In the global context, the awareness of the need for more depth discussion on the application of corporate governance arises from the occurrence of a series of financial scandals that hit large firms in the United States, such as Enron, WorldCom, and Global Crossing. United States as a big country with a dynamic market system, capable of doing functions of controls on the behavior of managers and has a strong regulatory system even can be cracked by various fraudulent practices of management.
In the case of Asia, it is so widely believed that one major cause of the crisis is the weaknesses in corporate governance practice. The policy of excessive debt in the form of foreign exchange and bank lending to companies in their cronies is something common in Asia, particularly Indonesia, Thailand, and Korea. As a result, when there were turmoil in the financial system, companies went bankrupt and this caused a massive chain effect so that the macro-economic stability also fell down.
The phenomenon of global, regional, and domestic has opened the eyes that in order to build a sustainable economic system, the practice of good corporate governance cannot be abandoned. The theme of corporate governance becomes one of the priorities, in academic discussions, practitioners, and policy makers.
Numerous studies have been conducted by some experts to assess whether the corporate governance structure influences firm performance or firm value. The results are mixed.
Bauer et all (2003) examine the impact of corporate governance and firm performance using Net Profit Margin (NPM) and Return on Equity (ROE) and find a negative relationship which is different from the result of the earlier research conducted by Gompers et all (2003) in which they document a strong correlation between takeover measures and Tobin'q.
Bhagat and Black (2002) find some evidences that companies suffering from low profitability as a result of increasing the independence of their board of directors. Drobetz et al (2003) also record a positive relationship between a self constructed corporate governance indexes on firm value for German companies.
While Larcker et al (2004) failed to find persuasive evidence that corporate governance influence company performance or value. Studies in Australia by Linden and Matolcsy (2004) find no evidence of any significant relationship between the corporate governance score and financial performance.
In line with the above illustration, this research tries to examine the impact of corporate governance on financial performance of companies listed in Indonesia Stock Exchange. The research question is whether corporate governance has a positive impact to financial performance of publicly companies listed in Indonesia Stock Exchange.
Objective of the Study
The purpose of this study is to examine the impact of corporate governance on financial performance of Indonesian companies listed in Indonesia Stock Exchange. This study explores three corporate governance mechanism, ownership concentration, board size and dominant independent commissioner, which may contribute to the financial performance of those companies.
Several theories attempt to explain and analyze corporate governance. Each of these theories explains corporate governance based on a different perspective arising from different disciplines. Agency theory emerged from the disciplines of finance and economics. Another theory, namely stakeholder theory, emerged from a perspective that is more oriented to social aspects.
Principal Agent Theory
Agency theory was first stated by Jensen and Meckling (1976) in their paper with title "Theory of the Firm Managerial Behavior, Agency Costs and Ownership Structure." The manager of a company is called as an "agent" and its shareholder as a "principal". Shareholders delegate decision making to business managers who are representative or agents of the shareholders. The separation of ownership and control lead to the problem that managers do not always issue a decision that aim to meet the principals' interest. The agency theory assumes that the difference in the purpose of principal and interests of agents can create conflict. It is because corporate managers tend to pursue their own personal purposes. (Solomon, 2007)
Another assumption proposed by Eisenhardt (1989) is that it is not easy and costly to monitor the activities of managers (Solomon, 2007). The agency cost emerges from the shareholder's effort to ensure that the manager will act for the best interest of the company.
There is a number of ways to align the interests of shareholders and manager. Agency theory suggests that the problem of agency can be solved by the establishment of an optimal contracts nexus between managers and shareholders. This includes remuneration and debt contracts (Solomon, 2007).
Furthermore, there are direct ways that can be done to monitor the management of the company that helps solve the agency conflict. Among them are the following ways. The first way is that shareholders can control how the company runs through a vote at the General Meeting of Shareholders (GMoS). Shareholder voting rights is an important part of their financial assets. Shareholders can influence the composition of the board of directors or board of commissioners in the companies they invest through a vote at the General Meeting of Shareholders. Many other issues can be resolved through the use of shareholder voting rights. Voting by shareholders is one of the main activities of the shareholders.
The second way is to conduct shareholder resolutions in which a group of shareholders collectively lobby against managers in respect of issues which do not satisfy them. The shareholders also have the option to divest or sell their shares. This divestment action represents a failure of the company to maintain its investors.
Monitoring the activities of managers also can be done through external control (market mechanism). If markets were perfectly efficient in which company can compete to get fund, then it is not necessary to set up corporate governance system, as explained:
We should not worry about governance reform, since in the long run, product market competition would firms to minimize costs, and as part of this cost minimization to adopt rules, including corporate governance mechanisms, enabling them to raise external capital at the lowest costâ€¦competition would take care of corporate governance (Shleifer and Vishny, 1997, p 738).
Nevertheless, markets are usually not perfect. Thus, interference is required in the aim to boost the implementation of corporate governance to help company obtain funding and make company more accountable to shareholders.
The exposition of stakeholder theory was first presented by Freeman (1984) who suggested a general theory of a firm. Since then, many stakeholder theory-based writing emerged. This theory includes corporate accountability to a wider group of stakeholder.
The basis of stakeholder theory is that the company has become very large, and cause people to be very pervasive, so companies need to implement the accountability to all various societies and not just to their shareholder (Solomon, 2007). As cited in Solomon (2007), stakeholders are involved in an exchange relationship with the company (Freeman, 1984; Pearce, 1982; Hill and Jones, 1992). This means that stakeholders are influenced by the company and they also can affect the company. Shareholders, creditors, suppliers, customers, employees, local communities, and the general public, including social environment are part of stakeholders
Due to the great impact of companies to stakeholders, the companies should be made accountable. In the UK, Accounting Standards Steering Committee (ASSC, 1975) proposed in their Corporate Reports that companies could be accountable by encouraging them to disclose more reports freely that the traditional income statement and balance sheet. The additional reports are such as a report of money exchanges with government, a report of future prospects, a report of the transaction and foreign currency, a report of value-added, a report of corporate objectives, and an employment report (Solomon, 2007).
The view of pure ethics explains that it is good for a company to be socially responsible by satisfying the interests of its stakeholder. Quinn and Jones (1995) argue that as human being corporate managers have to pay attention to their moral obligation. The ethical behavior must be conducted without considering the benefit of that action.
Another view argues that it is difficult to pursue ethical business unless the behavior can be profitable. This view can be understood due to the manner of shareholders and managers. Moreover, the prevailing legal system and corporate governance structure also create such condition (Solomon, 2007).
Because of the unique responsibility of managers, there need to be an alignment between the interests of managers and the interest of all stakeholders (Hill and Jones, 1992).
There is a parallel between the general class of stakeholder-agent relationship and the principal-agent relationship articulated by agency theory. Both stakeholder-agent and principal-agent involve an implicit or explicit contract, the purpose of which is to try and reconcile divergent interest. In addition, both relationships are policed by governance structure. (p 134).
It is not easy to match the wants and interests of different stakeholder. However, there should be significant efforts to achieve a harmonization. Hill and Jones (1992) in Solomon (2007) showed that many of the terminology and concepts of agency theory can also be applied to both the agency-stakeholder relationships. Principal-agent relationship in agency theory can be accounted as a part of the stakeholder group relationships.
In developing a stakeholder-agency theory, Solomon (2007) states that Hill and Jones attempted to develop an adjustment of agency theory in order to include the theory of power that arises from the perspective of stakeholder. In summary, they argued that the perspective of agency theory and stakeholder theory can be united in a single model by creating an assumption about market efficiency.
The creation of the value for stakeholder by focusing attention on efforts to maximize the value for local communities, employees, and environment can be considered the same with the creation of financial value for shareholders. Paying no attention to the needs of stakeholder could lower the financial performance and even cause failure of the company. A company that are well organized possibly will have a rich management system and have a good relationship with the stakeholder. Conversely, companies that have a bad relationship with its stakeholder in general have poor management system and lead to low financial performance (Solomon, 2007). This scenario is widely accepted in practice.
In the long term, there are fewer inconsistencies between the main goals of agency theory with stakeholder theory. Only with consideration and attention to stakeholder interests and the interests of shareholders, the company can obtain its long term profit, especially maximizing shareholder welfare. Thus, companies can be ethical and at the same time making a profit by considering the positive relationship between social responsibility with financial performance.