Corporate Governance Mechanisms And Firm Performance Accounting Essay

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This research project attempts to provide evidence of the relation between corporate governance mechanisms and firm performance in the UK. Corporate governance has become a major concern among investors and regulators over the last few decades. Arthur Levitt, the previous chairman of the Securities Exchange Commission, emphasizes on the importance of corporate governance in attracting investments "If a country does not have a reputation for strong corporate governance, capital will flow elsewhere. If investors are not confident with the level of disclosure, capital will flow elsewhere"(Levitt 1999).

The information that presented in annual reports, are considered the main source for investors to ensure the firm will continue and grow in the future. Investors expect the information in annual reports represent truly and fairly the financial situation of the company. Despite that, annual reports do not cover many aspects of the firms. Many high-profile companies have collapsed, although their annual reports had been prepared correctly. Academic studies and investigation committees have linked such that collapses to corporate governance (Cadbury 1992; Ribbon 1999).

Cadbury (1992) defines corporate governance as "Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies … The responsibilities of the board include setting the company's strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship". In other definition, corporate governance has been described as "the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment"(Shleifer & Vishny 1997).

Surprising failures of the accounting and auditing functions in recent years have exposed both the inadequacies of Anglo-American governance model, and the inability of accounting information as currently presented to satisfy the interests of an increasing range of stakeholders. Therefore, there has been considerable pressure on those responsible for the regulation of the accounting and governance functions to address these perceived inadequacies. In response, many committees were formed (e.g., Cadbury Report late 1980s, Smith report 2003) resulted in many recommendations to reform the accounting and governance status.

The purpose of this research is to investigate the association between corporate governance and firm value. This research may offer new insights into the relationship between the corporate governance and firm value in particular, and contribute to the extant literature involving additional factors that affect the function of corporate governance. Therefore, the main research question in this study will investigate:

What is the effectiveness of corporate governance on the firm value?

Different committees have suggested that there are several characteristics should be followed by audit committees to be effective (e.g. Ribbon 1999 in US, Cadbury 1992 and Smith 2003 in the UK). These committees mention to certain mechanisms that play the key roles in the effectiveness of corporate governance. In addition, the disclosure of corporate governance have been required by stock exchange markets for listed companies and they must follow the accounting regulations which are required mechanises of corporate governance and its responsibilities. The present study extends this line of work by addressing the link between certain characteristics that affect the corporate governance and firm value. Therefore, the second research question will be:

Are the mechanisms of corporate governance related to firm value?

This study concentrates on characteristics of board of directors, audit committees and the role of institutional ownership. It argues that:

There is a positive relation between the independence board of directors and firm value.

There is a positive relation between board size and firm value.

There is a positive relation between ownership of board of directors and firm value.

The intuitional shareholders affect the firm value.

There is a significant relation between independence of audit committee and firm value.

The size of audit committee could affect the firm value.

There is a positive relationship between the expertise of audit committee members and the firm value.

The activity of audit committee has impact on the firm value.

The effectiveness of ownership by audit committee members on the firm value.

Research Methodology and Data:

This research aims to investigate the relation between corporate governance and firm performance. To achieve that the data will be collected mainly from annual reports and financial databases. The annual reports include the data which are needed to conduct this research. The information are displayed in annual report according to Companies Act 2006, Listing Rules and Combined Code on Corporate Governance [1] . Companies Act 2006 obligates the listed companies to publish annual reports at the end of the financial year. It clarifies that the burdens and restrictions that organise the function of listed companies are issued by Companies Act and Listing Rules. The listing Rules, which is issued by Financial Service Authority, require the listed companies to include in their annual reports whether they comply with Combined Code.

The Combined Code is issued by Financial Reporting Council and updated regularly, the first issue of Combined Code was released on June 2008 by Hampel Committee and it concentrated on the role of non-executive directors, the latest update of Combined Code has been done on June 2008 and it can be noticed that there are no fundamental changes between the Combined Code of July 2003 and June 2008 [2] . The Combined Code on Corporate Governance (2003) requires the companies to include their annual reports information about the work and decisions of board of directors, identify the chairman, deputy chairman, chief executive, independent directors, non-executive directors, chairman, members and work of audit, remuneration and nomination committees, number of meetings of board of directors and its committees. Moreover, the companies are required by the Combined Code to make their information available on their websites.

Therefore, the annual reports of UK companies can be gathered from academic databases or the websites of the companies. Hemscott Database is one of the academic databases that offers data of UK firms, that data include details of the board structure of each company, including the name and number of executive and non-executive directors in committees. It also provides information on the current, and previous, posts held by directors. From this it can be calculated the average number of directorships held by the non-executive members of the board of directors committees. It, also, shows non-executive directors who had previously been an executive director of the firm or who had held a senior post with a company's advisors or auditors. Other biographical information includes the length of time a director has served on the board. In addition, it provides information on the shareholdings of executive and non-executive directors and externally held shareholdings in excess of 3% (Weir, Laing & McKnight 2002).

Financial data will be collected from Datastream Database, which gives access to historical financial information. It also provides a range of charting and reporting tools to enable researcher to display, download and manipulate data. Additional information can be collected from Fame database, which gives access to information on up to 1.8 million UK & Irish public & private companies. For the top 500,000 of these companies, up to 10 years information is available. Fame utilises over 170 search criteria, and all financial items are searchable, with time series searching possible. Integrated analysis features are also available.

Collecting data by using secondary sources has been used to collect data from US and UK companies in previous studies. In the US, many studies, that have investigate matters related to corporate governance, have collected data from proxy statement [3] (e.g. Carcello & Neal 2000; DeZoort, Hermanson & Houston 2003; Smith 2006; Turpin & DeZoort 1998; Vafeas 2005; Xie, Davidson & DaDalt 2003; Zhang, Zhou & Zhou 2007). In the UK, different methods have been used to collect data to investigate matters regarding corporate governance, some studies have used questionnaire and information from annual reports as a method to collect their data, for instance Collier and Gregory (1996) and (1999), and Windram and Song (2004); Others used interview only to gather the data, for example Mackay and Sweeting (2000). However, majority of studies, that have collected data by using the secondary sources to collect their data, and that sources are databases, which include annual reports and financial information, for example (Dahya, McConnell & Travlos 2002; Florackis 2005; Franks, Mayer & Renneboog 2001; Song & Windram 2000, 2004; Weir, Laing & McKnight 2002; Young 2000).

Using primary sources to collect data have their limitations and advantages. For instance, using questionnaire to collect data can offer a deep understanding of the phenomenon from people who involved directly in that issue, but the survey has intrinsic limitations. First, the main limitation of using questionnaire is the low percentage of responses. In addition to that, some of responses are, sometimes, unusable; consequently this will make the percentage of response more lower. Also, the findings of studies, that have used questionnaire, could not be generalised to another subjects that have not been included in the examination. Furthermore, the respondent may misunderstand the questions and they may give inaccurate information to show the work goes perfectly and professionally (Brace 2008).

Interview, as a tool for data collection, has its advantages and disadvantages. On one hand, it allows the researcher to gather accurate data in depth and with more details and give the interviewee the chance to explain their opinion about fundamental issues. Moreover, interview is considered the most flexible method of data collection, since it is conducted by conversation, so, it helps to develop line of enquiry. On the other hand, it is difficult to analysis the data from the interview because the responses are non-standard, so the interview is time-consuming to analysis and to collect, in particular if the interviewees are geographically widespread. In addition, it is hard to avoid the impact of interviewer on the context of data and, also, what the interviewee say is not necessary to be the truth, consequently, this impact will affect the reliability of the data (Denscombe 2003).

In order to avoid these limitations and because of the availability of the data from secondary sources, it was decided that the questionnaire will not be used as a tool of collecting data. Therefore, archival data will be used to conduct this research, that data can be collected from annual reports in different ways. Using data from annual reports has several advantages. First, the data can be collected from several databases, therefore, it will not be non-response bias, which many researcher face when they collect data. Second, the measurements of this study, which will be used to calculate the performance of the companies, can be calculated by using data from annual reports.

Population and sample selection:

The population of the sample of this study is the listed company on London Stock Exchange with financial year ending during 2007. This year is selected because it is the most recent year for which full financial statement data is available for the sample companies and, also, it comes before the effectiveness of financial crisis, which could make abnormal effect on the performance of the companies in the UK in general.

Furthermore, the selection of 2007 as the year of data collection is supported by recent changes and updated which have been made by Financial Service Authority. These changes are Higgs (2006), who reviews the role of non-executive directors; Smith Report (2003), who reviews the role of audit committee and its importance; and few changes in Combined Code on Corporate Governance (2006). Consequently, collecting data from annual reports of financial year of 2007 could represent all that changes and give clear picture about the situation of corporate governance.

The sample of this study is limited to companies that are listed on the London Stock Exchange in financial year 2007. The sample of the study will be all companies that their data are available on Hemscott Database and Datastream Database.