), based on a literature survey, argue that the relationship between board size and a company’s performance shows consistent results, which is a negative relationship. Supporting this, the study of DeAndreas, Azofra, and Lopez (2005), observing the OECD countries about the association between the board size and firm value, finds a negative relationship between these variables. This negative relationship is persistent after testing for robustness by controlling the variables board composition, internal functioning, country effect, industry effect, and market performance measurements.
The statement of Hermalin and Weisbach (2003) above is contradicted by other studies which find a positive relationship are found in the literature. The meta-analysis of Kiel and Nicholson (2003) found a positive correlation between board size and market-based company’s performance (but not for accounting measurement). Similarly, the study of Beiner, Drobetz, Schmid and Zimmermann (2004), modelling the interrelationships between the influencing aspects and mechanisms such as leverage and ownership structure, cannot find a significant association between board size and firm valuation. Then, Kula (2005) also finds no significant results of the effect of the structure variables, i.e., size, the proportion of independent directors, and the board committees’ structure, on the firm performance. Finally, from a banking sample study, Adams and Mehran (2005) also cannot find the relationship between board size and firm value.
Turning to the third effective board’s factor, the board leadership structure is derived from two opposition theories namely agency and stewardship theory. According to Van den Berghe and Levrau (2004), agency theory recommends the separation of the roles of CEO and chairperson on the board, hence reducing the domination of management on the board. In contrast, the stewardship theory advocates the unitary structure where a CEO also serves as the chairperson, to increase the trust and the motivation of the board. Similar to the other elements of good boards, the vexing results is found in the board leadership structure. The
study of Abdullah (2004), which could not find a relationship between the leadership structure and firm performance, presumed that the reason was the short-term period of measurement in their study. This unclear relationship is similar to the study of Dalton et al. (1998), which is quoted by Van den Berghe and Levrau (2004) in their literature review. On the other hand, the study of Kula (2005) finds a positive impact of separation between chairperson and general manager on company’s performance. Compared to Abdullah (2004), Kula uses multiple indicators of firm performance such as indicators of dividends, profits, sales volume and market share.
Having discussed some elements of effective boards intensively discussed in the academics literature: composition, size, and leadership, Van den Berghe and Levrau (2004) report some other elements of a good board of directors. These additional elements of good boards are based on interviews with 60 directors of Belgian listed companies. From a boards’
point of views, one of the most important elements of a good board is the quality of board meetings. This was followed by board composition and operation of board of directors as a decision-making group. Two other criteria less frequently considered under directors’
perspective are the role of board of directors, and the relationship amongst board, management, and shareholders.
The first element of a good board from a board’s perspective was the quality of board meetings (Van den Berghe and Levrau, 2004). It relates to the ‘raw materials’ of the meetings, which are information and the people themselves. Information can be explained by the degree to which the directors are well informed and well prepared. To be well informed and well prepared, the willingness of the directors to do continuous study is crucial. However, the learning process about the company’s business should occur not only in the meetings but also outside the meetings. In addition to well-informed and well-prepared board members, the quality of the meetings themselves is important for good meetings. To create high quality of
meetings, the members of the board have to be critical, neutral, and objective, and at the same time preserve a comfortable and constructive climate. In this case, the role of the chairperson is also important to create good meetings. The chairperson must be a strong leader so that he/she can drive the board. He/she has to monitor the presence and preparation of the other members. The way of making decisions, which are neutral from management or shareholders, well-thought and resulted from depth discussions, also contributes to the effective board’s meetings. Finally, the participation and involvement of all board’s members ensure the creation of high quality board meetings.
The issues in board composition from a boards’ perspective are similar to those in academics’ discussions and corporate governance rating systems; they relate to insider, outsider, and independent directors. However, under board perspective, the issue of diversity and complementary of the board is also concerned. There is a belief that diversity gives competitive advantage and positive perspectives to the board (Burke, 1994 in Hyland and Marcellino, 2002 and Campbell 1996 in Carter, Simkins and Simpson, 2003). Following this view, Van den Berghe and Levrau (2004) argue that, to be effective, the board should consist of different personalities and backgrounds, including educational, occupational, and functional backgrounds. In addition to these, some years experience of directing companies and knowledge at least in accountancy, law, and industry are important. Whereas, whether the board should include of foreign directors depends on the business environment. The empirical studies related to this issue found that diversity adds value (Carter, Simkins and Simpson, 2003). The diversity, which is identified as including representative of gender and minority group of society in the composition of the board, is attested to improve the company’s financial performance. Regarding to the organisation concern on diversity issue, the regional study of Hyland and Marcellino (2002) found there is a positive relationship between organisation size and women representation on the board. Supporting this, Carter, Simkins
and Simpson (2003) find the diversity increases alongside the size of company but decreases with an increase of insider directors.
The third element of a good board under directors’ perspective, relates to the nature of board itself as a decision-making group. Van den Berghe and Levrau (2004) explain that as a group, the members need to work as a team. Moreover, it is necessary that every member has moral principles and values, and pursue a group’s common vision and interests. Finally, trust and a sense of humour and informal meetings outside formal meetings might increase the quality of board as a decision-making group.
The next element contributing to creating an effective board is a good understanding of the company’s strategy as well as its business environment. Van den Berghe and Levrau (2004) report that, based on directors’ views, this knowledge is important so that a board can perform their strategic and oversight role effectively. Finally, an effective board must keep a good relationship with both shareholders and management. Therefore, a conducive-working environment where every part of the company can carry out their job effectively should be constructed.
Having discussed the theory and presented the empirical evidence, one question that should be examined further is why the results are inconclusive. This thesis suggests that the inconclusive results show persistence in a gap between theory and reality. Hence, it is attractive to be investigated. Nonetheless, two following arguments should be considered. The first is the endogenous problem amongst the variables (Hermalin and Weisbach 2003, p.8).
Therefore, rather than investigating the effectiveness of corporate governance implementation by positing one-way relationship, there is possibility of interdependency amongst the variables (Bhagat and Jefferies Jr, 2002). Accordingly, as the firm performance is a product from continuous activity of the firm, from previous periods to current years, one year or a short horizon observation might cause difficulty in interpreting the results. The second
argument is that there is a lack of an `integrative’ model in the study. It is the ‘partial’
approach of corporate governance measurement; ignoring the ‘soft’ criteria, causing vexing results (Zahra and Pearce II, 1989; Korac-kakabadse, Kakabadse, and Kouzmin, 2001; Wan and Ong, 2005).
Accommodating the integrative model, a study by Kula (2005), designed to find the characteristics of effective boards, explores not only the issue of the structure of boards but also the roles and process of corporate boards. In addition, rather than focusing on one performance measurement, the research employed multiple indicators. This study, exploring the control roles, finds a positive link between a board role variable, resource acquisition, and performance but no significant result for board service role and performance. The study also finds a positive relationship between the variables of board process, namely board effectiveness and information access, and firm performance. Finally, even though this study attempts to broaden the investigation by including role and process of a board, Kula (2005) does not accommodate the endogenous issue of factors influencing corporate performance.
Another study which also used an integrative model was done by Wan and Ong (2005). They explored the issue through another perspective, which rather than focusing on
‘one-to-one effect’ of board structure on firm value, proposed an indirect relationship between these variables. Indeed, they start at the point of investigating the direct relationship between board structure and board processes, then the processes and board performance. Their study concludes that board structure is not the determinant of performance but the board process.
Despite the similarity of this study to others that identify the structure as board leadership structure and the representation of outside directors, it differs in that this study takes ‘soft’
elements into the concept namely effort, conflict, and the presence and use of various skills.
Then, whilst financial or accounting measures are constructed to represent performance,
measures of the effectiveness of board role indicator and a transparency index are also introduced.
A prior integrative study conducted by Zahra and Pearce II (1989) proposed a “model of boards’ attributes and roles.” This model was developed by comparing the four diverse perspectives on the roles of corporate boards, which are a legalistic perspective, a resource dependence perspective, a class hegemony perspective, and an agency theory perspective.
These perspectives show different linkage between boards and company performance. The model introduces specific relationships amongst four board attributes and three vital board roles. The attributes, identified as building blocks of the model, consist of composition, characteristics, structure and process, while the roles are specified as the board function in service, strategy and control. In addition to the attributes, Zahra and Pearce II (1989) emphasis three important features of the model. The first feature is a contingent nature the relationship of board variables (attributes and roles) and company performance as they are influenced by the internal variables, such as company size and CEO style, and external factors, i.e., environment, industry, and regulation. In the next feature, the model leads to a specific series of relationship amongst variables, depending on theoretical orientation of the scholar. The final feature, the multiple character of company performance, will be recognised consequently. The study not only focuses on short-term measurement but also measures systemic and social indicators. Therefore, putting the whole factors in the model, the study tries to get the real picture of the relationship between corporate governance and company’s performance.
Supporting the integrative model, Korac-kakabadse, Kakabadse, and Kouzmin (2001, p. 24) state ‘these kind integrative studies provide inclusive results, suggesting the corporate governance has, at least, an indirect effect on company performance.’ Similarly, Van den Berghe and Levrau (2004) suggest that in evaluating the corporate board, better insight should
be considered. It means the evaluation tools should also cover the intangible elements influencing the board such as ‘style of meeting’ and ‘style of debate’.
2.2.2. Board Committee Structure
A board committee is established to assist the board of directors. Amongst the types of board committees, audit committees are set up to help the oversight function of the board of directors in order to increase financial disclosure. Indeed, financial disclosure becomes a matter related to the phenomena of corporate collapse (Clarke, Dean, & Oliver, 2003;
Commonwealth of Australia, 2002). In the case of Asian, and following the Asian crisis, the effectiveness of audit committee is being questioned; thus there is a great concern in the audit committee (Allen, 2000b). In fact, the phenomena of corporate collapse around the world has led to legislation or regulation reforms in both the accounting field and in the stock exchange (Clarke, Dean, & Oliver, 2003; Commonwealth of Australia, 2000b; Allen, 2000). In the 20th century; following the biggest American corporate scandals: Enron and Worldcom, the Sarbanes-Oxley Act becomes the magna carta of corporate disclosure, especially in relation to the audit committee issue (Findlaw, 2005; EIRIS, 2005).
However, previous recommendations were suggested by the Blue Ribbon Committee (BRC) in order to improve the effectiveness of a Corporate Audit Committee. BRC (1999, pp.10-15) recommends three important points which should be strengthened are independence, effectiveness, and accountability. To increase audit committee independence, BRC defines the meaning and the circumstances so that independence can be assured. Then, to increase audit committee effectiveness, the issues considered important are financial literacy, the needs for a formal written charter and its review and assessment, and the disclosure of a formal written charter adoption in the company’s proxy statement. Finally, for accountability, BRC recommends some mechanisms of relationship amongst the audit committee, the outside auditors, and management. Regarding to the mechanisms between the
audit committee and the external auditor, BRC suggests that two things, which influencing the objectivity and the independence of the auditor, must be specified. These are the ultimate accountability of outside auditor to both board of directors and the audit committee, and the relationship between the auditor and the company. Then, to increase the accountability, the letter from the audit committee must be disclosed. The letter contains information of firstly, the review activity of management to the audited financial statements, secondly the discussion between the external auditor and the audit committee about the auditor’s judgement regarding to a quality matter of the accounting principles.
In addition to the recommendations, the report of BRC also addresses ‘guiding principles for Audit Committee Best Practices’ (BRC 1999, pp.37-44). The guiding principles relate to the issue of independence, diligent and knowledge of the audit committee member.
Indeed, the principles can improve the key role of audit committee in the context of a ‘three- legged-stool’ relationship, which is relationship between board of directors (including the audit committee), financial management (including the internal auditors), and the external auditors.
Akin to the best practice suggested by BRC, DeZoort et.al (2002) consider four determinants of Audit Committee Effectiveness (ACE) namely composition, authority, resources, and diligence. Regarding to the composition, the issues are similar to the BRC’s recommendations that audit committee should be independence, financially literate, have integrity and objectivity. Similar to BRC’s recommendation, diligence is defined as the willingness of committee members working as a team in the context of a ‘three-legged-stool’
relationship. However, related to the resource component of ACE, DeZoort et.al (2002) emphasis the size of the committee and the circumstances so that ACE can be achieved. The size, between three and six members under BRC report, is considered suitable. Finally, all
criteria will interdependent as for example they will ensure fulfilment of the audit committee’s authority or responsibilities.
Unlike the issue of board of directors, which heretofore stimulated studies to solve the agency problem, the issue of board committee has heightened since the current phenomena of corporate collapses. The ineffectiveness of audit committees has become one of the problems. DeZoort et.al (2002) in addressing the financial fraud scandals, stated that the function of audit committees needs to be improved are related to their independence, composition, expertise, disclosure of activities, discussion of financial reporting quality, and materiality assessment.
Independence is one of the most important variables in the audit committee composition, as the literature shows that the independence has a favourable impact on the audit function. Abbott, Park, and Parker (2000) find that firms, composed of independent directors in their audit committee and where the audit committee meets at least twice per year, are less likely associated to both fraudulent and engage in misleading reporting. Next, Xie, Davidson III, and DaDalt, (2003) find there is small possibility that earnings management occurs when the audit committee consists of more independent than outside directors. In addition, Mangena and Pike (2005) find that the companies are more likely to disclose less interim information when audit committee is less independent. Similarly, the study of Khrisnan (2005) suggests that independent audit committee decreases the incidence of internal control problems.
Regarding other criteria for effective audit committee, the literature shows that experience, knowledge and ability also add value to committee audit effectiveness. In particular, these criteria enhance the interim disclosure (Mangena and Pike, 2005). In addition to increase the effectiveness, DeZoort and Salterio (2001) find that, in the case of auditor-
auditing knowledge were positively associated with support for the auditor. Therefore, the financial disclosure will be more reliable. In the case of aggressive accounting activities, the literature suggests that an audit committee having more expertise and knowledge in financial literacy is more effective in constraining the earnings management (Bedard, Chtourou and Courteau, 2004; Xie, Davidson III, and DaDalt, 2003).
In addition the appointment of directors with financial expertise to the audit committee is also significantly and positively rated by the market (DeFond, Hann, and Hu, 2005;
Davidson III, Xie and Xu, 2004). DeFond, Hann, and Hu (2005) emphasis that the reaction, measured by cumulative abnormal returns (CARs), is only positive when the appointed outside director is independent and when the appointing companies have relatively strong corporate governance records before the appointing process. Regarding financial expertise, Davidson III, Xie and Xu (2004) find further that the auditing and audit firm experience is more important than corporate financial management and financial statement analysis experience.
Finally, the survey of Rezaee, Oibe, and Minmier (2003) on audit committee disclosures by Fortune 100 companies shows that the listed companies in the US comply with the self-regulatory requirements issued by the stock exchanges. Despite the fact that the process of fulfilling their oversight function should be the major issue in the audit committee reports, this survey found that the main focus in reports were audit committee roles and structure.
2.2.3. Measuring the Relationship Between Corporate Governance and Company’s Performance
Having discussed the specific variable of board governance: board of directors and audit committee, these following paragraphs present literature on the effect of the corporate governance practice as a whole on company’s performance. The evidence shows a positive
relationship between corporate governance and company’s performance (Black, Jang, and Kim, 2006; Brown and Caylor, 2005a; Beiner, Drobetz, Schmid, and Zimmerman, 2004;
Gompers, Ishii, Metrick, 2003).
In many of these studies, corporate governance has been measured by governance indices or governance scores, reflecting all the corporate governance variables as suggested by regulation or developed by scholars. Further, company’s performance has been valued by such measures as Tobin’s Q, ROA, ROE, sales growth, profit margin.
Similarly, the global investor survey of McKinsey study (2002) suggests ‘a majority of investors are prepared to pay a premium for companies exhibiting high governance standards.’ The premium for these companies are ranging from 12% to over 30%, as the lowest percentage of premium will be given by Northern American investors while the highest percentage will be offered by Eastern Europe and Africa.
In contrast to the findings of the favourable effect of corporate governance practice on the market, an Indonesian regional study of corporate governance, when using Tobin’s Q as the proxy, cannot find a positive relationship but, with a measure of a company’s operating performance namely ROE, it does show an evidence of a positive relationship between ROE and corporate governance (Darmawati, Khomsiyah, and Rahayu, 2004). An explanation for the Indonesian case, may not be that the market does not respond to the practice, but that, if there is a response, the response might take time. In other words, there might be a time lag for the Indonesian market to respond to corporate governance implemented by companies.
Besides this time lag assumption, another explanation might be that endogenous variables which were not accommodated by this prior study, caused the finding of no supporting results in favour of a relationship between corporate governance and company performance.
Having recognised that corporate governance positively relates to company performance, the next question is: what factors drive a company to implement corporate governance principles so that it increases its performance? The literature shows internal factors and external condition determine the corporate governance structure. The studies of Adams and Mehran (2003) and Gillan, Hartzell and Starks (2003), for example, find that one of the factors to affect the structure of the company’s corporate governance is investment opportunity. Specifically, the study of Adams and Mehran (2003), comparing the corporate governance structure in bank holding companies (BHC) and manufacturing firms, supports the view that governance structure is industry specified. Indeed, analysing the causes of the different governance structure, the main reasons are the dissimilarity in the investment opportunities and the regulation between these industries. The differences can be seen further, as firstly, on average, BHC board size and the percentage of its outside directors are significantly larger than the manufacturing firms. Secondly, BHC boards, on average, have more committees and meetings than the manufacturing firms. Next, the ratio of stock option of the BHC’s chief executives to salary plus bonuses is smaller than in the manufacturing firms. Fourthly, the BHC chief executives have smaller direct equity holdings than the manufacturing firms’ CEO. Finally, in the ownership structure, the ownership of institutional holder is fewer in BHC than in manufacturing companies.
Similarly, the study taken by Gillan, Hartzell, and Starks (2003), investigating a broader sample of companies from more various industries, finds that industry factors have an important role in explaining the index of total governance in corporate governance ranking systems. The factors, namely industry investment opportunities, product uniqueness, competitive and information environments, and average leverage, are pre-eminent variables in explaining the overall governance structure. In fact, they are more powerful than time effects and firm factors.
Despite the fact that investment opportunity becomes one of the factors influencing the corporate governance structure, Klapper and Love (2004) find that legal systems matter for the good corporate governance. Their study suggests that in the environment where shareholder protection and judicial efficiency is weak, improving the quality of corporate governance will be important as it may increase the company’s performance and valuation.
Apart from the discussion that investment opportunity is the main factor explaining the corporate governance practice, some studies show that the other factors, such as bad financial conditions or ownership structure, influence a company’s corporate governance but with inconsistent conclusions. As for example, examining the relationship between company’s performance and the proportion of independent directors, Hermalin and Weisbach (1988) report that the proportion of independent directors increases as firms experiencing financial trouble. Nonetheless, Evans, Evans, and Loh (2002) cannot find this such evidence.
They find that the reactions of firms experiencing declining performance are not by changing the ownership structure, the proportion of outside directors, or CEO pay levels, but by significantly increasing the board meeting frequency. Finally, whether ownership explains the corporate governance practice, the study of Barnhart and Rosenstein (1998), examining the sensitivity of simultaneous equations techniques in corporate governance research, finds a greater effect of managerial ownership on board composition than vice versa.
2.3. Conclusion
To sum up, this chapter has discussed specifically the board governance issue and also the association between overall corporate governance practice and company performance. In the board governance section, attributes related to composition, size, leadership structure, and board meeting are believed to increase the quality of the board. Similarly, in the board committee section, the characteristics related to composition, effectiveness, and size are considered to add to the quality of the board, besides another attribute: accountability. In the
final discussion, the literature suggests a positive relationship between overall corporate governance practice and company performance. The chapter also identifies some external and internal factors that influence the corporate governance practice of a company.
It is interesting to note that the empirical evidence on the issue above shows contradictory results. Two limitations are identified: an endogenous problem and the lack of an ‘integrative’ model. An endogenous problem in the relationship between corporate governance practice and company performance can be explained further that there might be interrelationship or two way-relationships between these variables. Therefore, the results of investigation based on one-way relationship between these variables could be misleading.
There are some econometrics procedures to detect this endogenous problem. While endogenous problem identified, simultaneous equation model shall be applied to investigate this kind relationship. Next, related to an ‘integrative’ model, this term refers to the model of Zahra and Pearce II (1989) and other model that accommodates soft elements of corporate governance.
This paper has recognised two limitations of previous research, however, this paper does not attempt to overcome the problems due to the time and data constraints. For completion of minor thesis, this paper only reports the preliminary examination using Ordinary Least Squares (OLS). The detection of endogenous problem in the relationship model will be reported in another paper in the future. Nonetheless, the theoretical framework of this thesis accommodate the issue of interrelationship problem between variables.
Above all, this paper believes that the preliminary results of the model using OLS give insight into the corporate governance practice in the Indonesian context. It also provides guidance for further research into the Indonesian case.
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 (+)
