The purpose of this study is to examine the relationship of board structure (namely board size, proportion of independent non-executive directors and duality role) on company performance. The research concentrated on Malaysian public listed company. The main aim of this context is to review the literature relevant to this study. Firstly, the literature reviews on three main area of board structure influence firm performance; board size, proportion of independent non-executive directors and duality role. Then, followed by relevant literature regarding the measurement of company performance.
2.2 Agency Theory
In business organizations there must be an effective corporate governance structures to minimize agency problem arise. The agency problem could be arising because of the separation of management and finance or from different perspective it refers to the separation of business ownership and control activities in the organization (Shleifer and Vishny, 1997).
As the introduction points out, Jensen and Meckling (1976) stated that the idea of agency theory is due to the principal-agent relationship in which it is more on the contract between two parties (principal and agent) with a purpose to perform some services to maximize the shareholders' wealth. The shareholders (principal) engage the management (agent) to act on behalf of them through tasks delegation and decision making authority.
Get your grade
or your money back
using our Essay Writing Service!
When the decision made by the agent was not in the best interest of the principal it leads to the conflict of interest behavior (Arnold and de Lange, 2004). A potential conflict of interest exists within two parties when the managers' personal interest overrides the maximization shareholders' wealth. Further Zainal Abidin, Mustaffa Kamal and Jusoff (2009) imply that the shareholders (principal) unable to monitor over the management activities and behaviors, therefore it brings an exposure to the agent to put less emphasis on maximizing returns to the shareholders.
The existence of information asymmetry also becomes a factor towards the agency problem in which the management has the competitive advantage on information over the shareholders (owners). Indirectly, this situation gives an opportunity to the managers to act and make a decision in their best interest while reducing the welfare of the owners (Arnold and de Lange, 2004).
As the agency problem goes on, companies have to incur agency costs to monitor the management action and to sustain an effective relationship between principal and agent. In line with Jensen and Meckling (1976), agency cost is divided into three categories: monitoring costs, bonding costs and residual losses. In order to minimize the agency costs, it was suggested that an effective corporate governance structures was seen as an alternative to reduce the agency problems and to better align the interest of principal-agent relationship (Fama and Jensen, 1983). According to the authors, the presence of board of directors is to monitor management behaviors as well as to protect shareholders' interest.
As it suggests, the appointment of boards is to act as a watchdog to monitor and looks around the behavior and action of managers to be in line with shareholders' interest (Jensen and Meckling, 1976).
2.3 Overview of Corporate Governance
2.3.1 Roles of Board of Directors
All companies all around the world have drawn an attention to the importance of having a group of board of directors as the representative of the shareholders in the company. While in the US, board of directors is claimed to be the middle person between management and shareholders to check and interpret the decision on behalf of the shareholders (Denis and McConnell, 2003).
Kakabadse, Kakabadse and Kouzmin (2001) conclude that the role board of directors can be classified into three which is service role (where the boards provide service on counseling to the management in formulating strategies to enhance reputation of companies as well as implementing a good decision making for shareholders' wealth. Next is control role (where the boards monitor the CEO and management performance with a purpose to safeguard shareholders' interest).Third is strategic role (it is more on the roles of the easiness in acquiring finance resources for the future success of the firm while guiding the corporate mission and the development of firm strategy).
According to Sunday O (2008), the code of corporate governance best practices of Nigeria mentioned the roles of the board of directors as:
Always on Time
Marked to Standard
The business of a firm is managed under the direction of a board of directors who delegates to the CEO and other management staff, the day to day management of the affairs of the firm.
The board sees to the appointment of a qualified person as the CEO and other management staff.
The directors, with their wealth of experience, provide leadership and direct the affairs of the business with high sense of integrity, commitment to the firm, its business plans and long-term shareholder value.
The board provides other oversight functions.
On the other hand, Ponnu (2008) summarized the responsibilities of the boards are to formulate the corporate goals and policy, to elect the senior executives and provide remuneration to them. Besides, board of directors is accountable to the fund providers (shareholders), authorities and stakeholders. Therefore, as far as board of directors is concern, the success of the company depends on the effectiveness of the board in fulfilling their duties on behalf of the shareholders and monitoring the management activities.
2.3.2 Board Structure and Malaysian Code of Corporate Governance
In Malaysia, code of corporate governance is seen to be an important tool to every company because of the 1997 Asian Financial crisis which brings a big impact to Malaysian companies as well as economy as a whole. Therefore, the first code of corporate governance was issued by Malaysian Institute of Corporate Governance in March 2002 for the guidance and awareness of corporate sector, investors and public. While significant improvement has been achieved, in 2007 the Code is revised to improve the quality of the board of public listed companies (PLCs) by taking into consideration the role of board of directors and audit committee.
A definition by the FCCG (Malaysia) in the Report on Corporate Governance (1999) states that:
"Corporate governance is the process and structure used to direct and manage the business and affairs of the company towards enhancing business prosperity and corporate accountability with the ultimate objective of realizing long term shareholder value, whilst taking into account the interests of other stakeholders."
As defined by Ibrahim, ur Rehman and Raoof (2010), corporate governance is the system functioning to direct and control the corporate sectors. By implementing good best practices code of corporate governance, it may direct the setting and achieve firm objectives. Then, it also can be used to evaluate and examine the financial performance of the firm.
However, Malaysian definition on corporate governance provided by Noordin (1999) is corporate governance is more about accountability and transparency. Transparency is more on the picture of how the company presents and shows itself transparently to the shareholders, public and other interest group. Besides, transparency can be related to the disclosure made to the outsiders about the actual managerial actions in fulfilling the shareholders' interest.
To enhance the good practices in corporate governance in Malaysia, the enforcement and control should be strengthened to encourage the accountability and transparency. According to the MCCG (revised 2007), the control mechanism can be divided into two: internal and external corporate governance control. For internal corporate governance control, the function is to monitor activities and take corrective action to accomplish organizational goals. The examples include monitoring by the board of directors, emphasizing the internal control procedures and internal auditor's roles and duties, balancing the power of Chairman and CEO and Remuneration based on the directors performances. While, external corporate governance controls encompass the controls of external stakeholders exercise over the organization.
As stated in MCCG (revised 2007) the efficiency and accountability of the board of directors in PLCs are emphasized in order to enhance the credibility of directors in discharging their duties on behalf of the shareholders. The Code emphasizes that the Board must comprise a combination of non-executive directors and independent non-executive directors to ensure board capability in exercise independent judgment. Furthermore, the Code has prescribed the requirement to balance the power and authority between CEO and Chairman. There should also be a clearly accepted division of responsibilities between these both positions.
In line with achieving shareholders' wealth, a good corporate governance practice can ensure the sustainability and survival of the firm to maintain the business life for a long term (Mohamad Mokhtar, Muhamad Sori, Abdul Hamid, Zainal Abidin, Mohd Nasir, Yaacob, Mustafa, Mat Daud and Muhamad, 2009). As far as we are concern, board of directors play an important roles in the organization to monitor and control managers' behavior to make sure company activities parallel with the objectives and achieving a valuable shareholders' rewards.
2.4 Board Structures and Firm Performance
2.4.1 Board Size and Firm Performance
This Essay is
a Student's Work
This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.Examples of our work
Board size is recognize as one of the element board structure which contribute as an important determinant of firm performance (Othman et. al. 2009). Board size consists of a small and a large number of directors on board. The MCCG does not specify in detail the exact number of directors on board. In fact, the Code recommended that the size of board should be in a sufficient number to encourage active participation of directors and can efficiently perform their tasks precisely. As mentioned in the study of Ibrahim and Abdul Samad (2011), board size is important in managing business affairs which may influence the company performance. The study suggested that a small board size is more efficient in conducting business affairs.
MCCG (revised 2007) described that to have an effectiveness of board, size of the board should be examined objectively. Mohd Saad (2010) found that in Malaysia, number of directors sit on the board before the implementation of corporate governance is sixteen, while during and after corporate governance implementation, the average size of the board is around six to ten persons. On the other hand, based on KLSE-PricewaterhouseCoopers (1999) the average numbers of directors sit in Malaysian Public Listed companies is eight. Whereas, in study of Nam & Nam, (2004) the average board size is around ten. From all this, as what recommended by Bursa Malaysia listing requirements (2002), the maximum number of directors recommended for public listed companies (PLCs) is ten, whereas for the non-Publicly Listed Companies is fifteen (Abdul Hadi, Fazilah, & Md. Ishak, 2005).
In fact, Sunday, (2008) discovered that the limited number of board size is seem to improve financial performance of companies. As study done by Othman R. et. al. (2009), there is a positive significant influence between board sizes in maximizing shareholders' wealth. It indicates that a large number of directors in a board of directors lead to the improvement of financial performance measured by ROI and EPS.
Zainal Abidin et. al., (2009) appeared to support the positive relationship based on sample size 75 companies which randomly selected on the main board of Bursa Malaysia. Finding of this study summarized that with a more number of directors on boards contribute to an enhancement of firm performance with a strong argument when company has larger board members there are more ideas and skills can be shared among them to make an improvement in companies' daily activities. Mohd Saad (2010) argued that financial performance sound to be good through a big size of boards because company will have more expertise directors on board which can work and cooperate together to make a decision for the benefit of company.
Contrary to study done by Cheng (2008), where it shows a large number of board size negatively associated with company's performance. A larger board will cause less effective discussion among them to reach any understanding in making a decision. Otherwise, smaller size of boards helps in reducing the free rider of directors. Meaning, firm performance will be more efficient with a smaller board size compared to having larger board size. A similar opinion shared by Mashayekhi and Bazaz (2008) where a negative relationship was proved between board size and firm performance proxy by ROA, ROE and EPS.
In other situation, there are studies which conclude board size does not have any significant relationship with corporate performance (Ponnu and Karthigeyan, 2010). It summarized board size does not explain any significant to influence the firm performance. The overall results provided different evidence subject to the different types of sample.
2.4.2 Proportion of Independent Non-Executive Directors and Firm Performance
The previous research acknowledges that independent non-executive director was appointed for a purpose to achieve a balance and effective board. Ponnu (2008) claimed that to establish an effective board there must have a balance of directors between executive and non-executive directors to enable the independent directors to work co-operatively with executive members by providing an independent view and judgment when it was required.
The non-executive directors are appointed because they believed to be independent and free from any conflict of interest as well as assumed to be the most effective monitors of management action (Ameer, Ramli, and Zakaria, 2008). Further, instead non-executive directors classify as an independent to the organization, they also have an independent viewpoint and are able to ask questions and probe further about an issue arises in the company. They are also able to bring in an experience from external environment which can be applied in the company (Siladi, 2006).
Proportion of independent non-executive directors plays an important role in influencing financial performance of company. As stated by Ibrahim and Abdul Samad (2011)and Ameer et.al. (2008), firm boards populated by non-executive directors have a significant positive effect on firm performance and it becomes a useful mechanism to address agency problems. A similar result also shared by Zainal Abidin et. al. (2009) which a higher proportion of independent non-executive directors on the board bring a positive impact towards firm performance based on Value Added Intellectual Coefficient (VAIC). The results summarized the important of proportion of non-executive directors on the board as required by MCCG and Bursa Malaysia Listing Requirement was seen as a good practice to achieve a long term corporate performance
On the other hand, a study by Bhagat and Black (1999) fail to obtain positive relationship between board composition and corporate performance. In which they found majority of independent non-executive directors on boards resulted the company to perform worse. Similarly, Aik Leng and Abu Mansor (2005) reported that the presence of independent directors has not improved firm performance. Among the reasons in contributing negative relationship are lack of skills own by independent directors, limited role they can play as well as limited time spent on company affairs.
While Ponnu (2008) found no significant relationship arise between board independent and company performance listed in main board. There are other studies which also found inconclusive evidence between board independence and financial performance (Abdullah, 2006 and Ponnu and Karthigeyan 2010). The result explained that the inclusion of independent non-executive directors on board does not bring any influence or any contribution towards firm performance.
2.4.3 Duality Role and Firm Performance
The MCCG (revised 2007) recommends a separation position and roles between Chairman and CEO in each company with intention to have an independent board, to have balance of power and abuse conflict of interest which can assist increase firm's value. Other reason to have a separation role is to keep away from a single person to conquer the board in making a decision also to encourage fair judgment and reasonable concern. However, for a company which prefers to maintain a dual leadership, the combined roles must be clearly explained in the annual report and that person must be independent enough to hold the position (Mohd Saad, 2010). Previously, there are several studies conducted to determine the influence or if there is any relationship between separate or combined CEO duality roles towards firm performance.
Aik Leng and Abu Mansor (2005) recommended no separation position of CEO and Chairman bring a positive influence and give superior company's financial performance. It shows no separation roles will made one person dominate the decision, also that person will aware to anything happen which could lead to the faster decision made (Chang, 2009).
Contrary to above literature, according to Ponnu (2008), there is no significant relationship between duality roles to firm performance proxy by ROA and ROE. Study was conducted during 1999 (before MCCG implementation) and during 2005(5 years after MCCG implementation). Not only that, Ibrahim and Abdul Samad (2011) and Wei Chen, Barry Lin, and Yi (2008) provided a similar evidence where they found no conclusive result. It confirms that no improvement in company performance after separation roles of CEO and Chairman or there is no significant effect of CEO duality to firm performance.
Contrary, Kholeif (2008) explained that CEO duality provide a negative relationship to firm performance. It means that, a combined role will lead to lower performance of companies whereas a separation role will lead to higher performance of companies. It illustrated the interests of shareholders are safeguarded when there is a separation position between the Chief Executive Officer (CEO) and the chairman of the board to a different person.
A unique finding released by Yan Lam and Kam Lee (2007) where it found a relationship between CEO duality and financial performance on the presence of the family control firm. It shows that CEO duality provides an improvement toward financial performance of non-family firms. While separation role is contributed to improvement in financial performance of family-controlled firms or in other word it provides negative relationship between the combined CEO/Chairman roles on firm performance.
2.4.4 Board Gender Diversity and Firm Performance
Board diversity can be defined as the mix of male and female proportion sit on board of directors. In recent years, issues regarding board gender diversity has become a highly debated governance issues and most probably important to the effectiveness of governance structure (McMahon, 2010). As discussed by Smith, Smith and Verner (2006) the involvement of women on top position and board of directors of the company is still low. Due to that, the encouragement of board diversity could help to increase the competitiveness of the firm and reduces the gaps of female participation on boards (McMahon, 2010).
As discussed by Marinova, Plantenga and Remery (2010), amongst many companies in Norway by year 2006, they must have at least 40% of female directors' participation on board chairs. Whereas, in Finland starting from 1st January 2010, the Finish listed that companies must have at least one female director to join the boards. An improvement of board gender was also noted among Malaysian listed companies, where the women participation on boards now comprise 8.2% in year 2010 which has been increased from 7.5% in 2009 (The New Straits Times Special, 2010).
The issue of gender diversity is seems to be a value-driver in firm strategy as well as performance. Kang, Ding, and Charoenwong (2010) suggested the more diverse of corporate boards may improve boards' ability to discharge their strategic duties and control. There is an assumption of positive relationship between participation of women directors towards firm performance in terms of firm productivity and profitability (Marinova, Plantenga and Remery, 2010).
It is agreed by the researchers from Catalyst (2004); Carter, Simkins, and Gary Simpson (2003) which showed a company with more diverse of boards achieved better financial value. It concludes that group of companies with the highest participation of female director are financially outperformed compare to the companies with the lowest female directors participation. The previous literature is in line with Galbreath (2011) where a positive link appeared between women participation on board to the economic value. The researcher comments that this is due to women abilities to engage with the stakeholders while responding to their need.
Contrary to that, board gender diversity is seemed not to give any impact to firm value (Marimuthu and Kolandaisamy 2009). The evidence on the relationship between gender diversity and corporate performance as found by Adams and Ferreira (2009) also mentioned that firms with the participation of women on boards have worse financial performance in terms of Tobin's q, while in terms of ROA, they have a better performance. The existence of women directors bring a significant impact on board inputs (attendance behavior and committee assignments). Therefore, the findings suggest that board gender diversity influence the monitoring activities by boards towards management to be in line with the shareholders interest.
On top of that, Smith, Smith and Verner (2006) found that there is a positive relationship between the involvement of female on boards of directors and corporate performance. The results conclude that the positive relationship depends on the level of education and qualifications of the person itself. It means, the qualification also plays an important role to judge the credibility of the women in holding the director's post.
2.4.5 Measurement of Firm Performance
Corporate financial performance was seen to be measured by using a different performance measures like long term market performance measurement and short term measurement namely non market-oriented measures (Zainal Abidin et. al., 2009). Accounting measures of firm performance is used to test the hypothesis of the study (Ponnu and Karthiyegan 2010).
There are numerous measurements used by previous study to evaluate corporate performance in order to instill investors confidence towards company they were invested. In fact, various studies tested the relationship exist between corporate governance characteristics which bring an influence toward corporate financial performance (Ponnu and Ramthandin 2008).
In order to measure shareholders' wealth, return on investment (ROI) and earnings per share (EPS) being used (Othman et. al., 2009). They found that ROI and EPS looks like an important indicators to the success of company in generating income to provide superior return to shareholders.
While in study of Ponnu (2008) and Ponnu and Karthiyegan (2010), to measure the superior performance of company, the widely used performance measures are return on asset (ROA) and return on equity (ROE). These two measurements are used by the researchers because it represents a tool to evaluate the real performance of company. Likewise ROA and ROE refer to an accounting-based performance measure commonly used in empirical research and it is generally accepted by the corporate governance researchers. On top of that, ROA is considered as a strong performance measure by a number of scholars (Ponnu and Karthigeyan, 2010).
On the other hand, Mohamad Mokhtar et. al., (2009) stated that the financial ratios used to measure firm performance are ROA, ROE, EPS and profit margin (PM). On top of that, Value Added efficiency of total resources is the other type of financial measurement used to effectively evaluate the financial performance of company. Performance of company was measured according to the firm's total resources which are calculated using Value Added Intellectual Coefficient (VAIC) methodology developed by an Austrian, Ante Pulic (Zainal Abidin et. al., 2009).
From the above literature, measurement of business performance is very important to the business entity and to the shareholders. It indicates that the performance measures will indicate how well the management of the company is and it measures the effectiveness of the company in utilizing the resources to run the business activities (Robinson, K., 1998). From that, we can say that performance measures would give a warning sign to the manager to take a corrective action and implement a strategic plan to achieve company goals and achieving shareholders wealth.
2.5 Chapter Summary
This chapter reviewed literature on the overview of corporate governance structures in Malaysia. Then, it followed by the literature review on the specific board structure size, proportion of independent non-executive directors, duality role, board gender diversity and their relationship with firm performance. From the literature, it can be concluded that board structure above can have positive or negative relationship with firm performance. The Government takes an effort to set up board structure guidelines under the MCCG to enhance board effectiveness and in return to improve Malaysian companies performance.