Impact of Corporate Governance on Financial Performance of

Firms: Evidence from Pakistan

Mohammad Shaoib Abdullah, Ph.D. Scholar, Assistant Professor
International Islamic University Islamabad Pakistan
Syed Zulfiqar Ali Shah, Ph.D. Scholar, Mohammad Ali Jinnah University
Arshad Hassan, Ph.D. Scholar, Mohammad Ali Jinnah University Islamabad Pakistan

ABSTRACT

The study investigates role of corporate governance on firm performance in the Pakistani Context.
Governance parameters include board size, inside directors’ shareholding, size of the board and audit committee
independence. Fixed effect model of panel data analysis using Tobin’s Q, MVA,ROA and ROE as a measures of
firm performance, is attempted. The data corresponds to a panel of 50, listed Pakistani firms for the period 2002–
2005. The regression analysis shows that Governance variables have impact on performance variables. The results
provide support for the proposed model, and suggest the need for further research into framework for governance
and Firm performance. The data corresponds to the panel of 50 listed Pakistani firms for the period of 2002 to 2005.

Key Words: Corporate Governance, firms performance

Field of Research: Finance

INTRODUCTION

Some of the most spectacular corporate collapses and losses in recent memory have highlighted the role
that corporate governance practices play in maintaining viable entities, and safeguarding Investors’ interests. The
governance failures at Enron, Parmalat and others since 2001 are harsh examples of the risks posed by corporate
governance breakdowns. Losses of tens of billions of dollars of Investors’ capital proved that the existing set of
corporate checks and balances on insiders’ activities could not protect Shareowners from the misplaced priorities of
Board Members and the manipulation and misappropriation of Company resources by management and other groups
that exercised significant and improper influence over the Company’s affairs.

In response to wide-ranging effects of recent corporate failures on the global markets, many countries,
industry groups and other constituencies have proposed or created new or amended corporate governance codes.
Many of these codes seek to establish internal controls or set an ethical tone that focus on Investors’ interests. While
these government–mandated and voluntary industry codes may help to restore a degree of Investor confidence in the
markets, they provide only part of the answer. Investors also must take the initiative to evaluate the presence or
absence of corporate governance safeguards of Companies in which they invest, as well as their corporate cultures.

For corporate governance structures to work effectively, Shareholders must be active and prudent in the use
of their rights. In this way, Shareholders must act like owners and continue to exercise the rights available to them.
Benjamin Graham and David Dodd stated in the 1930s that: “The choice of a common stock is a single act, its
ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being a
shareholder as in becoming one”. A number of studies published in recent years have shown a strong link between
good corporate governance and strong profitability and investment performance measures. For example, a joint
study of Institutional Shareholder Services (“ISS”) and Georgia State University found that the best–governed
Companies — as measured by ISS’s Corporate Governance Quotient — had mean returns on investment and equity
that were 18.7 % and 23.8% better, respectively, than those of poorly governed Companies during the year
reviewed. Research carried out by employees of the California Public Employees Retirement System (“CalPERS”)
on the effects of the system’s “Focus List” suggests that efforts by investment funds to improve the governance of
Companies which are considered poorly governed also produces good returns in excess of market performance.

On this basis, one would expect Investors to reward Companies that have superior governance with higher
valuations. Indeed, a study of U.S. markets by Paul Gompers of Harvard University and colleagues from Harvard
and the University of Pennsylvania found that portfolios of Companies with strong Shareowner rights protections
outperformed portfolios of Companies with weaker protections by 8.5% per year. A similar study in Europe found
annual disparities of 3.0%. Another study establishing and testing a governance rating system in the German market

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for the period from March 1998 to February 2002 shows that a portfolio consisting of the best governed Companies
outperformed a portfolio of the worst governed Companies by a statistically significant average of 2.33% per month.
This phenomenon is neither new nor limited to developed markets. Even before the collapse of Enron, Amar Gill, an
analyst in Malaysia, found that Investors in emerging markets experienced higher investment returns from
Companies with good governance. Of the 100 largest emerging markets Companies his firm followed, those with
the best governance based on management discipline, transparency, Independence, accountability, responsibility,
fairness and social responsibility — generated five-year returns well above average. The conclusion is that good
corporate governance leads to better results for Companies and for Investors.
Corporate governance, therefore, is a factor that Investors cannot ignore but should consider in seeking the best
possible results for themselves or their clients.

The definition of corporate governance differs from country to country. For the case of Continental
European countries such as Germany, the term refers to all the stakeholders of a firm while for Anglo-American
countries corporate governance focuses on generating a fair return for investors (see Goergen, Manjon and
Renneboog, 2005). The corporate governance devices utilized to ensure economic efficiency include among others
shareholder monitoring, creditor monitoring, executive remuneration contracts, dividend policy and the regulatory
framework of the corporate law regime and the stock exchanges. The increasing international integration,
deregulation and technological development and the resulting challenges are calling for a review of national
corporate governance systems. Countries that are in dire need of external financing require stronger and effective
corporate governance systems. Pakistan’s failure to attract external finance some of it from foreign investors – may
be largely attributed to weak investor protection.

In general, good corporate governance practices seek to ensure that: Board Members act in the best
interests of Shareholders; The Company acts in a lawful and ethical manner in their dealings with all stakeholders
and their representatives; All Shareholders have the same right to participate in the governance of the Company and
receive fair treatment from the Board and management, and all rights of Shareholders and other stakeholders are
clearly delineated and communicated; The Board and its committees are structured to act independently from
management, individuals or entities that have control over management, and other non-Shareowner groups;

Appropriate controls and procedures are in place covering management’s activities in running the day-to-
day operations of the Company; and The Company’s operating and financial activities, as well as its governance
activities, are consistently reported to Shareholders in a fair, accurate, timely, reliable, relevant, complete and
verifiable manner. How well a Company achieves these goals depends, in large part, on the adequacy of the
Company’s corporate governance structure and the strength of the Shareowner’s voice in corporate governance
matters, through Shareowner voting rights. The success of the Board in safeguarding Shareowner interests depends
on these factors.

In this study, we investigate the effects of Corporate Governance and its impacts on the financial
performance of the firm. At the heart of agency theory is the conflict of interests between the owners (principals)
and their managers (agents). Monitoring and incentive alignment are the tools suggested by agency theory to
resolve this agency conflict and align the interests of the agents with the principals (Jensen & Meckling, 1976;
Eisenhardt, 1989).

The study has been organized in the following manner. In section 2, literature review is presented,
followed by the chapter 3 which contains data and model details, the variables and the sample. Section 4 comprises
the discussion of the results, followed by the discussion and conclusions.

LITERATURE REVIEW

Empirical studies in corporate governance focus on the link between corporate governance and firm
performance. Areas emphasized in corporate governance of a firm are its ownership structure and board
effectiveness. Board effectiveness variable considered in various studies include board size, board independence,
CEO duality, and presence and activity of various board sub-committees.

Fama and Jensen (1983) characterized the responsibilities of the board of directors as being both the
approval of management decisions and the monitoring of management performance. This means that the chances of
managerial collusion (Fama, 1980) can be reduced by the outside directors, who may thus be regarded as another

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potential source of corporate monitoring (Winter, 1977, Fama, 1980 and Weisbach, 1988). These are ideally
regarded as professional referees who have the task of overseeing the competition between top managers and are
disciplined themselves by an external labour market which judges and prices their services according to their
performance as referees. Critics of the efficiency of this monitoring mechanism point out that managers inherently
dominate the board by choosing outside directors and providing the information they analyse (Mace, 1986). The
question is thus ultimately an empirical one. Against the hypothesis that board composition is a relevant source of
monitoring, Bhagat and Black (1997) find no evidence that the proportion of outside directors affects future firm
performance. This is, however, a notably weak test for the hypothesis that board composition is a source of
corporate monitoring given that, following, for instance, Demsetz (1983), different monitoring mechanisms may be
used in an optimal way, in which case no relation between these and performance would be observed.

(Demsetz, 1983, Demsetz and Lehn, 1985, Shleifer and Vishny, 1986) believe that large shareholders and
institutional investors are potentials controllers of equity agency problems and their increased shareholdings can
give them better incentive to monitor firms performance and managerial behavior. This in essence helps tp stop the
free rider problems associated with ownership dispersions. Both Demsetz, 1983, Demsetz and Lehn, 1985, Shleifer
and Vishny, 1986) reports that if the firm has outside people having large equity portions , it has positive abnormal
returns.

Shleifer and Vishny (1989) also develop a model whereby managers are able to entrench themselves by
making manager-specific investments that increase their value to shareholders. A consequence of these investments
is that managers can reduce the likelihood of replacement and are able to extract higher salaries and larger
perquisites from shareholders, as well as getting more discretion in determining corporate strategy.

Denis, Denis and Sarin (1997b) model the probability of top management turnover as a function of
ownership structure. Consistent with managerial entrenchment, they find that the likelihood of top management
turnover is significantly greater in poorly performing firms with low managerial ownership than in poorly
performing firms with higher managerial ownership. They conclude that larger equity ownership by managers
insulates them from internal monitoring efforts. Consistent with this, Dahya, Lonie and Power (1998) find UK
evidence that forced departures of CEOs tend to occur only when the top manager has less than 1% of the firm’s
capital and that, as the level of ownership increases, managers become increasingly entrenched in their positions.

Gompers, Ichii and Metrick (2003) find a significant association between a corporate governance index
built from 24 provisions and stock returns. They reckon that an investment strategy where investors buy firms with
the highest ranks in such index would yield substantial abnormal returns of 8.5%. They also observe that firms with
weaker governance measures have generally lower accounting-based performance measures, lower Tobin Qs, and
are engaged more actively in acquisitions and capital investments. Along the same lines, Black (2001), using a small
sample of Russian firms, finds a similar relation as he observes that a change in corporate governance scores from
the lowest to the highest rank significantly increases firm market value.

This particular research is of course still in its early stages. Apart from the problems in defining consensual
measures of firm performance (and indeed also of corporate governance indexes) and correctly controlling for all
non-corporate governance related factors, which most certainly will underline future research in this, a problem to
be solved lies on the possibility of inverse causality. Specifically, one may argue that performance may drive to a
certain extent a stronger compliance with corporate governance provisions. Therefore, similar to the analysis of the
determination of the set of corporate governance devices for a particular firm, once again we may find that a correct
specification of the corporate governance problem in the context of performance analysis may have to take
endogeneity in consideration.

Lewellen, Loderer and Martin (1987), found the evidence in support of the hypothesis that compensation
packages are designed to reduce agency costs. However, a comprehensive analysis of CEO pay in the US by Jensen
and Murphy (1990) reveals that most compensation contracts are characterized by a general absence of real
management incentives and that observed compensation patterns are inconsistent with the implications of formal
agency models of optimal contracting.

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 METHODOLOGY AND DATA DESCRIPTION

The sample was chosen from listed firms in Karachi Stock Exchange of Pakistan for the years 2002-2005, I
collected data from listed Companies Offices, official websites of listed companies, Security and Exchange
Commission of Pakistan website, Karachi Stock Exchange website, Paksearch database.

Initially we have selected 75 companies and collected data, but subsequently due to non availability of data
of some companies were dropped. Due to recent financial sector reforms and different governance compliance rules
we have excluded Financial sector Firms. Also due to their size and ratios it was difficult to draw comparison
between financial and other sectors also firms in the financial sector (the accounting treatment of profit and capital
structure of these firms is significantly different than that of other sectors). From possible 762 firms listed in Karachi
Stock Exchange. The main sample consisted of 50 companies after we applied the financial sector restriction and
eliminated companies with some missing data. We chose a variety of dependent variables in an attempt to capture a
full spectrum of Financial Performance. As discussed in the literature review, each of these variables has the
potential to be affected with Governance. These will allow me to investigate the effects of differences in
Governance characteristics on the financial performance. Return on Assets (ROA), Return on Equity (ROE),
Tobin’s Q, Market Value Added (MVA)

Corporate governance structures and systems vary greatly across countries and industry sectors. Maher and
Andersson (1999) classify systems of corporate governance across the world, based on the degree of ownership and
control and the identity of controlling shareholders, into two broad categories—the outsider systems (notably the US
and the UK) characterized by widely dispersed ownership and the insider systems (notably continental Europe and
Japan) characterized by concentrated ownership or control. They emphasize that the policies that promote the
adoption of specific forms of governance should attempt

As it is discussed in literature review chapter l the Governance variables used in empirical research also
vary in great deal, however keeping in view the Pakistani Context , the code of Corporate Governance, and
availability data, I have chosen, Size of Board, Attendance of Board, duality of Chairman and CEO, Insider
holdings, independence of Audit Committee.
a. Board Size b. CEO CHAIRMAN
c. Insider holdings d. independence of Audit Committee

METHODOLOGY

We have used Panel data analysis because data analysis is an increasingly popular form of longitudinal data
analysis among social and behavioral science researchers. A panel is a cross-section or group of people who are
surveyed periodically over a given time span.

Panel data analysis is a method of studying a particular subject within multiple sites, periodically observed
over a defined time frame. Within the social sciences, panel analysis has enabled researchers to undertake
longitudinal analyses in a wide variety of fields.

With repeated observations of enough cross-sections, panel analysis permits the research to study the
dynamics of change with short time series. The combination of time series with cross-sections can enhance the
quality and quantity of data in ways that would be impossible using only one of these two dimensions (Gujarati,
638). Panel analysis can provide a rich and powerful study of a set of people.

Furthermore Panel data analysis endows regression analysis with both a spatial and temporal dimension.
The spatial dimension pertains to a set of cross-sectional units of observation. This pooled data set, sometimes called
time series cross-sectional data.
The Panel Analysis Equation
Therefore, the equation explaining personal expenditures might be expressed as:

Performance Measures = F (Governance variables)

ROA = ß0 + ß1 (ACIND) + ß 2(CEOCHAIR) + ß 3(INSDRHLDG) + ß4(BOARDSIZE)
ROE = ß0 + ß1 (ACIND) + ß 2(CEOCHAIR) + ß 3(INSDRHLDG) + ß4(BOARDSIZE)
TOBINQ = ß0 + ß1 (ACIND) + ß 2(CEOCHAIR) + ß 3(INSDRHLDG) + ß4(BOARDSIZE)
MVA = ß0 + ß1 (ACIND) + ß 2(CEOCHAIR) + ß 3(INSDRHLDG) + ß4(BOARDSIZE)

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 Description of Variables
Variables Name Descriptions of Variables
[Market value of assets / Book value of assets] measured at each year-end.
Tobin’s q Market value of assets is estimated by [book value of debt + book value of
preferred stock + market value of Common Stock
Return on Assets [ROA] Calculated by dividing a company's annual earnings by its total assets
(net profit / equity – in book value –) to know that with respect to shareholders
Return on Equity [ROE]
equity how many times the company earned.
Market Value Added [MVA] It is the difference between the Market Value and book value of Equity
Indicator Variable with the value of 1 if the Audit Committee is headed by Non
Audit Committee Independence [ACIND] *
Executive director
Size of Board [BOARD SIZE] ** Number of Directors on Board
Indicator Variable with a Value of 1 if the roles of Chair and CEO are held by one
CEO CHAIRMAN duality [CEOCHAIR] ***
person
Insider Holding [INSDRHLDG] Percentage of Shares held by Directors of the Company
* Dummy Variable Returns 1 if Audit Committee is Independent
** Dummy Variable Taken Value 1 for a Larger Board and 0 for Smaller Board
*** Dummy Variable Returns 1 in case of duality

Data Analysis and Empirical Results

In this study we have examined role of corporate Governance with financial performance, to see the effects
more clearly we have chosen four different performance measures and divided them into 2 sets, one includes ROA,
and ROE, these are accounting based measures and other includes Tobin’s Q and MVA, these are market and
investor based measures. Table 1 explains the relationship of Corporate Governance with Accounting based
measures.
Table: -1
Tobin's Q MVA ROE ROA
Constant 0.69799759 -2814.39 0.234706118 0.0780111
(0.8303184) (-2.15931823) (3.86122066) (5.2301249)
ACIND 1.08391401 2160.612 0.09753281 0.00720481
(1.9100882) (3.300610653) (2.037593465) (0.5845359)
CEOCHAIR -1.6364565 -1683.39 -0.128294989 -0.007541
(-3.043248) (-2.796368627) (-2.80311170) (-0.653409)
INSDRHLDNG 0.00184172 -362.94 -0.001439859 -0.0280295
(0.1601255) (-0.574652351) (-1.46872987) (-2.319316)
BOARDSIZE 1.33690298 567.3716 0.103944033 0.03527426
(2.3104885) (3.766593736) (2.042332081) (2.7961508)
Significance F 0.0001619 1.20832E-07 0.00004624 0.0001983
R2 0.144015 0.209092324 0.147222019 0.1309322

Audit Committee independence

We can conclude that independence of audit committee bears positive relationship with both ROE and
ROA. These emphases the independent role of audit which one of the most important paradigms of corporate
governance, also this result is in line with the earlier studies. Also the result is similar with marker based
performance measures, that is Audit Committee independence, that audit committee independence is also positively
related with Tobins Q and MVA.

Dechow, Sloan, and Sweeney report that firms with a majority of inside directors and without an audit
committee are more likely to commit financial fraud, compared to a control sample matched by industry and size.50
Similarly, Mark Beasley also finds that firms that commit fraud have fewer independent directors than matched
control firms that did not commit fraud (he does not find evidence that the presence or absence of an audit
committee, or its composition, affects fraud incidence). These studies suggest that independent directors help to
control financial fraud, but it is also possible that managers who are prone to commit fraud resist oversight by
independent boards, so that manager fraud propensity drives both the likelihood of fraud and the degree of board
Independence. It can be concluded that my result is also of the similar conclusion regarding the audit committee
independence. It conforms with the earlier empirical researches conducted.

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CEO Chairman Duality
This is another area of corporate governance which requires the power to be divided and role of any one
person in board should not be out of balance in terms of powers and authority vested in. our analysis also reveal that
the duality is inversely related to the financial performance. So the relationship of CEO CHAIR duality is negative
with both ROA and ROE. This results also gets tremendous support from empirical results earlier studies conducted
in the related area.

Pi and Timme (1993) find cost efficiency and return on assets decreases when CEO is also the Chair. But
they do not consider the existing level of agency problems in these banks. Brinkley, Coles and Jarrell (1996)’s
findings are just opposite of Pi and Timme. They find no difference in industry adjusted returns (over a three year
period) between those that have combined titles and those that do not. Their findings could be observed either
because the sample includes both firms that can be hurt as well as firms that benefit from combined titles, or because
CEO and Chair being the same person really has no effect on performance or other mechanisms are in place. They
also find support for Vancil’s hypothesis that firms that have separate CEOs and Chairs are just in a transitional
process when CEOs pass the batons to the next generation.

Insider Holdings
Insider holdings are negatively related with ROA and MVA, which means that stronger insider holdings go
counter with corporate best practices , thus lesser the insider holdings , better will be financial performance.

Demsetz and Lehn (1985) tested empirically the relationship between accounting profit rate of 511 US
companies in 1980, and ownership concentration3 and find no significant correlation4. Contrarily, Morck, Shleifer
and Vishny (1988) and McConnell and Servaes (1990), using a cross-sectional specification, find a significant non-
linear relationship between management ownership and performance as proxied by Tobin’s Q. Morck, Shleifer and
Vishny (1988) have run piecewise linear OLS regressions for 371 large industrial firms of the Fortune 500 in 1980
allowing the coefficients on the ownership variable to change slope at 5 percent and 25 percent. Their results
indicate a positive relationship between ownership and Tobin’ Q in the 0 to 5 percent board ownership range, a
negative relation in the 5 to 25 percent range, and a positive relation beyond on 25 percent level. In the study of
McConnell and Servaes (1990) investigating the relationship between performance and insiders ownership for 1173
firms in 1976 and 1093 firms in 1986, they find a curvilinear relationship between Q and insiders ownership, Q first
increases then decreases as the fraction of shares held by insiders becomes more concentrated. Conclusions of these
two papers are the same concerning the fact that the relationship between insiders’ ownership and Q is not linear.
However, Mc Connell and Servaes (1990) were unable to replicate Morck, Shleifer and Vishny (1988) specification.
A mention has to be made to the study of Leech and Leahy (1991) about UK-listed firms, where they used a linear
specification of ownership concentration and found a negative linear relationship.

Size of the Board

In our research we have used the size of board as independent variable and transformed this variable from
actual size , instead of actual number we have converted the size of board into a dummy which results in smaller or
larger board., and we can conclude from this result that size of board is positively related with all performance
measures namely , ROA, ROE, Tobins Q and MVA. It conforms that larger board means wider knowledge and
decisions and thus quality decision leading to good strategies resulting in sound performance.

Empirical research has documented that board size and number of board meetings may be related to firm
performance. The evidence on the role of board size is inconclusive. Yermack (1996) and Eisenberg, Sundgren, and
Wells (1998) demonstrate that smaller boards are associated with better firm performances. However, in a meta-
analysis of 131 different study-samples with a combined sample size of 20,620 observations, Dalton, Daily,
Johnson, and Ellstrand (1999) document a positive and significant relation between board size and financial
performance. Given these conflicting results, we offer no directional expectations between earnings management
and board size.

A smaller board may be less encumbered with bureaucratic problems and may be more functional. Smaller
boards may provide better financial reporting oversight. Alternately, a larger board may be able to draw from a
broader range of experience. In the case of earnings management, a larger board may be more likely to have
independent directors with corporate or financial experience. If so, a larger board might be better at preventing
earnings management. So again the results are according to empirical research which support and document
evidence of both possible and negative relationship of size with performance.

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 CONCLUSION

This study examines Corporate Governance practices and their impact on Performance in Pakistan.
Towards the end, we can say that the variable I have discussed in this study definitely have impact on financial
performance, how ever there are other governance variables which are not included on this data do also have impact
on the corporate governance, these include the structure of board , independence of board, qualifications of board,
remunerations structure.

So there a strong need of further research in area feel that my preliminary work substantially contributes to
our understanding of relationship corporate governance and financial performance, moreover we have only taken
publicly listed companies, governance parameter is equally important to private limited and other type of business.
Another area of potential research is take closely held business and see the effectiveness of governance and
its causal link with financial performance.

Furthermore while analyzing the data we have seen a great deal of variation in presentation of governance
data, which give a room for misrepresentation and misstatement of facts relating to corporate governance. As the
requirement of code of corporate governance listed companies must declare separately the details relating to
compliance to the code of corporate governance, still that compliance statement need to improved and must be little
more objective in nature leaving less room for business to manipulate the facts.

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