Corporate Governance and Firm Performance

Introduction

Currently, extensive research has been conducted driven by the need to explore the role of corporate governance towards enhancement of performance of companies in different fields. Furthermore, researchers have formulated several theories hypothesizing the influence held by corporate governance on firm performance (Farrar, 2008; Abdullah, & Valentine, 2009; Yusoff, & Alhaji, 2012). In this chapter, an analysis of the theories will be carried out. Additionally, the chapter will analysis extensive existing studies concerned with how corporate governance improves firm’s performance. Within this study, following theories will be focused on are agency theory and the stewardship theory.

Review of theories

Agency theory

According to the agency theory, there exists direct correlation between principals and agents. Principals, in this case, are shareholders while agents are executives and managers. According to this theory, principals hire agents to carry out tasks. The theory proposes that executive officers in firms can be selfish. Stockholders expect managers to formulated strategized plans, decide on, and act upon factors that have the best interest of the principals and organizations progress (Nakano and Nguyen, 2013). However, agents are unlikely to put prioritize the interests of the principals during the decision making process. Agents may succumb to opportunistic behaviour and self-interest. As such, it is hard to achieve congruence between agent’s pursuits and principal’s aspirations. With respect to corporate governance, the basic view of agency theorists is that due to self-interest that managers may have, they are unlikely to act in a way that maximizes shareholder returns. As such, it is important for internal governance controls and structures to be implemented in order to protect shareholders’ interests (Agyemang et al., 2014). Corporate governance, according to the agency theory, thereby seeks to develop and control the instruments that shareholders have implemented in order to make sure that executives maximise their wealth through agency loss reduction.

Stewardship theory

The stewardship theory, on this part, assumes an alignment of the interests of managers and shareholders. The stewardship theory holds that company executives are normally driven to make decisions which are in line with those made by shareholders (Vintila and Gherghina, 2013). Stewardship theorists argue that managers are intrinsically reliable and trustworthy individuals. Advocates of the theory hold that better performance in organizations can be achieved when managers are granted greater power and autonomy.

Under the stewardship theory, corporate governance is based on the logic that executives and managers are usually focused on maximizing shareholders’ returns. Based on this theory, corporate governance is supposed to provide structures that facilitate and empower managers and which allow them to deliver better returns to shareholder (Ntim, 2011). The stewardship theory thereby underscores the importance of managers and other company executives in the performance of a company. Dig deeper into E-Health in Rural Healthcare Delivery with our selection of articles.

Corporate governance and performance

Presently, there is considerable research driven by the concept of corporate governance and the role it plays in firm performance. Many researchers are of the view that strong corporate governance improves company performance while weak corporate governance affects firm performance negatively. For example, in their study, Beiner et al (2004) established that its rise by one point resulted in the rise in market capitalisation by 8.6 percent. Zheka (2007), in his study, analysed the influence of corporate on performance of companies by developing a corporate governance index. The results from the study revealed that a one-point rise in corporate governance causes a 1.9 percent upsurge in performance. While most of the studies carried out have focused on general corporate governance and how it affects firm performance, there are a significant number of studies which gone a step further and analysed the individual variables that make corporate governance. They include board diversity, size, and independence.

Organization performance as measured by board size

The members forming directors board as a mechanism of corporate governance has attracted significant thoughtfulness from researchers due inconclusive empirical evidence available concerning its influence on organizational performance. In addition, the basic corporate governance theories disagree concerning their prediction of company performance as a subject of directors’ board size (Arora and Sharma, 2016). For example, the agency theory suggests increasing the board size lowers firm performance and vice versa. Conversely, the resource dependence theory holds the prediction that better organizational performance directly correlates with board size.

In a study done by Zakaria et al (2014) analysing 73 firms between 2005 and 2010 where it used ROA (return on assets) to measure firm performance, the findings indicated positive link between firm’s performance and influence of the size of the board. A similar study was carried out by Shukeri et al (2012) who established that board size is positively correlated with ROE (return on equity). This is further corroborated by a study carried out by Arora and Sharma (2016). In this study, Arora and Sharma (2016) established that a larger board provides depth that helps to enhance the decisionmaking process and thereby performance. However, in his study Samuel (2013) established contrary results. Examining 50 Nigerian companies in the period between 2001 and 2010 and using net profit after tax as a measure of performance, Samuel (2013) found that increasing members of a board has a negative effect on the companies’ financial performance. These findings are corroborated by a study carried out by Nakano and Nguyen (2013) who established that corporate performance and board size are inversely correlated. This conclusion was arrived at through the examination of 1771 Japanese companies. Finally, in a study on 8 banking companies in the period between 2007 and 2012, Agyemang et al (2014) established no significant connection between firm performance and board size.

Broadly, there is no consensus among researchers with regard to the firm’s performance as an element of size of board of directors. The lack of consensus raises two possibilities. The first one is board size affects company performance either positively or negatively. The second possibility is that board size influence neither constructively or negatively to outcome of a company.

Firm performance and Board independence

The independence of the board is also another element of corporate governance that has interested researchers. Board independence refers to the proportion of board members who are non-executive directors and thereby do not take part in the strategic and operational conduct of a company. Like in the case of size of the board, there is no agreement among studies on how board independence affects company performance. For example, in his study, Ntim (2011) established that inclusion of autonomous non-executive directors in the board had positively affected company performance. In their study, Lin and Chang (2014) found constructive connection between ROA and ROE of a company and the ratio of independent directors.

However, in his study of 40 Egyptian companies, Wahba (2015) established that increasing significantly independent non-executive directors would ultimately result in negative performance. Similar results were also obtained by Vintila and Gherghina (2013) in their examination of 334 companies between 2007 and 2011. Wang (2014), on his part, asserted that firm performance is not linked to board independence. Wang (2014) established this by investigating the effect of board autonomy among Chinese companies.

Firm performance as subject of board diversity

The issue of diversity has gained significant attention in society today. For example, there is increased pressure to gender and racial balance in companies. This also applies to board diversity. Board diversity has also appealed to scholars due to increased pressure on companies to ensure diversity on their boards. One area that researchers have focused on is how board diversity influences performance. For example, in their study of 90 Nigerian companies, Akpan and Amran (2014) found that inclusion of women as board members had an undesirable effect on the firm performance. However, in contrary results, Wachuddi and Mboya (2009) found that developing a diverse board of directors have no influence on banks’ financial performance.

Contrary to the results above, Zhang (2012) argued that performance of a company directly correlates to gender diversity in the board. Similarly, Campbell and Mínguez-Vera (2008) indicated that inclusion of women as board members impact significantly on organizational financial performance. The findings also found that the women ratio affected positively on organization’s performance. Broadly, the empirical literature on corporate governance provides mixed results. This is particularly with respect to the elements such as board diversity, size, and independence on corporate governance. There is thereby no conclusive evidence on how corporate governance impacts company performance. Another point of note is that the existing literature fails to highlight the role company governance plays in improving or lowering firm performance. For example, limited research is available on how board size improves firm performance. There was need to indicate, for example, that board size improves performance through the many ideas that are suggested. As such, while many studies have been carried out on corporate performance and its consequence on firm performance, there are still areas that need to be addressed

References

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